Shanghai University

Introduction to Econometrics
of Finance & Economics

Dr Jin Hongfei

Professor of finance
Chairman，Department of International Finance
Shanghai University of Finance & Economics

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Lectured by Dr. Hongfei Jin
 Shanghai University

Outline
of Finance & Economics

• What is econometrics
• Why we study econometrics
• The methodology of econometrics
• Types of Data
• Some application examples
• Summary

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Lectured by Dr. Hongfei Jin
 Shanghai University

What is econometrics
of Finance & Economics

• Literally, “econometrics” means

“measurement in economics”
– Too broad a definition to be of any use
• The application of statistical and
mathematical methods to analysis of
economic data, with a purpose of giving
empirical content to economic theories
and verifying them or refuting them.
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Lectured by Dr. Hongfei Jin
 Shanghai University
of Finance & Economics
Econometrics is an interdisciplinary field

Economics and Business

Statistics Econometrics Mathematics

Computer Science

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 Shanghai University

Why we study econometrics

of Finance & Economics

• The quantitative relationship between economic

variables is important
• The use of math, or logical consistency of theory
cannot ensure that economics is a science. ·
– Economic theory would be useless if the underlying
assumptions are wrong.
– To be a science, economic theory must be able to:
1.explain historical stylized facts and
2.predict future economic phenomena.

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 Shanghai University

Why we study econometrics？

of Finance & Economics

• Econometrics is primarily interested in

– Quantifying economic relationships
– Testing competing hypothesis
– Forecasting

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 Quantifying Economic
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of Finance & Economics

Relationships
• Outcomes of many policies tied to the magnitude of the
slope of supply and demand curves
• Often need to know elasticities before we can begin
practical analysis
• For example, if the minimum wage is raised,
unemployment may drop as more workers enter the
labor force
– However, this depends on the slopes of the labor supply and
labor demand curves
• Econometric analysis attempts to determine this answer
• Allows us to quantify causal relationships when the
luxury of a formal experiment is not available
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 Shanghai University

Testing Competing Hypothesis

of Finance & Economics

• Econometrics helps fill the gap between the

theoretical world and the real world
• For instance, will a tax cut impact consumer
spending?
– Keynesian models relate consumer spending to
annual disposable income, suggesting that a cut in
taxes will change consumer spending
– Other theories relate consumer spending to lifetime
income, suggesting a tax cut (especially a “one-shot
deal”) will have little impact on consumer spending
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 Shanghai University

Forecasting
of Finance & Economics

• Econometrics attempts to provide the

information needed to forecast future
values
– Such as inflation, unemployment, stock
market levels, etc.

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 Shanghai University

The Use of Models

of Finance & Economics

• Economists use models to describe real-world

processes
– Models are simplified depictions of reality
• Usually an equation or set of equations
• Economic theories are usually deterministic
while the world is characterized by randomness
– Empirical models include a random component
known as the error term, or i
– Typically assume that the mean of the error term is
zero
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 Steps involved in the formulation of
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of Finance & Economics

econometric models
Economic or Financial Theory (Previous Studies)

Formulation of an Estimable Theoretical Model

Collection of Data

Model Estimation

Is the Model Statistically Adequate?

No Yes

Reformulate Model Interpret Model

Use for Analysis

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 Shanghai University

Types of Data
of Finance & Economics

• Data provide the raw material needed to

– Quantify economic relationships
– Test competing theories
– Construct forecasts
• Data can be described as a set of observations
such as income, age, grade
– Each occurrence is called an observation
• Data are in different formats
– Cross-sectional
– Time series
– Panel data
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 Shanghai University

Cross-Sectional Data
of Finance & Economics

• Provide information on a variety of entities

at the same point in time

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 Shanghai University

Time Series Data

of Finance & Economics

• Provides information for the same entity at

different points in time

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Panel (or Longitudinal) Data

of Finance & Economics

• Represents a combination of cross-

sectional and time series data
– Provides information on a variety of entities at
different periods in time

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 What are the Special Characteristics
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of Finance & Economics

of Financial Data?

