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Multivariate Models
• All the models we have looked at thus far have been single
equations models of the form
y = Xβ + u
• y is an ENDOGENOUS variable.
where
Qdt = quantity of new houses demanded at time t
Qst = quantity of new houses supplied (built) at time t
Pt = (average) price of new houses prevailing at time t
St = price of a substitute (e.g. older houses)
Tt = some variable embodying the state of housebuilding
technology, ut and vt are error terms.
α + βP + γS + u = λ + µP + κT + v (6)
• Solving for P,
Q α γS u Q λ κT v
− − − = − − − (7)
β β β β µ µ µ µ
βP − µP = λ − α + κT − γS + v − u
(β − µ)P = (λ − α) + κT − γS + (v − u)
λ−α κ γ v −u
P= + T− S+ (8)
β−µ β−µ β−µ β−µ
µQ − µα − µγS − µu = βQ − βλ − βκT − βv
µQ − βQ = µα − βλ − βκT + µγS + µu − βv
(µ − β)Q = (µα − βλ) − βκT + µγS + (µu − βv )
µα − βλ βκ µγ µu − βv
Q= − T+ S+ (9)
µ−β µ−β µ−β µ−β
‘Introductory Econometrics for Finance’ by Dr. Le Trung Thanh 2020 6/67
Obtaining the Reduced Form (Cont’d)
• (8) and (9) are the reduced form equations for P and Q.
β̂ = (X 0 X )−1 X 0 (X β + u)
β̂ = (X 0 X )−1 X 0 X β + (X 0 X )−1 X 0 u
β̂ = β + (X 0 X )−1 X 0 u
• Taking expectations,
• We CAN estimate equations (10) & (11) using OLS since all
the RHS variables are exogenous.
• But ... we probably don’t care what the values of the π
coefficients are; what we wanted were the original parameters
in the structural equations - α, β, γ, λ, µ, κ.
3. An equation is over-identified
– Example given later
– More than one set of structural coefficients could be obtained
from the reduced form.
• How do we tell if an equation is identified or not?
Example
• In the following system of equations, the Y’s are endogenous,
while the X’s are exogenous. Determine whether each
equation is over-, under-, or just-identified.
Y1 = α0 + α1 Y2 + α3 Y3 + α4 X1 + α5 X2 + u1 (14)
Y2 = β0 + β1 Y3 + β2 X1 + u2 (15)
Y3 = γ0 + γ1 Y2 + u3 (16)
Solution
‘Introductory Econometrics for Finance’ by Dr. Le Trung Thanh 2020 15/67
What Determines whether an Equation is Identified
or not? (Cont’d)
G = 3;
• Assume that the error terms are not correlated with each
other. Can we estimate the equations individually using OLS?
Stage 1:
• Obtain and estimate the reduced form equations using OLS.
Save the fitted values for the dependent variables.
Stage 2:
• Estimate the structural equations, but replace any RHS
endogenous variables with their stage 1 fitted values.
Stage 2:
• Now Ŷ21 and Ŷ31 will not be correlated with u1 , Ŷ31 will not be
correlated with u2 , and Ŷ21 will not be correlated with u3 .
• It is still of concern in the context of simultaneous systems
whether the CLRM assumptions are supported by the data.
Y2 = λ1 + λ2 z2 + ε1 (27)
Y3 = λ3 + λ4 z3 + ε2 (28)
• Obtain the fitted values from (27) & (28), Ŷ21 and Ŷ31 , and
replace Y2 and Y3 with these in the structural equation.
• We do not use the instruments directly in the structural
equation.
• It is typical to use more than one instrument per endogenous
variable.
• How Might the Option Price / Trading Volume and the Bid /
Ask Spread be Related?
Consider 3 possibilities:
1. Market makers equalise spreads across options.
2. The spread might be a constant proportion of the option
value.
3. Market makers might equalise marginal costs across options
irrespective of trading volume.
• The S&P 100 Index has been traded on the CBOE since 1983
on a continuous open-outcry auction basis.
• Transactions take place at the highest bid or the lowest ask.
• The average bid & ask prices are calculated for each option
during the time 2:00pm – 2:15pm Central Standard time.
• The following are then dropped from the sample for that day:
1. Any options that do not have bid / ask quotes reported during
the 1/4 hour.
