FINANCIAL TIME-SERIES

ECONOMETRICS
Mar 2, 2002
SUN LI JIAN
INTRODUCTION
Contents
1. Models,Data and Process
The nature of the econometric approach
The Process of an econometric analysis
2. Applications of Financial Econometrics
Dynamic effects of various shocks
Empirical finance
Refining data
3. Key Features of Financial Time Series
The regression model
Time series models
Dynamic model
4. Contents of Time Series Modeling
Stationary stochastic time series model
Nonstationary stochastic process
Multiple time series modeling
Time series models of heteroskedasticity
State space model
5. Text and Software
Text
Software
6. Some Basic Tools
Difference equations and their solutions
Solution methodology
Stability conditions
Impulse response function
The basics of time series analysis software
7. Summary and Conclusions
Appendix: TSP Program to Accompany Chapter 1
Box: Empirical Research on Exchange Rate
Bibliography
1. MODELS, DATA AND PROCESS
The Nature of The Econometric
Approach
structural analysis
evaluation
forecasting
The Process of An Empirical Analysis
model specification
structural equations and reduced forms
parameters conditions
sampling and refining data
Identification and estimation
statistical test
economic interpretation
Time Series Analysis
Theor
y
Facts
Model Data
Statistic
al
Theory
Econometri
c Theory
Refined
Data
Econometri
c
Techniques
Estimation of Econometric Model with the
Refined Data Using Econometric
Techniques
Evaluatio
n
Forecasting
Structural
Analysis
Econometric Approach
Structural Analysis
Econometric Model
Linear model
Greene (2000)
Nonlinear model*
Davidson Mackinnon (1993)

Static model
Time series model
Enders 1995
Dynamic model
Christian Gourieroux (1997)
Structure Change Maddala and Kim,1998)
Chow test
Time-varying parameters
Evaluation
The Simulation Approach
Identification
Limited-information estimation
Full-information estimation
Monte Carlo studies

Other Approaches
The Instruments-targets approach
The Social-welfare-function approach
Forecasting
Forecasting Methods
Sample information
Economic theory

Introduction to Forecasting Techniques
Time series model (ARIMA,GARCH,KALMAN-filter)
Statistical model (Monte Carlo techniques,MSFE)
Data and Refining
Type
Quantitative versus qualitative data
Time-series versus cross-section data (Panel Data)
Non-experimental versus experimental data
Micro versus macro data
Nature
Degrees of freedom
Multicollinearity
Serial correlation
Structural change
Errors in measurement
Non-stationary
Source
IMF international financial statistics (CD-ROM)
2. APPLICATIONS OF FINANCIAL ECONOMETRICS
Dynamic Effects of Various Shocks
Transmission mechanism of financial crisis
Credit channel of policy
Empirical Finance
Forecasting(price of capital assets, risk premium,etc.)
Predictability of asset returns
Market microstructure
Term structure
Financial integration
Refining Data
Missing data
Base changes (GDP,M1,etc.)
Nonstationary (EX,IR,etc.)
3. KEY FEASURES OF FINANCIAL TIME SERIES
The Regression Model
The Method of ordinary least squares
Assumption (disturbance term;observations, independent
variables)
The Gauss-Markov theorem (BLUE,consistency)
Other methods of estimation
Maximum likelihood
Moments
Bayesian approach
The Probability distribution for OLS estimator
Parameters and disturbance term
t,F,P tests and significance (confidence intervals)
Applications (structural break,prediction,model selection)
Extensions
Diagnosis and treatment
) (
t t t
u x y + + = | o
Time Series Models
Differences between LRM and TSM
Exogenous variables,sequence,theory
Components
Trends
Seasonality
Cycle
Irregularity (convergence)
Conditional heteroskedasticity (volatility)
Non-linearity (state dependency)
Determinants
Function structure:
Lag order:
Dynamic Model
Transfer process (impulse response function)
)] , ,... , ( [
2 1 t p t t t t
u x x x f x

=
f
p
)] , ,... , , ( [
2 1 t p t t t t t
u y y y x f y

=
4. CONTENTS OF TIME SERIES MODELING
Stationary Stochastic Time Series Model
ARMA
ARIMA
Nonstationary Stochastic Process
Unit root test
Cointegration and error correction model
Multiple Time Series Modeling
VAR
Granger test
Structural VAR
Time Series Models of Heteroskedasticity
ARCH
GARCH
State Space Model
KALMAN filter
Regime switching model
Other Useful Financial Econometric
Models
Methods of Instrumental Variables
GMM
Discrete and Limited Dependent Variable
Models
Probit,logit and tobit models
Computationally Intensive Methods
Monte Carlo methods
The bootstrap
Permutation test
Nonparametric and semiparametric estimation
Panel Data Analysis
Survival Data Analysis
Event-Study Analysis
5. TEXT AND SOFTWARE
Text
Enders,Walter. (1995) Applied Econometric
Time Series. John Wiley & Sons,Inc.
TSP (Ver.4.4) Reference Manual (1997)
Greene,William H. (2000) Econometrics
Analysis.4
th
ed. Prentice-Hall International,Inc.
Software
(http://emlab.berkeley.edu)
TSP,SHAZAM,RATS
GAUSS,S-PLUS
SPSS,SAS,STATA
Mathematica,Excel
6. SOME BASIC TOOLS
Difference Equations and Their
Solutions
The special form of nth-order linear difference equation


