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Applied Financial
Econometrics
Theory, Method and
Applications
Moinak Maiti
Applied Financial Econometrics
Moinak Maiti
Applied Financial
Econometrics
Theory, Method and Applications
Moinak Maiti
Department of Finance
National Research University
Higher School of Economics
St. Petersburg, Russia
© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer
Nature Singapore Pte Ltd. 2021
This work is subject to copyright. All rights are solely and exclusively licensed by the
Publisher, whether the whole or part of the material is concerned, specifically the rights
of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on
microfilms or in any other physical way, and transmission or information storage and
retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology
now known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc.
in this publication does not imply, even in the absence of a specific statement, that such
names are exempt from the relevant protective laws and regulations and therefore free for
general use.
The publisher, the authors and the editors are safe to assume that the advice and informa-
tion in this book are believed to be true and accurate at the date of publication. Neither
the publisher nor the authors or the editors give a warranty, expressed or implied, with
respect to the material contained herein or for any errors or omissions that may have been
made. The publisher remains neutral with regard to jurisdictional claims in published maps
and institutional affiliations.
This Palgrave Macmillan imprint is published by the registered company Springer Nature
Singapore Pte Ltd.
The registered company address is: 152 Beach Road, #21-01/04 Gateway East, Singapore
189721, Singapore
To my parents: Mr. Lakshmi Kanta Maiti and Mrs. Sandhya Maiti.
—Moinak Maiti
Preface
vii
viii PREFACE
Thanks for all the helps you given to me during the lecture. And all the
lecture materials we used in the class are associated with most current
researches and study, that are very useful and practical. I personally
benefited from this.
I would like to continue my studies for both the subjects because I
learned a lot, it would be great. In any case, I want to say thank to you
for your passion and teaching.
I would want to take this opportunity to express my heartfelt apprecia-
tion for your contribution to the publication of my term paper and other
assistance you have given me. It was a great beginning for my research
career.
Thank you professor for the course! It was very useful and practical
oriented.
Moinak Maiti
ix
About This Book
1. Introduction
2. Random Walk Hypothesis
3. Geometric Brownian Motion
4. Efficient Frontier & Portfolio Optimization
5. Introduction to Asset Pricing Factor Models
6. Risk Analysis
7. Introduction to Fat Tails
8. Threshold Autoregression
9. Introduction to Wavelets
xi
xii ABOUT THIS BOOK
Moinak Maiti
Praise For Applied Financial
Econometrics
xiii
xiv PRAISE FOR APPLIED FINANCIAL ECONOMETRICS
am surprising with the update of this book as it has included current latest
development in financial econometrics such as fat tails, threshold regres-
sion, and Wavelets analysis. I confidently recommend “Applied financial
econometrics” and I trust that it would provide huge benefits for finance
students but also promoting their future development.”
—Dr. Canh Phuc Nguyen, Senior Lecturer, University of Economics Ho
Chi Minh City
“This book is a complete balance between the theory and the practice. It
is a comprehensive book with excellent features.”
—Dr. Saakshi, Assistant Professor, Indian Institute of Management
Ranchi
“Dr. Maiti has written a must-read primer for anyone considering financial
econometrics… This book has several real world examples that take us
towards the data sciences ... such as examples on forecasting, non-linear
data series, predictive modelling etc…”
—Dr. Amrit Mukherjee, Postdoctoral Fellow, Zhejiang University
“I have had the pleasure of knowing Moinak since his student days when
he was an offsite intern for Bloomberg LP at Pondicherry University. He
consistently impressed me with his rigor and tenacity. He brings the same
spirit to the title “Applied Financial Econometrics”. His work considers
existing econometric theory and aspires to juxtapose it against emerging
research and practice.”
—Joel Pannikot, Head, India at CMT Association; Former Head of
Asia-Pacific Strategy-Education, Bloomberg LP
“This book has a lucid representation and relevant content for the 21st
century financial econometrician. Highly recommended to all students,
academicians and working professionals in this area as the book provides
both theoretical as well as pragmatist insights.”
—Dr. Abhijeet Lele, Assistant Professor, Symbiosis Institute of Business
Management Pune
“An indefatigable effort has been taken by the author to provide prac-
tical knowledge on trending topics of finance. This book going to make
a difference.”
