Answers to the Specimen Exam paper (These are only skeleton answers, you need to explain the answer

in more detail in an exam) 1) Financial data, although usually plentiful in same forms can be limited in numbers of observations. The main problems with observations arises with accounting data, particularly balance sheet data, which is often only produced annually. In many countries this accounting data has only become available recently and even in developed countries, changes in the accounting rules, mean that data can only be used relatively recently. The main way of overcoming this problem is to use a panel, which comprises both cross sectional and time series data. So if there are 10 years of annual data and 0 companies, this would produce 00 observations. !s with other types of data, financial data can suffer from unobserved heterogeneity in cross section form, the use of the panel allows this to be overcome using a fi"ed or random effects approach. b) There are basically two assumptions that can be made about the error term, either there e"ists fi"ed effects or random effects, where it is assumed different sections re#uire varying constants or error terms. The main possible assumptions are$ a) The intercept and slope are constant over time and space, the error term captures differences over time and individuals. b) The slope coefficients are constant, intercept varies over individuals. c) Slope coefficients are constant, intercept varies over individuals and time d) Intercept and slope coefficients vary over individuals e) Intercept and slope coefficients vary over individuals and time. c) The main way to account for these unobserved fi"ed effects is to introduce a dummy variable for each individual %minus 1 as usual with dummy variables, unless the common intercept is being e"cluded). In this case the unobserved effect is being treated as the coefficient of the individual& specific dummy variable. In this case we get the following model$
y it =

j xijt + i Ai + uit
j= i =1

'here Ai ta(es the value of 1 for an observation relating to individual i and )ero otherwise. In the above e"ample we have omitted the intercept for the whole regression and included an intercept for each individual. This is an alternative to omitting one of the individual dummies. *#ually the same process can be adopted for the time series components, whereby a dummy variable is included for each time period, this has the effect of pic(ing up any unobserved effects for each year, month etc.

%In this #uestion the constant is +0 whereas it should have been +1 although in general it does not matter what the constant is called) d) This is a random effects model, where it is assumed it is the error term that varies across time and space. If the unobserved effects are distributed randomly, we can treat the i %different intercepts) as random variables, drawn from a given distribution. This involves subsuming the unobserved effects into the disturbance, rather than assuming they are constant therefore being modelled using separate intercepts. In this case there are two components to the error term, the , part which relates to the individual& specific error terms for each individual and the u part referring to the common error term across all individuals and times. 'hen conducting a random effects estimation, the usual assumptions about the error term apply and in addition we assume that the two error components are independent. !part from assuming the random effects are drawn randomly from a distribution, we also assume that the unobserved effects are independent of the observed x variables. To determine whether fi"ed or random effects models are most appropriate, the -ausman test is used, where the null hypothesis is that the random effects model is most appropriate. ) !n !utocorrelation Function %!.F) can be used to produce the correlogram and determine if a series is stationary or not.

k cov ariance%lagk ) = 0 var iance Where 1 k +1 k =

If /( is plotted against (, the population correlogram is obtained. To produce a correlogram and determine if a series is stationary$ a) .ompute the sample covariance and variance at lag ( for series y. 0 0 k = k plotted from ( 1 1 onwards. b) Then 00 0 k values would If a time series is stationary, the correlogram will indicate that all be )ero, non&stationary series usually have values significantly above )ero, then 0 k can be 2udged declining for higher values of (. The statistical significance of either by its standard error or the 3&statistic. c) 3&statistic 4 0.05 6 78 1 8.9:, ;< 4 7867:60.01 1 =:. 9 d) .hi&s#uared %9) 4 17.70>. 3&statistic suggests the series is stationary, the ;< suggests non&stationary, the difference is due to the relative small sample si)e, the ;< is more li(ely to be accurate. c)

yt = yt 1 0.>7 yt + ut yt = Lyt 0.>7 L yt + ut %1 L + 0.>7 L ) yt = ut 1 L + 0.>7 L = 0 %1 1.7 z )%1 0.7 z ) = 0 z = 0.::>, z =

!s only one root lies outside the unit circle, the process is non&stationary. e) !n out&of&sample forecast uses different data to carry out the estimation of the model and to do the forecast, in effect a number of observations are left at the end of the sample to do the forecast. !n in&sample forecast is one where the model is estimated over the entire length of the sample, then the forecast is carried out using the same observations at the end of the sample as those included in the model estimation. The out&of&sample forecast is usually felt to be best as it is more rigorous, it should be relatively easy to produce forecasts using data that has also been used to estimate the model?s parameters. f) Financial loss functions measure the number of times the forecast correctly predicts turning points in the data and whether it can correctly predict whether the data is positive or negative, i.e. moving up or down. This is particularly important with financial data, as this determines if a profit is made or not. The formula for these loss functions is$
@ correct signs =
T 1 z t +s T %T1 1) t =T1

z t +s = 1 $ % y t +s . f t , s ) > 0 z t +s = 0otherwise

Aften the accuracy of the forecast is not important to ma(e a profit, but whether the mar(et or option is moving up or down. =a) Simultaneous e#uation bias occurs where there are endogenous e"planatory variables, which produces inconsistent estimates. Biven the following simple model ct = 0 + 1 yt + u t %1)
y t = ct + I t % )

