Term Paper on

Application of Financial
Econometrics

Indian Institute of Management

Bangalore
Prepared By: Ankit Kariya
 I. Introduction

This term paper explores the applications of the various financial econometric techniques for

the analysis and modeling time series of financial data with the major focus on S&P 500 Index.

But to explore the power of financial econometrics tools I have also worked on some other

small data bases. In this term paper, I have tried to apply three broad categories of financial

econometric methods. First I have used the univariate time-series models for understanding the

basic structure of S&P 500 Index and simple as well as logarithmic returns of S&P 500 Index.

These are the class of models that attempts to model and forecast financial variables by using

the historical data of the same series rather than using structural relationships from financial

theories. The primary purpose of this class of models is to capture empirically important

characteristics of the observed data that might have arisen from a variety of different structural

models. This is discussed in the section II of this term paper. Next I have looked at the non-

linear financial econometric models especially ARCH/GARCH models for modeling the

volatility of S&P 500 Index returns. These models allow the behavior of a series to follow

different patterns at different points of times. It is presented in the section III. Last I have tried

to study the model of long term relationship in finance specifically cointegration relationship

to get some flavor of structural modelling. Generally, if we linearly combine two non-

stationary series, resultant series will also be non-stationary. But if two non-stationary series

are cointegrated, their linear combination be will stationary. I have studies the cointegration

relationship between spot Nifty Index and its futures using Engle-Granger two step method.

And I have also studies the cointegration relationship between real exchange rates i.e. relative

purchasing power parity (Relative PPP) using Johnsen technique. It is discussed in the section

IV.

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 II. Univariate Modelling
In this section the univariate models for understanding the basic structure of S&P 500 Index

series and series of its simple as well as logarithmic returns. I have obtained daily data of S&P

500 Index from January 3, 2007 to March 17, 2017 from Yahoo Finance. It has 2570 daily

observations. Figure 1 shows the time plots of daily closing price and trading volume of S&P

500 Index and Figure 2 depicts daily log returns of the same from January 3, 2007 to March

17, 2017.

Figure 1 Time plots of daily closing price and trading volume of S&P 500 Index from January 3, 2007 to March 17, 2017.

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Figure 2 Time plots of daily log returns of S&P 500 Index from January 3, 2007 to March 17, 2017.

A. Return Distribution

Table 1 below presents basic summary statistics of S&P 500 Index returns. Figure 3 shows the

histogram of S&P 500 Index returns while Figure 4 gives the comparison between empirical

and normal density of S&P 500 Index returns. From observation of Table 1, Figure 3 and Figure

4, we can see that S&P 500 Index returns has meso kutic negatively skewed distribution. For

the final concluding evidence on normality we perform the Jarque - Bera Normality Test on

S&P 500 Index returns. We get chi-squared value of 11249.85 with corresponding p-value of

approximately zero and thus we reject the null hypothesis that S&P 500 Index returns follows

normal distribution.

Table 1 Descriptive Statistics of S&P 500 Index Returns

No.
Mean Median Max Min SD Obs. 1st_Qu. 3rd_Qu. Skew. Kurtosis
10.38
0.01% 0.06% % -9.93% 1.31% 2570 -0.45% 0.58% -0.57 10.19

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Figure 3 Histogram of S&P 500 Index Simple % Returns from March 3, 2007 to March 17, 2017.

Figure 4 S&P 500 Index Simple Returns Empirical Vs Normal Density.

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B. Auto Correlation Function

To understand the structure of the time series S&P 500 Index returns of I have calculated auto

correlation function (ACF) and Partial auto correlation function of S&P 500 Index returns.

Table 2 presents the values of ACF and PACF of the S&P 500 Index returns for five lags.

While the Figure 5 and Figure 6 presents the ACF and PACF for 50 lags.

Next to test the joint hypothesis that all five of the auto correlation coefficients are

simultaneously zero or not we perform Ljung-Box Test. I get chi-squared value of 44 with

corresponding p-value of approximately zero and thus we reject the null hypothesis that all

five the auto correlation coefficients are simultaneously insignificant.