—Srividya Mortha, Data Management Consultant, Wells Fargo
xviii PRAISE FOR APPLIED FINANCIAL ECONOMETRICS
1 Introduction 1
2 Random Walk Hypothesis 47
3 Geometric Brownian Motion 67
4 Efficient Frontier and Portfolio Optimization 89
5 Introduction to Asset Pricing Factor Models 113
6 Risk Analysis 153
7 Introduction to Fat Tails 203
8 Threshold Autoregression 223
9 Introduction to Wavelets 255
Index 281
xix
About the Author
xxi
Abbreviations
xxiii
xxiv ABBREVIATIONS
xxv
xxvi LIST OF FIGURES
Fig. 2.3 Price movements follow random walk model with random
drift (holding period return) 54
Fig. 2.4 Variance ratio test window 56
Fig. 2.5 Test for random walk assuming no heteroskedasticity 57
Fig. 2.6 Test for Exponential Random walk assuming
no heteroskedasticity 58
Fig. 2.7 Test for Martingale 58
Fig. 3.1 Brownian Motion path plot 70
Fig. 3.2 Geometric Brownian Motion paths plots with 20
stimulations 71
Fig. 3.3 Geometric Brownian Motion paths plots with 40 and 400
stimulations 72
Fig. 3.4 A, B: American call option price estimates using Binomial
Option Pricing 74
Fig. 3.5 A, B: American put option price estimates using Binomial
Option Pricing 75
Fig. 3.6 A, B: Plain Vanilla call option price estimates using
Monte Carlo Simulation 78
Fig. 3.7 A, B: Asian Arithmetic put option price estimates using
Monte Carlo Simulation 80
Fig. 4.1 Portfolio diversification 91
Fig. 4.2 Mean variance efficient frontier 96
Fig. 4.3 Multifactor Mean Variance (MMV) efficient frontier 97
Fig. 4.4 Capital market line and mean variance efficient frontier 99
Fig. 4.5 Security market line 100
Fig. 4.6 Mean Variance Efficient Frontier and 5000 portfolios plot 102
Fig. 4.7 Mean Variance Frontier 104
Fig. 5.1 Graphical representation of the linear asset pricing model 120
Fig. 5.2 Graphical representation of the implied cross-sectional
relationship 121
Fig. 5.3 Scenario 1 scatter plots of the data 126
Fig. 5.4 Scenario 2 scatter plots of the data 126
Fig. 5.5 Regression Equation Estimation window 129
Fig. 5.6 CAPM estimates for Portfolio 1 and Portfolio 25 130
Fig. 5.7 Fama–French three factor model estimates for Portfolio 1
and Portfolio 25 131
Fig. 5.8 VIF estimates of Fama–French three factor model
for Portfolio 25 132
Fig. 5.9 GRS test estimates for CAPM and Fama–French three
factor model 133
Fig. 5.10 Panel Regression Equation Estimation window 134
Fig. 5.11 Constant coefficients model estimates 135
LIST OF FIGURES xxvii
xxix
CHAPTER 1
Introduction
1.1 Background
The term “econometrics” was emphasized by Ragnar Frisch in the inau-
gural issue of the Journal of the Econometric Society (Econometrica)
editorial note1 published in the year 1933. Even though Pawel Ciompa
have used the term “Oekonometrie” (Econometrics in German) in the
year 1910, almost two decades beforehand Frisch. Modern economists
favour Frisch version of econometrics that “aims at a unification of
the theoretical quantitative and the empirical-quantitative approach to
1 Frisch, R. (1933). Editor’s note. Econometrica, 1(1), 1–4. Retrieved March 20, 2021,
from http://www.jstor.org/stable/1912224.
5 http://sofie.stern.nyu.edu/.
1 INTRODUCTION 5
As the entire study centres around the framed hypotheses and a minor
mistake in framing the hypotheses could result into an absolute disaster.
So, any financial econometrics study requires in-depth understanding of
the hypotheses testing for the different statistical methods and economet-
rics models used. Testing of hypothesis concludes either with rejection
of the null hypothesis or acceptance of the alternative hypothesis. Rejec-
tion of the null hypothesis indicates that the null hypothesis is not true
and alternative hypothesis could be accepted or vice versa. Decision of
acceptance or rejection of the null hypothesis is based on the obtained
p-values or t-values.
