Empirical Finance

Dr. Alexander Glas

FAU Erlangen-Nürnberg

Summer term 2023

Alexander Glas (FAU) EmFi - Lecture 04 Summer term 2023 1 / 17

Empirical Finance

1. Introduction
1.1 Lecture overview
1.2 Examples of financial time series
1.3 Returns and their distributions
1.4 Statistical concepts
1.5 Linear regression model
Book chapters: Stock and Watson, Chapters 4-7 and 15.4

Alexander Glas (FAU) EmFi - Lecture 04 Summer term 2023 2 / 17

Learning goals

This lecture serves as a refresher of the linear regression model.

Importantly, we will discuss the classical OLS assumptions.

You are able to explain which of the classical OLS assumptions hold
when working with time series data and which ones need to be adjusted.

You know how to adjust estimators of the OLS standard errors in the
presence of heteroskedasticity and / or autocorrelation.

Alexander Glas (FAU) EmFi - Lecture 04 Summer term 2023 3 / 17

1. Introduction
1.5 Linear regression model

General idea of regression:

Dependent variable: Y
Exogeneous (explanatory) variables: X1 , X2 , . . . , XK
Conditional expectation of Y:

Y = E[Y|X1 , X2 , . . . , XK ] + (Y − E[Y|X1 , X2 , . . . , XK ])
= E[Y|X1 , X2 , . . . , XK ] + ε (1)

Properties of ε:
1 E[ε|X1 , X2 , . . . , XK ] = 0
2 E[ε] = 0
3 E[Xk ε] = 0, k = 1, . . . , K
4 E[h(X1 , X2 , . . . , XK )ε] = 0 for each function h(·)

Alexander Glas (FAU) EmFi - Lecture 04 Summer term 2023 4 / 17

1. Introduction
1.5 Linear regression model
Linear regression model:

Yi = β1 + β2 Xi2 + β3 Xi3 + . . . + βK XiK + εi (2)

Classical OLS assumptions:

A1 E[εi |Xi2 , . . . , XiK ] = 0
A2 (Yi , Xi2 , . . . , XiK ), i = 1, . . . , n, are i.i.d.
A3 There is no perfect multicollinearity.
A4 0 < E[Xik4 ] < ∞, k = 2, . . . , K, and 0 < E[ε4i ] < ∞
A5 Var[εi |Xi2 , . . . , XiK ] = σε2 (conditional homoskedasticity)
A6 εi |Xi2 , . . . , XiK is normally distributed.
Among other things, A1 implies that in the linear regression model:

E[Yi |Xi2 , . . . , XiK ] = β1 + β2 Xi2 + β3 Xi3 + . . . + βK XiK

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1. Introduction
1.5 Linear regression model

Question: How can we estimate the parameters β1 , β2 , . . . , βK ?

For example, consider the case K = 2 ⇒ Yi = β1 + β2 Xi2 + εi

Alexander Glas (FAU) EmFi - Lecture 04 Summer term 2023 6 / 17

1. Introduction
1.5 Linear regression model

Ordinary Least Squares (OLS) estimator:

Let b1 , b2 , . . . , bK denote arbitrary estimators of β1 , β2 , . . . , βK .

The OLS estimators β̂1 , . . . , β̂K are those values of b1 , b2 , . . . , bK that minimize
the sum of squared residuals:
n
X
(Yi − b1 − b2 Xi2 − . . . − bK XiK )2
i=1

The OLS predictions and prediction errors (residuals) are given by

bi = β̂1 + β̂2 Xi2 + β̂3 Xi3 + . . . + β̂K XiK
Y

and
εbi = Yi − Y
bi .

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1. Introduction
1.5 Linear regression model
Coefficient of determination:
The goodness of fit of a regression can be expressed via the coefficient of
determination R2 : Pn ¯ 2 Pn
bi − Y)
(Y b b2i
i=1 ε
R2 = Pi=1
n = 1 − Pn
i=1 (Yi − Ȳ) i=1 (Yi − Ȳ)
2 2

Range: 0 ≤ R2 ≤ 1
In order to compare the goodness of fit of two regressions with a different number of
explanatory variables we use the adjusted coefficient of determination:
n−1
R̄2 = 1 − (1 − R2 )
n−K
Standard error of regression:
The standard error of the regression,
v
u n
u 1 X 2
σ̂ε = t εb ,
n − K i=1 i

is an (unbiased) estimator of σε .

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1. Introduction
1.5 Linear regression model

Finite sample properties of the OLS estimators:

Under A1 - A3, A5 and A6:

β̂1 , . . . , β̂K are unbiased and efficient (BLUE) estimators of β1 , β2 , . . . , βK .
β̂1 , . . . , β̂K are jointly normal and

β̂k |X2 , . . . , XK ∼ N (βk , σβ̂2 )

k

with Xk = (X1k , . . . , Xnk )′ , k = 2, . . . , K.

