Econometrics For Finance

Credit Hours = 3
Course Code= 512
By
Misraku M.(Ph.D)
 Course Content
• Has Six Chapters
Chapter One: Introduction to Econometrics Analysis
Chapter Two: Simple Regression Model Assumptions and
Estimations
Chapter Three: Statistical Inferences for Simple Regression
Chapter Four: Multiple Linear Regression Models
Chapter Five: Violation of classical linear regression model
assumptions and diagnostics
Chapter Six: Limited Dependent and Time series Models

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 CHAPTER ONE

INTRODUCTION TO
ECONOMETRICS ANALYSIS

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 Chapter Outline

• What is Econometrics?
• Econometric models
• Methodology of econometric research/the
practice of econometrics
• Data types

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1.1 Econometrics: Definition and its Role

• Literally speaking, the word ‘econometrics’ means measurement

in economics. But its scope is beyond measurement.
• Economic theories (e.g. consumption theory, investment theory)
suggest many relationships among economic variables.
• However, important questions such as:
– Is the suggested theoretical relationship true or not? If one
variable(say X) changes in a certain magnitude, by how
much will another variable(say, Y) change?
– Given the value of one variable; can we forecast or predict
the corresponding value of another? cannot be exactly
answered by economic theory alone.

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 1.1 Econometrics: Definition and its
Role…
• Economic theories that postulate the relationships between
economic variables have to be checked/evaluated against data
obtained from the real world.
• Econometrics helps us to carryout such an evaluation of
economic theories in empirical terms.
• Its role is to provide measurement and quantitative analysis of
actual economic phenomena or economic relationship based
on Economic theory, data and methods of model constructed.

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 1.1 Econometrics: Definition and its
Role…
• In general, econometrics
– integrates economic theory, mathematical modeling, and
statistical techniques for the purpose of testing
theories/hypotheses, estimating and forecasting economic
phenomena.
– is the application of statistical and mathematical methods
to the analysis of economic data with a purpose of giving
empirical content to economic theories/laws and verifying
or refuting them.

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 1.1 Econometrics: Definition and its
Role…
• Specifically, it is concerned with the use of statistical methods
to
– attach numerical values to the parameters of economic
models and
– also with the use of these models for prediction, and policy
purpose.
• Econometrics has become strongly identified with regression
analysis.
• This relates a dependent variable to one or more independent
or explanatory variables.

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 Making Economic Decisions
To use information effectively:

}
Economic theory
Economic
decisions
Economic/finan
cial data

*Econometrics* helps us combine

economic theory and economic data .

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 1.2. Econometric model
• An econometric model consists of the following:
 A set of behavioural equations derived from the economic
model/theory.
 These equations involve some observed variables and some
‘disturbances’.
 The disturbances account omitted variables from the model and all
unforeseen forces.
 A specification of the probability distribution of the
‘disturbances ‘.
• Then, we can proceed to test the empirical validity of the
economic model and use it to make forecasts or use it in
policy analysis
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 1.3 Methodology of econometric research
• Econometric research, in general, involves the following four
general stages:
• 1. Specification/formulation of the model or maintained
hypothesis in explicit stochastic equation form, together with
the a priori theoretical expectations about the sign and size of
the parameters of the function.
• This is model specification aspect

• 2. Estimating the model:

• Collecting data on the variables of the model and estimating
the coefficients of the function with appropriate econometric
techniques.

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1.3 Methodology of econometric research…

• 3. Testing hypothesis and model

adequacy:
– Evaluation of the estimated coefficients of the
function on the basis of economic, statistical,
and econometric criteria
• 4. Prediction & policy aspect:
– if the model is adequate, we can use for
prediction and policy purpose

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1. Economic Theory
e.g. “ Keynes (John Maynard Keynes) postulated a positive relationship between consumption
and incomes”—Keynesian consumption theory.
It’s qualitative in nature. Magnitude of r/ship between the two is not given.

