Shanghai University
Introduction to Econometrics
of Finance & Economics
Dr Jin Hongfei
Professor of finance
Chairman，Department of International Finance
Shanghai University of Finance & Economics
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Lectured by Dr. Hongfei Jin
Shanghai University
Outline
of Finance & Economics
• What is econometrics
• Why we study econometrics
• The methodology of econometrics
• Types of Data
• Some application examples
• Summary
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Lectured by Dr. Hongfei Jin
Shanghai University
What is econometrics
of Finance & Economics
• Literally, “econometrics” means
“measurement in economics”
– Too broad a definition to be of any use
• The application of statistical and
mathematical methods to analysis of
economic data, with a purpose of giving
empirical content to economic theories
and verifying them or refuting them.
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Lectured by Dr. Hongfei Jin
Shanghai University
of Finance & Economics
Econometrics is an interdisciplinary field
Economics and Business
Statistics Econometrics Mathematics
Computer Science
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Lectured by Dr. Hongfei Jin
Shanghai University
Why we study econometrics
of Finance & Economics
• The quantitative relationship between economic
variables is important
• The use of math, or logical consistency of theory
cannot ensure that economics is a science. ·
– Economic theory would be useless if the underlying
assumptions are wrong.
– To be a science, economic theory must be able to:
1.explain historical stylized facts and
2.predict future economic phenomena.
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Lectured by Dr. Hongfei Jin
Shanghai University
Why we study econometrics？
of Finance & Economics
• Econometrics is primarily interested in
– Quantifying economic relationships
– Testing competing hypothesis
– Forecasting
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Lectured by Dr. Hongfei Jin
Quantifying Economic
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of Finance & Economics
Relationships
• Outcomes of many policies tied to the magnitude of the
slope of supply and demand curves
• Often need to know elasticities before we can begin
practical analysis
• For example, if the minimum wage is raised,
unemployment may drop as more workers enter the
labor force
– However, this depends on the slopes of the labor supply and
labor demand curves
• Econometric analysis attempts to determine this answer
• Allows us to quantify causal relationships when the
luxury of a formal experiment is not available
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Lectured by Dr. Hongfei Jin
Shanghai University
Testing Competing Hypothesis
of Finance & Economics
• Econometrics helps fill the gap between the
theoretical world and the real world
• For instance, will a tax cut impact consumer
spending?
– Keynesian models relate consumer spending to
annual disposable income, suggesting that a cut in
taxes will change consumer spending
– Other theories relate consumer spending to lifetime
income, suggesting a tax cut (especially a “one-shot
deal”) will have little impact on consumer spending
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Lectured by Dr. Hongfei Jin
Shanghai University
Forecasting
of Finance & Economics
• Econometrics attempts to provide the
information needed to forecast future
values
– Such as inflation, unemployment, stock
market levels, etc.
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Lectured by Dr. Hongfei Jin
Shanghai University
The Use of Models
of Finance & Economics
• Economists use models to describe real-world
processes
– Models are simplified depictions of reality
• Usually an equation or set of equations
• Economic theories are usually deterministic
while the world is characterized by randomness
– Empirical models include a random component
known as the error term, or i
– Typically assume that the mean of the error term is
zero
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Lectured by Dr. Hongfei Jin
Steps involved in the formulation of
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of Finance & Economics
econometric models
Economic or Financial Theory (Previous Studies)
Formulation of an Estimable Theoretical Model
Collection of Data
Model Estimation
Is the Model Statistically Adequate?
No Yes
Reformulate Model Interpret Model
Use for Analysis
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Lectured by Dr. Hongfei Jin
Shanghai University
Types of Data
of Finance & Economics
• Data provide the raw material needed to
– Quantify economic relationships
– Test competing theories
– Construct forecasts
• Data can be described as a set of observations
such as income, age, grade
– Each occurrence is called an observation
• Data are in different formats
– Cross-sectional
– Time series
– Panel data
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Lectured by Dr. Hongfei Jin
Shanghai University
Cross-Sectional Data
of Finance & Economics
• Provide information on a variety of entities
at the same point in time
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Lectured by Dr. Hongfei Jin
Shanghai University
Time Series Data
of Finance & Economics
• Provides information for the same entity at
different points in time
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Lectured by Dr. Hongfei Jin
Shanghai University
Panel (or Longitudinal) Data
of Finance & Economics
• Represents a combination of cross-
sectional and time series data
– Provides information on a variety of entities at
different periods in time
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Lectured by Dr. Hongfei Jin
What are the Special Characteristics
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of Financial Data?
• Frequency & quantity of data
Stock market prices are measured every time there is
a trade or somebody posts a new quote.