The test statistic
β̂k − βk,0
t=
σ̂β̂k
for H0 : βk = βk,0 follows a t distribution with n − K degrees of freedom.
The F-test for J linear restrictions on the βk is F(J, n − K)-distributed.

Alexander Glas (FAU) EmFi - Lecture 04 Summer term 2023 9 / 17

1. Introduction
1.5 Linear regression model

Large sample properties of the OLS estimators:

Under A1 - A4 (i.e., we allow for conditional heteroskedasticity and drop the

normality assumption):
β̂k is a consistent estimator of βk .
β̂1 , . . . , β̂K are asymptotically normal with
a
β̂k ∼ N (βk , σβ̂2 ).
k

The test statistic

β̂k − βk,0
t=
σ̂β̂k
for H0 : βk = βk,0 asymptotically follows a standard normal distribution.
The test statistic J · F for J linear restrictions on the βk is asymptotically
χ2 (J)-distributed.

Alexander Glas (FAU) EmFi - Lecture 04 Summer term 2023 10 / 17

1. Introduction
1.5 Linear regression model

For K = 2 and under A1 - A4 we obtain:

1 Var[(Xi2 − E[X2 ])εi ]
σβ̂2 =
2 n (Var[X2 ])2

Under the additional assumption A5 (Var[εi |Xi2 ] = σε2 ), the ‘normal’ OLS
standard error (i.e., the estimator of σβ̂2 ) is given by:
s Pn 2
1
n−2 i=1 ε
bi
σ̂β̂OLS = Pn 2
i=1 (Xi2 − X̄2 )
2

The heteroskedasticity-robust (White) standard error is:

v
u 1 Pn 2 b2
u1 i=1 (Xi2 − X̄2 ) ε i
White
σ̂β̂ = t n−2 Pn
n 1 2 2
2


n (X
i=1 i2 − X̄2 )

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1. Introduction
1.5 Linear regression model

Regression tables in R:

Data for ten African countries

Y: Child mortality rate (number of deceased infants per 1000 births)
X: GDP per capita in USD

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1. Introduction
1.5 Linear regression model

Regression with time series (Example with K = 2)

Yt = β1 + β2 Xt + εt (3)

Assumptions:
A1 E[εt |Xt , Xt−1 , . . .] = 0
A2 a) (Yt , Xt ) is strictly stationary, i.e., for each n and time periods t1 , . . . , tn ,
(Yt1 , Xt1 , Yt2 , Xt2 , . . . , Ytn , Xtn ) and (Yt1 +s , Xt1 +s , Yt2 +s , Xt2 +s , . . . , Ytn +s , Xtn +s )
follow the same distribution for arbitrary s.
b) (Yt , Xt ) and (Yt−j , Xt−j ) ‘become independent’ for j → ∞.
A3 Appropriate assumptions on the moments of Xt and εt
How to estimate σβ̂2 in this case? Consider:
2

PT !
1
T t=1 (Xt − E[Xt ])εt
Var(β̂2 ) = Var
σX2

Alexander Glas (FAU) EmFi - Lecture 04 Summer term 2023 13 / 17

1. Introduction
1.5 Linear regression model

Based on our result from Problem Set 3 we obtain:

1 σv2
Var(β̂2 ) = fT
T (σX2 )2

with
vt = (Xt − E[Xt ])εt
σv2 = Var[vt ]
and
T−1
X T −j
fT = 1 + 2 ρj ,
T
j=1

where ρj = Corr(vt , vt−j ).

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1. Introduction
1.5 Linear regression model

To estimate Var(β̂2 ), we replace

1 σv2
T (σX2 )2

by (σ̂β̂White )2 and fT by
2
m−1
X m−j
f̂m = 1 + 2 ρ̂j
m
j=1

where ρ̂j ’s denote sample autocorrelations and truncation parameter m < T.

Stock and Watson propose m = [0.75 · T 1/3 ], where [a] is the integer part of a.

The corresponding standard error is referred to as Newey and West (1987) or

HAC (heteroskedasticity- and autocorrelation-consistent) standard error:
q
σ̂β̂NW = σ̂β̂White f̂m
2 2

Alexander Glas (FAU) EmFi - Lecture 04 Summer term 2023 15 / 17

Summary

Under the classical OLS assumptions, the OLS estimator is the Best
Linear Unbiased Estimator (BLUE).

Most of the OLS assumptions also hold in time series settings, so that we
can rely on OLS estimation.

An important exception is the i.i.d. assumption, which is often violated

due to the presence of autocorrelation in time series applications.

Under the assumption of no serial correlation, the OLS estimator is still

the BLUE.

In the presence of autocorrelation, we can use HAC standard errors for

inference (hypothesis testing, confidence intervals).

Alexander Glas (FAU) EmFi - Lecture 04 Summer term 2023 16 / 17

References I
Newey, W. K. and West, K. D. (1987). A Simple, Positive Semi-definite, Heteroskedasticity and
Autocorrelation Consistent Covariance Matrix. Econometrica, 55(3):703–708.

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