Econometrics and Economic Data

Advanced Financial Modeling

 Learning outcomes
• Econometrics

• Intuition, observation and a model

• kinds of data
 What is Econometrics
• Literally interpreted, econometrics means
“economic measurement.” Although measurement
is an important part of econometrics, the scope of
econometrics is much broader

• Econometrics may be defined as the social science

in which the tools of economic theory,
mathematics, and statistical inference are applied
to the analysis of economic phenomena
 What is Econometrics
• The method of econometric research aims,
essentially, at a conjunction of economic
theory and actual measurements, using the
theory and technique of statistical inference
as a bridge pier.

• Econometrics is concerned with the empirical

determination of economic laws
 Why a Separate Discipline?
• As the preceding definitions suggest, econometrics is an
amalgam of economic theory, mathematical economics,
economic statistics, and mathematical statistics.

• Economic theory makes statements or hypotheses that are

mostly qualitative in nature.

• The main concern of mathematical economics is to express

economic theory in mathematical form (equations) without
regard to measurability or empirical verification of the
theory.
 Why a Separate Discipline?
• Economic statistics is mainly concerned with
collecting, processing, and presenting economic
data in the form of charts and tables

• Although mathematical statistics provides many

tools used in the research, the econometrician
often needs special methods in view of the unique
nature of most economic data, namely, that the
data are not generated as the result of a controlled
experiment.
 Why a Separate Discipline?
• In econometrics the modeler is often faced with
observational as opposed to experimental data.

• This has two important implications for empirical modeling in

econometrics. First, the modeler is required to master very
different skills than those needed for analyzing experimental
data.

• Second, the separation of the data collector and the data

analyst requires the modeler to familiarize himself/herself
thoroughly with the nature and structure of data in question.
 Common applications of econometrics
• The most common application of econometrics is
the forecasting of such important macroeconomic
variables as interest rates, inflation rates, gross
domestic product, corporate cash and leverage
policies.

• Whereas forecasts of economic indicators are highly

visible and often widely published, econometric
methods can be used in economic areas that have
nothing to do with macroeconomic forecasting
Common applications of econometrics
• Political campaign expenditures on voting
outcomes
• The effects of number of clicks on internet
usage etc
 Methodology of Econometrics
• 1. Statement of theory or hypothesis or research
questions
• 2. Specification of the mathematical model of the theory.
• 3. Specification of the statistical, or econometric, model.
• 4. Obtaining the data.
• 5. Estimation of the parameters of the econometric
model.
• 6. Hypothesis testing.
• 7. Forecasting or prediction.
• 8. Using the model for control or policy purposes.
 Steps in Empirical Economic Analysis
• Econometric methods are relevant in virtually
every branch of applied research. They come
into play either when we have an economic
theory to test or when we have a relationship
in mind that has some importance for
business decisions or policy analysis.
• An empirical economic analysis uses data to
test a theory or to estimate a relationship.
 Statement of theory or hypothesis or
research questions
• How to Start
• It may seem obvious, but it is worth emphasizing
that the first step in any empirical analysis is the
careful formulation of the question of interest.
• The question might deal with testing a certain
aspect of an economic theory, or it might pertain
to testing the effects of a government policy.
• In principle, econometric methods can be used
to answer a wide range of questions.
 Hypothesis
• A hypothesis is an educated guess about
something in the world around you. It should
be testable, either by experiment or
observation. For example:
• A new medicine you think might work.
• A way of teaching you think might be better.
• A possible location of new species.
 Statement of theory or hypothesis or
research questions
• In some cases, especially those that involve the
testing of economic theories, a formal economic
model is constructed. An economic model consists
of mathematical equations that describe various
relationships.

• Take for example I have observed that stocks of

firms with higher stock liquidity can sell their stocks
easily. Does this mean that higher stock liquidity will
enable firms to raise more equity.
 Statement of theory or hypothesis or
research questions
• Based on the above observations I derive the following
propositions/ suggestions

• Higher stock liquidity enables firms and investors to sell

stock easily

• Higher stock liquidity may result in lower transaction cost

• Higher stock liquidity may result in lower advertisement

costs hence may tempt firm to opt for equity rather than
debt in their issues for new funding.
 Statement of theory or hypothesis or
research questions
• Based on above proposition we develop following questions for
investigations

• Do Firms with higher stock liquidity report lower cost of issuing

equity?

• Do this lower cost of equity will lead an inverse relationship

between debt financing and stock liquidity?

• On the contrary, we can also ask ourselves, stock liquidity means

good reputation in the market. Due to this reputation do FIs
extend more debt to such firms ( a positive relationship)?
Specification of the mathematical model of
the theory.
• Such questions are then converted into
models.