The special form of the forcing process


The solution form of difference equations


Solution Methodology
Iteration (e.g. first-order)
With initial condition:forward from the specific period
Without initial Condition: backward to infinity

t
n
i
i t i t
u y a a y + + =

=

1
0

=

=
0 i
i t i t
u c |
{ } | | C t f y
t t
, , c =
) (
0
y
) ( i
) (
1
0
1 0 1
1
0
1 0

=

=
+ + =
t
i
i t
i t
t
i
i
t
a y a a a y c
Structural decomposition methods
e.g.
General solution:
Homogeneous solution
Characteristic equation and characteristic root






Particular solution (challenge solution)
(1)Method of undetermined coefficients
t h
t
A y d o = > 0
t h
t
t h
t
A y t y d o o = = = ; 0
) cos( 0
2 1
| u | + = < t r y d
t h
t
] ) ( 2 /[ ) cos( ; ) (
2 / 1
2 1
2 / 1
2
a a a r = = u
]} 4 ) [( {
2
2
1
a a d + =
sp
t
dp
t
h
t t
y y y y + + =
c y u
dp
t
d
t
= = 0

=

= =
0 i
i t i
sp
t t
s
t
y u c o c
t t t t
u y a y a a y + + + =
2 2 1 1 0
) (
s
t
d
t t
u u u + =
(2)Lag operators
for , then

for , then

Stability Conditions
Inside unit circle
Necessary condition:

Sufficient condition:
Unit root process
Unit root exit, if
Impulse Response Function
The effect of stochastic shock:
) (
i t t
i
y y L

1 < a
) 1 /( ) 1 (
3 3 2 2
aL y y L a L a aL
t t
= + + + +
1 > a

=

=
0
1
) ( ) ( ) 1 /(
i
t
i
t
y aL aL aL y
1
1
<

=
n
i
i
a
1
1
<

=
n
i
i
a
1
1
=

=
n
i
i
a
) , (
1
C t g
p
t
n t
=
c
c
+
c
The Basics of Time Series Analysis
Software
Starting and quitting
Interactive mode
batch mode
Fundamental program structure and some important
commands
Constructing and manipulating data
Data set-up(frequency,numbers)
Data input(external file;format;subsets)
Data transformation(dynamic equation;order change)
Refining data(seasonality,etc.)
Descriptive statistics(mean,variance,correlation,etc.)
Data output(print,plot,output,type,etc.)
Linear regression analysis
Analysis command(OLS)
The interpretation of the test statistics
The economical implication of empirical results
7. SUMMARY AND CONCLUSIONS
Econometrics utilizes economic theory,facts(data) and statistical
techniques,to measure and to test certain relationships among
economic variables,thereby giving these results to economic
reasoning.
Empirical finance provides analytical tools needed to examines
the behavior of financial markets.Topics covered include
estimating the dynamic impact multiplier of financial
shocks,forecasting the value of capital assets,measuring the
volatility of asset returns, testing the financial integration, and
more.
Time-series econometrics is concerned with the estimation of
difference equations containing stochastic components. These
solution can be divided into two parts: a homogeneous portion
and particular portion .The former is especially important in that
it yields the characteristic roots which determine the system
stability,the latter will be solved by the use of lag operators.
This chapter introduces some basic concepts of the soft used to
time series analysis and describes commands for setting up
observations, reading data,making transformation,and
illustrating OLS estimation method.
Appendix : TSP Programs to
Accompany Introduction
OPTIONS CRT;
? Monetary Approach to Exchange Rate
FREQ M;
SMPL 80 :1,90:12;
LOAD(FILE=C:\DATA\EXCISE1.XLS);
PRINT SJA MJA IJA YJA MGE IGE
YGE;
? Data statistic description
MSD(CORR,COVA)MJA MGE IJA IGE;
? Data transformations
SJAGE=SJA/SGE;
LOGSJAGE=LOG(SJAGE);
LOGM=LOG(MJA)-LOG(MGE);
DI=IJA-IGE;
LOGY=LOG(YJA)-LOG(YGE);
PLOT LOGM * LOGY +;
PLOT DI %;

? Empirical analysis (technique:OLS)
OLSQ LOGSJAGE C LOGM DI LOGY;
ESLSJAGE=@FIT;
ESRES=@RES;
PLOT LOGSJAGE + ESLSJAGE*;
PLOT ESRES %;
END;
Box: Empirical research on
Exchange Rate
CASE OF MONETARIST APPROACH
Assumption:
(a) perfect substitutes in consumer demand functions
(b) perfect substitutes between domestic and foreign bonds
(c) domestic and foreign elasticities are equal
Model:
(1)
(2)
(3)
(4)
(5)

t t t t t
i y p m c o | + =
t t t t
p p s v + =
-
t t t t t
u i i y y m m s + + =
- - -
) ( ) ( ) ( o |
t t t t t
s s E i i q + =
+
-
) ( ) (
1
t t t t t t
E y y m m s , t t | + + =
+
- - -
1
) ( ) ( ) (
) (
- - - - -
+ =
t t t t t
i y p m c o |
Bibliography
Campell,J.Y., Lo,A.W. and MacKinlay,A.C. (1997) The Econometrics
of Financial Markets. Princeton University Press.
Frankel,J. A. and A.K.Rose (1995) Empirical research on nominal
exchange rates. In G.M.Grossman and K.Rogoff,eds., Handbook of
international economics, vol.3. Amsterdam:North Holland.
Hodrick, R. (1978) An empirical analysis of the monetary approach to
the determination of the exchange rate. In J.Frenkel and
H.G.Johnson,eds., The Economics of Exchange Rates, Addison-
Wesley.