Contents 1 Introduction and Outline of the Course 2 2 Course Objectives 3 3 Course Structure 4 4 The Course Author 8 5 Study Materials 9 6 Assessment 9 References 18
Financial Econometrics 2 University of London 1 Introduction and Outline of the Course Welcome to the course on Financial Econometrics. The first objective of this course is to introduce the main econometric methods and techniques used in the analysis of issues related to finance. A course with the title Financial Econometrics assumes that such a field exists. However, as this quote reveals, this is far from true: What is financial econometrics? This simple question does not have a simple answer. The boundary of such an interdisciplinary area is always moot and any attempt to give a formal definition is unlikely to be successful. Broadly speaking, financial econometrics [aims] to study quantitative problems arising from finance. It uses statistical techniques and economic theory to address a variety of problems from finance. These include building financial models, estimation and inferences of financial models, volatility estimation, risk management, testing financial economics theory, capital asset pricing, derivative pricing, portfolio allocation, risk-adjusted returns, simulating financial systems, hedging strategies, among others (Fan, 2004: 1). In this course, we define financial econometrics as the application of statisti- cal techniques to problems in finance. Although econometrics is often associated with analysing economics problems such as economic growth, consumption and investment, the applications in the areas of finance have grown rapidly in the last few decades. Your textbook by Chris Brooks, Intro- ductory Econometrics for Finance, lists the following examples: 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. 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. 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. The above list does not include all the possibilities, and you might think of many other topics that could be added to the list. Course Introduction and Overview Centre for Financial and Management Studies 3 If financial econometrics is simply the application of econometrics to finance issues, does this mean that econometric tools you have studied in previous courses are the same as those used in this course? A simple answer to this question is yes. Many of the concepts that you have encountered in the previ- ous courses such as regression and hypothesis testing are highly relevant for this course. In fact, all the topics introduced in this course will require that you have a deep understanding of these concepts. However, the emphasis and the set of problems dealt with in finance issues are different from the eco- nomic problems you have encountered in previous courses. To start with, the nature of the data in finance issues is very different. Financial data are ob- served at a much higher frequency (in some instances minute-by-minute frequency). For macroeconomic data, we consider ourselves lucky if we are able to observe data on a monthly basis. Furthermore, recorded financial data such as stock market prices are those at which the transaction took place. There is no possibility for measurement error. This is in contrast to macro- economic data, which are revised regularly. Also the properties of financial series differ. For instance, in the course Econometric Analysis and Applications you spent a lot of time analysing whether the series has a unit root and devising methods to estimate models when the variables are integrated of order one. In financial econometrics, these issues are not a major concern. Although we observe prices most of the time, financial econometrics mainly deals with asset or portfolio returns. Since returns are stationary, most of the methods used in this course also apply to stationary series. This may imply that models of financial returns are much easier to deal with. However, this is not the case. The analysis of financial data brings its own challenges. As you will see from Unit 1, financial returns possess some common properties that need to be incorporated in econometric models. For instance, returns of assets such as stocks and bonds exhibit time-varying volatility. This requires introducing new models and estimation techniques to model time varying volatility. Not only that, financial returns can exhibit asymmetry in volatility, which requires further modification of existing models. Furthermore, financial data are not normally distributed. As you have seen in previous courses, the assumption of normality has been central for estimation and hypothesis testing. Unfortunately, even in finance applica- tions, existing econometric techniques still find it difficult to deal with models that assume non-normal distribution. 2 Course Objectives After studying this course you will be able to define and compute measures of financial returns interpret sample moments of financial returns discuss the stylised statistical properties of asset returns Financial Econometrics 4 University of London formulate models using matrix notation derive the OLS estimators using matrix algebra use matrix algebra to analyse sources of variation of risk explain the principles of maximum likelihood estimation derive the maximum likelihood estimators and discuss their properties use maximum likelihood estimation, and apply the hypothesis tests available under maximum likelihood estimation analyse and estimate models of autoregressive, moving average, and autoregressive-moving average models forecast using AR, MA, and ARMA models apply the Box-J enkins approach to time series models model and forecast volatility using autoregressive conditional heteroscedastic (ARCH) models estimate, interpret, and forecast with generalised autoregressive conditional heteroscedastic (GARCH) models extend GARCH models to analyse the asymmetric effect of shocks on volatility construct, estimate and interpret multivariate GARCH models test for spill-over of volatility between assets use vector autoregressive (VAR) models to analyse and interpret interaction between financial variables examine the impact of shocks on financial variables using impulse response analysis undertake tests of hypotheses and Granger causality in a VAR framework formulate limited dependent variable models, including logit and probit models estimate and interpret logit and probit models discuss models with multinomial linear dependent variables. 