• Such questions can delineate into one mind

either formally from an established or
seminal theory or informally just from
observations or intuitions
Specification of the mathematical model of
the theory.
• We can develop a single model or multiple
model based on our questions.
• Lets start
• Model 1 cost of equity and stock liquidity
TCE  f ( SL, SIZE , LEV , Risk )

• In the above model CE is the cost of equity, Size

is firm size, Lev is leverage and Risk is firm risk.
Specification of the mathematical model of
the theory.
• We can also develop a model for stock
liquidity and leverage as we propose firms
with higher stock liquidity might report less
leverage.
LEV  f ( SL, SIZE , Tang , Risk )
Specification of the mathematical model of
the theory.
• Similarly we can also incorporate all three in a
single model
LEV  f ( SL, CE , SIZE, Tang , Risk , NDTS , OWNC, GROW )

• In the above model Lev is firm leverage, SL is stock

liquidity, CE is cost of equity, SIZE is firm Size, Tang
is tangibility, Risk is firm risk, NDTS is non debt tax
shield, OWNC is the ownership concentration and
GROW is the growth opportunity.
 Estimation of the parameters of the
econometric model
• Operational form of the model called
econometric model
• Econometric analysis are done in this form of
model
• After incorporating the data and getting our
variables ready for the regression estimation
our model take the form of:
Levi ,t  0 1 Liqi .t   2 ROAi ,t   3 Sizei ,t   4TANG i ,t   5NDTSi ,t
  6HOLDER5i ,t   6 GROW   i .t
 Estimation of the parameters of the
econometric model
• The constants 0, ,1 , …,
6 are the parameters
(coefficients) of the econometric model, and
they describe the directions and strengths of
the relationship between dependent variable
and independent variable.
 Estimation of the parameters of the
econometric model
• In the operational form of model:

• is leverage of firm “i” at time “t”. It is measured by using three proxies as

short term debt to total asset, long term debt to total asset, total liabilities
to total assets, is the stock liquidity of firm “i” at time “t”. It is measured by
considering four measures such as AMIVEST measure, AMIHUD illiquidity
measure, modified liquidity ratio (MLR), liquidity ratio and Pastor &
Stambaugh stock liquidity measure (2003). is the growth opportunities of
firm “i” at time “t” and Market value to book value of assets is used as the
proxy. is the size of firm “i” at time “t”. Natural log of total assets used as
proxy of size used. is the tangibility of assets of firm “i” at time “t”. Net
property, equipment and plant to total assets used as the proxy of
tangibility. is the ownership concentration of largest five share holder of
firm “i” at time “t”. The percentage of five percent shareholders used as
proxy. is the error term of firm “i” at time “t”.
 Obtaining Data and Estimation of the
Econometric Model
• To estimate the econometric model , that is, to
obtain the numerical values of β1 and β2, we
need data.

• Now that we have the data, our next task is to

estimate the parameters of our model
 Hypothesis Testing and Forecasting or
Prediction
• Hypothesis testing in statistics is a way for you to test
the results of a survey or experiment to see if you have
meaningful results. You’re basically testing whether your
results are valid

• If the chosen model does not refute the hypothesis or

theory under consideration, we may use it to predict the
future value(s) of the dependent, or forecast, variable Y
on the basis of the known or expected future value(s) of
the explanatory, or predictor, variable X.
 Steps in Empirical Economic
Analysis(Example)
• One example of a model originating from a
theory of maximum utility
 Steps in Empirical Economic Analysis
• Operational form of the crime model
 Steps in Empirical Economic Analysis
• The choice of these variables is determined by the
economic theory as well as data considerations. The
term u contains unobserved factors, such as the wage
for criminal activity, moral character, family background,
religious inclination and errors in measuring things like
criminal record.

• we can never eliminate “u” entirely. In fact, dealing with

this error term or disturbance term is perhaps the most
important component of any econometric analysis.
 Steps in Empirical Economic Analysis
• Once an econometric model such as crime
model or has been specified, various
hypotheses of interest can be stated in terms
of the unknown parameters. For example, in
crime econometric equation , we might
hypothesize that wagem, the wage that can
be earned in legal employment, has a negative
effect on criminal behavior.
Steps in Empirical Economic Analysis- Data

• An empirical analysis, by definition, requires

data. After data on the relevant variables have
been collected, econometric methods are
used to estimate the parameters in the
econometric model and to formally test
hypotheses of interest. In some cases, the
econometric model is used to make
predictions in either the testing of a theory or
the study of a policy’s impact.
 The Structure of Economic Data
• Economic data sets come in a variety of types.
Whereas some econometric methods can be
applied with little or no modification to many
different kinds of data sets, the special
features of some data sets must be accounted
for or should be exploited. We next describe
the most important data structures
encountered in applied work.
 Cross-Sectional Data
• A cross-sectional data set consists of a sample of
individuals, households, firms, cities, states,
countries, or a variety of other units, taken at a given
point in time. It is also called snapshot of a data.
Sometimes, the data on all units do not correspond
to precisely the same time period.

