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Centre for Financial and Management Studies

SOAS, University of London

1999, revised 2003, 2007, revised 2009, 2010, revised 2013

All rights reserved. No part of this course material may be reprinted or reproduced or utilised in any form or by any electronic,

mechanical, or other means, including photocopying and recording, or in information storage or retrieval systems, without

written permission from the Centre for Financial & Management Studies, SOAS, University of London.

Analysis

Course Introduction and Overview

Contents

1

Course Objectives

2

2

2

3

2

4

Learning Outcomes

8

5

Study Materials

8

6

Assessment

11

Course Objectives

This course provides an introduction to econometric methods. In brief, the

course examines how we can start from relationships suggested by financial

and economic theory, formulate those relationships in mathematical and

statistical models, estimate those models using sample data, and make

statements based on the parameters of the estimated models. The course

examines the assumptions that are necessary for the estimators to have

desirable properties, and the assumptions necessary for us to make statistical

inference based on the estimated models. In addition, the course explores what

happens when these assumptions are not satisfied, and what we can do in these

circumstances. The course concludes with an examination of model selection.

The course, and its more advanced sequel, Econometric Analysis and

Applications, were designed and written by Dr Graham Smith, who is Senior

Lecturer in the Department of Economics, SOAS, where he teaches

econometrics to MSc students and carries out research on empirical finance.

His main research interests focus on emerging stock markets and he has

published extensively in international refereed journals. His recent research

demonstrates that stock market efficiency is determined by market size,

liquidity and the quality of markets.

The course has been revised by Dr Jonathan Simms, who is a tutor for

CeFiMS, and has taught at University of Manchester, University of Durham

and University of London. He has contributed to development of various

CeFiMS courses including Econometric Analysis and Applications; Financial

Econometrics, Risk Management: Principles & Applications; Public Financial

Management: Reporting and Audit; and Introduction to Law and to Finance.

The paragraphs following the list of topics presented in the units provide brief

descriptions of the units content. They are intended as an introduction and

overview of the course. More complete, detailed explanation, analysis and

discussion are provided in the units themselves, and in the course textbook. So

dont worry if you do not understand everything in this short introduction.

Unit 1 Introduction to Econometrics and Regression Analysis

1.1

1.2

1.3

1.4

1.5

1.6

1.7

What is Econometrics?

How to Use the Course Texts

Ideas The Concept of Regression

Study Guide

An Example The Consumption Function

Summary

Eviews

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1.8 Exercises

1.9 Answers to Exercises

Unit 2 The Classical Linear Regression Model

2.1

2.2

2.3

2.4

2.5

2.6

Study Guide

Example the Single Index Model (SIM)

Summary

Exercises

Answers to Exercises

3.1

3.2

3.3

3.4

3.5

3.6

Study Guide

Example The Capital Asset Pricing Model

Summary

Exercises

Answers to Exercises

4.1

4.2

4.3

4.4

4.5

4.6

Study Guide

Example A Multi-Index Model

Summary

Exercises

Answers to Exercises

Unit 5 Heteroscedasticity

5.1

5.2

5.3

5.4

5.5

5.6

Study Guide

Example Price-Earnings Ratio

Summary

Exercises

Answers to Exercises

Unit 6 Autocorrelation

6.1

6.2

6.3

6.4

6.5

6.6

Study Guide

Example The Single-Index Model

Summary

Exercises

Answers to Exercises

7.1

7.2

7.3

7.4

7.5

Study Guide

Examples

Summary

Exercises

Appendix 1: Small-Sample Critical Values for the Jarque-Bera Test

Appendix 2: Stock Market Indices

Unit 8 Model Selection and Course Summary

8.1

8.2

8.3

8.4

8.5

8.6

8.7

Study Guide

Example: the Demand for Money Function

Summary

Exercises

Answers to Exercises

Course Summary: What you do and do not know

regression we mean an equation that captures the mathematical relationship

between the variables, and also the imperfect nature of that relationship. The

unit introduces the stages of an econometric investigation:

statement of the theory

collection of data

mathematical model of the theory (an exact relationship between

variables)

econometric model of the theory (a stochastic model of the relationship

between variables)

parameter estimation

checking for model adequacy

tests of hypotheses

prediction.

Unit 1 also provides guidance on how to use the study materials. In addition,

it provides a brief revision of how to calculate financial rates of return.

Each unit includes a worked example. (In Unit 1, the example concerns the

relation between spot and forward exchange rates.) All of the units also

contain exercises for you to do in order to develop your own understanding

and confidence, from a wide range of econometric studies. Data for the

exercises are provided. The data used in the examples are also provided so

that you can replicate the results presented in the unit (replicating the results

in the example is presented as an exercise).

The course uses the software package Eviews. Results from Eviews are

presented in the units. You are provided with a copy of Eviews to do the unit

exercises. Answers for the exercises are provided at the end of each unit, but

you look at the answers only after you have done the exercises yourself!

Data on the stock price of Delta Airlines Inc. and the New York Stock

Exchange Composite Index are introduced in the exercises in Unit 1. This

data set is used in a number of units throughout the course, in the worked

examples or the exercises. By applying different econometric tools with the

same data set, it is hoped you will develop a rounded view of how the

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methods you will learn relate to each other. A variety of other models and

data sets are also used.

Unit 2 presents the classical linear regression model. It explains the method of

ordinary least squares (OLS) and how that can be used to estimate the

unknown parameters of a regression equation using sample data. In this unit we

are concerned with models containing two variables; we are trying to discover

how one variable the explanatory variable explains another variable the

dependent variable and estimate the parameters in that relationship.

We then need to ask whether we can make statements about the true,

unknown, parameters of the model, based on our estimated values. To do this

we need to make a number of assumptions. These assumptions, if satisfied,

ensure that the estimators we use have desirable properties (in brief and

oversimplified terms: the estimators are accurate and efficient). If the

assumptions are satisfied, we can also make predictions about the unknown

model parameters, and we can specify, precisely, how confident we are about

those predictions. Unit 2 also explains goodness of fit: how closely our

estimated model fits our sample data. These ideas are demonstrated using the

single-index market model applied to Delta Airlines Inc., and the British

retailer Marks & Spencer.

Unit 3 explores how to test hypotheses. Based on our estimated model

coefficients, can we answer questions of the form:

Is the true, unknown coefficient negative, zero, or positive?

Does it take a particular value?

Is there actually a relationship between the two variables?

Unit 3 uses the capital asset pricing model (CAPM) for GlaxoSmithKline to

demonstrate hypothesis testing. Hypothesis testing is demonstrated further in

the exercises with the single-index model. So, for example, we might be

concerned with how we can test whether the stock we are interested in is

defensive or aggressive; is the company beta less than one or greater than

one? The efficiency of foreign exchange markets is also examined.

Unit 4 extends the analysis to the multiple regression model; these are

regression models in which one variable is explained by two or more

variables. The unit examines the assumptions necessary to estimate and make

predictions with such models. The unit asks what happens if, in a multiple

regression model, there is a relationship between any of the explanatory

variables, in addition to the relationships we hope to discover between the

explanatory variables and the dependent variable (this is called multicollinearity). The techniques of multiple regression are demonstrated with an

example of a multi-index model.

Units 5, 6 and 7 are concerned with what happens if a number of the

assumptions of the classical linear regression model are not satisfied. What

are the consequences for the properties of the ordinary least squares

estimators, and can we still make predictions about the unknown model

parameters based on our estimated model?

Centre for Financial and Management Studies

and simplified explanation; a more detailed and precise explanation is

provided in Unit 5. Unit 1 explains how we can specify a mathematical

relationship between variables. The actual relationship between variables is

not exact, and we attempt to capture this by including an error or disturbance

term in the regression equation. One of the assumptions we make is that the

variance of the disturbance term how much it varies about its mean value

is constant for all observations. This is the assumption of homoscedasticity,

and is explained in Unit 2.

In some econometric studies this assumption may not be satisfied. Consider a

cross-section study of commission rates for different brokerage companies.

The disturbance term also attempts to capture those influences on commission rates that we have not included in our model. Is it likely that the variance

of this disturbance term will be constant for all brokerage companies? If the

variance of the disturbance term is not constant, we say there is heteroscedasticity. Unit 5 examines the consequences of heteroscedasticity:

What are the effects on the properties of OLS estimators, and can we

still make predictions based on our estimated model?

The unit examines how heteroscedasticity can be identified, and how we can

deal with it, either by transforming the model or by using a different estimation

method. If we know what form the heteroscedasticity takes, we can use the

method of weighted least squares. Heteroscedasticity is demonstrated with a

study of price-earnings ratios estimated for a cross-section of companies.

Unit 6 is concerned with autocorrelation. Again, here is a very simple and

brief explanation; a more precise and formal explanation is provided in Unit

6. Consider again the disturbance term that we include in our regression

equation. The disturbance term reflects the stochastic nature of the relationship between variables, and also attempts to capture the elements that we

have not included in the model. Another assumption we make about the

disturbance term is that the disturbance terms for different observations (e.g.

if using annual data, last year and this year, or if using daily data, yesterday

and today) are not related.

This is the assumption of noncorrelated disturbances, and is explained in

Unit 2. If the disturbances for different observations are related, we say that

the disturbance term is serially correlated or autocorrelated. For example,

an economic or financial shock in one month may have persistent effects in

following months, and if the model does not explicitly include such

persistence effects, the disturbance terms in different months will be

correlated. Unit 6 examines the implications of autocorrelation for the

properties of OLS estimators, and also the consequences for prediction based

on OLS estimators. It also shows how to identify autocorrelation using plots

and more formal tests, and what can be done to take account of autocorrelation, including changing the method of estimation. The effects of

autocorrelated disturbances are demonstrated with the single-index market

model for Delta Airlines, and a model of spot and forward exchange rates.

6

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predictions about the true, unknown model parameters, based on our

estimated values, we need to assume that the disturbance terms are distributed normally that is, they follow a normal distribution. You are probably

already familiar with the normal distribution from your other studies. It is a

probability distribution with known properties, which allows us to make

statements concerning the unknown model parameters with a certain degree

of confidence for example, we can reject a hypothesis about a parameter

with a 5% chance of being wrong, or we can be 95% confident that an

unknown parameter takes a value within a certain range of values.

If the disturbance terms are not normally distributed, we are unable to make

such predictions, and it also has consequences for the properties of the OLS

estimators. Unit 7 explains the effects of having disturbances that are not

distributed normally, the tests to detect non-normal disturbances, and what

can be done about non-normal disturbances. This includes the use of dummy

variables to take account of outliers (data points which are very different

from the rest of the sample). These methods are demonstrated with two

examples: stock market returns and the single-index model for Marks &

Spencer. The exercises include consideration of the SIM for Delta Airlines

and for Bank of America.

Unit 8 is concerned with model selection. One of the assumptions we make is

that the model we estimate is correctly specified: the regression equation

includes all relevant variables, and the functional form of the relationship is

specified correctly variables are included correctly as levels, or their logged

values are included, or perhaps squared values of the variables are included.

If the model is not correctly specified, this has consequences for the

properties of the OLS estimators and for prediction based on those estimators. In particular, Unit 8 examines the consequences of omitting a relevant

explanatory variable, including an irrelevant explanatory variable, and using

the wrong functional form.