Wrongly rejecting the null or alternative hypothesis could give rise to
the circumstances of Type I (alpha) and Type II (beta) errors. Rejec-
tion of null hypothesis even when that’s true would result into Type I
error. Likewise fail to reject the null hypothesis even when that’s false
would result into Type II error. Type I errors largely arise due to scepti-
cisms and by selecting the correct critical values it could be eliminated to
6 M. MAITI
where
Rpit −Rft = Individual stocks or excess portfolio returns
Rmt − Rft = excess market returns
Rft = Risk free rate
α = alpha
β = beta coefficient
ε = “Error terms” or “noise terms” or “disturbance terms” or
“residuals terms”.
Stochastic specification (ε) in the above model is not readily observable
like the other variables. Often study in applied financial econometrics
makes some reasonable assumptions about the shape of the distribution
of each (ε).
Which are as follows:
1.4.1 EViews
EViews econometrics software is currently being promoted by the IHS
Markit. It is a window based and user friendly econometrics software
that offers basics to advanced statistical forecasting and modelling tools
for interaction. Today EViews is well accepted by the practitioners and
academics in practice. Users include 600+ central banks, financial insti-
tutions, IMF, Federal reserves, United Nations, World bank, 1,600+
university’s economics and business departments, over 50% of Fortune’s
Top 100 Companies, and others. EViews provides user with three choices
for the interface: first graphical user interface, second single commands,
and third program files.
EViews offers several product and pricing options for the users
namely Standard, Enterprise, University Edition, Student Version Lite,
and others. EViews Student Version Lite is a free version available to the
students and faculty members for usage. EViews Student Version comes
with various limitations such as length of use (1 year), image only copy
paste options, limit in total observations (15,000), only available for 64-
bit devices, and many others. Presently EViews 11 Student Version Lite
version is available to download in their official website.6 First down-
load the EViews 11 Student Version Lite software. Then register yourself
with EViews by providing basic information (such as name, university,
email, and others) to request a serial number. Upon successful registra-
tion EViews will send the 24-character serial number to the registered
email. This 24-character serial number is required as a part of the instal-
lation and product activation/registration. Then get installed the EViews
11 Student Version Lite software in your system to use. EViews also
provides several useful resources for knowledge purpose under the section
“Learning Resources” could be accessed from their official websites.
6 http://www.eviews.com/home.html.
1 INTRODUCTION 13
EViews can read several types of available data formats such as MS Excel,
SPSS, SAS, txt, csv, and many others. Basically there are two ways by
which data that can be imported into the EViews.
First approach:
File → Import → select the file → Finish
Second approach:
File → New → Workfile → The “Workfile Create” new window will
appear as shown in Fig. 1.3.
It provides users with three choices of workfile structure and thirteen
choices of data frequency. Once details are chosen then click OK button,
and a new “workfile” window will be displayed. Right click on the work-
file window, then select paste and finish. Final output after importing
the data (EUR_USD, and GBP_USD exchange rates daily closing price)
14 M. MAITI
into the EViews interface following any one of the above-mentioned two
approaches is shown in Fig. 1.4.
Plotting Graphs
User can plot several type of graphs using EViews.
For plotting the multiple series into a single graph: select the series
variables (eur_usd and gbp_usd) and open as “Group”. A new workfile
window will be displayed with the titled “Group”. Then click on the View
→ Graph → A new window with “Graph Options” will appear as shown
in Fig. 1.5.
After selecting the details and clicking OK button in the Graph
Options window. Likewise, to plot the individual series graph simply
click on any of the series variables (eur_usd) in the workfile window
and follow the remaining steps as stated above. Final output for both
cases (group and individual) is displayed in Fig. 1.6. The sharp decline
pattern of EUR_USD & GBP_USD pairs in the figure is during the
global lockdown period of the COVID pandemic.
1 INTRODUCTION 15
Descriptive Statistics
To estimate the descriptive statistics of the two series variables eur_usd
and gbp_usd, perform the following steps: Open Group workfile window
→ View → Descriptive Stats → Individual Samples.
Then the final output with descriptive statistics looks as illustrated in
Fig. 1.7. Jarque-Bera test statistics indicate that EUR_USD series follows
normal distribution among the two series. GBP_USD series is more
volatile (Standard deviation value is higher) and have heavy tails (Kurtosis
value is higher) as compared to the EUR_USD series.