Table 2 ACF and PACF of S&P 500 Returns from March 3, 2007 to March 17, 2017.

Lag ACF PACF

1 -0.10226 -0.10226
2 -0.05225 -0.06337
3 0.03573 0.02391
4 -0.0192 -0.01635

5 -0.04681 -0.0479

Figure 5 of S&P 500 Returns from March 3, 2007 to March 17, 2017.

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Figure 6 PACF of S&P 500 Returns from March 3, 2007 to March 17, 2017.

C. ARIMA Modelling

To identify correct lag of the AR process for SPR, I have used AIC criteria using maximum

likelihood estimate of variance. AIC values of for different lags is plotted in the Figure 7 and

we can see that lag of S&P 500 Index returns as this criterion is 12.

Figure 7 AIC Values for S&P 500 Returns from March 3, 2007 to March 17, 2017

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 Next step in building towards the ARIMA model is to identify the order of the series.

It starts with testing for unit root using the Dickey-Fuller test and if null hypothesis of is not

rejected, testing for higher order. For unit root we get Dickey-Fuller test statistic value (-

13.5063) with corresponding p-value of 0.01. Thus, we conclude that series is stationary i.e.

has order zero.

Now the last thing needed to complete the ARIMA model estimation is the optimal lag

of MA structure. To get it we first fit ARIMA (12,0,0) to the S&P 500 Index returns as we

know the its AR (9) and I (0) series then we check the ACF of residual of these model and

perform Ljung-Box Test on the residuals of this model. Figure 8 gives the plot of ACF of

residuals of ARIMA (12,0,0) for 12 lags. We can see that ACF values for all initial lags is

approximately zero. I have also performed Ljung-Box test for significance of ACF of residual

of ARIMA (12,0,0).

Figure 8 ACF of Rerisudals of ARIMA (12,0,0)

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 I get chi-squared value of 0.14 with corresponding p-value of approximately one and

thus we fail reject the null hypothesis that all twelve auto correlation coefficients are

simultaneously insignificant. So, our final estimated univariate time series model for the S&P

500 Index returns is ARIMA (12,0,0). And the coefficients for the estimated model are given

in the Table 3.

Table 3 Coefficients of ARIMA (12,0,0) for S&P Returns

Lag 1 Lag 2 Lag 3 Lag 4 Lag 5 Lag 6 Lag 7 Lag 8 Lag 9 Lag 10 Lag 11 Lag 12
-0.103 -0.065 0.022 -0.023 -0.045 0.011 -0.020 0.031 -.011 0.049 -0.018 0.037

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 III. Volatility Modelling

In this section I will discuss the non-linear models especially ARCH/GARCH for modeling

the volatility of S&P 500 Index returns. As earlier noted these models allow the behavior of a

series to follow different patterns at different points of times. Figure 13 presents the observed

volatility of S&P 500 Index returns from jaggo.

Figure 9 Realized Volatility of S&P 500 Returns

First I check whether AR kind of structure is useful in volatility modelling using ACF plot and

Ljung-Box test for 12 lags. I have used 12 lags here as well as it was the lag identified for AR

model of S&P 500 Index returns. ACF plot for volatility of S&P 500 Index returns is given in

the Figure 9. For Ljung-Box test, I get chi-squared statistic value 2000 with corresponding p-

value of approximately zero and thus we reject the null hypothesis that all twelve auto

correlation coefficients are simultaneously insignificant.

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Figure 10 ACF of daily volatility of S&P 500 Index Returns from jaggo

First simple model like basic AR model for volatility modelling is Auto Regressive Conditional

Heteroscedasticity (ARCH). The results of the ARCH (12) test of volatility of S&P 500 Index

returns from jaggo is given in the Table 4 and so we conclude that S&P 500 Index returns

volatility can be modelled using the ARCH (12).

