Session 0

Session 0.
Econometric Review Alejandro Bernales
Finance II (IN 5303)

Session 0. Econometric Review
Alejandro Bernales
Universidad de Chile
Universidad de Chile
Session 0. Econometric Review Alejandro Bernales
Goals
Linear regression models: what do they mean?

(Ordinary) Least Squares estimation methods
Spurious regression and intuition of cointegration
Elements of time series analysis
White noise processes and notion of unpredictability
Autoregressive processes
Moving-average processes
GARCH models
Universidad de Chile 2/29


Suppose there is a relationship between some variable, y, and one or more other
variables (the x's):
y = f(x1, x2, , xk)
Assuming f is linear (a lot of models are linear or log-linear):
y = 0 + 1x1+ 2x2 + + kxk
This is a special kind of economic model
One approach to get an econometric model is to simply append an error term to the
relationship,
y = 0 + 1x1+ 2x2 + + kxk +
Why do we have an error term ?

Remember: we are now in SOCIAL SCIENCE!!!
Human behavior is difficult to model through equations.
This is the challenge of economics and finance!!!
To characterize, with a simple model, an important part of the human behavior.

y = 0 + 1x1+ 2x2 + + kxk +
The term is called the error (and also called as residual or disturbance term)
In essence, it makes the linear relationship between y (dependent variable) and the
xs (independent variable) a random association:
Deviations from y are accepted from the values predicted by the xs
y [0 + 1x1+ 2x2 + + kxk] = y yfit =
represents several types of random influences
Omitted variables
Effects connecting the y to the xs that cannot be capture by a linear
relationship
Measurement errors of the variables involved
Irrational behaviors
Basic point: when is a pure random shock, it will have special, interesting
properties (white noise)
White noise: we will learn its meaning later in this session
Linear regression models: Estimation

PROBLEM: 0, 1,..., k are not known and until they are (somehow) estimated
The estimated version is then
y 0 1 x1 2 x2 ... k xk e
where e has replaced the errors

How can we estimate the unknown coefficients?
Suppose we are interested in the relationship between two variables
We examine the bivariate case for a simple exposition. We can easily
generalise to the k-variable case


Questions that could be asked:
1. Is there a potential relationship (does theory or prior empirical evidence suggest
one)?
2. What is the nature of the relationship (positive, negative?)
3. What is the strength of the relationship (is it significant?)


Monthly data (1984-2003=19*12=228 months)
We want to analyze the bivariate regression model

y = 0 + 1x + where: y= market returns ; x=exchange rates 7


One intuitive approach is to compare the actual values for yt (in our example, the
market returns) with the fitted values
y 0 1 x1
Idea: we can minimize the sum of the squared differences between yn and the fitted
values for n with the objective to find the coefficients 0 and 1
This is the least squared method:
N
min RSS
0 , 1

min
( y n
0 , 1

y n
n 1
) 2
N N
min (
0 , 1

y n

n 1
0
x
1 1
2
) min (
0 , 1

en ) 2
n 1
Where N is the number of observations.

Our estimated model is: y = 0.006 0.321 x
8

Linear regression models: Strength of the linear

association
Two measures, slightly different, for the strength of the linear association:
1. The R2 (coefficient of determination),
N
the proportion of variation in y explained by variation
in x. Calculated as en2 N
1
R 1
y
2 n 1
N y
( yn y ) 2
n 1
N n 1
n
Notice that by construction 0 R2 1

As R2 approaches unity, it means that the maintained linear model can explain ALL of the
sample variation in the phenomenon of interest (y)
N 1
2. The adjusted R2 (adjustment for number of regressors employed): R 2 1 (1 R 2 )
N k
where k is the number of regressors
Why is the adjustment (the role played by k) important?

