DO FinECT AppendixA 2020 PDF

Financial Econometrics (29:390:300)
APPENDIX A: Basic Mathematical Tools
Daniela Osterrieder
Topics:
The Summation Operator and Descriptive Statistics
Properties of Linear Functions
Proportions and Percentages
Some Special Functions and Their Properties
Spring Semester 2020

[Wooldridge App. A]
D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 1 / 32
Basic Mathematical Tools
Appendix A
Jeffrey M. Wooldridge (2015). Introductory Econometrics (A

Modern Approach) - 6th edition. Cengage Learning.
APPENDIX A:
Basic Mathematical Tools

The Summation Operator

The summation operator is used to express sums of many numbers.
Let {xi ∶ i = 1, 2, . . . , n} denote a set of n numbers
Example e.g. n = 5, then the set is:


The summation of all n elements of the series xi can be written as
n
∑ xi ≡ x1 + x2 + . . . + xn
i=1
Properties of the Summation Operator

(1) Let c be any constant number, then
n
∑c = n ×c
i=1
(2) Let c be any constant number, then

n n
∑(c × xi ) = c ∑ xi
i=1 i=1

(3) Let yi be another series with n elements and let a and b be any
constant numbers, then
n n n
∑ (axi + byi ) = a ∑ xi + b ∑ yi
i=1 i=1 i=1
Note that the following operation is not correct
n
xi ∑ni=1 xi
∑ ≠ n
i=1 yi ∑i=1 yi
(Please Excuse My Dear Aunt Sally)

Descriptive Statistics
Now we can define several descriptive statistics; i.e. numbers that

summarize some properties of a data set
Sample Mean/Sample Average
1 n
x̄ ≡ ∑ xi
n i=1
describes the central tendency of a set of data

Let di be the deviation of each value in the set {xi } from the mean,
i.e. di = xi − x̄
→ ∑ni=1 di = ∑ni=1 (xi − x̄ ) = ∑ni=1 xi − ∑ni=1 x̄ = n1 n ∑ni=1 xi − n x̄ =
n x̄ − n x̄ = 0

Sample Variance
n
̂) ≡ 1 ∑ (xi − x̄ )2
Var(x
n i=1
describes the variation of the data relative to the sample mean (squared
distance)
→ Use properties of summation operator to find
1 n 2 1 n 2 2
∑ (xi − x̄ ) = ∑ x − (x̄ )
n i=1 n i=1 i
Problem: cannot be interpreted in terms of the original measurement

units, since “destroyed” by squaring.

Sample Standard Deviation
¿
Á1 n √
À ∑ (xi − x̄ )2 1 n
≡Á (≠ ∑ (xi − x̄ )2 !)
n i=1 n i=1
describes the variation of the data relative to the sample mean (absolute
distance)
→
¿ ¿
Á1 n Á1 n 2
À ∑ (xi − x̄ )2 = Á
Á À ∑ x − (x̄ )2
n i=1 n i=1 i
Note: can be interpreted in terms of the original measurement units.

Sample Covariance
̂ 1 n
Cov(x , y) ≡ ∑ (xi − x̄ ) (yi − ȳ)
n i=1
describes the common variation of two data sets (x and y) relative to the
respective sample mean
→ Use properties of summation operator to find
1 n 1 n
∑ (xi − x̄ ) (yi − ȳ) = ∑ xi yi − ȳ x̄
n i=1 n i=1
Problem: cannot be interpreted in terms of the original measurement units,

since “confounded” by multiplying two potentially very different units.
Sample Correlation
̂, y) ≡ √
1
n∑ni=1 (xi − x̄ ) (yi − ȳ)
Corr(x √
1 n 2 1 n 2
n (x
∑i=1 i − x̄ ) n ∑i=1 (yi − ȳ)
describes the common variation of two data sets (x and y) relative to the
respective sample mean, standardized by the two respective sample
standard deviations. Note that
̂, y) ≤ 1
−1 ≤ Corr(x
Note: Can be interpreted without any reference to/knowledge of the