Now I estimate the ARCH (12) model for the S&P 500 Index returns volatility. Summary of

the estimated model is given in the Table 5. Correlation between ARCH (12) estimated

volatility and realized volatility is almost 90%. Figure 11 presents the standardized residuals

for ARCH (12) model for the volatility of S&P 500 returns from jaggo. The plot of standardized

residuals does not have any systematic pattern.

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 Table 4 Estimated ARCH (12) Model for the volatility of S&P Returns from jaggo

Coefficient SE t-Value Pr(>|t|)

(Intercept) 0.0000 0.0000 2.15 0.03

x1 -0.0401 0.0198 -2.03 0.04

x2 0.1964 0.0196 10.04 0.00

x3 -0.0689 0.0199 -3.46 0.00

x4 0.0678 0.0199 3.41 0.00

x5 0.1651 0.0200 8.27 0.00

x6 0.0956 0.0202 4.74 0.00

x7 0.0791 0.0202 3.92 0.00

x8 0.0214 0.0200 1.07 0.28

x9 0.0592 0.0199 2.97 0.00

x10 0.0579 0.0199 2.91 0.00

x11 0.1467 0.0196 7.5 0.00

x12 0.0830 0.0198 4.2 0.00

Residual standard error: 0.000499 on 2545 degrees of freedom

Multiple R-squared: 0.313, Adjusted R-squared: 0.31

F-statistic: 96.8 on 12 and 2545 DF, p-value: <0.0000000000000002

Table 5 Estimated Coefficients for ARCH (12) model for the volatility of S&P 500 returns from jaggo

mu omega alpha1 alpha2 alpha3 alpha4 alpha5

0.001 0.000 0.045 0.140 0.083 0.103 0.062
alpha6 alpha7 alpha8 alpha9 alpha10 alpha11 alpha12
0.059 0.073 0.090 0.073 0.069 0.044 0.000

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Figure 12 Standardized Residuals for ARCH (12) model for the volatility of S&P 500 returns from jaggo

A natural extension of ARCH (12) model that allows the conditional variance to depend upon

the previous values of own lags is GARCH (12, p). I will first try GARCH (12, 1). Figure 11

presents the standardized residuals for GARCH (12, 1) model for the volatility of S&P 500

returns and it is not significantly better than ARCH (12). And results do not change for different

lags of own previous values or the lag of autoregressive part.

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Figure 13 Standardized Residuals for GARCH (12,1) model for the volatility of S&P 500 returns from jaggo

Next I have used volatility estimated from GARCH (12,1) to create two sigma confidence

interval arounds. It is presented in the Figure 14. All the observations lie in the two-sigma

confidence bend based on GARCH (12,1) estimated volatility.

Figure 14 S&P 500 daily realized returns with two sigma confidence interval based on GARCH (12,1) forecasted volatility

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 IV. Cointegration
In this section I have tried to model long term relationship in between financial series

specifically cointegration relationship. In most cases, if variables with different orders of

integration are linearly combined, the combination will have an order of integration equal to

that of the largest. But there is an important exception to this rule, cointegrated series. If two-

time series are cointegrated, their linear combination be will stationary. I have investigated two

such series in this section.

A. Long-term relationships between spot and futures of Nifty Index

I have obtained 251 observations of spot and future values of Nifty Index from

www.nseindia.com. This data corresponds to period March, 2016 to December, 2016. First I

have done Augmented Dickey-Fuller test to check the order of integration of log of future and

spot values of Nifty Index. Results of it are presented in the Table 6. As expected both spot and

future log prices follows unit root process while returns of both spot and future Nifty Index are

stationary processes.

Table 6 ADF tests on log prices and returns of Nifty Index

Data: Log Future Nifty Index Data: Log Spot Nifty Index

Dickey-Fuller = -0.718, Lag order = 5, p-value = 0.97 Dickey-Fuller = -0.853, Lag order = 5, p-value = 0.96

Data: Future Returns Nifty Index Data: Spot Returns Nifty Index

Dickey-Fuller = -6.53, Lag order = 5, p-value = 0.01 Dickey-Fuller = -6.67, Lag order = 5, p-value = 0.01

From theory cost of carry we know that if the markets are efficient, changes in the log of the

spot price of a Nifty Index and its corresponding changes in the log of the futures price of it

would be expected to be perfectly contemporaneously correlated and cross autocorrelation of

these changes would be zero. Mathematically it can be represented as below.