'here c is consumption, y is output, I is investment and u is the error term. <y substituting %1) into % ) gives the reduced form e#uation$

yt =

0 1 1 + It + ut %1 1 ) 1 1 1 1

%=)

where the endogenous variable y is e"pressed as a function of an e"ogenous variable I. -aving estimated the reduced form e#uation, it is then possible to estimate the original parameters 1 and . Csing e#uation %=) above, we can

show that the cov% yt , ut ) 0 . <y calculating the value of y and the e"pected value of y, also ta(ing into account that *%ut)10, we can show that$
E %ut ) = 0 %1 1 ) %1 1 ) Therefore the estimators fail the fourth Bauss&Dar(ov assumption, where the error term and e"planatory variable are related. cov% yt , ut ) =

b) The E!F has many advantages, among them is the fact that the e#uations can be estimated by A;S individually, as all the e"planatory variables are lagged, meaning they are predetermined. So at time t they are (nown, thus there can not be any feedbac( from the left hand side %;-S) variables to the right hand side %rhs) variables. In addition it overcomes the problem of deciding which variables are endogenous or e"ogenous as all variables are by definition endogenous as they all act as dependent variables. This is a particular criticism of estimating Simultaneous *#uation models, where it is necessary to specify which variables are endogenous and which e"ogenous, before they can be estimated using two stage least s#uares. %-owever in a E!F it is possible to specify a purely e"ogenous variable as a regressor, in this case there would be no e#uation in which it was a dependent variable). In addition the problem of model identification does not occur when using a E!F. Groviding there are no contemporaneous terms acting as regressors, A;S can be used to estimate each e#uation individually, as all the regressors are lagged so therefore treated as pre& determined. c) Dost financial data is endogenous, as it is mar(et determined. -owever one problem with assets is that it is often difficult to state a specific model, to overcome this general models are stated, where it is assumed all variables are endogenous and interact. !lthough this is atheoretical, it helps to catch the influences on the asset. di) The order condition states to be identified, each e#uation must e"clude at least %n&1) variables, where n is the number of endogenous variables %e#uations). n is in this case, so 1 variable must be e"cluded for the e#uation to be identified. The first e#uation e"cluded 1 variable %lagged y) so is e"actly identified, the second e#uation does not e"clude any, so in not identified. ii) Indirect ;east S#uares can only be used where an e#uation is e"actly identified. It involves setting up the reduced form e#uations, then estimating these e#uations using A;S and finally producing the original structural coefficients from the estimated coefficients on the reduced form e#uations. This could not be done with e#uation as it is not identified. 8a) The E!F %and E*.D) overcomes the simultaneous e#uation bias as it includes only lagged variables as e"planatory variables, in the case of the 8 variables and lags, the following model would be produced.

 9 ot + u1t st = 0 + 1 pt 1 + st 1 + =it 1 + 8 ot 1 + 7 st + : it + > pt + 9 ot + u t it = 0 + 1 pt 1 + st 1 + =it 1 + 8 ot + 7 st + : it + > pt + 9 ot + u =t ot = 0 + 1 pt 1 + st 1 + =it 1 + 8 ot + 7 st + : it + > pt + 9 ot + u 8t

pt = 0 + 1 pt 1 + st 1 + =it 1 + 8 ot 1 + 7 st + : it + > pt +

b) If an e"ogenous variable is included, then it can not be used as a dependent variable in a separate e#uation, therefore if there are 7 variables in a model, one of which is e"ogenous, then there will be 8 separate e#uations, all of which could include the e"ogenous variable as an additional e"planatory variable. -owever this can then produces problems with the order condition. c) Ane problem with the E!F %and e#ually a E*.D) is the difficulty in interpreting the coefficients, due to the numbers of lags. !s the signs on the coefficients often contradict each other, as do the t&statistics, we carry out Branger causality tests on groups of lags of the same variable, to determine if there is any causal effect from one variable to another. -owever the Branger causality tests do not determine the sign of the effect or how long it lasts. This re#uires impulse response functions, where the effect of a unit shoc( to an error term on the variables is assessed. i.e. if we have a system of two e#uations consisting of two endogenous variables y1t and y 1t with a single lag for each variable such as$
yt = A1 yt 1 + ut

the matrices and vectors in full would be$

y1t 0.8 0.y1t u1t = + y t 0. 0.1yt1 ut

The ne"t step is to calculate the value for each dependent variable, given a unit shoc( to the variable y1t at time t = 0 . The value of each dependent variable can be determined at t = 0,1, ,= etc. In this case there is no effect in the y t variable due to the way the model is set up, however if the y1t 1 variable in the y t e#uation, had been different to )ero, then the shoc( would have affected both variables. This enables us to simplify the wor(ings. If at time period 1 we have the following relationship$
y1 = A1 y0

'here

If we have a unit shoc( to error term u10 , this implies that$

u10 y0 = u 0

 0.8 0. 1 0.8 y1= = 0 . 0.1 0 0.