original measurement units

Median describes the central tendency of a set of data
Is the number in the set {xi } such that 50% of the values in {xi } are
larger than it and 50% are smaller
Example: Let {xi } = {5, 20, 0.5, −3, −10, 2, 0, 9, −1.5} and
{yi } = {5, 20, 0.5, −3, −10, 2, 0, 9, −1.5, 1}
Sort the data in increasing order, i.e. {−10, −3, −1.5, 0, 0.5, 2, 5, 9, 20}
and {−10, −3, −1.5, 0, 0.5, 1, 2, 5, 9, 20}
If n is odd (as in set {xi }), then the median is simply the number in
the middle
→ The median of {xi } is 0.5

If n is even (as in set {yi }), then the median is the average of the
two numbers in the middle
→ The median of {yi } is 21 (0.5 + 1) = 0.75
Comparison Sample Mean and Median

In comparison, the sample mean of {xi } is
1
9 (5 + 20 + 0.5 − 3 − 10 + 2 + 0 + 9 − 1.5) = 2.44
In comparison, the sample mean of {yi } is
1
10 (5 + 20 + 0.5 − 3 − 10 + 2 + 0 + 9 − 1.5 + 1) = 2.3

Linear Functions
Linear functions are of special importance in Econometrics; we typically

assume that the relation between two (or more) variables can be described
by a linear function.
If x and y are two variables that are related by the following function
y = β0 + β1 x
then y is a linear function of x . The parameters β 0 and β 1 describe this

relation. We say
β 0 is the intercept
β 1 is the slope
This implies that a change, ∆, in y is equal to β 1 times a change in x .
That is ∆y = β 1 ∆x , i.e. the marginal effect of x on y is constant

Example
Assume that the relationship between a country’s inflation and
unemployment level is given by
inflation = 2.20 − 0.10 × unemployment
Interpretation: If unemployment were zero, a country would have an

(annual) inflation of 2.2
Interpretation: For each additional percent of unemployment, inflation
decreases by -0.1
Interpretation: If unemployment increases by 10%, inflation decrease
by 10 × 0.10 = 1

Example

If x1 , x2 and y are three variables that are related by the following function
y = β 0 + β 1 x1 + β 2 x2
then y is a linear function of x1 and x2 . The parameters β 0 , β 1 , β 2

describe this relation.
A change in y, ∆y, is equal to β 1 ∆x1 + β 2 ∆x2 .
If x2 is held fixed, i.e. ∆x2 = 0, then ∆y = β 1 ∆x1 .
→ We say that β 1 is the partial effect of x1 on y

→ Compare to Ceteris paribus

Assume 42 adults in 50 have a high-school degree
Proportion
42
⇒ The proportion of adults with a high-school degree is 50 = 0.84
Percentage
42
⇒ The percentage of adults with a high-school degree is 50 × 100 = 84%
→ Proportion × 100 = Percentage

Assume income in 1994 is equal to x0 and in 1995 equal to x1
Proportionate Change/Relative Change

⇒ The proportionate/relative change in income between 1994 and 1995 is
x1 −x0 ∆x
x0 = x0
Percentage Change
⇒ The percentage change in income between 1994 and 1995 is
x1 −x0 ∆x
x0 × 100 = x0 × 100
→ (Proportionate/relative change) × 100 = Percentage change
If x0 and x1 are already measured in percentages, then we can define the

percentage point change in income between 1994 and 1995 as ∆x = x1 − x0

Example:
The (one-day holding period) return on the S&P 500 between
December 31, 2014 and January 2, 2015 was 0.034%
Returns are often reported as proportionate price changes, i.e. the net
return on the S&P 500 between December 31, 2014 and January 2,
2015 was 0.00034
The gross return on the S&P 500 between December 31, 2014 and
January 2, 2015 was 1.00034