• Quality
Recorded asset prices are usually those at which the
transaction took place.
No possibility for measurement error but financial
data are “noisy”.
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Lectured by Dr. Hongfei Jin
Shanghai University
Data Sources
of Finance & Economics
• Data is gathered by many sources
including
– Government
– Non-government organizations
– Research organizations
– Individual researchers
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Lectured by Dr. Hongfei Jin
Shanghai University
of Finance & Economics
Some Examples
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Lectured by Dr. Hongfei Jin
Shanghai University
of Finance & Economics
Example 1 [Macroeconomics]
Fiscal Policy in Closed Economy
• If the government does not increase its public
spending, the GDP will be 80 billion RMB. But
government’s desired output is 100 billion RMB.
• How to use the fiscal policy?
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Lectured by Dr. Hongfei Jin
Example 1 (cont’d)
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of Finance & Economics
• In a closed economy, the standard Keynesian
theory can be summarized by two simple equations:
Yt C t I t G t ,
C t Yt ,
1 − Yt I t G t .
∂Yt 1 ,
∂G t 1 −
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Lectured by Dr. Hongfei Jin
Shanghai University
of Finance & Economics
Example 2 [Marketing]
Pricing the Commodity
• Suppose you are a manager of marketing
department in a corporation. Your objective is to
maximise the profit.
• The cost of every unit product is constant c.
• If you can control the price of the product, at
what price would you like to set?
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Lectured by Dr. Hongfei Jin
Example 2 Pricing the product (cont’d)
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of Finance & Economics
• Suppose the demand is only determined by its
price, and has the hyperbolic form
q Ap α
A 0, α 0
α 1
R pq Ap TC qc
Π R TC Ap α 1 -Ap α c
Π
Ap α 1(( α 1 )p αc) 0
p
αc
p
α 1
So, we must know the value of
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Lectured by Dr. Hongfei Jin
Shanghai University
of Finance & Economics
Example 3 [Labor Economics]
Is there sex or race discrimination in labor market
WAGEi EDUi EXPERENCEi . . .
GENDERi MINORITYi ui
We can test whether θ or φ is zero or not.
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Lectured by Dr. Hongfei Jin
Shanghai University
of Finance & Economics
Example 4
Effect of Economic Reforms on a Transitional Economy
Economic theory predicts that the introduction of the bonus
and contract systems provides stronger incentives for
workers to work harder, thus increasing the productivity.
Is this statement true or not?
Consider an extended production function
ln Yit ln A it ln L it ln K it
Bonus it Contract it u it ,
No effect: 0.
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Lectured by Dr. Hongfei Jin
Shanghai University
of Finance & Economics
Example 5 [Finance]
The Efficient Market Hypothesis (EMH) and
Predictability of Financial Returns
• The weak form of efficient market
hypothesis states that it is impossible to
predict future stock returns using the
history of past stock returns.
• Is the stock market efficient?
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Lectured by Dr. Hongfei Jin
Example 5 (cont’d)
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of Finance & Economics
Consider following autoregression model:
p
Y t 0 ∑ j Yt−j t ,
j1
Where Yt is the stock return in time period t.
If the joint hypothesis
1 2 p 0.
is accepted, then we can say that the stock market
is efficient
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Lectured by Dr. Hongfei Jin
Examples of the kind of problems that
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of Finance & Economics
may be solved by an Econometrician
1.Testing whether financial markets are weak-
form informationally efficient.
2.Testing whether the CAPM or APT represent
superior models for the determination of
returns on risky assets.
3.Measuring and forecasting the volatility of
bond returns.
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Lectured by Dr. Hongfei Jin
Examples of the kind of problems that
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of Finance & Economics
may be solved by an Econometrician (cont’d)
4.Explaining the determinants of bond credit
ratings used by the ratings agencies.
5.Modelling long-term relationships between
prices and exchange rates
6.Determining the optimal hedge ratio for a spot
position in oil.
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Lectured by Dr. Hongfei Jin
Examples of the kind of problems that
Shanghai University
of Finance & Economics
may be solved by an Econometrician (cont’d)
7.Testing technical trading rules to determine
which makes the most money.
8.Testing the hypothesis that earnings or dividend
announcements have no effect on stock prices.
9.Testing whether spot or futures markets react
more rapidly to news.
10.Forecasting the correlation between the returns
to the stock indices of two countries.
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Lectured by Dr. Hongfei Jin
Shanghai University
Summary
of Finance & Economics
• Econometrics is an interdisciplinary field.
• From the interesting application examples, we can learn
that econometrics is a very useful tool in economic
research and decision-making.
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Lectured by Dr. Hongfei Jin