3 Course Structure Unit 1 Statistical Properties of Financial Returns 1.1 Introduction 1.2 Calculation of Asset Returns 1.3 Stylised Facts about Financial Returns 1.4 Distribution of Asset Returns 1.5 Time Dependency 1.6 Linear Dependency across Asset Returns Exercises | Answers to Exercises Unit 2 Matrix Algebra, Regression and Applications in Finance 2.1 Introduction Course Introduction and Overview Centre for Financial and Management Studies 5 2.2 Matrix Algebra: Some Basic Concepts and Applications 2.3 OLS Regression Using Matrix Algebra 2.4 Applications to Finance Exercises | Answers to Exercises Unit 3 Maximum Likelihood Estimation 3.1 Introduction 3.2 The Maximum Likelihood Function: Some Basic Ideas and Examples 3.3 The Maximum Likelihood Method: Mathematical Derivation 3.4 The Information Matrix 3.5 Usefulness and Limitations of the Maximum Likelihood Estimator 3.6 Hypothesis Testing Exercises | Answers to Exercises Unit 4 Univariate Time Series and Applications to Finance 4.1 Introduction 4.2 The Lag Operator 4.3 Some Key Concepts 4.4 Wolds Decomposition Theory (Optional section) 4.5 Properties of AR Processes 4.6 Properties of Moving Average Processes 4.7 Autoregressive Moving Average (ARMA) Processes 4.8 The Box-Jenkins Approach 4.9 Example: A Model of Stock Returns 4.10 Conclusions Exercises | Answers to Exercises Unit 5 Modelling Volatility Conditional Heteroscedastic Models 5.1 Introduction 5.2 ARCH Models 5.3 GARCH Models 5.4 Estimation of GARCH Models 5.5 Forecasting with GARCH Model 5.6 Asymmetric GARCH Models 5.7 The GARCH-in-Mean Model 5.8 Conclusions Exercises Unit 6 Modelling Volatility and Correlations Multivariate GARCH Models 6.1 Introduction 6.2 Multivariate GARCH Models 6.3 The VECH Model 6.4 The Diagonal VECH Model 6.5 The BEKK Model 6.6 The Constant Correlation Model 6.7 The Dynamic Correlation Model 6.8 Estimation of a Multivariate Model Financial Econometrics 6 University of London Unit 7 Vector Autoregressive Models 7.1 Introduction 7.2 Vector Autoregressive Models 7.3 Issues in VAR 7.4 Hypothesis Testing in VAR 7.5 Example: Money Supply, Inflation and Interest Rate Exercises | Answers to Exercises Unit 8 Limited Dependent Variable Models 8.1 Introduction 8.2 The Linear Probability Model 8.3 The Logit Model 8.4 The Probit Model 8.5 Estimation using Maximum Likelihood 8.6 Goodness of Fit Measures 8.7 Example: Dividends, Growth and Profits 8.8 Multinomial Linear Dependent Variables 8.9 Ordered Response Linear Dependent Variable Models (optional section) Exercises | Answers to Exercises The objective of the course is to extend your knowledge and equip you with methods and techniques that allow you to analyse finance-related issues. This course starts by illustrating how to measure financial returns, the main vari- able that we try to model in financial applications. There are various definitions of returns, and Unit 1 illustrates how to compute the various types of returns. After defining financial returns, Unit 1 presents some stylised facts about the properties of financial returns. These include volatility clus- tering, asymmetric volatility and non-normality. Unit 1 then introduces various measures of moments of the distribution of financial returns, and how these can be computed for samples of financial returns. The material covered in this unit sets the scene for the rest of the course and thus it is important that you make yourself familiar with these concepts. Unit 2 provides a brief introduction to the main principles of matrix algebra. In your previous courses Econometric Principles and Data Analysis and Econometric Analysis and Applications, you developed the basic regres- sion concepts and statistical tools without referring to matrix algebra. That was essential for you to grasp some basic concepts involved in regression analysis. However, in most theoretical and practical applications, the researcher often deals with multivariate relations. As you will discover in this unit, the simplest way to tackle these multivariate relations is to switch to matrix notation. Matrix algebra eliminates the need to use summa- tion signs and subscripts and helps present the results in a simple way. In some of the units of this course, it will be very difficult to present the proofs and results without using matrix notation. Although matrix notation simpli- fies the presentation of the results, the fact remains that you may be learning a new language. Learning a new language can be exciting but it is also chal- lenging. To help you to understand and apply matrix algebra, we use matrix Course Introduction and Overview Centre for Financial and Management Studies 7 algebra in some financial applications, namely the multi-factor models and portfolio theory. Unit 3 provides a brief review of the maximum likelihood estimation method. In all the previous econometrics courses you have studied, the least squares (LS) method was used to derive the estimates of the models parameters