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 Correlation (ln (ft ), ln(st )) 1 (a)

Correlation (ln (ft ), ln(sts )) 0 s > 0 (b)

Correlation (ln(fts ), ln(st )) 0 s > 0 (c)

We will test these predictions using the error correction model. We will use Engle-Granger

two step method to estimate the error correction model. In step one we estimate the

potentially cointegration equation between log of Nifty spot and Nifty future. We do this by

regressing log of Nifty spot on the log Nifty future and we preform the ADF test on residuals

of this model to check whether cointegration relationship exists between these series. The

summary of it is presented in the Table 7 and from it we can infer that the residuals from

cointegrating regression are stationary.

Table 7 Estimated Potentially Coingrating Relationship and ADF test on the residuals of this equation

Estimate Std. Error t value Pr(>|t|)

(Intercept) 0.36377 0.04478 8.12 0.000000000000046 ***

log Future 0.95907 0.00496 193.21 < 0.0000000000000002 ***

Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1

Multiple R-squared: 0.995, Adjusted R-squared: 0.995

F-statistic: 3.73e+04 on 1 and 200 DF, p-value: <0.0000000000000002

Data: Residual

Dickey-Fuller = -6.60, Lag order = 5, p-value = 0.01

The next step in building an error correction model by Engle-Granger two step method is to

use the lag of first stage residuals as the correction term in the following general equation.

ln st = 0 + zt1 + 1ln st1 + 1ln ft1 + vt

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Summary of this estimated model is presented in the Table 8. The estimated coefficient of none

of the variables is statistically significant. The coefficient for the error correction term is

negative, indicating that difference between the logs of the spot and future prices is positive in

one period, the spot Nifty Index is likely to follow next period but it is not statistically

significant.

Table 8 Estimated error correction model for relationship between spot and future Nifty Index

Dependent variable:
Spot Returns
Correction Term -0.013
(0.175)
Future Return Lag -0.577
(0.514)
Spot Return Lag 0.609
(0.513)
Constant 0.0003
(0.001)

Observations 192
R2 0.008
Adjusted R2 -0.008
Residual Std. Error 0.008 (df = 188)
F Statistic 0.519 (df = 3; 188)
*
Note: p<0.10 **p<0.05 ***p<0.01

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B. Relative Purchasing Power Parity (Relative PPP)

Relative PPP states that the long-term exchange rate between two countries is equal to the ratio

of their relative price levels i.e. real exchange is constant. Mathematically real exchange rate

is defined as below.

where Rt is the real exchange rate, Et is the nominal exchange rate in domestic currency per

unit of foreign currency, Pt is the domestic price level and *Pt is the foreign price level. Taking

logarithms of above equation and rearranging it we get the following testable equation

+ =

+ = 0

where the lower-case letters indicate logarithmic transforms of the corresponding upper case

letters earlier used. We will test this relationship using Engle-Granger Two Step Procedure

used earlier.

To test this relationship, I have collected consumer price index (CPI) and exchange rate data

for the Japan, Switzerland, United Kingdom, United States, China, and India from January

2007, to December 2016 from IMF website. First step is to check whether the log nominal

exchange rates have unit root. I have used ADF test to check it and results of it are presented

in the Table 9 below. We can clearly see the log nominal exchange rates has unit root.