The unit explains methods to identify misspecified equations. These include

tests specifically designed to identify misspecified models. In addition,

evidence of heteroscedasticity, autocorrelated errors, or non-normal errors,

may be a further sign that a model is not correctly specified. Unit 8 also

shows how we can decide between different specifications of a particular

economic relationship. It demonstrates model selection using the Delta

Airlines data set, and also the SIM for IBM stock. Finally, Unit 8 includes a

summary of the course, to help with your revision for the final examination.

More advanced topics in econometrics are studied in the CeFiMS course

Econometric Analysis & Applications. These include more use of dummy

variables, dynamic models: lags and expectations; simultaneous equation

models; time series analysis: stationarity and nonstationarity, and forecasting.

Learning Outcomes

After studying this course you will be able to:

explain the principles of regression analysis

outline the assumptions of the classical normal linear regression model,

and discuss the significance of these assumptions

explain the method of ordinary least squares

produce and interpret plots of data

use the program Eviews to estimate a regression equation, and interpret

the results, for bivariate (two-variable) regression models and multiple

regression models

test hypotheses concerning model parameters

test joint hypotheses concerning more than one variable

discuss the consequences of multicollinearity, the methods for

identifying multicollinearity, and the techniques for dealing with it

explain what is meant by heteroscedasticity, and the consequences for

OLS estimators and prediction based on those estimators

assess the methods used to identify heteroscedasticity, including data

plots and more formal tests, and the various techniques to deal with

heteroscedasticity, including model transformations and estimation by

weighted least squares

explain autocorrelation, and discuss the consequences of autocorrelated

disturbances for the properties of OLS estimator and prediction based

on those estimators

outline and discuss the methods used to identify autocorrelated

disturbances, and what can done about it, including estimation by

generalised least squares

discuss the consequences of disturbance terms not being normally

distributed, tests for nonnormal disturbances, and methods to deal with

non-normal disturbances, including the use of dummy variables

discuss the consequences of specifying equations incorrectly

discuss the tests used to identify correct model specification, and

statistical criteria for choosing between models

use Eviews to conduct tests for heteroscedasticity, correlated

disturbances, nonnormal disturbances, functional form, and model

selection

use Eviews to estimate models in which the disturbance term is

assumed to be heteroscedastic or autocorrelated.

Study Materials

These course units are your central learning resource; they structure your

learning unit by unit. Each unit should be studied within a week. The course

units are designed in the expectation that studying the unit and the associated

readings in the textbook, and completing the exercises, will require 15 to 20

hours during the week.

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Textbook

In addition to the course units you must read the assigned sections from the

textbook, which is provided with your course materials:

Damodar N Gujarati and Dawn C Porter (2010) Essentials of

Econometrics, New York: McGraw-Hill.

We have specifically used this textbook because it provides an excellent userfriendly introduction to econometric theory and techniques. You will notice

that Gujarati and Porter present examples from finance, economics and

business, because it is an introduction to econometrics in general. The

examples and exercises in the course units are drawn entirely from finance.

In each course unit there is a section, called Study Guide, which leads you

through the relevant parts of the textbook, and helps you to read and

understand the analysis presented there. If, while studying this course, you

find you need some revision in basic probability and statistics, you may find

it useful to look at parts of Appendices A to D in the textbook, which cover

probability, probability distributions, and statistical inference.

Eviews

You have been provided with a copy of Eviews, Student Edition. This is the

econometrics software that you will use to do the exercises in the units, and

also the data analysis part of your assignments. The results presented in the

units are also from Eviews.

Instructions to install Eviews, and to register your copy of the software, are

included in the booklet that comes with the Eviews CD. (Your student edition

of Eviews will run for two years after installation, and you will be reminded

of this every time you open the program.)

You must register your copy of Eviews within 14 days of installing it on

your computer. If you do not register your copy within 14 days, the

software will stop working.

Eviews is very easy to use. Like any Windows program, you can operate it in

a number of ways:

there are drop-down menus

selecting an object and then right-clicking provides a menu of available

operations

double-clicking an object opens it

keyboard shortcuts work.

There is also the option to work with Commands; these are short statements

that inform the program what you wish to do, and once you have built up

your own vocabulary of useful Commands, this can be a very effective way

of working. You can also combine all of these ways of working with Eviews.

In each unit there are instructions to help you use Eviews to do the exercises.

In addition, Eviews includes help files, which you can read as pdf files, or

Centre for Financial and Management Studies

navigate via the Eviews help and search facility. Unit 1 includes a section

introducing Eviews.

Although easy to use, Eviews is a very powerful program. There are

advanced features that you will not use on this course, and you should not be

worried if you see these, either in the menus or the help files. The best advice

is to stay focused on the subject that is being studied in each unit, and to do

the exercises for the unit; this will reinforce your understanding and also

develop your confidence in using data and Eviews.

Exercises

As already noted, there are exercises in every unit. These require you to work

with Eviews and data files, available from the VLE in the course area for this

study session, to do your own econometric analysis. It is very important that

you attempt these exercises, and do not just look at the Answers at the end of

the units. Your understanding of the material you have studied in the unit will

be greatly improved if you do the exercises yourself. You will also develop

better understanding and confidence in using Eviews.

The Instructions that accompany the exercises in the first few units are quite

detailed, because they are intended to help you to start working with Eviews.

As the units progress, it is assumed that you will gradually develop your

understanding of the basic Eviews operations, and the Instructions then focus

more and more on what new operations are required to do the Exercises in

the units. If you find that you have forgotten how to do something, look back

at the Instructions in the early units, because the basic operations will be the

same.

Podcast

There is a podcast to accompany Econometric Principles & Data Analysis, in

which Dr Simms discusses the course with Pasquale Scaramozzino, Professor

of Economics at the Centre for Financial and Management Studies. The

podcast is 18:26 minutes in length. Timings in the podcast are indicated

below in brackets.

The podcast begins by explaining what the course does (from 0:28), and

provides advice on how to study econometrics (1:16). Dr Simms then

discusses how to get the most out of the materials (2:58), including the

examples and exercises, and Eviews, and explains the choice of the textbook,

Essentials of Econometrics. The podcast then addresses the question of how a

course in econometrics helps the understanding of financial markets (7:30).

The discussion here emphasises the importance of being able to interpret

regression results, and assessing the quality of those results; obtaining

estimated equations is not enough in itself. Following this, the podcast

considers how econometrics bridges the gap between theoretical financial

models and financial data (11:56), explaining how econometrics allows us to

test whether a particular theoretical model is appropriate or not, and how

qualities displayed by the data can be used to improve models.

10

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your assignments, you are also encouraged to apply the methods you are

learning to data sets with which you are familiar from your own working

environment (14:37), and to consider how the methods relate to your work or

areas of interest this may enable you to develop a more intuitive understanding of the econometric techniques. Finally (16:57) there is a summary of

the podcast discussion, and a consideration of the general approach to take to

your study of econometrics, especially if you are unfamiliar with statistics

and maths, or are returning to these subjects after a period of time.

We suggest that you listen to the podcast before you start studying Unit 1,

and perhaps again half-way through the course when you have finished Unit

4. It may also provide a helpful revision at the end of the course, reinforcing

your understanding of what you have learnt and providing an overall context.

We hope that you enjoy this course.

Assessment

Your performance on each course is assessed through two written assignments and one examination. The assignments are written after week four

and eight of the course session and the examination is written at a local

examination centre in October.

The assignment questions contain fairly detailed guidance about what is

required. All assignment answers are limited to 2,500 words and are marked

using marking guidelines. When you receive your grade it is accompanied by

comments on your paper, including advice about how you might improve,

and any clarifications about matters you may not have understood. These

comments are designed to help you master the subject and to improve your

skills as you progress through your programme.

The written examinations are unseen (you will only see the paper in the

exam centre) and written by hand, over a three-hour period. We advise that

you practise writing exams in these conditions as part of your examination

preparation, as it is not something you would normally do.

You are not allowed to take in books or notes to the exam room. This means

that you need to revise thoroughly in preparation for each exam. This is

especially important if you have completed the course in the early part of the

year, or in a previous year.

Preparing for Assignments and Exams

There is good advice on preparing for assignments and exams and writing them

in Sections 8.2 and 8.3 of Studying at a Distance by Talbot. We recommend

that you follow this advice.

The examinations you will sit are designed to evaluate your knowledge and

skills in the subjects you have studied: they are not designed to trick you. If

you have studied the course thoroughly, you will pass the exam.

11

Examination and assignment questions are set to test different knowledge and

skills. Sometimes a question will contain more than one part, each part

testing a different aspect of your skills and knowledge. You need to spot the

key words to know what is being asked of you. Here we categorise the types

of things that are asked for in assignments and exams, and the words used.

All the examples are from CeFiMS exam papers and assignment questions.

Definitions

Some questions mainly require you to show that you have learned some concepts, by

setting out their precise meaning. Such questions are likely to be preliminary and be

supplemented by more analytical questions. Generally Pass marks are awarded if the

answer only contains definitions. They will contain words such as:

Describe

Define

Examine

Distinguish between

Compare

Contrast

Write notes on

Outline

What is meant by

List

Reasoning

Other questions are designed to test your reasoning, by explaining cause and effect.

Convincing explanations generally carry additional marks to basic definitions. They will

include words such as:

Interpret

Explain

What conditions influence

What are the consequences of

What are the implications of

Judgment

Others ask you to make a judgment, perhaps of a policy or a course of action. They will

include words like:

Evaluate

Critically examine

Assess

Do you agree that

To what extent does

Calculation

Sometimes, you are asked to make a calculation, using a specified technique, where the

question begins:

Using any financial model you know

Calculate the standard deviation

Test whether

It is most likely that questions that ask you to make a calculation will also ask for an

application of the result, or an interpretation.

12

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Advice

Other questions ask you to provide advice in a particular situation. This applies to policy

papers where advice is asked in relation to a policy problem. Your advice should be based

on relevant principles and evidence of what actions are likely to be effective.

Advise

Provide advice on

Explain how you would advise

Critique

In many cases the question will include the word critically. This means that you are

expected to look at the question from at least two points of view, offering a critique of

each view and your judgment. You are expected to be critical of what you have read.

The questions may begin

Critically analyse

Critically consider

Critically assess

Critically discuss the argument that

Examine by argument

Questions that begin with discuss are similar they ask you to examine by argument, to

debate and give reasons for and against a variety of options, for example

Discuss this statement

Discuss the view that

Discuss the arguments and debates concerning

Details of the general definitions of what is expected in order to obtain a

particular grade are shown below. Remember: examiners will take account of

the fact that examination conditions are less conducive to polished work than

the conditions in which you write your assignments. These criteria are used

in grading all assignments and examinations. Note that as the criteria of each

grade rises, it accumulates the elements of the grade below. Assignments

awarded better marks will therefore have become comprehensive in both

their depth of core skills and advanced skills.