2. Any options with fewer than 10 trades during the day.
• The option price is defined as the average of the bid & the
ask.
• We get a total of 2456 observations. This is a pooled
regression.
=0 if Ci or Pi < $3
=1 if Ci or Pi ≥ $3
• Equations (29) & (30) and then separately (31) & (32) are
estimated using 2SLS.
‘Introductory Econometrics for Finance’ by Dr. Le Trung Thanh 2020 36/67
Results 1
Comments
– No diagnostics.
– Why do the CL and PL equations not contain the CR and PR
variables?
• or
y1t β10 β11 α11 y1t−1 u1t
= + +
y2t β20 α21 β21 y2t−1 u2t
yt = β0 + β1 yt−1 + ut
g ×1 g ×1 g × gg × 1 g ×1
• This model can be extended to the case where there are k lags
of each variable in each equation:
• We can also extend this to the case where the model includes
first difference terms and cointegrating relationships (a
VECM).
‘Introductory Econometrics for Finance’ by Dr. Le Trung Thanh 2020 46/67
Vector Autoregressive Models Compared with
Structural Equations Models
• Advantages of VAR Modelling
– Do not need to specify which variables are endogenous or
exogenous - all are endogenous
– Allows the value of a variable to depend on more than just its
own lags or combinations of white noise terms, so more
general than ARMA modelling
– Provided that there are no contemporaneous terms on the
right hand side of the equations, can simply use OLS
separately on each equation
– Forecasts are often better than “traditional structural” models.
Cross-Equation Restrictions
• In the spirit of (unrestricted) VAR modelling, each equation
should have the same lag length
LR = T [log|Σ̂r | − log|Σ̂u |]
k0
MSBIC = logΣ̂ + log(T )
T
2k 0
MHQIC = logΣ̂ + log(log(T ))
T
where all notation is as above and k is the total number of
regressors in all equations, which will be equal to g 2 k+g for g
equations, each with k lags of the g variables, plus a constant
term in each equation. The values of the information criteria
are constructed for 0, 1, ... lags (up to some pre-specified
maximum k̄)).
‘Introductory Econometrics for Finance’ by Dr. Le Trung Thanh 2020 52/67
Does the VAR Include Contemporaneous Terms?
or
Ayt = β0 + β1 yt−1 + ut
• If both sides are pre-multiplied by A−1
yt = A−1 β0 + A−1 β1 yt−1 + A−1 ut
or
yt = A0 + A1 yt−1 + et
• This is known as a standard form VAR, which we can estimate
using OLS.
‘Introductory Econometrics for Finance’ by Dr. Le Trung Thanh 2020 55/67
Block Significance and Causality Tests
y1t α10 β11 β12 y1t−1
= +
y2t α20 β21 β22 y2t−1
γ γ12 y1t−2
+ 11
γ21 γ22 y2t−2
δ11 δ12 y1t−3 u1t
+ +
δ21 δ22 y2t−3 u2t
y1t = α10 + β11 y1t−1 + β12 y2t−1 + γ11 y1t−2 + γ12 y2t−2
+ δ11 y1t−3 + δ12 y2t−3 + u1t
y2t = α20 + β21 y1t−1 + β22 y2t−1 + γ21 y1t−2 + γ22 y2t−2
+ δ21 y1t−3 + δ22 y2t−3 + u2t
Lags of variable
Dependent
variable SIR DIVY SPREAD UNEM UNINFL PROPRES
SIR 0.0000 0.0091 0.0242 0.0327 0.2126 0.0000
DIVY 0.5025 0.0000 0.6212 0.4217 0.5654 0.4033
SPREAD 0.2779 0.1328 0.0000 0.4372 0.6563 0.0007
UNEM 0.3410 0.3026 0.1151 0.0000 0.0758 0.2765
UNINFL 0.3057 0.5146 0.3420 0.4793 0.0004 0.3885
PROPRES 0.5537 0.1614 0.5537 0.8922 0.7222 0.0000
The test is that all 14 lags have no explanatory power for that particular equation in the
VAR.
Source: Brooks and Tsolacos (1999).
Explained by innovations in
0.02
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
–0.02
–0.04
–0.06
–0.08
0.04
0.02
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
–0.02
–0.04