• Frequency & quantity of data

Stock market prices are measured every time there is
a trade or somebody posts a new quote.

• Quality
Recorded asset prices are usually those at which the
transaction took place.
No possibility for measurement error but financial
data are “noisy”.
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 Shanghai University

Data Sources
of Finance & Economics

• Data is gathered by many sources

including
– Government
– Non-government organizations
– Research organizations
– Individual researchers

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 Shanghai University
of Finance & Economics

Some Examples

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of Finance & Economics
Example 1 [Macroeconomics]
Fiscal Policy in Closed Economy
• If the government does not increase its public
spending, the GDP will be 80 billion RMB. But
government’s desired output is 100 billion RMB.

• How to use the fiscal policy?

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 Example 1 (cont’d)
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of Finance & Economics

• In a closed economy, the standard Keynesian

theory can be summarized by two simple equations:
Yt  C t  I t  G t ,
C t    Yt ,

1 − Yt    I t  G t .
∂Yt  1 ,
∂G t 1 − 
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 Shanghai University
of Finance & Economics
Example 2 [Marketing]
Pricing the Commodity
• Suppose you are a manager of marketing
department in a corporation. Your objective is to
maximise the profit.
• The cost of every unit product is constant c.
• If you can control the price of the product, at
what price would you like to set?

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 Example 2 Pricing the product (cont’d)
Shanghai University
of Finance & Economics

• Suppose the demand is only determined by its

price, and has the hyperbolic form
q  Ap α
A  0, α  0
α 1
R  pq  Ap TC  qc
Π  R  TC  Ap α  1 -Ap α c
Π
 Ap α  1(( α  1 )p  αc)  0
p
αc
p 
α 1

So, we must know the value of 

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 Shanghai University
of Finance & Economics
Example 3 [Labor Economics]
Is there sex or race discrimination in labor market

WAGEi    EDUi  EXPERENCEi . . .

 GENDERi  MINORITYi  ui

We can test whether θ or φ is zero or not.

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 Shanghai University
of Finance & Economics
Example 4
Effect of Economic Reforms on a Transitional Economy

Economic theory predicts that the introduction of the bonus

and contract systems provides stronger incentives for
workers to work harder, thus increasing the productivity.
Is this statement true or not?
Consider an extended production function
ln Yit  ln A it   ln L it   ln K it
 Bonus it  Contract it  u it ,

No effect:     0.
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 Shanghai University
of Finance & Economics
Example 5 [Finance]
The Efficient Market Hypothesis (EMH) and
Predictability of Financial Returns

• The weak form of efficient market

hypothesis states that it is impossible to
predict future stock returns using the
history of past stock returns.

• Is the stock market efficient?

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 Example 5 (cont’d)
Shanghai University
of Finance & Economics

Consider following autoregression model:

p
Y t  0  ∑  j Yt−j  t ,
j1

Where Yt is the stock return in time period t.

If the joint hypothesis

1   2      p  0.
is accepted, then we can say that the stock market
is efficient
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 Examples of the kind of problems that
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of Finance & Economics

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.
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 Examples of the kind of problems that
Shanghai University
of Finance & Economics

may be solved by an Econometrician (cont’d)

4.Explaining the determinants of bond credit

ratings used by the ratings agencies.
5.Modelling long-term relationships between
prices and exchange rates
6.Determining the optimal hedge ratio for a spot
position in oil.

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 Examples of the kind of problems that
Shanghai University
of Finance & Economics

may be solved by an Econometrician (cont’d)

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.
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 Shanghai University

Summary
of Finance & Economics

• Econometrics is an interdisciplinary field.

• From the interesting application examples, we can learn

that econometrics is a very useful tool in economic
research and decision-making.

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