70% and above: Distinction As for the (60-69%) below plus:

with the conceptual issues

develops a sophisticated and intelligent argument

shows a rigorous use and a sophisticated understanding of relevant

source materials, balancing appropriately between factual detail and key

theoretical issues. Materials are evaluated directly and their assumptions

and arguments challenged and/or appraised

shows original thinking and a willingness to take risks

13

shows a detailed understanding of the major factual and/or theoretical

issues and directly engages with the relevant literature on the topic

develops a focussed and clear argument and articulates clearly and

convincingly a sustained train of logical thought

shows clear evidence of planning and appropriate choice of sources and

methodology

issues involved

shows evidence of planning and selection from appropriate sources,

demonstrates some knowledge of the literature

the text shows, in places, examples of a clear train of thought or argument

the text is introduced and concludes appropriately

issues, but with little development

misunderstandings are evident

shows some evidence of planning, although irrelevant/unrelated

material or arguments are included

question set

does not engage with the relevant literature or demonstrate a knowledge

of the key issues

contains clear conceptual or factual errors or misunderstandings

Your final examination will be very similar to the Specimen Exam Paper that

you received in your course materials. It will have the same structure and

style and the range of question will be comparable. We do not provide past

papers or model answers to papers. Our courses are continuously updated and

past papers will not be a reliable guide to current and future examinations.

The specimen exam paper is designed to be relevant to reflect the exam that

will be set on the current edition of the course.

Further information

The OSC will have documentation and information on each years examination registration and administration process. If you still have questions, both

academics and administrators are available to answer queries. The Regulations are also available at

, setting out

the rules by which exams are governed.

14

University of London

UNIVERSITY OF LONDON

MSc Examination

for External Students

15DFMC230|15DFMC330

Financial Economics

Finance

Specimen Examination

This is a specimen examination paper designed to show you the type of examination

you will have at the end of this course. The number of questions and the structure of

the examination will be the same, but the wording and requirements of each question

will be different.

The examination must be completed in three hours. Answer FOUR questions

Question One and then THREE other questions.

The examiners give equal weight to each question; therefore, you are advised to

distribute your time approximately equally over four questions.

Candidates may use their own electronic calculators in this examination

provided they cannot store text. The make and type of calculator MUST BE

STATED CLEARLY on the front of the answer book.

It must be attached to your answer book at the end of the examination.

You must answer Question One and then any other THREE questions.

All candidates must attempt Question 1.

1

Corporation using weekly data for the period from 1 September 2009 to 27

August 2012 is provided below. MSFT is the price of Microsoft Corporation

stock, C is an intercept and SP is the Standard & Poors 500 index.

Dependent Variable: DLOG(MSFT)

Method: Least Squares

Sample (adjusted): 8/09/2009 27/08/2012

Included observations: 156 after adjustments

Variable

Coefficient

Std. Error

t-Statistic

Prob.

C

DLOG(SP)

8.97E-05

0.867121

0.001650

0.067407

0.054359

12.86391

0.9567

0.0000

R-squared

Adjusted R-squared

S.E. of regression

Sum squared resid

Log likelihood

F-statistic

Prob(F-statistic)

0.517967

0.514837

0.020539

0.064962

385.7823

165.4801

0.000000

S.D. dependent var

Akaike info criterion

Schwarz criterion

Hannan-Quinn criter.

Durbin-Watson stat

0.001896

0.029487

-4.920286

-4.881185

-4.904405

2.177215

F-statistic

Obs*R-squared

0.821681

1.668569

Prob. F(2,152)

Prob. Chi-Square(2)

0.4416

0.4342

Equation: DLOGMSFT_C_DLOGSP

Specification: DLOG(MSFT) C DLOG(SP)

Omitted Variables: Squares of fitted values

t-statistic

F-statistic

Likelihood ratio

Value

2.219073

4.924283

4.941733

df

153

(1, 153)

1

Probability

0.0280

0.0280

0.0262

F-statistic

Obs*R-squared

Scaled explained SS

0.119699

0.243711

0.268446

Prob. F(2,153)

Prob. Chi-Square(2)

Prob. Chi-Square(2)

Page 2 of 5

0.8873

0.8853

0.8744

The calculated Jarque-Bera statistic for the least squares estimation of the single-index

model is 6.410157 (Prob. = 0.040556).

a

equation.

2

ii

Serial correlation

iii

Functional form

iv

Normality

Heteroscedasticity.

market return is 2 per cent (or 0.02). Is this forecast likely

to be accurate?

a

A consistent estimator

BLUE.

Answer all parts of this question. Using daily data for the period 1 March 2010 to

5 April 2012 (532 observations after adjustments), the following multi-index

model was estimated by ordinary least squares

Rt = 0.002 + 0.902RM ,t + 0.103RO,t + 0.001TSt + 0.002RPt

(

(0.002)

(0.003)

(3.1)

where

is the daily log return on the stock of the American energy

multinational ConocoPhillips,

is the daily log return on the NYSE

Composite Index,

is a

Test the following null hypotheses, explaining carefully in each case the null and

alternative hypotheses, the test statistic, degrees of freedom and the critical value

of the test statistic.

Page 3 of 5

a

b

is independent of

the coefficient on

and

are

both zero. For your information, the following equation

was also estimated using the same data and OLS

R 2 = 0.703

(3.2)

4

a

detected?

multicollinearity are relatively unimportant but the practical

consequences are potentially serious. Explain and discuss.

a

consequences for the validity of t and F tests.

Given

Yi = 1 + 2 X i + ui

( )

where var ui = 2 X i2

show how this model can be transformed so that the

disturbances have constant variance.

6

a

What is autocorrelation?

detecting autocorrelation.

d.

Yt = + X t + ut

ut = ut 1 + vt

| |<1

vt ~ IID 0, 2

explain the steps involved in obtaining CochraneOrcutt estimates of the unknown parameters.

Page 4 of 5

a

What is nonnormality?

estimators if the disturbance terms are not distributed

normally?

distributed normally?

distributed normally, what would you do?

a

ii

How might

i

ii

be detected?

END OF EXAMINATION

Page 5 of 5

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Analysis

Unit 1 An Introduction to

Econometrics and Regression

Analysis

Contents

1.1 What is Econometrics?

3

6

8

16

17

1.6 Summary

20

1.7 Eviews

21

1.8 Exercises

22

30

References

34

Unit Content

This unit provides an introduction to econometrics and regression analysis. It

outlines the differences between financial and economic theory and econometrics. The unit explains how stochastic relations between variables are

different to mathematical relations between variables. It explains how uncertainty may be modelled using a disturbance term. The unit introduces the

steps involved in an econometric investigation. Unit 1 also introduces you to

Eviews, the econometrics software you will be using for this course.

Learning Outcomes

After studying this unit, the readings, and the exercises, you will be able to

discuss and apply the following

the sample regression function

the disturbance (or error) term

the residual term

how to use Eviews to open pre-existing text files containing data

how to create and interpret a scatter plot

how to obtain summary statistics

how to create transformations of variables.

Chapter 1 The Nature and Scope of Econometrics, from Damodar Gujarati

and Dawn Porter (2010) Essentials of Econometrics, New York: McGrawHill/Irwin.

You will also be asked to read Chapter 1, A Quick Walk Through, in

Richard Startz (2009) Eviews Illustrated An Eviews Primer, Irvine California: Quantitative Micro Software. This file will be installed on your computer

when you install your copy of Eviews, and it is accessed via Help in Eviews.

Installation and registration of Eviews

Instructions for installing and registering your copy of the Eviews Student

Edition are in the booklet that comes with the Eviews CD. Instructions to

help you use Eviews to do the Exercises are included in section 1.8 of the

unit.

You must register your copy of Eviews. If you do not, it will stop working

14 days after installation.

Data Files for exercises

You will also be asked to work through exercises, and the data files you need

for these are available from the Online Study Centre, in the course area for

this study session.

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Welcome to this course. The aim of the course is to give you an introduction

to econometric methods or, more specifically, to linear regression, which is

the major statistical foundation of econometric work. This course requires

that you work with data; we hope you will find this interesting and useful,

and that you enjoy the course.

A principal concern of financial and economic theory is relations between

variables. In finance, you may have already studied many of these including

the capital asset pricing model; arbitrage pricing theory; efficient markets

hypothesis; optimal hedging ratios; bid-ask spreads. If you have studied

economics, you may be familiar with consumption, investment, and demand

for money functions; labour supply and labour demand functions; the expectations-augmented Phillips curve; and many others. You could, in fact, view the

whole of economic and finance theory as a set of relations among variables.

What is econometrics? Econometrics is concerned with quantifying financial

and economic relations. Econometrics is of use in providing numerical

estimates of the parameters involved and for testing hypotheses embodied in

the theoretical relationships. Broadly defined, econometrics is

the application of statistical and mathematical methods to the analysis

of economic data, with a purpose of giving empirical content to economic

theories and verifying them or refuting them.1

This definition is not the only possible one; in fact, in your textbook you will

come across a number of definitions, which each puts the emphasis slightly

differently. Common to all definitions, however, is the stress on the empirical

nature of econometric work: the subject matter of econometrics concerns the

interaction of, and confrontation between, theory and data in quantifying

economic and financial relationships.

Hence, econometrics is not purely a branch of mathematical economics or

mathematical finance. Indeed, mathematical finance or economics need not

have any empirical content at all. Econometrics makes use of mathematical

methods, but its emphasis is on empirical analysis. However, econometrics is

not just a box of tools to work with data. It requires, undoubtedly, a good

training in statistical techniques, but these techniques need to be situated in

an interactive process between theory and the data.

To give empirical content to financial and economic theories and to verify

them or refute them, the econometrician is confronted with three types of

problems, which are of lesser or no concern to the theorist.

First, in economic or financial theory we develop models out of a priori

reasoning based on relatively simple assumptions. To do this, we abstract

from secondary complications by assuming that other things remain equal

Maddala, GS (1992: 1)

variables. In effect, this method reduces to intellectual experimentation with

causal relations postulated by theory. For example, in demand theory we say

that the quantity demanded of a commodity (which is not an inferior good)

will fall if its price rises, other things being equal.

This method is fruitful in theory but, unfortunately, in empirical economics

and finance the scope for experimentation is severely limited. A researcher

cannot alter a commoditys price (or an assets price), holding other things

constant, in order to see what happens to demand. In general, financial and

economic data are not the outcome of experiments, but rather the product of

observational programmes of data gathering and collection in a world where

other things are never equal. In econometrics, therefore, we can only resort to

careful observation; the basic art of econometric work is more like unravelling a complex puzzle than setting up an experiment in a laboratory.

Second, we need to address the difference between deterministic and stochastic relationships. This issue arises in a different way in economics and in

finance. To make the point, we will explain the distinction between deterministic and stochastic relationships with an example from economics, and then

address it from a financial perspective.

In most economic theory we work with deterministic relationships between

economic variables. Take a simple example: the Keynesian consumption

function. In economic theory we assume that if we know the level of aggregate real income, consumption will be uniquely determined. That is, for each

value of aggregate real income there corresponds a given level of aggregate

consumption. This is a convenient device to enable us to work out exact

solutions for the interplay between variables within the confines of the

assumptions of an economic model.

In reality, however, we do not expect this relationship to be exact: it may be

stable perhaps, but it is surely imperfect. Hence, in econometric work we deal

with imperfect relationships between variables. It follows that our models

cannot be deterministic in nature. We investigate functions between variables

that we believe to be reasonably stable, on average, but there will always be a

degree of uncertainty about outcomes and conclusions derived from such a

model. Econometric modelling requires that we make explicit assumptions

about the character of these imperfections, or disturbances as they are more

commonly labelled. That is, we work with stochastic variables and we need

to model their stochastic nature. This is what makes us enter the areas of

probability theory and statistical inference and estimation.