2. Mathematical Expression/formulation:
Writing the above statement in maths form as:
Consumption = f(Income) ==> C = f(Y)= a +bY,
b=MPC = dC/dY = f’(Y) > 0 ;assume 0 < MPC < 1
Exact/deterministic r/ship between C and Y

3. Collect statistics/economic data:

Year C Y Investigate the important features of the data:
1980 2447.1 3776.3 Find the mean, variance,
1981 2476.9 3841.1
…. …. …. standard deviation,
2000 4651.8 5991.7 correlation, etc.

4. Econometric - Regression model

Ct = 1 + 2 Yt + ut => C/Y = 2
=> estimating the relationship
Ut is the disturbance term, capturing all unobservable factors 13
The stages and practice of econometric research:

• Statement of economic theory or hypothesis

• Specification of the mathematical model of the theory
• Specification of the econometric model of the theory
• Obtaining data for estimation.
• Estimation with statistical properties
• Hypothesis testing and/or Model adequacy
• Analyze and evaluate implications of the results
• Forecasting or prediction
• Using the model for policy purpose
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 Econometric research/Economic Empirical Study

Economic Theory; hypothesis; Past Experience, studies

C = f(Y) ==>
Formulating mathematical and econometric model Ct = 1 + 2Yt + ut

Gathering data: Statistics: daily, monthly, quarterly, yearly data

Estimating the model: Simple OLS method or other advances

Is the model adequate? H0: 2>0,

Testing the hypothesis: positive relationship or not If not true

Interpreting the results:

Policy implication and decisions

Forecasting/prediction

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Important Note:
• It is not true that econometricians just take the
theories they are given and test them, learning
nothing from the tests.
• Based on the results, they either verify or refute
the economic theory or suggest alternative
theories.

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 1.4 Types of Economic Data

Broadly three types of data can be employed in

quantitative analysis or economic empirical study :
 time series data, cross-sectional data, and panel data.
Cross-sectional data are data on one or more variables
collected at a single point in time. For example, the data
might be on:
–  Income and employment status of households in AA in
2021
– wages of employees of garment factories in Ethiopia in 2018
– Magnitude of saving in Ethiopia’s commercial banks.
• Units of observation can be a sample of individuals,
households, firms, states, countries, regions, etc
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 Cross-sectional data

The individual observation numbers are indicated

using the index i , and the total number of
observations available for analysis by N.
• Vectors or Rows (like in a spreadsheet)
• No natural ordering of the observations in a cross-
sectional sample.
• On the other hand, in a time series context, the
ordering of the data is relevant since the data are
usually ordered chronologically.

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Cross-sectional data

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 Time series data

Time series data

• are data that have been collected over a period of time on one
or more variables.
• have associated with them a particular frequency of
observation or collection of data points
– The frequency is simply a measure of the interval over, or the regularity
with which, the data are collected or recorded(daily, weekly, monthly,
quarterly or annually)
• Vectors or Columns (like in a spreadsheet)
Eg. Time Series data and their Frequency:
– Exchange rate: daily data over time
– Industrial production: Monthly, or quarterly
– Government budget deficit -Annually
– Money supply -quarterly, or annually
– The value of a stock -As transactions occur
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 Time series data

 The time dimension is the most important, and the analysis will be
conducted using the values of the variables over time.
• It is usual to denote the individual observation numbers using
the index t, and the total number of observations available for
analysis by T.

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Time series data

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 Panel Data

• Panel data have the dimensions of both time series and

cross-sections.
• Panel data or longitudinal data is a record of data over time
across the same units of the sample(cross-sections).
• It consists of a time series for each cross-sectional member
in the data set.
• Contains repeated observations over the same units
• Variables are denoted by using the index it-Xit or Yit
Example:
 Bank deposit in commercial banks in Ethiopia from 2010-
2020
 Bank GDP and trade of SSA Misrakucountries
M.(Ph.D) from 1990-2014 23
 Panel Data

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CHAPTER END

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