and for hypothesis testing. Least Squares is just one of many estimation tech- niques available for econometricians. In Units 4, 5, 6 and 8 of this course, you will encounter models such as GARCH, ARMA and binary choice mod- els that cant be estimated by least squares. Instead, econometricians rely on maximum likelihood estimation, which is a flexible technique, more general than OLS and, under fairly general conditions, yields consistent and efficient estimates of the parameters. However, like any estimation technique, maxi- mum likelihood is based on a certain underlying philosophy and certain principles. In Unit 3, you will be introduced to these principles and how these can be applied to derive estimates of the parameters and test hypotheses about the estimated parameters. This is one of the most challenging units, but hopefully, by using various examples, you will be able to gain a deep under- standing of how the estimation method works, and you will be able to identify its strengths and weaknesses. Unit 4 presents univariate time series models. In these types of models, a series is modelled in terms of its own past values and some disturbance terms (also known as shocks). Univariate time series models were introduced in the course Econometric Analysis and Applications. These models are different from the structural models you have studied in other courses, in the sense that these models are atheoretical that is, they are not based on any underlying theoretical frameworks but are data driven. These models are the first build- ing blocks for estimating financial returns and help illustrate some of the key properties of financial returns. The aim of this unit is to introduce these mod- els, such as the autoregressive model (AR), the moving average model (MA), and a combination of these two (ARMA models). Unit 5 presents some of the econometric methods used for modelling and forecasting volatility of asset returns. Volatility models have attracted the attention of academics and practitioners, and are widely used in many areas of finance, including models of Value-at-Risk, option pricing, and portfolio allocation. One of the stylised facts about asset returns is that the variance of the error terms is not equal at every point in time, and hence the error terms are said to suffer from heteroscedasticity. Thus, in modelling financial re- turns, one should consider approaches that relax the assumption of homoscedasticity. ARCH and GARCH models do exactly that. They relax the assumption of constant variance and exploit the heteroscedasticity feature to model the variance of returns over time. As you will study in this unit, ARCH models are also flexible enough to allow us to incorporate asymmetry in the volatility of financial asset returns. Please note that in this course we refer to homoscedasticity and heteroscedasticity; in Eviews, and elsewhere, you will also see the spellings homoskedasticity and heteroskedasticity. Financial Econometrics 8 University of London Unit 6 extends the GARCH model from the univariate to the multivariate setting. This proves to be an important extension as it allows researchers and financial analysts to model time-varying conditional covariance and correla- tion between the returns of various financial assets. This new technique opened the way for many financial applications such as dynamic asset pricing models, portfolio selection, dynamic hedging, value-at-risk, and volatility transmission between assets and markets. Multivariate GARCH models also help researchers to model some of the features of asset returns, such as corre- lation clustering. Unit 7 presents the Vector Autoregressive (VAR) models, which can be thought of as generalisations to the univariate time series models. VAR mod- els represent an improvement over univariate time series models because they allow variables to be modelled not only in terms of their own lags and their own shocks, but also in terms of the lags of other variables. This pro- vides greater flexibility and allows us to examine the dynamic interactions between a set of variables. VAR models have become very popular in the econometrics literature and are widely used in the areas of macroeconomics and finance. The tools which have developed around VAR, such as impulse response analysis, Granger causality and variance decompositions (all dis- cussed in this unit) have become central to understanding the interaction among variables. VAR models have also been used extensively for forecast- ing purposes, where these models have exhibited a better performance than structural models, especially in out-of-sample forecasting. Unit 8 deals with models in which the dependent variable i.e. the variable that needs to be explained by a set of determinants, is in fact a dummy vari- able. There are many cases where these models can be useful. For instance, financial analysts may be interested as to why some firms list on the stock market while others dont; why some firms issue dividends while others dont; and why some firms decide to raise external finance while others dont. In all these examples, what we observe is whether a firm lists or not, issues dividends or not, or raises external finance or not. Thus, the relevant dependent variable is a dummy variable that takes the value of 1 if the event occurs, and zero if the event does not occur. Such models, known as limited dependent variable models, raise a set of estimation issues that are different from the ones you have encountered so far. The purpose of this unit is to introduce you to limited dependent models and discuss how these models can be applied to finance issues. 