How does the distinction between deterministic and stochastic relationships

arise in finance? Uncertainty is a fundamental element of risk, and the

measurement and management of risk are central aspects of finance. To

demonstrate this, consider the single-index model (which you will examine

and estimate in Unit 2). In the single-index market model the return on a

company stock is considered to be a function of three elements. There is a

fixed element which is specific to the company. There is also a deterministic

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relationship between the return on the company stock and the return on a

relevant market index: For each value of the return on the market index there

corresponds a given value for the return on the company stock. (This part of

the model captures the concept of market-determined risk.) In addition, the

return on the company stock is explained by a company-specific disturbance

or error. (The company-specific error captures the concept of companyspecific risk.) The single-index model includes the company-specific disturbance not just to make the model more realistic; it is included because we

specifically want to understand the stochastic nature of the return on the

company stock, and thus get a better understanding of the risk associated

with the stock.

Third, in financial and economic models we work with theoretical variables.

Econometrics, in contrast, deals with observed data. Obviously, there is a

certain correspondence between them; data collection is inspired by theoretical frameworks. For example, national income account data were constructed

after the ascendancy of Keynesian economics, which concerns the analysis of

theoretical aggregates such as output, demand, employment and the price

level. However, observed variables do not fully correspond to their theoretical equivalents because of errors in measurement, conceptualisation and

coverage. This is usually less of a problem for econometrics applied in a

financial context than it is for economics. Financial data on asset prices, for

example, is more closely related to the actual transactions taking place, so

measurement error is less likely. However, we should be aware that movements in financial data may be the result of the particular operating or

reporting features of a market, say, in addition to the desired trading activities

of the participants that our theories suggest. In econometrics we need to be

aware of the nature of the observed data and its implications for investigating

theoretical propositions.

These three elements:

the fact that we cannot hold other things constant in empirical analysis

the imperfect nature of relationships between variables and

the discrepancies between theoretical variables and observed data

give econometrics its distinctive flavour. We cannot move straight from a

financial or an economic model (as formulated by theory) to the data before

we come to terms with these issues. Econometric methods, therefore, aim to

address these issues so as to enable us to engage in meaningful investigation

of economic and financial theories.

Note that we talk about methods and, hence, emphasise the need for methodological groundwork to approach these types of problems. There are no hard

and fast rules to deal with them. There is not a box of magic tricks, which

always work and give us straight answers. Rather, we are left with the task of

studying methodological approaches to issues, which are complex, varied,

but challenging.

This course, Econometric Principles and Data Analysis, deals with regression analysis. Why this focus? We have seen that, in empirical analysis, our

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data never behave exactly as our theoretical models would lead us to believe.

Theoretical models are useful abstractions, which provide the applied researcher with analytical handles to make sense of an often bewildering

economic and financial reality. Good theory allows us to search for patterns

within the data and to give meaning to such patterns. But we need to disentangle these patterns in the middle of a great deal of chance variations and

uncertainties of outcomes, which our theories could not possibly aim to

explain. Regression analysis provides us with an analytical framework to

handle relations between variables, especially between variables whose

relation is imperfect.

Indeed, regression analysis seeks to establish statistical regularities among

observed variables. To do this, we need to come to terms with the uncertainty

inherent in the behaviour of our data. For this, we need to equip ourselves

with statistical theory which allows us to model uncertainty as part of

relations between variables. This is the purpose of this course, Econometric

Principles and Data Analysis, of which this is the first unit.

The following are the main points to remember.

In econometrics we pose the question how to confront theory with data

so as to quantify our financial and economic relationships, to verify

them or to refute them.

In practice, we deal with imperfect relationships between variables

which we can only observe (with errors and, often, through proxies) in

a context which we do not control (we cannot experiment).

It follows that we can only resort to careful observation of complex

phenomena in order to check our theories against the empirical

evidence. This raises questions about econometric methods:

methodological issues about gathering and evaluating such empirical

evidence. Whatever conclusions we draw in such a context will always

involve a considerable degree of uncertainty, even if our models are

correctly specified. For this reason, we resort to probability theory and

statistical inference to deal with uncertainty in assessing outcomes and

conclusions of empirical analysis.

Since our concern is primarily with investigating relations between

variables, regression analysis constitutes the major tool of statistical

analysis in econometrics.

It is quite possible that you are worried about studying econometrics. After

all, it involves working with mathematics and statistics, and you may feel

that this is not one of your greatest strengths. Alternatively, you may be one

of those who welcome this greater emphasis on mathematics and statistics.

Whichever view you hold, it is useful to be aware of a particular problem that

invariably arises when studying econometrics.

Teaching and learning econometrics almost inevitably involves a preoccupation with technical details: definitions of technical terms, mathematical

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in technical notation. This is normal and, indeed, necessary. But this preoccupation with technical detail often implies that students lose a perspective

on What is it all about? or Why are we doing this? That is, there is a need

to keep a focus on the kind of basic questions, uncluttered by notation and

technical detail, which give substance to the subsequent technical exercises.

We need to get an overview of a problem before we explore it aided by our

technical skills. We need to know the simple questions and intuitive insights

which often prompted elaborate technical enquiries.

For this reason, the course texts will always start with a section on ideas or

issues.

The purpose of this is to explain in simple words, with the minimum of

technical notation, the basic substance of the unit. The aim is to give you an

intuitive feel for the subject matter before going into technical detail. If you

feel that mathematics and statistics are not your strongest subjects, this

regular section will give you a few analytical handles to hold on to when

studying relevant techniques.

But, alternatively, if you are confident with mathematics and statistics, it is

important not to skip this section. Technical expertise is not just a question of

ones ability to work out the steps in a technical procedure or to understand a

mathematical derivation. It also involves understanding the type of questions

a technique tries to address as well as the assumptions on which it is based.

Good technical expertise is more than understanding a set of technical skills

(narrowly defined); it also involves analytical insights and judgement of the

appropriateness of particular technical procedures in specific conditions.

The section on ideas or issues will be self-contained; no references will be

made to reading parts of the assigned textbook. Take your time to read it

carefully, and to reflect whether you understand the type of questions which

will be addressed subsequently in technical detail: get familiar with the

forest before you start looking at the trees. In other words, use this section to

provide you with the analytical handles to facilitate the study of the relevant

techniques.

Next, the course texts will have a reading section, or Study Guide, which

guides your study of the textbook, Gujarati and Porters Essentials of

Econometrics. The purpose of these sections is to structure your reading of

the textbook as well as to provide brief comments, elaborations and crossreferences to exercises and examples, and to suggest short cuts in coping

with the material.

The section after that will normally contain one example. This section has

two purposes. Firstly, the example highlights a specific aspect of the topic

under study in a particular unit of the course. Secondly, the example also tries

to give you a bit of the flavour of econometrics in action. Generally, you will

be asked to participate in the analysis of the example. The examples aim to

highlight the links between economic theory and empirical investigation, and

try to illustrate the problems that can arise when we work with real data.

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The next section will provide a brief summary of the main issues raised in the

unit. This will be followed by a section of exercises. It is most important that

you work through all of these exercises. The exercises have three purposes:

to check your understanding of basic concepts and ideas

to verify your ability to use technical procedures in practice and

to develop your skills in interpreting the results of empirical analysis.

The final section of the units will include brief answers to these exercises,

which you should not look at until after youve worked out the answers for

yourself!

You will be using Eviews to do the econometric exercises, and this unit

has an additional section describing this program, which is a widely used

econometrics software package. Instructions to use Eviews will accompany

the exercises, where necessary.

This basic structure of the course texts will be maintained throughout your

study of this course. The section on ideas or issues gives you an overview of

the topic of the unit, using non-technical language. The core of the course

text is the study guide. This guides you through your reading of the textbook

and refers you to the exercises whenever appropriate. The example in each

unit demonstrates a problem dealt with in the course material using real data.

By using examples drawn from areas of finance, using real data, this section

also aims to provide cross-references to the theory courses.

The summary draws your attention to the main points made in the unit. The

exercises are important and you should always work through them. The

exercises will help you to understand the course material. In addition, the

knowledge and experience you gain from doing the exercises will help you to

write assignments and answer examination questions.

The remainder of this unit will deal with the introduction to regression

analysis. As you will see, it is structured along the pattern outlined above.

Regression is the main statistical tool of econometrics. What is regression?

Broadly speaking,

regression methods bring out relations between variables, especially

between variables whose relations are imperfect in that we do not have

one Y for each X.2

An example may help. Consider the relation between corporate bond spreads

(this is the Y-variable) and the earnings before interest of companies (this is

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the X-variable). The spread for a corporate bond is the difference between the

interest rate on the corporate bond and the interest rate on government bonds

of equivalent maturity. Interest rates on corporate bonds are higher than those

on government bonds to reflect expected default loss, different tax treatments

and the riskier return associated with corporate bonds. We would expect that

a company with higher earnings before interest would be less likely to

default, and hence the bond spread for that company would be lower.

Hence, we expect that, on average, the corporate bond spread is inversely

related to earnings before interest. But we do not expect this relation to be

perfect. That is, if we were to sample 10 companies with identical earnings

before interest (i.e. equal X-values), we would not expect to get 10 identical

corporate spreads (the Y-values). Differences between the markets in which

the firms operate, in management and in other financial variables (e.g.

coupon rates, coverage ratios) will account for differences in bond spreads.

But, importantly, it is still valid to say that, on average, the bond spread

declines as the level of earnings before interest increases. That is what

Mosteller and Tukey (quoted above), mean when they say that a relation

exists between two variables but that it is imperfect in that we do not have

one Y for each X.

This leads us to the discussion of the concept of regression. Regression

methods aim to bring out this average relation between a dependent variable

on the one hand and one or more independent variables on the other. In our

example the average inverse relation between the bond spread and the level

of earnings before interest is the regression of the former variable on the

latter. But, obviously, there will be variation in how markets view the bonds

of individual companies that have broadly the same earnings.

In fact, anyone familiar with data analysis knows very well that we can

always take an average of one or another aspect of a number of individuals,

but we rarely meet the average individual. So it is also with regression as an

average relation: individual observations will rarely conform to the average

relationship between Y and X. Hence, in regression analysis we seek to

establish statistical regularities in the middle of a great deal of chance variation and uncertainty in outcomes. For this reason, regression methods

involve statistical modelling of the chance variation in the data as well as of

the average relationship.

In summary, we hope that our model captures the basic structure of interaction between economic and financial variables, and we expect that the

behavioural relations are reasonably stable, but imperfect. At most, we expect

these relations to hold on average. In other words, we seek to discover

structure and regularity within data in the middle of a great deal of uncertainty in outcomes. It is similar to separating sound from noise when trying to

listen to a badly tuned radio.

Therefore, a regression model embraces two components:

a regression line (which defines the basic structure) and

disturbances.

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Firstly, the regression line models the average relation between the dependent variable and its explanatory variable(s). To do this we make an explicit

assumption about the shape of the regression curve: linear, quadratic, exponential, etc.

Secondly, we recognise the existence of chance fluctuations due to a multitude of factors beyond our control. We model this element of uncertainty (the

noise) in the form of a disturbance term, which constitutes an integral part of

our model. This disturbance term is a catch all for all the variables considered as irrelevant for the purpose of the model as well as all unforeseen

events.3 It is a random variable which we cannot observe or measure in

practice.

Sometimes we are not interested in the disturbance term as a variable in its

own right, but we are interested in understanding how the disturbance term

affects our attempts to investigate the behavioural relations in the model. In

other circumstances we might be particularly interested in the properties of

the disturbance term, if it reflects an element of uncertainty and risk that we

are trying to understand.