Special Functions
A nonlinear function that plays a crucial role in financial econometrics, is
the natural logarithm. Often referred to as the log function
y = log(x ) = ln(x ) = loge (x ), x >0

The Log Function

The Log Function
Properties of the log-function

(1) log(x ) < 0 for 0 < x < 1
(2) log(1) = 0
(3) log(x ) > 0 for x > 1
(4) log(1 + x ) ≈ x for x ≈ 0
(5) log(x1 × x2 ) = log(x1 ) + log(x2 )
(6) log(x1 /x2 ) = log(x1 ) − log(x2 )
(7) log(x c ) = c log(x )

The Log Function and Returns

We often transform gross returns into logarithms for empirical analysis
Property (4) shows that for net return around 0 this is inconsequential
(Very) large returns will be “smoothed”
Log returns can be interpreted as continuously compounded returns
(i.e. the frequency of compouding does not matter)
Log returns are time-additive (Properties (5) and (6)). If I am
insterested in weekly return, but I only know the five one-day holding
period returns, I can simply add their log returns
Monday log return R1 = log(1 + P1P−P
0
0 P1
) = log( P0
) = log(P1 ) − log(P0 )
P2 −P1 P2
Tuesday log return R2 = log(1 + P1 ) = log( P 1
) = log(P2 ) − log(P1 )
P3 −P2 P3
Wednesday log return R3 = log(1 + P2 ) = log( P2 ) = log(P3 ) − log(P2 )
Thursday log return R4 = log(1 + P4P−P
3
3 P4
) = log( P3
) = log(P4 ) − log(P3 )
P5 −P4 P5
Friday log return R5 = log(1 + P4 ) = log( P 4
) = log(P5 ) − log(P4 )
Weekly log return R1−5 = log(P5 ) − log(P0 ) = log(1 + P5P−P 0
0
)

The Log Function and Changes

More generally, from Property (4) and (6) it follows that if x0 , x1 > 0, then
x1 x1 − x0 ∆x ∆x
∆ log(x ) = log(x1 ) − log(x0 ) = log( ) = log(1 + ) = log(1 + )≈
x0 x0 x0 x0
∆x
if the proportionate/relative change is small (i.e. if x0 ≈ 0)
It follows that
∆x
100 × ∆ log(x ) ≈ 100 ×
x0
that is approximately equal to the percentage change
E.g.
100 × (log(41) − log(40)) = 2.46926
41 − 40 ∆x
100 × = 2.5 (Note: = 0.025 ≈ 0)
40 x0
The Log Function and Elasticities

Why is this useful?
Assume log(y) is linear in log(x ), that is

log(y) = β 0 + β 1 log(x )
∆ log(y)
Recall that β 1 is the marginal effect of log(x ) on log(y), i.e. β 1 = ∆ log(x )
From above it follows that

∆y
∆ log(y) 100 × ∆ log(y) 100 y0
β1 = = ≈
∆ log(x ) 100 × ∆ log(x ) 100 ∆x
x0
Percentage change in y
=
Percentage change in x
= the Elasticity of y with respect to x

The Log Function and Elasticities
To summarize: If we transform our data series x and y into logarithms, we

can interpret the slope parameter β 1 in a linear function (constant
elasticity function) as follows
If x changes by 1%, then y changes by β 1 %. This is the same as

calling β 1 the elasticity of y with respect to x .
Example:
Let q be the demanded quantity of e.g. oil and let p be the price. Assume
log(q) = 4.7 − 1.25 × log(p)
→ If the price of oil increases by 1%, the demanded quantity decreases by
1.25%. The price elasticity of demand is -1.25.