To compare regression models with different complexity,
e.g., y = 0 + 1x1+ vs. y = 0 + 1x1+ 2x2 +
Important:
9
We can show that by construction, R2 can increase with k
Linear regression models: Strength of the relationship

What is the strength of the relationship given by the model y = 0 + 1x + ?
This is reflected in 1
Is it statistically reliable?
This task is very simple
Step 1 - Set up a null hypothesis such as
H0 : 1 = 0
and an alternative hypothesis such as
HA : 1 0 (two-tailed test)
Step 2 - Calculate a t statistic: 1 1
t
1
var( 1 )
is a sample estimate of the variance of the coefficient (i.e. this will be given by the
majority of econometric packages)
Step 3 - Compare the test statistic t1 to the critical value from the statistical table for the t
distribution with (N-k) degrees of freedom and with significant level:
t 1 t / 2, N k
where N is the sample size and with a 100(1- /2) percent critical value
For our example:
H0 : 1 = 0 t1 = 3,129 and t5%/2,(228-2)=1.96
At a standard significance level (size) of 5% (i.e. 100(1- /2) =97.5% critical value), the
10
slope is statistically significant
Linear regression models: Spurious Regression

Consider the following example (a simple one). The results from estimating the regression
of the growth of child (inches) who born in 1985 (dependent variable) and the GDP of China
from 1985 (independent variable):
Are they really related? It is clear that there is no a relationship

But, the results are:
Is this really as
good as it looks?
Look at the picture
It is likely that the

interesting R2 may
simply derive from
the fact that the
series are drifting
together
Potential solutions:
-A little bit more complex since implies a
concept called cointegration (which we will

not study here).
-Easy solution: i) To check the economic intuition behind the relationship; ii) to try to make the same
analysis with first: y instead of y and x instead of x.
11

Time Series Analysis

So far we have used statistical model in which the behaviour of y was explained by a
number of (at least partially) exogenous, pre-determined influences summarized by the
regressors x1, x2,..., xk
What if a lot can be learned about the behavior of yt using the past of the variable?
This is the objective of time series econometrics
This branch of statistics/econometrics supplies key tools to finance

Example: if markets are efficient, it is claimed that prices should be a random
walk, Pt = Pt-1 + t
12


But, before starting with time series, lets remember some things from statistics:
E[] is the unconditional expectation
E[yt] denotes the usual mean of a random variable
Et[]E [|It] is the conditional expectation at time t, where It is the information set
2y is the variance of y
2y,t,t-k Cov[yt, yt-k] is the autocovariance between yt and yt-k
k is the autocorrelation function (ACF ), which is also know as correlogram, measuring the
correlation between yt and yt-k. This is given by
Partial autocorrelation function (PACF)

Measures the correlation between an observation k periods ago and the current observation,
after controlling for the observations in between.
13


There are several time series models
We will review four models in this session:
White Noise
Autoregressive of order p, denoted AR(p)
Moving average of order q, denoted MA(q)
Mixed autoregressive moving average, denoted ARMA(p; q)
The fundamental tool employed to discover which type of process best fits the data on y t are
the ACF and PACF
In addition , we will review some especial models to characterize particular volatility

patterns of some time series:
GARCH models.
14

Time Series Analysis: Stationary Models

White noise
A White Noise process is characterized by the absence of structure

Definition: A stochastic process yt, t = 1, 2, , T is said to be white noise if:
1. It has a zero mean: E(yt) = 0
2. It has a constant variance 2y = E[(yt - E(yt))2]
3. It has zero autocovariance E[(yt - E(yt)) (yt-k - E(yt-k))] = 0 for all values of k
4. All autocorrelations are zero k = 0 (for all ks)
A white noise process is unpredictable

Sums of white noise process are still white noise
15


White noise
16


Moving average (MA(q)) Processes
Definition: A stochastic process yt, t = 1, 2, , T is said to be MA of order q1 if
where ut is white noise, 0 is usually set equal to 1

Properties:
17


18


19


Autoregressive (AR(p)) Processes
Definition: A stochastic process yt, t = 1, 2, , T is said to be autoregressive of order p1 if
where ut is white noise, 0 is a constant (intercept) term and the i are parameters/ coefficients
A shock to yt today tends to be reversed in time through the terms iyt-i
If the is are positive, an AR(p) process is characterized by persistence

This means that a shock to yt today tends to cause long-lasting effects and propagates in time
through the terms iyt-i
If the is are negative, an AR(p) process is characterized by cyclical behavior
An AR(p) process has
Unconditional mean equal to
The necessary and sufficient for stationarity condition is that 1 + 2 + + p <1

Covariance:
ACF
PACF: significant to order of process then zero 20


21


22


ARMA(p,q) Processes
These are a combination of AR and MA processes
A process yt is ARMA(p,q) if
where ut is white noise.
23