In both cases, we need to model the probabilistic nature of the disturbance

term. In other words, we try to model the character of the uncertainty inherent

in the data. This is no easy task, and we always need to think carefully whether

the assumptions we make about the nature of these chance variations are

indeed appropriate for the type of issue under study. Not surprisingly, a great

deal of econometric theory and practice is concerned with these assumptions.

It is useful to express these important ideas a little more formally. We start

with the population regression function. This is a theoretical construct, which

contains a hypothesis about how the data are generated. For the simple, twovariable linear regression model we have

(1.1)

in which Y is the dependent variable, X is the explanatory variable sometimes called the regressor, u is the disturbance term, and the subscript i

indicates the ith observation. 1 and 2 are the regression parameters; 1 is the

intercept, or constant, and 2 is the slope coefficient. Typically, the variables

Y and X are observable, the disturbance is not observable, and the parameters

1 and 2 are unknown. The presence of the random disturbance means that Y

is stochastic; for each value of the explanatory variable, X, there is a distribution of Y-values.

In this explanation of regression we will continue to use the i subscript to

indicate the ith observation. In many financial applications we will examine

series that vary over time, and it will be more meaningful to use a t subscript

to indicate that the observation refers to period t. This will allow us to use

t 1 to refer to the previous period, etc.

10

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The population regression function may be viewed as comprising two components: a systematic element represented by a straight line which shows the

statistical dependence of Y on X; and a random, or stochastic, element represented by the disturbance (error) term u. The systematic element can be

expressed as

(1.2)

that is, the average (or expected), value of Y conditional on a given value of X

is a linear function of X or, more concisely, the average value of Y for each

value of X. That is, the population regression function joins the conditional

means of Y. The disturbance term, u, is the focus of much attention. It accounts for the variation in Y around the population regression line. In Unit 2

you will learn about the important assumptions made about u.

A prime objective of econometrics is to quantify the unknown parameters

and . Using a sample of data on Y and X, we obtain estimates,

of the unknown population parameters.4

and

(1.3)

in which

and

are random variables (the particular estimates obtained

depend on the particular sample of data on Y and X used) that differ from the

population parameters 1 and 2. Consequently, the sample residuals, ei,

differ from the unknown population disturbances, ui. Whereas the disturbance term accounts for the variation in Y around the population regression

line, the residuals give us the vertical deviations of the observed Y-values

from the estimated regression line derived from sample data. The residuals,

therefore, are not identical with the disturbances, but clearly they do tell a

story, which may enable us to assess whether or not our assumptions about

the behaviour of the disturbances seem reasonable. How to analyse the story

or stories told by residuals is a matter we address in the second half of the

course.

The predicted value of the dependent variable is given by the sample

regression line

(1.4)

in which

, that is the estimator of the population conditional mean. The

Notice that we focus on the linear regression model. That is, we are concerned with a model that is linear in the parameters to be estimated. The

model

11

(1.5)

is linear in 1 and 2. With the sample regression line

(1.6)

is the predicted value of Y (in units of Y) if X = 0. Also,

; this

unit increase in

Now consider the model (in which e stands for exponential, not the residual)

(1.7)

which, after taking natural logarithms of both sides of the relation, can be

written as

or

(1.8)

where 1 = ln.

This model is also linear in the parameters to be estimated, 1 and 2. We

may view the model as

(1.9)

where

and

. This model is known by a number of different

names logarithmic, double log, log-log, log linear, and constant elasticity

and is frequently used in applied work when it characterises the form of the

functional relationship between the variables. It has the useful property that the

slope coefficient measures the elasticity of Y with respect to X because

(1.10)

With this logarithmic model, a 1 per cent increase in X results in a 2 per cent

increase in Y. Note that here we mean a 1 per cent proportionate increase in X,

not that X increases by 100 basis points (1 basis point equals 0.01 per cent).

Although regression analysis is related to correlation analysis, conceptually

these two types of analysis are very different. The main aim of correlation

analysis is to measure the degree of linear association between two variables,

and this is summarised by a sample statistic, the correlation coefficient. The

two variables are treated symmetrically. Both are considered random; there is

no distinction between dependent and explanatory variables, and no implication of causality in a particular direction from one variable to the other.

Regression analysis, however, can incorporate relationships between two or

more variables and the variables are not treated symmetrically. The dependent and explanatory variables are carefully distinguished. The former is

12

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random and the latter is often assumed to take the same values in different

samples often referred to as fixed in repeated samples. The underlying

economic or financial theory implies that X, an explanatory variable, causes

Y, the dependent variable. Moreover, with more than one explanatory variable, regression analysis quantifies the influence of each explanatory variable

on the dependent variable.

Regression methods allow us to investigate associations between variables,

but the inspiration as to which relations to investigate obviously comes

from theory. We are not interested in detecting spurious (false or bogus)

associations between variables. Indeed, relations have to be meaningful

and whether they are, or not, depends on theoretical argument.

This does not mean, however, that data play only a passive role in economic

and financial analysis. The role of data is not just to provide numerical

support to theoretical arguments. Empirical investigation is an active part of

theoretical analysis in as much as it is concerned with testing theoretical

hypotheses against the data as well as, in many instances, providing clues and

hints towards new avenues of theoretical enquiry. This requires that we

translate our theoretical insights into empirically testable hypotheses, which

we can investigate with observed data. Hence, the process between theory

and the data is interactive: we must continuously investigate the empirical

content of our theoretical propositions in order to test our theories, and pick

up signals from the data that enable us to improve our theoretical insights.

Most of the data we use in applied economic analysis are not obtained

through experimentation but are the result of observational programmes.

National income accounts, agricultural and industrial surveys, financial

accounts, employment surveys, population census data, household budget

surveys and price and income data, among others, are collected by various

statistical offices. They are partial records of what happens; they are not the

outcome of experiments. As we have noted, finance data more closely relate

to actual transactions, but, like economic data, they are not the outcome of

experiment.

The character of this economic and financial data makes the work of an

econometrician quite different from that of a psychologist or an agricultural

scientist. In the latter cases, experiments play a prominent role in analysis,

and much of the emphasis in research work is put on the careful design of

experiments in order to be able to single out effect and response between two

variables while controlling for the influence of other variables (that is, by

holding them constant). In economics and finance, the scope for experimentation is very limited.

We cannot change the price of a stock, holding all other prices constant,

merely to see what would happen in its demand. In theory, we do just that by

assuming that other things are equal and postulating cause and effect

between the remaining variables. In empirical analysis, however, other things

13

are never equal, and we can only carefully observe the behaviour of economic agents from survey data. As you will see in subsequent units, multiple

regression techniques allow us to account for the influence of other variables while investigating the interaction between two key variables, but this

is not the same as holding other variables constant.

The econometrician, therefore, needs to be, above all, a careful observer.

Empirical analysis in economics and in finance allows us to search for

patterns in our data through careful observation backed by theoretical understanding; but experimentation is not really an option we have available,

because we do not have control over the overall context that determines the

movement of our variables.

In analysing data, we should follow the advice ascribed to Darwin. It is

obviously pleasing if the empirical evidence seems to support our theoretical

hypotheses, but more importantly we should take special note of any

signs given by the data that go against our arguments. That is, we should not

approach our data merely to confirm answers to well-defined questions

derived from theoretical argument, but we should also look out for hints from

the data about what we do not know that is, about questions that we have

not confronted yet. A careful observer uses data not just to confirm his or her

theories, but also to get clues from empirical analysis to advance ones

theoretical grasp of a problem. It is primarily this aspect that enables data to

be used to play an active part in the process of analysis.

Much analysis in financial econometrics is concerned with rates of return,

including returns on shares, stock indices, commodities and exchange rates.

Therefore, at this point in Unit 1 it might be useful, briefly, to refresh your

understanding of returns. In your study of finance or risk management, or in

your work, you may already be familiar with arithmetic and logarithmic rates

of return. For example, logarithmic returns are used especially in the BlackScholes-Merton model of options pricing.

First consider arithmetic returns. Suppose we have a stock that is worth $1000

at the start of the year and $1050 at the end of the year. Ignoring any dividends, we say that the arithmetic or simple or proportionate rate of return is

r=

1000

It is the increase (or decrease) in value, divided by the original value. Put

another way, if the stock, initially valued at $1000, benefits from a 5% return

over the year, then the value at the end of the year will be

In general terms, if the price at the start of the year is

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P1 = P0 1 + r

(1.11)

r=

(P P ) .

1

(1.12)

P0

to conduct a short thought exercise. In the previous example, we can think of

the return, r, being applied to the asset once a year (if it makes more sense to

you, think of r as the interest paid on a sum of money in a bank account, paid

annually). Now suppose that this growth rate is applied at more times through

the year, but the rate of return at each point of the year is adjusted to take

account of the increased number of times the return is experienced. Continuing the 5% example, if the return is applied twice in a year, the stock will

benefit from a return of 2.5% in the first six months, and another 2.5% in the

second six months. After six months the asset price will be

0.05

= 1025

1000 1 +

2

2

0.05

P1 = 1000 1 +

= 1050.625

2

The growth of 0.025 or 2.5% in the first six months also benefits from

growth of 0.025 or 2.5% in the second six months. This is known as compounding, and it explains why the value of the stock at the end of the year is

more than 1050. In general, if the return is applied m times in a year, the asset

price at the end of the year will be

(1.13)

We could increase m to 12 or 365, to see what the price of the stock would be

if the return were applied (or compounded) every month or every day. We

could also ask what continuous compounding would look like. Continuous

compounding or continuous growth is when the return is experienced an

infinite number of times in the year, but the return at each point of the year is

infinitesimally small. That is, what happens if m approaches infinity? You

can see that

will approach zero, but the expression in brackets will be

raised to the power infinity. The limit of this expression when m approaches

infinity is , where e is equal to 2.718 (to three decimal places). The value e

is known as the base of natural logarithms.

Going back to our example, if the stock is initially valued at $1000, and

experiences continuous growth at an annual rate of 5 per cent (or 0.05), it

will be valued at the end of the year at

1000e0.05 = 1051.27

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(1.14)

We can calculate the logarithmic rate of return (also known as the continuously compounded return) as

(1.15)

where ln represents the natural logarithm, or the logarithm to base e. To see

this, take natural logarithms of the end-of-year continuously compounded

stock price

( )

( )

ln P1 = ln P0 er = ln P0 + ln er = ln P0 + r ln e = ln P0 + r

since the natural log of e is 1.

In one of the exercises at the end of the unit you will show that arithmetic

returns are not symmetric: if a stock valued at $1000 experiences first a

return of minus 10% and then a return of 10%, it will not be equal to $1000

at the end. On the other hand, you will find out that logarithmic returns are

symmetric. You will also use Eviews to calculate arithmetic and log returns.

Note that in this course, returns will always be calculated as decimals, so a

return of 5%, for example, will be shown in Eviews and in any other calculations as 0.05. It will not be shown as 5.00. A consistent approach is

necessary, and the decimal representation makes calculations a little bit

simpler.

First, let us consider notation. In econometrics, population parameters and

their estimators are normally denoted by Greek letters, and the course units

follow this standard practice. The textbook, however, differs. Table 1.1

summarises the principal difference and similarities in notation.