etc

'hen the time path of the impulse response is charted, it would show it moving towards 0, which implies the relationship is stable and the effect of the shoc( had died away #uic(ly. -owever in practise these impulse response functions are difficult to interpret.

d) There is disagreement over whether all the variables in a E!F should be I%0) or not. For instance Sims who developed the E!F suggests if all the variables are differenced to produce I%0) stationary variables, you are missing some important long&run information which needs to be included. In practise E!Fs often contain both I%0) and I%1) variables, although this has implications for the stationarity of the error term. If all the variables are I%1) we could have done a test for cointegration and then formed the E*.D, if cointegration had been found. If there is no cointegration it suggests a E!F with differenced variables is best). 7a) The Hohansen has a number of advantages over the *ngle&Branger cointegration test. It allows for more than two endogenous variables and can produce more than one cointegrating vector. The I and + coefficients then provide the long and short run relationships respectively. In addition as it is a ma"imum li(elihood test we can test restrictions on the cointegrating vectors. The disadvantages are that in producing more than one cointegrating vector, which vector is most appropriate for assessing the I and + coefficients, when more than one are presentJ Similarly which test statistic is best, when the two disagreeJ Finally 'ic(ens %155>) suggest the main fault with the Hohansen is that we are too li(ely to re2ect the null hypothesis of no cointegration, when we should accept it. b) The error correction term can be interpreted as the speed of ad2ustment bac( to e#uilibrium following a shoc(. The closer it is to 1, the #uic(er the ad2ustment, in addition it needs to be negative otherwise the model is not stable. !lso if there is evidence of cointegration, the error correction term should be significant, based on the t&statistic. In the Hohansen approach the + coefficient represents the short&run ad2ustment, as with the coefficient on the error correction term.

c) The !KF test is used to test for the presence of a unit root and is based on the test for a random wal(, where the null hypothesis is that the variable is stationary. !s with the *ngle&Branger test for cointegration, where the residual is tested for stationarity using the !KF test, in the Hohansen D; test the multivariate version of the !KF test is carried out. !s with the !KF test we are testing the coefficients %in matri" form) on the lagged level terms to determine if the ran( of that matri" is 0. The number of cointegrating vectors depends on the ran( of that matri". Cnli(e the !KF based tests for cointegration, the Hohansen techni#ue produces two statistics, the li(elihood ratio test based on ma"imal eigenvalue of the stochastic matri" and the test based on trace of the stochastic matri". These statistics are then used to determine the number of cointegrating vectors. The test is based around an e"amination of the matri", where can be interpreted as a long&run coefficient matri". The test for cointegration between the variables is calculated by loo(ing at the ran( of the matri" via its eigenvalues d) The Trace test indicates cointegrating e#uations, where the ma"imal eigenvalue test suggests only 1. 'e would therefore assume a single cointegrating e#uation is present. ii) These are interpreted in the usual way, i.e. a 1@ rise in i10 gives a 1.>@ rise in i17, a 1@ rise in i= gives a 0.5@ fall in i17 and a 1@ rise in i1 gives a 0.0>@ rise in i17. :) The !F.- effect is the presence of bunching in the volatility of the error term, often termed serial correlation of the heteros(edasticity. This can be due to the ris(iness of financial data, which can be modelled using an !F.- model. This is one stylised fact relating to financial data, in addition financial data also suffers from$ & lepto(urtosis, or fat tales of their distribution. & !symmetric ad2ustment or the leverage effect, whereby a fall in asset prices produces greater volatility than a rise. b) i) This is a !F.-% ) model with a two lags on the s#uared error terms. This suggests the conditional variance is determined by the s#uared error term lagged once and twice. ii) The non&negativity constraint is re#uired as all coefficients need to be positive, given they are variances with s#uared terms and it is not possible to have a negative s#uared value. iii) The conditional variance relates to the continual updating of the variance as more information becomes available, usually written as t = VAR %u ) t L u t 1 , ut etc ,which is the conditional variance given information from the error term lagged once. iv) !s this is a non&linear model we can not use A;S, instead we need to use a ma"imum ;i(elihood approach. c) The B!F.- model differs to the !F.- model in that it includes the lagged conditional variance as a further e"planatory variable. It can be shown that a B!F.-%1,1) model is more parsimonious than an !F.- model with numerous lags, but has the e#uivalent information. To do this, you can through a process of lagging the B!F.- model and substituting it into the original B!F.model show that an !F.- model with infinite numbers of lags is the same as

the B!F.-%1,1) model. This has advantages, mainly because the !F.- model with numerous lags suffers from$ & multicollinearity of the lags & The increased possibility of negative coefficients & how to decide on the appropriate number of lags d) It can be used to model asymmetry through either a T!F.- model, which includes a dummy variable to account for greater volatility after a negative shoc( than a positive shoc(. !lso *B!F.- can be used, which incorporates a term that if negative and significant suggests the asymmetrical effect. I.e. the following T!F.- model t = 0 + 1ut 1 + t 1 + ut 1 I t 1 'here I is a dummy variable that ta(es the value of 1 when the shoc( is less than 0 %negative) and 0 otherwise. To determine if there is asymmetric ad2ustment, depends on the significance of the last term, which can be determined using the t&statistic.