4 The Course Author Bassam Fattouh graduated in Economics from the American University of Beirut in 1995. Following this, he obtained his Masters degree and PhD from the School of Oriental and African Studies, University of London, in 1999. He is a Reader in Finance and Management and academic director for the MSc in International Management for the Middle East and North Africa at Course Introduction and Overview Centre for Financial and Management Studies 9 the Department for Financial and Management Studies, SOAS. He is also currently Senior Research Fellow and Director of the Oil and Middle East Programme at the Oxford Institute for Energy Studies at the University of Oxford. He has published in leading economic journals, including the Jour- nal of Development Economics, Economics Letters, Economic Inquiry, Macroeconomic Dynamics and Empirical Economics. His research interests are mainly in the areas of finance and growth, capital structure and applied non-linear econometric modelling, as well as oil pricing systems. 5 Study Materials This course mainly uses one textbook: Chris Brooks (2008) Introductory Econometrics for Finance. This textbook has been chosen for a number of reasons. It is extremely clear, contains a large number of examples and covers a lot of ground. Further- more, it is a useful textbook to refresh your memory of some basic concepts you have studied in previous courses (especially Chapters 2, 3 and 4 of the textbook). Equally important, the textbook uses the Eviews package, which is quite powerful while at the same time fairly easy to use. Finally, the textbook has a very useful companion website with rich resources for students includ- ing inteiactive multiple choice questions, solutions to end of chapter questions, Eviews data and workfiles, and links to useful websites. The link for this companion website can be found at: http://www.cambridge.org/features/economics/brooks/student.html Although the textbook covers a lot of subject areas, in some units you may need to rely more heavily on the course notes and some suggested readings. The units in the course will closely follow the presentation in the textbook. However, for some of the units, this is not feasible either because the chapter does not cover the topic at all, or covers it in a superficial way. In such cases, you may find that the course notes are more demanding than the material presented in the textbook, because the course notes analyse the issues using mathematics (though at a very basic level). This is necessary to gain a deeper understanding of the issues being considered. Throughout this course, it is essential that you do all the readings and solve all the exercises. In this course, each idea builds on the previous ones in a logical fashion, and it is important that each idea is clear to you before you move on. You should therefore take special care not to fall behind with your schedule of studies. 6 Assessment Your performance on each course is assessed through two written assignments and one examination. The assignments are written after Financial Econometrics 10 University of London week four and eight of the course session and the examination is written at a local examination centre in October. The assignment questions contain fairly detailed guidance about what is required. All assignment answers are limited to 2,500 words and are marked using marking guidelines. When you receive your grade it is accompanied by comments on your paper, including advice about how you might improve, and any clarifications about matters you may not have understood. These comments are designed to help you master the subject and to improve your skills as you progress through your programme. The written examinations are unseen (you will only see the paper in the exam centre) and written by hand, over a three hour period. We advise that you practice writing exams in these conditions as part of you examination preparation, as it is not something you would normally do. You are not allowed to take in books or notes to the exam room. This means that you need to revise thoroughly in preparation for each exam. This is especially important if you have completed the course in the early part of the year, or in a previous year. Preparing for assignments and exams There is good advice on preparing for assignments and exams and writing them in Sections 8.2 and 8.3 of Studying at a Distance by Talbot. We rec- ommend that you follow this advice. The examinations you will sit are designed to evaluate your knowledge and skills in the subjects you have studied: they are not designed to trick you. If you have studied the course thoroughly, you will pass the exam. Understanding assessment questions Examination and assignment questions are set to test different knowledge and skills. Sometimes a question will contain more than one part, each part test- ing a different aspect of your skills and knowledge. You need to spot the key words to know what is being asked of you. Here we categorise the types of things that are asked for in assignments and exams, and the words used. The examples are from CeFiMS exam papers and assignment questions. Definitions Some questions mainly require you to show that you have learned some concepts, by setting out their precise meaning. Such questions are likely to be preliminary and be supplemented by more analytical questions. Generally Pass marks are awarded if the answer only contains definitions. They will contain such words as: Describe Define Examine Distinguish between Course Introduction and Overview Centre for Financial and Management Studies 11 Compare Contrast Write notes on Outline What is meant by List Reasoning Other questions are designed to test your reasoning, by explaining cause and effect. Convincing explanations