Table 1.1

Notation

Course units

Textbook

Population parameters

B1, B2

Their estimators

Disturbances

ui

ei

N

b1, b2

ui

ei

n

Residuals

Number of observations

For this unit you are requested to study Chapter 1 of the course textbook,

Gujarati and Porters Essentials of Econometrics. This chapter has three main

sections, the first two of these address two questions: What is econometrics?

and Why study econometrics? These sections are straightforward, and you

can read them relatively quickly.

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Reading

Dawn Porter (2010)

Essentials of

Econometrics, sections

1.1 and 1.2 Chapter 1

The Nature and Scope

of Econometrics.

Please now read sections 1.1 and 1.2, pages 13, of Gujarati and Porters textbook.

The next section of the textbook is particularly important. It sets out a methodology of econometrics; that is, it explains how you might proceed in a

typical econometric study. Gujarati and Porter identify eight steps associated

with the typical econometric investigation. All of these eight steps are

discussed in the context of a model of labour force participation. Although

this particular example is drawn from economics, you will see that the steps

described are relevant to econometric investigation in any discipline, including finance. You will see that in this example the data are plotted in a scatter

diagram (often called a scatter plot). This can be helpful in giving a simple

illustration of the relationship among two variables in the data. Notice also

the central role of estimating the parameters of the model and so obtaining

the estimated regression line.

The notation in the textbook differs slightly from the notation in these units.

In the context of the model of labour force participation, Gujarati and Porter

define CLFPR as the civilian labour force participation rate and CUNR as the

civilian unemployment rate and write the population regression function as

(1.16)

which is comparable to our population regression function

.

(1.1)

Reading

Please read carefully section 1.3, pages 312, of the textbook.

Dawn Porter (2010)

Essentials of

Econometrics, Chapter

1, Section 1.3 The

Methodology of

Econometrics.

Market

The eight steps explained in the textbook are typical of any econometric

investigation and you are now going to follow them in another example,

examining the hypothesis of efficiency in the foreign exchange market.

Statement of the Theory

Efficiency in markets is a central assumption of many theories in finance and

economics. The efficient markets hypothesis states that current prices will

reflect all available information. Applied in the exchange rate market, the

hypothesis suggests that the forward exchange rate is the markets expectation of the spot rate that will exist in the future. Any difference between the

forward rate formed in the previous period and the spot rate in the current

period should be entirely random and unpredictable. In addition, there should

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be a close relation between the forward rate from the previous period and the

spot rate in the current period.

Collection of Data

The data to be used are monthly time series data for the spot exchange rate

between UK sterling and the US dollar, measured in dollars per pound, and

the one-month-ahead forward exchange rate, also measured in dollars per

pound. The data cover the period January 1982 to January 2012. The source

of the data is www.bankofengland.co.uk.

Figure 1.1 shows a scatter plot of the current spot rate, S, against the forward

rate available in the previous month, F(1). The figure suggests that the

relationship is upward sloping and it seems to be reasonably linear.

Figure 1.1 Scatter plot of S (current spot rate) on F(1) (previous forward rate),

19822012

Y

280,000

240,000

200,000

160,000

120,000

80,000

100,000

350,000

X

The relation between the current spot rate and the forward rate in the previous month in its simplest form can be presented as a linear relationship

(1.17)

where

is the spot rate in period t;

is the one-month ahead forward rate

available in the previous period,

; 1 is a constant (or intercept) and 2 is

the slope of the function. For the efficient markets hypothesis to hold we

would expect

and 2 = 1 .

Econometric Model of the Theory

The econometric model is stochastic. It includes a random error,

, which

captures the influence of all the other variables that may influence the spot

exchange rate.

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(1.18)

The disturbance term

function there is a unique value of the spot rate for each value of the

previous forward rate. With the econometric model, we have a relation in

which there is no longer a unique value of the spot rate for each value of the

previous forward rate. In the context of the efficient markets hypothesis the

disturbance term has additional interpretation: according to the hypothesis,

any difference between the previous forward rate and the current spot rate

should be random and unpredictable.

Parameter Estimation

Using these data and Eviews, it is possible to obtain estimates of the parameters 1 and 2 to obtain the average relationship between

and

. The

problem of estimating the coefficients of the population regression function

will be discussed in Unit 2. The function estimated with our data is

(1.19)

and this represents the average relationship between the spot exchange rate

and the previous forward exchange rate. The estimated value of 1 , 1 , is

0.064 and the estimated value of , is 0.962. Consequently if the for2

ward exchange rate increases by 0.01, the spot rate in the next period

increases on average by 0.00962. The interpretation of the intercept is not as

straightforward. Mechanical interpretation of the estimate tells us that the

spot exchange rate is $0.064 per pound if the forward exchange rate in the

previous period is zero. On its own, this statement is without meaning.

However, in the context of the efficient markets hypothesis, we may ask if

the estimated constant indicates there is a systematic and predictable difference between the average spot rate in a period, and the spot rate expected by

the markets in the previous period (as measured by the forward rate), and

whether this difference could be exploited by traders.

Checking for Model Adequacy

How appropriate is the model? Should some other variable(s) be included,

and is the functional form correct? For example, research on the efficient

markets hypothesis in exchange markets has used the natural logarithms of

the spot and forward exchange rates. Alternatively, researchers have focussed on the rates of return on the spot and forward exchange rates, and not

the levels. Researchers have also examined if the difference between the

spot rate and the previous forward rate (

) can be explained by the

difference that was observed in earlier periods. With the relevant data, we

could estimate various specifications of the relation between spot and

forward exchange rates. How do we choose the best model? This is discussed in Unit 8.

19

Do the results conform to the theory of the efficient markets hypothesis?

With our theory we expect 1 = 0 and 2 = 1 . Is each of these hypotheses

supported by the results? Our estimates would appear to be consistent with

what we expected to obtain, but we should conduct formal tests to check that

this is actually the case. Formal tests of hypotheses will be discussed in

Unit 3.

Prediction

How might the estimated model be used for prediction? We could use it to

predict what the spot exchange rate would be if the forward rate in the

previous period was a particular amount. Suppose the forward exchange rate

in the previous month was $1.50 per 1.00. The predicted level of the spot

rate is

St = 0.064 + 0.962 1.50 .

(1.20)

Therefore

.

That is, the spot rate is predicted to be $1.507 per 1.00 if the forward rate in

the previous period is $1.50 per 1.00.

1.6 Summary

In this unit we introduced some basic ideas on econometrics and regression

analysis. The most important points to remember are the following:

Econometrics is the application of statistical and mathematical methods

to the analysis of data, with a purpose of giving empirical content to

economic and financial theories and verifying them or refuting them.

Three elements account for the difference in the work of an econometrician

in relation to an economic or finance theorist:

1 the fact that we cannot hold other things constant in empirical analysis

2 the imperfect nature of relations between variables which makes the

conclusions and outcomes of empirical analysis always contain a

considerable element of uncertainty, and

3 the discrepancy between theoretical variables and observed data in terms

of coverage and precision of measurement.

Regression analysis constitutes the statistical foundation of econometric

theory and practice. Its aim is to bring out relations between variables,

especially between variables whose relation is subject to chance variation and

to the influence of unforeseen events.

Regression involves finding an average line, which summarises the relation

of Y on X among considerable chance variation and uncertainty of outcome.

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analysis is formally modelled through the introduction of a disturbance term

in our behavioural equations. This is a stochastic variable, which we cannot

observe in practice. However, the residuals of a sample regression function

may provide us with an indication as to the behaviour of these unknown

disturbances.

Regression allows us to investigate the association between variables, but this

does not imply any causality between them. To establish causality we need to

use economic and finance theory.

In empirical work in economics and finance we cannot use experimentation.

Econometric analysis, therefore, is based on careful observation of data

drawn from a context that we do not control.

In terms of practical skills, this unit requires that:

you are familiar with the scatter plot as a practical tool of empirical

analysis

you know how to enter data in Eviews by opening a pre-existing text

file

you know the Eviews commands or operations to obtain a summary of

descriptive statistics of a variable, make a scatter plot, create logarithms

of variables, and create rates of return.

1.7 Eviews

If you have not done so already, now would be a good time to install and

register your copy of the Eviews Student Edition. Instructions for installation

and registration are in the booklet that comes with the Eviews CD.

It is important to remember that you must register your copy of Eviews.

If you do not, it will stop working 14 days after installation!

Reading

Please now quickly read Chapter 1, A Quick Walk Through, in Eviews Illustrated An

Eviews Primer. You can access this in Eviews via the Help button on the top toolbar. This

chapter provides a quick overview of using Eviews; it also follows the steps described in

this unit and in the reading from Gujarati and Porter. Do not worry about the detail of

this reading at this stage it is intended to give you a quick idea of some of the things

you will be learning in these units.

Eviews Illustrated,

Chapter 1 A Quick

Walk Through.

Eviews is a very easy package to use. Many of the mouse and keyboard

operations that you would use in other Windows packages also work in

Eviews.

With the Exercises in the units there are instructions to help you work with

Eviews. To begin with, the instructions are quite detailed. However, as you

move on to later units, you should become familiar with the basic operations

in Eviews, and the instructions will concentrate on new information required

21

for each set of exercises. Therefore, if you forget how to do something, refer

back to the instructions in the earlier units, (or use Help in Eviews).

These instructions are specifically related to the exercises, and they do not

provide an overall guide to Eviews. This is because there is excellent, comprehensive Help provided by Eviews. You can access the Eviews Help

information in a number of ways. Perhaps the easiest is to go to Help on the

top toolbar, then Eviews Help Topics...

In the Eviews Help Topics you can look through the Contents, use an A-Z

Index, or use the Search facility. Eviews Help Topics... links to the Users

Guide I, Users Guide II, and the Command Reference (more on Commands

later). If you prefer, you can access these pdf files directly, again via the Help

button in Eviews. The pdf file Users Guide I includes the contents pages for

Users Guide I and Users Guide II, and the entries in the contents pages link

to the relevant pages in the files. You can also search within the pdf files.

Although easy to use, Eviews is a very powerful econometrics package. It has

many features that you will not use in this course, so dont worry if you see

methods or notation in the Help files that are not covered in this course.

Everything you need to understand is described in the course units, readings,

and exercises.

Lastly, answers to the exercises are provided at the end of the unit, for you to

check you have understood and done the exercises correctly. If you do the

exercises yourself, you will develop a good understanding of the course

materials, and the models and methods described in the units; you will also

become more confident using these methods and using Eviews.

Do not go straight to the answers!

1.8 Exercises

1 What is the critical distinction between econometrics and (i) economic or

finance theory and (ii) mathematical finance and economics?

2 The file C230C330_U1_Q2.txt contains the data used in the example in

the unit. It is monthly time series data on the exchange rate between the

US dollar and UK sterling, measured in dollars per pound. The current

spot exchange rate is denoted S, and the one-month ahead forward rate is

denoted F. The data relate to the period January 1982 to January 2012, and

the source of the data is www.bankofengland.co.uk.

a. Produce a plot of the spot rate, S, over time. Comment on the plot. Are

there any noteworthy episodes?

b. Produce a scatter plot of the current spot rate, , on the vertical axis

and the forward rate available in the previous period,

, on the

horizontal axis. Comment on the scatter plot; would a linear regression

seem appropriate?

c. Produce a plot over time of the difference between the current spot rate

and the forward rate available in the previous period,

.

