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Lecture 12

BUS 10123 Lecture Notes - Lecture 12: Financial Econometrics, Government Budget Balance, Stock Market Index

Business Administration Interdisciplinary
Course Code
BUS 10123
Eric Von Hendrix

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Chapter 1
The Nature and Purpose of Econometrics
What is Econometrics?
Literal meaning is “measurement in economics”.
Definition of financial econometrics:
The application of statistical and mathematical techniques to problems in finance.
Examples of the kind of problems that
may be solved by an Econometrician
1. Testing whether financial markets are weak-form informationally efficient.
2. Testing whether the CAPM or APT represent superior models for the determination of
returns on risky assets.
3. Measuring and forecasting the volatility of bond returns.
4. Explaining the determinants of bond credit ratings used by the ratings agencies.
5. Modelling long-term relationships between prices and exchange rates
Examples of the kind of problems that
may be solved by an Econometrician (cont’d)
6. Determining the optimal hedge ratio for a spot position in oil.
7. Testing technical trading rules to determine which makes the most money.
8. Testing the hypothesis that earnings or dividend announcements have no effect on
stock prices.
9. Testing whether spot or futures markets react more rapidly to news.
10.Forecasting the correlation between the returns to the stock indices of two countries.
What are the Special Characteristics
of Financial Data?
Frequency & quantity of data
Stock market prices are measured every time there is a trade or somebody posts a
new quote.
Recorded asset prices are usually those at which the transaction took place. No
possibility for measurement error but financial data are “noisy”.
Types of Data and Notation
There are 3 types of data which econometricians might use for analysis:
1. Time series data
2. Cross-sectional data
3. Panel data, a combination of 1. & 2.
The data may be quantitative (e.g. exchange rates, stock prices, number of shares
outstanding), or qualitative (e.g. day of the week).
Examples of time series data
Series Frequency
GNP or unemployment monthly, or quarterly
government budget deficit annually
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money supply weekly
value of a stock market index as transactions occur
Time Series versus Cross-sectional Data
Examples of Problems that Could be Tackled Using a Time Series Regression
- How the value of a country’s stock index has varied with that country’s
macroeconomic fundamentals.
- How the value of a company’s stock price has varied when it announced the
value of its dividend payment.
- The effect on a country’s currency of an increase in its interest rate
Cross-sectional data are data on one or more variables collected at a single point in
time, e.g.
- A poll of usage of internet stock broking services
- Cross-section of stock returns on the New York Stock Exchange
- A sample of bond credit ratings for UK banks
Cross-sectional and Panel Data
Examples of Problems that Could be Tackled Using a Cross-Sectional Regression
- The relationship between company size and the return to investing in its shares
- The relationship between a country’s GDP level and the probability that the
government will default on its sovereign debt.
Panel Data has the dimensions of both time series and cross-sections, e.g. the daily
prices of a number of blue chip stocks over two years.
It is common to denote each observation by the letter t and the total number of
observations by T for time series data, and to to denote each observation by the letter i
and the total number of observations by N for cross-sectional data.
Continuous and Discrete Data
Continuous data can take on any value and are not confined to take specific numbers.
Their values are limited only by precision.
o For example, the rental yield on a property could be 6.2%, 6.24%, or 6.238%.
On the other hand, discrete data can only take on certain values, which are usually
o For instance, the number of people in a particular underground carriage or the
number of shares traded during a day.
o They do not necessarily have to be integers (whole numbers) though, and are
often defined to be count numbers.
o For example, until recently when they became ‘decimalised’, many financial
asset prices were quoted to the nearest 1/16 or 1/32 of a dollar.
Cardinal, Ordinal and Nominal Numbers
Another way in which we could classify numbers is according to whether they are
cardinal, ordinal, or nominal.
Cardinal numbers are those where the actual numerical values that a particular variable
takes have meaning, and where there is an equal distance between the numerical
o Examples of cardinal numbers would be the price of a share or of a building, and
the number of houses in a street.
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