• In survey analysis there might be some minor time

differences while collecting data from different
respondents. Such minor difference are often ignored
 Cross-Sectional Data
• An important feature of cross-sectional data is
that we can often assume that they have been
obtained by random sampling from the
underlying population.

• However this is not possible in every case

( financial and non financial firms)
Example of cross sectional data

Table: Firms data for the year ended 31st Dec, 2001
firm id firm name no of shareholders Shareprice Mkt cap Lev age
1 Abbott Lab 1233 450 554850 45 34
2 Abbot 12323 435 5360505 65 54
3 FATIMA 43434 343 14897862 67 34
4 AzgardNine 212 55 11660 45 55
5 GhaniGlass 3434 343 1177862 65 56
6 Treet 322324 454 146335096 34 34
Example of cross sectional data
 Time Series Data
• A time series data set consists of observations on an
entity, variable or several variables over time. Examples
of time series data include stock prices, money supply,
consumer price index, gross domestic product, annual
homicide rates, and automobile sales figures.

• Because past events can influence future events and

lags in behavior are prevalent in the social sciences,
time is an important dimension in a time series data
set.
 example

Data for abbot labortries for for the last 6 years

Year firm id firm name no of shareholders Shareprice Mkt cap Lev age

2015 1 Abbott Lab 1233 450 554850 45 34

2016 1 Abbott Lab 12323 435 5360505 65 54

2017 1 Abbott Lab 43434 343 14897862 67 34

2018 1 Abbott Lab 212 55 11660 45 55

2019 1 Abbott Lab 3434 343 1177862 65 56

2020 1 Abbott Lab 322324 454 146335096 34 34

 Time Series Data
• A key feature of time series data that makes
them more difficult to analyze than cross-
sectional data is that economic observations
can rarely, if ever, be assumed to be
independent across time (autocorrelation).

• Most economic and other time series are

related, often strongly related, to their recent
histories.
 Autocorrelation
• Autocorrelation is a mathematical
representation of the degree of similarity
between a given time series and a lagged
version of itself.

• An autocorrelation of +1 represents a perfect

positive correlation, while an autocorrelation
of negative 1 represents a perfect negative
correlation.
 Time Series data frequency
• Another feature of time series data that can require
special attention is the data frequency at which the
data are collected. In economics, the most common
frequencies are daily, weekly, monthly, quarterly, and
annually. Stock prices are recorded at daily intervals
(excluding Saturday and Sunday).

• The money supply in the economy is reported tri-

weekly. Many macroeconomic series are tabulated
monthly, including inflation and unemployment rates.
 Time Series data frequency
• Many weekly, monthly, and quarterly
economic time series display a strong seasonal
pattern, which can be an important factor in a
time series analysis.

• One simple example might be companies

producing mosquito repellent might see their
sales sky rocket in hot season and low in cold
season.
 Pooled Cross Sections
• Some data sets have both cross-sectional and
time series features. However no cross section
is repeated across the different points of time.
 Pooled Cross Sections

Year firm id firm name no of shareholders Shareprice Mkt cap Lev age
2015 1 Abbott Lab 1233 450 554850 45 34
2015 2 KRL 12323 435 5360505 65 35
2015 3 ABL 43434 343 14897862 67 36
2015 4 PAKElectron 212 55 11660 45 37
2015 5 Seimens 3434 343 1177862 65 38
2015 6 Dawood 322324 454 1.46E+08 34 39
2016 7 HBL 554850 34 18864900 34 42
2017 8 Azgard9 5360505 54 2.89E+08 35 43
2018 9 Treet 14897862 34 5.07E+08 36 44
2019 10 Fatima 11660 55 641300 37 45
2020 11 FFCL 1177862 56 65960272 38 46
2021 12 FFBL 146335096 34 4.98E+09 39 47
Pooled Cross Sections
 Panel or Longitudinal Data
• A panel data (or longitudinal data) set consists
of a time series for each cross-sectional
member in the data set. As an example,
suppose we have wage, education, and
employment history for a set of individuals
followed over a ten-year period. Or we might
collect information, such as investment and
financial data, about the same set of firms
over a five-year time period.
Panel or Longitudinal Data
 Panel or Longitudinal Data
• The key feature of panel data that
distinguishes them from a pooled cross
section is that the same cross-sectional units
(individuals, firms, or counties in the
preceding examples) are followed over a given
time period.