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Comment on the plot; are there periods when the current spot rate

differs noticeably from what is predicted by the previous forward rate?

d. Produce a scatter plot with the difference between the current spot rate

, on the

and the forward rate available in the previous period,

vertical axis, and this difference one month ago,

, on the

horizontal axis. Comment on the scatter plot; does there appear to be a

relationship between the two transformed series?

Data files

The file C230C330_U1_Q2.txt is a tab separated text file. Eviews can open

data stored in a wide variety of different sorts of file, including text files and

Excel files. Text files are very basic, they are readable by many applications,

(you could open them in Excel, in Eviews, and even in Word), and they are

robust to upgrades in software. For these reasons, the data files for the course

are all provided in the simplest (and most accessible) format, text files.

The first line of C230C330_U1_Q2.txt contains the labels for the three columns: Date, S and F. (Please note that in Eviews certain names are reserved

and cannot be used as names for data series. For example, C is reserved for the

constant term. If you attempt to import a variable named C, Eviews will

rename it C01.) The next row contains the data for the first observation:

31-Jan-82, 1.8835 and 1.8837, separated by tabs. Row 3 is 28-Feb-82, 1.8225,

1.8237, and so on. The final row contains 31-Jan-12, 1.578 and 1.5777. A

useful tip when working with data is to note the first and last observations for

your variables, so that you can check files have been opened successfully (and

completely).

Open foreign data as a workfile

To open the file in Eviews, go to File/Open/Foreign Data as Workfile ...

This dialogue box allows you to browse folders to find the file

C230C330_U1_Q2.txt

After you have found and opened the file, you will get the dialogue box Text

Read Step 1 of 4. This shows the preview window how Eviews will

interpret the data in the file. You can check that the first values are as noted

above. Click Next.

Step 2 of 4 asks about the delimiter between entries; this is a single tab, as

indicated, so click Next.

Step 3 of 4 identifies that the column headers (the names of the variables) are

in line 1. Click Next.

Step 4 of 4 concerns the Import Method: Eviews will create a new workfile

containing the data series. Step 4 also concerns the Structure of the Data to be

Imported: In this case the data are dated, with the dates specified by a date

series, and in the text file that series is called date. Just click on Finish.

You should now see the Workfile window (C230C330_U1_Q2) with a list of

variables. To see the values of a series, double-click on the name of the

23

series. A new window will open, displaying the values for the series in

spreadsheet view.

(When opening the text files of data, do not use File/Open/Text File... This

really will open the file as if it is a file of text, and not as data.)

Eviews will recognise that the data are monthly, and it will arrange the values

into observations: 1982M01, 1982M02, etc. However, Eviews also takes the

Date values from the first column in the text file and assigns them to a series

in its own right, in this case with values 1982-01-31, 1982-02-28, etc. In

many contexts this date series will not be used, especially if you use annual

data, in which case it would contain values like 2,009; 2,010 etc. However, in

other contexts (daily data with irregular breaks, like the data series in Q4),

Eviews uses the date series to index the observations. Therefore it is best to

retain this series but to ignore it.

Note that in general the undo feature (Control and z) does not work in Eviews

(although it does work when editing in the Command line). If you have made

a mistake when creating a new series, for example, you will have to delete

the series and create it again. To delete an object in the Workfile window,

right-click the object: a list of possibilities appears, including Delete. And

save your Workfiles frequently.

Saving a Workfile

To save this Workfile, make sure the Workfile window is selected (highlighted), go to File on the top toolbar in Eviews, Save As..., and provide a

filename and folder where you wish to save the Workfile. Eviews will

assume you wish to save the file as a Workfile; so the filename will be

c230c330_u1_q2.wf1 in this case, unless you have renamed the file. Note that

in the Save window there is a button on the bottom left that allows you to

Browse folders (that is, to display the folders for browsing) or to Hide folders.

After clicking Save, Eviews will ask you what level of precision you wish to

use to save the Workfile. Leave the default choice as it is, and click OK.

(If the Workfile window is highlighted, Eviews will save the Workfile. If the

Command line is highlighted, Eviews will ask if you wish to save the Workfile or the command log. If you save the command log, it will be saved as a

simple text file.)

Producing a Graph

Analysing graphs of your data is a very useful method for identifying general

patterns, relations between series, or noteworthy changes in the data. To

demonstrate this, Q2a examines a plot of a series over time; Q2b examines a

scatter plot where one series is plotted against another; Q2c requires a plot of

transformed series over time; and Q2d considers a scatter plot of two transformed series.

To produce a plot of the current spot rate, S, select the object s in the Workfile window. Then go to Quick on the top bar of Eviews, and select Graph...

(Eviews then shows the series selected, which is s. If you had not already

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selected s, you can type the name of the series directly into the Series List

box). Click on OK. This brings up the Graph options window. The selected

type of graph is Line & Symbol, which is what you want in this case, so click

on OK. This should produce a plot of s over time. The graph already has a

title label, s. If you move the mouse pointer over the graph, the observations

and values are displayed in the bottom left of the screen; resting on a point on

the line will show you which observation you are pointing to and what the

value is.

To save the graph in your Workfile you will have to Name it. With the Graph

window open, click on Name, and give a Name to identify the object. Note

that Names for objects cannot include spaces; one suggestion is to use

underscore (_) instead of a space.

To use the graph in other applications, you can save the graph in a variety of

formats, or you can simply copy and paste it into a Word document (both

very useful when writing assignments). Note that all the instructions that

follow will refer to Microsoft Word; operations for other word processing

software may not be the same. Click on the graph area so that the plot area is

highlighted (this selects everything, even though only the plot area is highlighted).

To save the graph, right click and select Save graph to disk... The Graphics

File Save dialogue box then gives you the opportunity to provide a filename

for the saved graph, and to browse to the folder where you want the file to be

saved. You can also choose the format for the file (e.g. Windows Metafile

(*.wmf), Enhanced Metafile (*.emf), *.jpg, *.bmp, etc). Note that Browsing

to change the File name/path, and clicking Save, does not save the graph.

You also need to click on OK in the Eviews Graphics File Save dialogue box.

If you prefer to copy the graph, select the graph, right click and choose Copy

to clipboard ... This then gives you a few options for the copied graph (e.g.

use colour, *.wmf or *.emf). Click on OK. Go to your Word document, then

press Control and v, or click on Paste, and the graph will be pasted into your

document.

Using Commands (an alternative)

So far, the instructions above have used the drop down menus in Eviews. An

alternative is to use Commands. (For an introduction to using Commands, see

Command and Programming Ref available in Eviews Help Chapter 1

Object and Command Basics.) The command line is the space below the

top toolbar in Eviews. As an example, typing (without the inverted commas):

graph myplot.plot s, then pressing the Enter (or return) key, will produce

the graph for question 2a. To see the graph, type the command: show

myplot followed by Enter, and the graph will be displayed.

You will now notice there is a new object in the Workfile window. Double

clicking on the object myplot also opens the graph.

You may prefer to use Commands, or you may prefer to use the dropdown

menus, or you may prefer to switch between them. If you like using the

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25

you work through the exercises in the units.

Notice that once you have pressed the Enter key to execute the Command,

the Command stays in the Command area. If you want to do a similar operation again, you can edit the Command line then run it again; just move the

cursor into the line containing the Command (make the edit if required) and

press Enter.

Producing a Scatter Plot

Next, produce a scatter plot with

on the

horizontal axis. Go to Quick on the top bar of Eviews, and select Graph...

Type the names of the series in the Series List box. Note that in scatter plots

in Eviews, the first series name you type in the series list will be measured on

the horizontal axis and the second series name will be measured on the

vertical axis. Also note that the Series List can include names of series that

you have created or imported, and also expressions. To see how this works,

type the series list for this graph: f(-1) s. Click on OK. Then in the Graph

Options window, under Graph type, select Scatter, and click OK. This should

produce a scatter plot of

on

. Note that if you had typed s and then f(1) in the series list, you would get a scatter plot of

on . The expression

f(-1) indicates that you want to use the value of F from the previous period,

(known as the first lagged value of F).

The Command to produce this scatter plot is graph myscatter.scat f(-1) s,

which will produce a graph object named myscatter.

You can add labels to the graph using the AddText button. Type in the text

for the label. You can specify the position (e.g. Top and centred for a title for

the graph), but you can drag the textbox to wherever you want on the graph

after you have clicked OK. If you made a mistake when you added the text

label, just double click on the text label and you can edit the text in it.

Question 2c requires a plot of

box (or Command), the expression for this will be s-f(-1). To help interpret

the graph, you might wish to add a zero line. This is a horizontal line that

goes through zero (measured on the vertical axis). To add this line, have the

Graph open, and go to Options. On the left of the window you will see the

Option pages arranged in a tree system. Click on Axes & Scaling, and then

Data axis labels. Under Axis ticks & lines you will see a button titled No

zero line. Click on this and select Zero line, background, and click on OK.

on the vertical axis, and

Question 2d requires a scatter plot with

on the horizontal axis. Can you think what two expressions are

required for this graph (to go in the Series List box or to put in your Command)? And what order should they be in to produce this scatter plot?

The series list will be s(-1)-f(-2) followed by s-f(-1). And remember that it is

a Scatter graph. Once you have produced the graph, you can add a horizontal

zero line as before (like the graph in Q2c). You can also add a vertical zero

26

University of London

line (passing through zero on the horizontal axis). To do this, select Options,

Axes & Scaling, and then Data axis labels. Select the button titled Left axis,

towards the top of the window, and select Bottom axis. Click on the No

zero line button and select Zero line, background. This should add a vertical

zero line to the graph.

Generating New Series

As you can see, it is possible to type expressions for series (transformations

of series) directly into the Graph Series List or in Commands. Sometimes it

will be more convenient, or you may prefer it, to create new series that

incorporate the transformations, and then work with the new series. So in

Q2c you could create a new series, call it Z, equal to the difference between

the current spot rate and the forward rate from the previous period, and then

plot Z.

You can create a new series in a number of ways. From the top toolbar click

on Quick/Generate Series... This brings up the Generate Series by Equation

dialogue box. In the box titled Enter equation, type (without the inverted

commas): z=s-f(-1) then click on OK. You will see that there is a new series

in the Workfile window. Alternatively, in the Workfile window you could

click on the button Genr, to bring up the same Generate Series by Equation

dialogue box.

Or, to generate the new series using a Command, type: genr z=s-f(-1) in the

Command space, and then Enter.

Note that if you are using Commands, you can use the editing functions to

create and edit your commands: Copy (the control key and c), Cut (control

and x), and Paste (control and v). Rightclicking in the command space also

gives a drop down menu with these editing functions.

As you can see, there are many ways to work with objects (series, graphs,

etc) in Eviews. Often rightclicking on any object in the Workfile window will

enable you to open, copy or delete that object.

Now save your Workfile (this saves the original series, the Named graphs,

and new series if you have generated them). Remember that if the Workfile

window is highlighted, clicking on File/Save As ... will allow you to save the

Workfile. If the cursor is in the Command space and the Command Space is

highlighted, clicking on File/Save As... prompts Eviews to ask if you wish to

save the Workfile or the log of Commands in the Command line.

3 A share is valued at $1000 at the start of year 1. In year 1 it experiences a

return of -20%, and in year 2 it experiences a return of +20%. Calculate

the value of the share at the end of year 1 and the end of the year 2 using

a) arithmetic returns, and

b) logarithmic returns.