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Table 9 ADF Test of Log of Nominal Exchange rates

Data: Log Nominal Rs-Dollar Exchange Rate Data: Log Nominal Rs-Pound Exchange Rate

Dickey-Fuller = -2.34, Lag order = 4, p-value = 0.44 Dickey-Fuller = -1.89, Lag order = 4, p-value = 0.62

Data: Log Nominal Rs-Swiss Franc Exchange Rate Data: Log Nominal Rs-Yen Exchange Rate

Dickey-Fuller = -2.07, Lag order = 4, p-value = 0.55 Dickey-Fuller = -2.11, Lag order = 4, p-value = 0.53

In step one we estimate the potentially cointegration equation between log of nominal exchange

rate, lop CPI of India, and CPI of foreign country. We do this by regressing log of nominal

exchange rate on lop CPI of India and CPI of foreign country and we preform the ADF test on

residuals of this model to check whether cointegration relationship between these series. The

summary of it is presented in the Table 10 and Table 11, from it we can infer that the residuals

from cointegrating regression are not stationary. There is no point in performing the next step

to estimate the error correction model when there is cointegrating relationship between the log

of nominal exchange rate and the log of CPI. The failure detects the cointegrating relationship

is not surprising as CPI and for that matter any of the available price indexes is not perfect

proxy for the overall price levels in the economy at different periods of time.

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Table 10 Estimated Potentially Coingrating Relationship for Relative PPP

Dependent variable:
Rs_Dollar Rs_Yen Rs_Franc Rs_Pound
(1) (2) (3) (4)
CPI India 0.758*** 0.738*** 0.922*** 0.500**
(0.110) (0.040) (0.020) (0.223)
CPI US -0.613
(0.561)
CPI Japan -5.816***
(0.642)
CPI Switzerland 1.582***
(0.476)
CPI UK -0.610
(0.755)
Constant 3.230 22.748*** -7.649*** 4.915**
(2.100) (2.886) (2.202) (2.474)

Observations 120 120 120 120

R2 0.865 0.743 0.948 0.435
Adjusted R2 0.863 0.738 0.947 0.425
Residual Std. Error (df = 117) 0.064 0.099 0.054 0.093
F Statistic (df = 2; 117) 376.220*** 169.010*** 1,058.700*** 45.020***

*
Note: p<0.10 **p<0.05 ***p<0.01
Table 11 ADF test on the residuals of estimated cointegrating equation for Relative PPP

Data: Residuals of Rs-Dollar Data: Residuals of Rs-Swiss Franc

Dickey-Fuller = -2.02, Lag order = 4, p-value = 0.57 Dickey-Fuller = -2.97, Lag order = 4, p-value = 0.17

Data: Residuals of Rs-Yen Data: Residuals of Rs-Pound

Dickey-Fuller = -3.38, Lag order = 4, p-value = 0.06 Dickey-Fuller = -1.92, Lag order = 4, p-value = 0.61

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 V. Conclusion

In this term paper, I have explored the applications of the various financial econometric

techniques for the analysis and modeling time series of financial data. I have tried to apply

three broad categories of financial econometric methods. First I have used univariate time-

series models for understanding returns of S&P 500 Index. It was useful in the understanding

the broad structure of the series but it has very limited forecasting powers. Next I have looked

at the non-linear financial econometric models especially ARCH/GARCH models for

modeling the volatility of S&P 500 Index returns. These models are easy to implement and

understand but again has very limited forecasting ability. Last I have tried to study the model

of long term relationship in finance specifically cointegrating relationship for spot Nifty Index

and its futures and nominal exchange rates and the price levels i.e. relative purchasing power

parity (Relative PPP) using Engle-Granger two step method. I could detect the coingrating

relationship between the spot Nifty Index and its futures but the error correction term was

insignificant. This might be since error term didnt represented the error in the relationship per

se but it was due to the carry as the model was estimated with low frequency data. I could not

find the coingrating relationship between the log of nominal exchange rate and the log of CPI.

The probable reason for this is that CPI is not a good proxy for the overall price levels in the

economy.

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 Reference

1. Chris, Brooks. "Introductory econometrics for finance." Cambrige, Cambrige

University (2008).

2. Tsay, Ruey S. An introduction to analysis of financial data with R. John Wiley &

Sons, 2014.

3. https://www.imf.org/external/np/fin/data/param_rms_mth.aspx

4. https://www.nseindia.com/products/content/equities/indices/historical_index_data.ht

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