generally carry additional marks to basic definitions. These will include words such as: Interpret Explain What conditions influence What are the consequences of What are the implications of Judgment Others ask you to make a judgment, perhaps of a policy or of a course of action. They will include words like: Evaluate Critically examine Assess Do you agree that To what extent does Calculation Sometimes, you are asked to make a calculation, using a specified technique, where the question begins: Use indifference curve analysis to Using any economic model you know Calculate the standard deviation Test whether It is most likely that questions that ask you to make a calculation will also ask for an application of the result, or an interpretation. Critique In many cases the question will include the word critically. This means that you are expected to look at the question from at least two points of view, offering a critique of each view and your judgment. You are expected to be critical of what you have read. The questions may begin Financial Econometrics 12 University of London Critically analyse Critically consider Critically assess Critically discuss the argument that Examine by argument Questions that begin with discuss are similar they ask you to examine by argument, to debate and give reasons for and against a variety of options, for example Discuss the advantages and disadvantages of Discuss this statement Discuss the view that Discuss the arguments and debates concerning The grading scheme Details of the general definitions of what is expected in order to obtain a particular grade are shown below. Remember: examiners will take account of the fact that examination conditions are less conducive to polished work than the conditions in which you write your assignments. These criteria are used in grading all assignments and examinations. Note that as the criteria of each grade rises, it accumulates the elements of the grade below. Assignments awarded better marks will therefore have become comprehensive in both their depth of core skills and advanced skills. 70% and above: Distinction as for the (6069%) below plus: shows clear evidence of wide and relevant reading and an engagement with the conceptual issues develops a sophisticated and intelligent argument shows a rigorous use and a sophisticated understanding of relevant source materials, balancing appropriately between factual detail and key theoretical issues. Materials are evaluated directly and their assumptions and arguments challenged and/or appraised shows original thinking and a willingness to take risks. 60-69%: Merit as for the (5059%) below plus: shows strong evidence of critical insight and critical thinking shows a detailed understanding of the major factual and/or theoretical issues and directly engages with the relevant literature on the topic develops a focussed and clear argument and articulates clearly and convincingly a sustained train of logical thought shows clear evidence of planning and appropriate choice of sources and methodology. 5059%: Pass below Merit (50% = pass mark) shows a reasonable understanding of the major factual and/or theoretical issues involved Course Introduction and Overview Centre for Financial and Management Studies 13 shows evidence of planning and selection from appropriate sources, demonstrates some knowledge of the literature the text shows, in places, examples of a clear train of thought or argument the text is introduced and concludes appropriately. 4549%: Marginal Failure shows some awareness and understanding of the factual or theoretical issues, but with little development misunderstandings are evident shows some evidence of planning, although irrelevant/unrelated material or arguments are included. 044%: Clear Failure fails to answer the question or to develop an argument that relates to the question set does not engage with the relevant literature or demonstrate a knowledge of the key issues contains clear conceptual or factual errors or misunderstandings. [approved by Faculty Learning and Teaching Committee November 2006] Specimen exam paper Your final examination will be very similar to the Specimen Exam Paper that follows . It will have the same structure and style and the range of question will be comparable. CeFiMS does not provide past papers or model answers to papers. Our courses are continuously updated and past papers will not be a reliable guide to current and future examinations. The specimen exam paper is designed to be relevant to reflect the exam that will be set on the current edition of the course. Further information The OSC will have documentation and information on each years examination registration and administration process. If you still have ques- tions, both academics and administrators are available to answer queries. The Regulations are also available at www.cefims.ac.ukiegulations.shtml, setting out the rules by which exams are governed. Financial Econometrics 14 University of London
UNIVERSITY OF LONDON Centre for Financial and Management Studies MSc Examination for External Students 91 DFMC359
FINANCE Financial Econometrics Specimen Examination This is a specimen examination paper designed to show you the type of examina- tion you will have at the end of the year for Financial Econometrics. The number of questions and the structure of the examination will be the same but the wording and the requirements of each question will be different. Best wishes for success in your final examination. The examination must be completed in THREE hours. Answer THREE questions. The examiners give equal weight to each ques- tion; therefore, you are advised to distribute your time approximately equally between three questions.