Comment on the values you have obtained for the share price at the end of

year 2.

4 The tab delimited text file C230C330_U1_Q4.txt contains the share price

of Delta Airlines Inc. (DAL) and the New York Stock Exchange

27

Composite Index (NYA). The data are daily, for the period 1 March 2010

to 1 March 2012, and both series are measured in US dollars (source:

http://finance.yahoo.com). The text file also includes a column of dates.

a) Plot the series DAL and NYA over time. Comment on the plots.

b) Plot the daily logged return of Delta Airline shares over time, and

comment on the plot.

c) Produce a scatter plot with the daily logged return of Delta shares on

the vertical axis, and the daily logged return on the NYSE composite

index on the horizontal axis. Comment on the scatter plot.

d) Calculate the means, standard deviations, and minimum and

maximum values for the Delta Airline daily logged return and daily

arithmetic return. Comment on the values you have obtained.

The file contains three columns. The first column contains the date; the

second column contains the share prices for Delta Airlines Inc. (DAL); and

the third column contains the value for the NYSE Composite Index (NYA).

For reference, on 1/3/2010 DAL is 13.17 and NYA is 7100.75; on 2/3/2010

DAL is 12.78 and NYA is 7135.97; and on 1/3/2012 DAL is 9.64 and NYA

is 8175.11.

When you produce the plots of the Delta share price and NYSE Composite

Index for Q4a, you may notice gaps in the graph due to the irregular dates.

To close the gaps in the graph, go to Options, select the Graph type page, and

in the Sample breaks section, put a tick in the Connect adjacent box.

For Q4b you need to plot the daily logged return for the shares of Delta

Airlines. Recall from the unit that the daily logged return is equal to

(1.21)

that is, the natural logarithm of the share price minus the natural logarithm of

the share price from the day before. You can obtain a plot of this variable in a

number of ways. You can create a new series, call it r, and the expression for

r will be r=log(dal)-log(dal(-1)). What does this equation do? The first term is

the natural logarithm of the current value of dal (in Eviews, log stands for the

logarithm to base e, and not base 10). The second term takes the value of dal

from the observation before, and then takes the natural logarithm of it.

Logged returns are used widely in econometrics. Therefore, Eviews has a

built-in function or short-cut for this calculation: You can create the daily log

return for Delta shares with the expression r = dlog(dal). Now you can plot

the series r. Alternatively, you can type the expression dlog(dal) directly in

the Quick/GraphSeries list box. Or the Command to produce the required

graph (called plot_dlogdal) would be graph plot_dlogdal.plot dlog(dal).

For the scatter plot in Q4c, you could create a new series for the daily log

return on the NYSE Composite Index, or you can work directly with the

expressions in the Graph Series list, or use a Command. Working with the

expressions, the Series list would be dlog(nya) dlog(dal). Remember that in a

Scatter plot, the first series name in the list will be measured on the horizontal axis, and the second will be on the vertical axis.

28

University of London

Sample statistics

You can produce sample statistics for a series using Quick (on the Eviews top

toolbar)/Series Statistics/Histogram and Stats, then typing in the name of the

series and clicking on OK. Copying and Pasting this output into Word will

copy the complete graph (the histogram and the statistics). You could do this

for the logged return for Delta shares, and then repeat this operation for the

arithmetic return.

The arithmetic return is

(1.22)

that is, the current share price minus the share price in the previous period, all

divided by the share price in the previous period. In Eviews the equation to

create this series, call it ra, would be ra=(dal-dal(-1))/dal(-1). Alternatively,

there is a built-in function @pch which produces the one-period percentage

change (expressed as a decimal). So the equation to produce the daily arithmetic return for dal would be ra=@pch(dal).

Alternatively, you can produce descriptive statistics for a number of series

together. If you have created two new series for the logged return and arithmetic return, then in the Workfile window select the two objects (click on

one, then press the Control key and click on the other), then just doubleclick

the two series or right click, then Open Group. In the Group Window, switch

to the Stats Table: click on View/Descriptive Stats/Common Sample. This

produces a table showing mean, median, maximum, minimum, etc. You can

select all of the table (including the row labels) by clicking in the empty top

left-hand cell, then right click and copy (or the Control key and C), then paste

into Word. (In the Copy Precision dialogue box, just leave the default selection formatted and click on OK.) At this stage of the course you can

ignore most of this output.

Alternatively, on the Eviews toolbar you can go to Quick/Group Statistics/Descriptive Statistics/Common Sample, and then type in the names of the

required series in the Series list box, including any necessary transformations

e.g. dlog(dal) @pch(dal).

Or, if you have generated new series for the logged returns and arithmetic

returns, you can produce the descriptive statistics for the series using the

Command r.stats for the series of log returns, r; and ra.stats for the series

of arithmetic returns, ra.

29

1

relations among variables. Such theory can frequently be written in the

form of a mathematical model. An econometric model may be obtained

from an appropriate mathematical model with the addition of a random

error term. By using data to estimate the econometric model we can in

effect quantify financial and economic relations.

2 a) The plot of S over time is shown in Figure 1.2. The plot of the current spot

rate, measured as US dollars per pound, reveals a number of notable

episodes. For example, there is a sharp depreciation of sterling in 1992,

when sterling left the European Exchange Rate Mechanism. (A lower value

for S means that one pound will buy fewer dollars, or equivalently, it takes

fewer dollars to buy one pound). There is another sharp depreciation of sterling against the dollar (and other currencies) after the 2008 financial crisis.

Figure 1.2 Plot of S 19822012

2.2

2.0

1.8

1.6

1.4

1.2

1.0

1985

1990

1995

2000

2005

2010

against

is shown in Figure 1.1 in the unit.

The scatter plot shows that

and

have the expected positive

relationship. The relationship seems to be approximately linear and

seems to be relatively strong, in that the observations appear close to a

regression line drawn in the scatter plot.

c) Figure 1.3 shows the plot of

over time. This is the difference

between the current spot rate and the one-month ahead forward rate

that was available one month previously. According to the efficient

markets hypothesis, the forward rate should be a good predictor of the

spot rate, so that any differences between

and

should be

random. Any differences also reflect information that has become

available between the time the forward exchange rate was formed, and

the current spot rate was formed. In the first few years of the sample

there are months when

is consistently negative. If

is

30

University of London

it suggests that the forward market is

consistently under-predicting the value of the spot rate. Looking back

at Figure 1.2, sterling was steadily depreciating in this period. This

means the forward market is consistently underpredicting the extent of

the depreciation in the spot rate. Again in 2008, there are relatively

for a few months, and the same

large negative values for

interpretation might be applied: the forward market is not adequately

predicting the depreciation in sterling.

Figure 1.3 Plot of S F(-1) 19822012

.16

.12

.08

.04

.00

-.04

-.08

-.12

-.16

-.20

-.24

1985

1990

1995

2000

2005

2010

against

. That

is, the difference between the current spot rate and the forward rate

one month ago, plotted against the difference in the previous period.

Figure 1.4 Scatterplot of S F(-1) against S(-1) F(-2) 19822012

.16

.12

.08

S-F(-1)

.04

.00

-.04

-.08

-.12

-.16

-.20

-.24

-.3

-.2

-.1

.0

S(-1)-F(-2)

.1

.2

31

The scatter plot allows us to examine whether the forecasting error between

and

can be explained by the forecasting error in the earlier period,

. Figure 1.4 suggests there is no obvious relationship, positive or

negative, between the forecasting error in one period and the forecasting

error in the period that follows.

3 The value of the share at the start of year 1 is $1000, and in year 1 it experiences a return of 20% or 0.20. In year 2 the return is +20% or +0.20.

a) Using arithmetic returns, the share price at the end of year 1 is

The share price at the end of year 2 is

b) Using logarithmic returns, the share price at the end of year 1 is

The share price at the end of year 2 is

or $1000

Arithmetic returns are not symmetric: a negative return, followed by a

positive return of the same magnitude, does not restore the share to

the original price. However, logarithmic returns are symmetric: a

negative return followed by a positive return of the same magnitude

does restore the share to the original value.

4 a) The plot of the Delta Airlines Inc. share price and the NYSE

Composite Index is shown in Figure 1.5.

Figure 1.5 Plot of DAL and NYA March 2010 to March 2012

8,800

8,400

8,000

7,600

7,200

16

6,800

14

6,400

12

10

8

6

2010M07

2011M01

2011M07

2012M01

The Delta Airlines share price is measured on the left-hand axis and

the NYSE Composite Index is measured on the right-hand axis.

Presented in this way the plots are not directly comparable, but you

can see there are periods when both series generally move together,

and there are other times when one series exhibits sharp movements

that are not shown in the other series.

32

University of London

b) Figure 1.6 shows the plot of the daily logged return of the Delta

Airlines share price. The daily logged return crosses the zero line

frequently. Occasionally there are large positive and negative daily

returns, of around +0.12 (12%) and 0.12 (minus 12%).

Figure 1.6 Plot of DAL daily logged return March 2010 to March 2012

.12

.08

.04

.00

-.04

-.08

-.12

-.16

2010M07

2011M01

2011M07

2012M01

c) Figure 1.7 shows the scatter plot of the daily logged return on Delta

shares (on the vertical axis) against the daily logged return on the

NYSE Composite Index (on the horizontal axis). There would seem to

be a positive, linear relationship between the two series.

Figure 1.7 Scatter plot of DAL daily logged return and NYA daily logged return

.12

.08

DLOG(DAL)

.04

.00

-.04

-.08

-.12

-.16

-.08

-.04

.00

DLOG(NYA)

.04

.08

d) The histogram and statistics for the Delta daily logged return is

shown in Figure 1.8. The descriptive statistics for the daily logged

return and daily arithmetic return for the Delta share price are

shown in Table 1.2.

Centre for Financial and Management Studies

33

80

Series: DLOG(DAL)

Sample 1/03/2010 1/03/2012

Observations 506

70

60

50

40

30

Mean

Median

Maximum

Minimum

Std. Dev.

Skewness

Kurtosis

-0.000617

-0.000895

0.104360

-0.120286

0.029401

0.088426

4.036065

Jarque-Bera

Probability

23.29091

0.000009

20

10

0

-0.10

-0.05

-0.00

0.05

0.10

DLOG(DAL)

-0.000617

-0.000895

0.104360

-0.120286

0.029401

0.088426

4.036065

@PCH(DAL)

-0.000185

-0.000895

0.110000

-0.113333

0.029448

0.222162

4.104456

23.29091

0.000009

29.88029

0.000000

Sum

Sum Sq. Dev.

-0.312020

0.436530

-0.093542

0.437919

Observations

506

506

Mean

Median

Maximum

Minimum

Std. Dev.

Skewness

Kurtosis

Jarque-Bera

Probability

For small changes, the logged return and arithmetic return are

approximately equal. However, for larger changes this approximation

is not so close. You can see this in the maximum and minimum values

for the two series in Table 1.2.

References

Gujarati D and D Porter (2010) Essentials of Econometrics, Fourth edition,

New York: McGraw-Hill Book Company.

Maddala GS (1992) Introduction to Econometrics, New York: Macmillan.

Mosteller F and JW Tukey (1977) Data Analysis and Regression: a second

course in statistics, Massachusetts: Addison-Wesley.

Startz Richard (2009) Eviews Illustrated An Eviews Primer, Irvine California: Quantitative Micro Software.

34

University of London

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