Econometric methods of analysis and forecasting of financial markets Lecture 1. Introduction to financial econometrics

This lecture helps to understand: What are the main features of financial econometrics. Why to learn it? What are the main types of data. What is an econometric model and regression? How to use it in your research? What are the main assumptions and methods of estimation.

Contents What is financial econometrics? Types of data Econometric model Simple regression Assumptions for linear regression Properties of OLS estimator t-ratio Multiple linear regression F-test

What is financial econometrics? application of statistical techniques towards different problems in finance. Useful for: testing theories and hypotheses in finance determining asset prices or returns defining the relationships between variables, testing the effect of changes in economic conditions on financial markets forecasting future values of financial variables

What is financial econometrics? Examples of the use of econometrics in finance: Testing whether the capital asset pricing model (CAPM) or arbitrage pricing theory (APT) represent better models for the determination of returns on risky assets Constructing long-term relationships between prices and exchange rates Testing whether spot or futures markets react more rapidly to news

Types of data cross-sectional data (one or more variables at a single point in time) Example: A cross-section of stock returns on the New York Stock Exchange. time series data (data on one or more variables over a period of time.) Example: annual data on Government budget deficit. panel data (cross-sections and time series data) Example: the daily prices of a number of blue chip stocks over two years

Econometric model relationship between dependent (explained) variable and one or more other independent (explanatory) variables. Explains how different movements in factors affect the variable of interest.

Simple regression The most restricted case: only one explanatory variable x. Examples: relationship between asset returns and market risk, stock prices and dividends Let us assume that from the theory: ↑x leads to↑y. To test it: form a scatterplot.

Simple regression

Assumptions for linear regression

Properties of OLS estimator

t-ratio

Multiple linear regression

F-test

Conclusions We’ve covered what is financial econometrics and why to learn it What are the main types of data How the simple linear regressions look like What are the main assumptions and methods of estimation

References Brooks C. Introductory Econometrics for Finance. Cambridge University Press Cuthbertson K., Nitzsche D. Quantitative Financial Economics. Wiley Tsay R.S. Analysis of Financial Time Series, Wiley, Y. Ait-Sahalia, L. P. Hansen. Handbook of Financial Econometrics: Tools and Techniques. Vol. 1, 1st Edition Alexander C. Market Models: A Guide to Financial Data Analysis. Wiley Cameron A. and Trivedi P.. Microeconometrics. Methods and Applications Lai T. L., Xing H. Statistical Models and Methods for Financial Markets. Springer Poon S-H. A practical guide for forecasting financial market volatility. Wiley, Rachev S.T. et al. Financial Econometrics: From Basics to Advanced Modeling Techniques, Wiley, 2007.