Do not remove this paper from the examination room. It must be attached to your answer book at the end of the examination.
University of London, 2010 PLEASE TURN OVER Course Introduction and Overview Centre for Financial and Management Studies 15 91 DFMC359 Financial Econometrics Answer THREE questions. 1 Answer all parts of the question. Consider the following GARCH(1,1) model
where is a daily stock return series. a) Explain carefully how you would estimate this model. b) Interpret the estimated coefficients of the model. c) Explain the difference between the conditional variance and the unconditional variance. Calculate the unconditional vari- ance for the model. Under what conditions will unconditional variance be stationary? d) Describe two extensions to the original GARCH model. What additional characteristics of financial data might they able to capture? 2 Answer all parts of the question. Suppose that you are interested in modelling the correlation be- tween the returns of the British Airways stock and the returns on crude oil. a) Write down a constant correlation problem for this model. b) Explain carefully how you would estimate the above model. c) Discuss the values of the coefficients estimates that you would expect. d) Discuss two alternative approaches to correlation modelling. What are the strengths and weaknesses of multivariate GARCH model compared to the alternatives you propose? 3 Answer all parts of the question. a) Explain why the linear model is inadequate as a specification for the limited dependent variable estimation. b) How does the logit model overcome the problem in part (a)? c) Describe the intuition behind the maximum likelihood esti- mation technique used for limited dependent variable model. d) How can we measure whether a logit model that has been es- timated fits the data well or not? Financial Econometrics 16 University of London 4 Answer all parts of the question. a) Explain the underlying philosophy behind maximum likeli- hood estimation. b) OLS and maximum likelihood are used to estimate the pa- rameters of a standard linear regression model. Will they give the same estimate? Explain your answer. c) Discuss the main advantages and limitations of the maximum likelihood method. d) Describe one hypothesis testing procedure that is available under the maximum likelihood estimation. 5 Answer all parts of the question. a) Discuss three stylised features of financial data. b) Can any of these features be modelled using linear time se- ries models? Explain your answer. c) Explain the moments of the random variable. How can you estimate these in empirical applications? d) Explain carefully the Bera-J arque test, stating clearly the null and alternative hypothesis. In case of financial data, do you expect the Bera-J arque test to accept or reject the null? Ex- plain your answer. 6 Answer all parts of the question. Consider the following three models, which a researcher suggests might be a reasonable model of stock market prices.
y t = y t 1 + u t (1)
y t = 0.5 y t 1 + u t (2)
y t = 0.8 u t 1 + u t (3) a) What classes of models are these examples of? b) What would the autocorrelation function for each of these processes look like? (Dont calculate the acf; simply consider the shape.) c) Describe the steps that Box and J enkins suggested should be involved in constructing the above models? d) What procedure may be used to estimate the parameter in equation 3? Explain how such a procedure works and why OLS is no appropriate. Course Introduction and Overview Centre for Financial and Management Studies 17 7 Answer all parts of the question. a) Explain why VAR models have become popular for applica- tion in economics and finance, relative to structural models derived from some underlying theory. b) Define carefully the following terms i structural VAR model ii standard VAR model. c) Describe and evaluate two methods for determining the ap- propriate lag lengths in VARs. d) Explain carefully the Granger Causality test in a multivariate framework. 8 Answer all parts of the question. Consider the following model where the dependent variable (say stock returns) is assumed to be dependent on k explanatory vari- ables such that
a) Write the above model in matrix form. b) Estimate the parameters of the model in part (a) using the method of least squares. c) What is mean by multifactor models? How are these models used in finance? d) Consider a two factor model such that
y = + X + u where is the vector of returns, is the vector of ones and X is the matrix of the factors. Calculate the expected value and the variance of returns. Comment on the results. [END OF EXAMINATION] Financial Econometrics 18 University of London References Brooks C (2008) Introductory Econometrics for Finance, Second Edition, Cambridge: Cambridge University Press. Fan J (2004) An introduction to financial econometrics, Department of Operation Research and Financial Engineering, Princeton, NJ : Princeton University, November.