ARMA(p,q) Processes
As one would expect of such a process, both the acf and the pacf decline geometrically the acf as
a result of the AR part and the pacf as a result of the MA part.
24


The process is probably:
White noise if:
acf has no significant coefficients AND
pacf has no significant coefficients
MA(q) if:
acf has significant coefficients up to lag q AND
pacf decays quite quickly
AR(p) if:
acf decays quite quickly AND
pacf has significant coefficients up to lag p
ARMA(p,q) if:
acf decays quite quickly AND
pacf decays quite quickly
If there are significant coefficients in both of them:
if q > p select an MA(q) model
if p > q select an AR(p) model
if p = q experiment !
25

Time Series Analysis: Non-stationary Models

There some time series processes you could observe that the volatility change over time and
presents volatility clustering :
In fact, this is the case of asset returns.

How can we model that?
GARCH model
Robert Engle received a Nobel price for this.
26

Time Series Analysis: GARCH models

GARCH (p,q):
yt a0 a1 x1t a2 x2t ... ak xkt t
t t zt
p q
i
t
2 2
t i j t2 j
i 0 j 0
where zt are iid innovations with zero mean and unit variance.
I will not enter in detail in this type of time series, BUT remember that we will use some
GARCH models later on in the course when we will study risk management.
All these models can be easily calculated with any basic econometric software.
27

Teaching assistant example

1- Calculate the parameters, using the optimizer of excel through least squares, of the
following regression
y = 0 + 1x1+ 2x2
y: is human development index (HDI) per country in 2013. You can take the data from:
http://hdr.undp.org/en/content/table-1-human-development-index-and-its-components
x1: Gross domestic product based on purchasing-power-parity (PPP) per capita GDP for 2013.
You can take the data from IMF:
http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/download.aspx
x2: Index of economic freedom in 2013, which you can take from:
http://www.heritage.org/index/download
-Repeat the same exercise using a statistical or econometric softwere (or matlab):
-Show that you obtain the same values for the betas, calculate R^2 and R^2 (adjusted), and
calculate t statistics
-Provide some comments about the results.

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Session 0.

Econometric Review Alejandro Bernales

Finance II (IN 5303)

Linear regression models: what do they mean?

Universidad de Chile 2/29

Linear regression models: what do they mean?

Why do we have an error term ?

Universidad de Chile 3/29

Linear regression models: what do they mean?

y = 0 + 1x1+ 2x2 + + kxk +

Linear regression models: Estimation

The estimated version is then

where e has replaced the errors

Universidad de Chile 5/29

Linear regression models: Estimation

Universidad de Chile 6/29

Linear regression models: Estimation

We want to analyze the bivariate regression model

Universidad de Chile 7/29

Linear regression models: Estimation

This is the least squared method:

Where N is the number of observations.

Universidad de Chile 8/29

Linear regression models: Strength of the linear

Notice that by construction 0 R2 1

Why is the adjustment (the role played by k) important?

Linear regression models: Strength of the relationship

Linear regression models: Spurious Regression

Are they really related? It is clear that there is no a relationship

It is likely that the

concept called cointegration (which we will

Universidad de Chile 11/29

Time Series Analysis

This is the objective of time series econometrics

This branch of statistics/econometrics supplies key tools to finance

Universidad de Chile 12/29

Time Series Analysis

2y,t,t-k Cov[yt, yt-k] is the autocovariance between yt and yt-k

Partial autocorrelation function (PACF)

Universidad de Chile 13/29

Time Series Analysis

In addition , we will review some especial models to characterize particular volatility

Universidad de Chile 14/29

Time Series Analysis: Stationary Models

A White Noise process is characterized by the absence of structure

A white noise process is unpredictable

Universidad de Chile 15/29

Time Series Analysis: Stationary Models

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Time Series Analysis: Stationary Models

Definition: A stochastic process yt, t = 1, 2, , T is said to be MA of order q1 if

where ut is white noise, 0 is usually set equal to 1

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Time Series Analysis: Stationary Models

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Time Series Analysis: Stationary Models

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Time Series Analysis: Stationary Models

If the is are positive, an AR(p) process is characterized by persistence

The necessary and sufficient for stationarity condition is that 1 + 2 + + p <1

PACF: significant to order of process then zero 20

Universidad de Chile 20/29

Time Series Analysis: Stationary Models