The Log Function and Semi-Elasticities

If instead, y and x are related by
log(y) = β 0 + β 1 x
then
∆y
100 × ∆ log(y) 100 × y0
100 × β 1 = ≈
∆x ∆x
Percentage change in y
=
Unit change in x
= the Semi-Elasticity of y with respect to x
If x changes by 1 unit, then y changes by 100 × β 1 %. This is the

same as calling 100 × β 1 the semi-elasticity of y with respect to
x.
The Log Function and Semi-Elasticities
Example:
Let wage be hourly wage in US$ and educ is years of education. Assume
log(wage) = 2.78 + 0.094 × educ
→ One additional year of education leads to an hourly wage increase of

9.4%. The semi-elasticity of wages with respect to education is 9.4.

The Log Function
If instead, y and x are related by
y = β 0 + β 1 log(x )
then
β1 ∆y ∆y
= ≈
100 100 × ∆ log(x ) 100 × ∆x
x0
Unit change in y
=
Percentage change in x
β1
If x changes by 1%, then y changes by 100 units.

The Log Function
Example:
Let hours be hours worked per week. Assume hours = 33 + 45.1 × log(wage)
→ If hourly wage increases by 1%, the hours worked per week increases by
0.451 (i.e. approximately half an hour).

The Exponential Function
Finally, notice that the inverse function of the log function is the
exponential function
y = log(x ) ⇔ x = exp{y} = e y
In the example of constant semi-elasticity:
log(wage) = 2.78 + 0.094 × educ
Can be re-written as
wage = exp{2.78 + 0.094 × educ}

The Exponential Function
i.e. if our data seem to have an exponential relation, we can take

logarithms to get back to linear functions

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Financial Econometrics (29:390:300)

APPENDIX A: Basic Mathematical Tools

Spring Semester 2020

Jeffrey M. Wooldridge (2015). Introductory Econometrics (A

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 2 / 32

The Summation Operator

Let {xi ∶ i = 1, 2, . . . , n} denote a set of n numbers

Example e.g. n = 5, then the set is:

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 3 / 32

The Summation Operator

Properties of the Summation Operator

(2) Let c be any constant number, then

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 4 / 32

The Summation Operator

Note that the following operation is not correct

(Please Excuse My Dear Aunt Sally)

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 5 / 32

Now we can define several descriptive statistics; i.e. numbers that

Sample Mean/Sample Average

describes the central tendency of a set of data

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 6 / 32

Problem: cannot be interpreted in terms of the original measurement

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 7 / 32

Note: can be interpreted in terms of the original measurement units.

Problem: cannot be interpreted in terms of the original measurement units,

Note: Can be interpreted without any reference to/knowledge of the

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 10 / 32

Median describes the central tendency of a set of data

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 11 / 32

Comparison Sample Mean and Median

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 12 / 32

Linear functions are of special importance in Econometrics; we typically

then y is a linear function of x . The parameters β 0 and β 1 describe this

That is ∆y = β 1 ∆x , i.e. the marginal effect of x on y is constant

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 13 / 32

Properties of Linear Functions

inflation = 2.20 − 0.10 × unemployment

Interpretation: If unemployment were zero, a country would have an

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 14 / 32

Properties of Linear Functions

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 15 / 32

Properties of Linear Functions

then y is a linear function of x1 and x2 . The parameters β 0 , β 1 , β 2

A change in y, ∆y, is equal to β 1 ∆x1 + β 2 ∆x2 .

If x2 is held fixed, i.e. ∆x2 = 0, then ∆y = β 1 ∆x1 .

→ We say that β 1 is the partial effect of x1 on y

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 16 / 32

Proportions and Percentages

Assume 42 adults in 50 have a high-school degree

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 17 / 32

Proportions and Percentages

Assume income in 1994 is equal to x0 and in 1995 equal to x1

Proportionate Change/Relative Change

If x0 and x1 are already measured in percentages, then we can define the

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 18 / 32

Proportions and Percentages

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 19 / 32

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 20 / 32

The Log Function

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 21 / 32

The Log Function

Properties of the log-function

D. Osterrieder (RBS) Financial Econometrics Spring Semester 2020 22 / 32