financial econometrics introduction

8/11/2019 Financial Econometrics Introduction

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FINANCIAL ECONOMETRICS:

SCOPE AND METHODS

By Prabath. S. Morawakage


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Financial Econometrics

Concerns A mission for models that describe financial

time series such as prices, returns, interestrates, financial ratios, defaults etc.

Reason for the existence of such subject?

Main Question in Financial Econometrics

Its a multi discipline

Finance Economics

Mathematics

Statistics


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The universe cannot be read until we havelearnt the language and become familiar withthe characters in which it is written. It iswritten in the language of mathematics; theletters are triangles, circles, and othergeometrical figures, without which it is

humanly impossible to comprehend a singleword.

Galileo -1623


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It was only in the second half of the 20thcentury that a quantitative description ofeconomics became a mainstream discipline:econometrics (i.e., the quantitative science ofeconomics) was born.


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Data Generating Process

We write mathematical models, that is, relationshipsbetween different variables and/or variables indifferent moments and different places.

The basic tenet of quantitative science is that thereare relationships that do not change regardless ofthe moment or the place under consideration sea waves - random movement

in every moment and location the basic laws of hydrodynamics

hold without change

asset price - random movement

but econometric laws should hold in every moment and forevery set of assets


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Econometric models model the economy orfinancial markets

Information efficiency today Vs yesterday

Because the economy and financial markets areartifacts subject to change, econometric modelsare not unique representations valid throughouttime; they must adapt to the changingenvironment.

financial econometrics uses both continuoustime and discrete time models Derivatives Pricing CAPAM


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What is Data generating Process In a discrete dynamic model the mathematical relation ship

between variables at different time is called the datagenerating process

E.g. pt + 1 = + pt+ t+ 1

if we consider any two consecutive instants of time,there is a combination of prices that behave as randomnoise E.g. pt+ 1 pt= t + 1

an econometric model can be regarded as amathematical device that reconstructs a noise sequencefrom empirical data.


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Static models (i.e, models that involve onlyone instant) are used to express relationshipsbetween different variables at any giventime.

Static models are used, for example, to

determine exposure to different risk factors.

However, because they involve only one instant,static models cannot be used to make forecasts;

forecasting requires models that link variables intwo or more instants in time.


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Financial Econometrics at

WorkApplying financial econometrics involves threkey steps:

1. Model selection 2. Model estimation

3. Model testing


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Modeling issues

How do we apply statistics given that there is only one realization of

financial series?

Given a sample of historical data, how do we choose between linear

and nonlinear models, or the different distributional assumptions ordifferent levels of model complexity?

Can we exploit more data using, for example, high-frequency data?

How can we make our models more robust, reducing model risk?

How do we measure not only model performance but also the abilityto realize profits?


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Important factors to be

considered Time horizon

Model Riskiness

Model Robustness


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APPLICATIONS

There has been a greater use of econometricmodels in investment management since theturn of the century. Application areas include:

Portfolio construction and optimization

Risk management

Asset and liability management

financial econometrics introduction

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