Histogram and descriptive statistics of the individual series variables
(eur_usd) may also be plotted as shown in Fig. 1.8 by doing the following:
Open EUR_USD workfile window → Descriptive Statistics & Tests →
Histogram and Stats.
16 M. MAITI
1.35 EUR_USD
1.30 1.15
1.14
1.25
1.13
1.20 1.12
1.11
1.15
1.10
1.10 1.09
1.08
1.05
1.07
EUR_USD GBP_USD 1.06
EUR_USD GBP_USD
Mean 1.103688 1.281412
Median 1.105131 1.299714
Maximum 1.139796 1.326260
Minimum 1.065735 1.149439
Std. Dev. 0.015976 0.043912
Skewness -0.203787 -1.793153
Kurtosis 2.692283 5.114089
Observations 65 65
12
Series: EUR_USD
10 Sample 1 66
ObservaƟons 65
8
Mean 1.103688
Median 1.105131
6
Maximum 1.139796
Minimum 1.065735
4
Std. Dev. 0.015976
Skewness -0.203787
2 Kurtosis 2.692283
0 Jarque-Bera 0.706349
1.07 1.08 1.09 1.10 1.11 1.12 1.13 1.14
Probability 0.702455
Correlation Analysis
Correlation analysis among the two series variables “eur_usd and
gbp_usd” can be estimated by following steps.
Open Group workfile window → View → Covariance analysis →
Covariance Analysis window will appear as shown in Fig. 1.9. Interface
offers several methods to choose namely ordinary, Spearman rank-order
and Kendall’s tau for estimating correlations among the variables.
Upon selecting the necessary fields and clicking the OK button. The
correlation analysis output will appear as shown in Fig. 1.10. Estima-
tion shows that the correlation coefficient value (0.434079) among the
variables is within the acceptable limit.
Unit Root Test
Stationarity is an important property of the time series. Stationary time
series are the ones whose statistical properties do not change over time.
Stationary time series do not have a unit root. Unit root test can be
performed in EViews by performing the following steps:
Correlation
Probability EUR_USD GBP_USD
EUR_USD 1.000000
-----
Fig. 1.12. Augmented Dickey-Fuller test statistics clearly indicate that the
EUR_USD series has a unit root. Then reperform unit root test for the
1st differential of original series [D(EUR_USD)]. Unit root test estimates
for the 1st differentiation of original series [D(EUR_USD)] is shown in
Fig. 1.12.
Augmented Dickey-Fuller test statistics clearly indicate that
[D(EUR_USD)] series has no unit root.
Equation Estimation
EViews provides very easy with an interactive interface to specify the
developed financial econometrics model for quantitative analysis. Follow
these steps to open the “Equation Estimation”.
EViews Main Window → Estimate Equation → The Equation Estima-
tion window will appear as shown in Fig. 1.13. Describe your developed
financial econometrics model for quantitative analysis in the form of
Program Design Language (PDL) or an explicit equation style within the
white text box under the heading “Equation specification”. Method field
provides user with more than dozen of the estimation techniques.
Exporting Estimation Output
It is very easy to export the EViews estimated output to the MS Doc,
MS Excel, and others. For alphanumeric outputs: ctrl + A → ctrl + C →
“Copy Options” window will pop up → Click on the OK button → ctrl
+ V (MS Doc, MS Excel, and others).
For image (graphs, diagrams, and others) outputs: Right click → Copy
to Clipboard → ctrl + V (MS Doc, MS Excel, and others).
Please note that EViews 11 Student Version Lite allows the users to
export estimation output only as image.
Null Hypothesis: EUR_USD has a unit root Null Hypothesis: D(EUR_USD) has a unit root
Exogenous: Constant Exogenous: Constant
Lag Length: 1 (Automatic - based on SIC, maxlag=10) Lag Length: 0 (Automatic - based on SIC, maxlag=10)
Augmented Dickey-Fuller test statistic -2.507821 0.1185 Augmented Dickey-Fuller test statistic -5.711042 0.0000
Test critical values: 1% level -3.538362 Test critical values: 1% level -3.538362
5% level -2.908420 5% level -2.908420
10% level -2.591799 10% level -2.591799
Fig. 1.12 Unit root test estimates for the original series and first differentiation
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