CH 3 Econometrics For FinanceStatistical Inferences Part 1

CH-3: Statistical Inferences(First Order criteria)
Outlines of CH-3:
 Hypothesis Testing
 Tests for individual significance(sd. error Z& t-test) with application
 Global significance tests: (Fisher or F-test) with application
 Goodness of fit
St. Mary's University
(
Econometric for finance by Teshome H. MSc in Econometrics ) April 4, 2024
Statistical inference
Statistical inference is the process of drawing
inference(conclusion) about a population based on the
information contained in a sample taken from the population.
Statistical inference is traditionally divided into two main

branches: estimation of parameters and hypothesis testing .
Econometric for finance by Teshome H. (MSc in Econometrics) April 4, 2024
..cont’d
 Estimation of the parameters: it is a procedure of obtaining an estimate of
the true value from, but unknown value of population parameter from sample
observation.
 For example, we may estimate the mean of the population by computing the mean of the
sample drawn from the population.
 An estimate is a numerical value of the unknown parameter obtained by
applying a rule or a formula called an estimator.
There are two kinds of estimates:

 Point estimates: it refers to when an estimate of unknown population
parameter is expressed by a single value.

 Interval estimate: it is an estimate expressed by a range of values within
whichfortrue
Econometric value
finance of theH.population
by Teshome ( parameters
)
MSc in Econometrics is believed
Aprilto lie.
4, 2024
3.1. Hypothesis Testing
Hypothesis Testing: is a fundamental framework in

regression analysis that allows to make inferences about
population parameters based on sample data.
The hypothesis testing framework in regression typically
involves testing the null hypothesis that there is no

relationship between the independent variables and the
dependent variable against the alternative hypothesis that
there is a significant relationship.
That is, it helps to test the statistical reliability of the
estimates (, ) (
..cont’d
A statistical test is based on :
A null hypothesis and an alternative hypothesis
 A rejection region based on a test statistic and a critical value.
The formal testing procedure involves a statement of
the hypothesis, usually in terms of a null. and an

alternative,. conventionally denoted H and H , 0 1
respectively.
 A one-sided test has the general form: Two side test is:
(
..cont’d
 General steps for testing hypothesis or reliability of OLS estimates:
 Estimate , , and
 State the null and alternative hypotheses
 Choose the test statistic and level of significance
 Find the tabulated(critical) value from their distribution
 Decision rule:
 But, there are three decision making approach:
 Test Statistic Approach: If the absolute value of the test statistic is greater than the
tabulated value, we reject Ho.
 The P-value(level of significance( Approach: If p value is 1%, 5% and 10%, reject the
null hypothesis (Ho).
 The Confidence Interval Approach: If the confidence interval contains

the hypothesized value, we fail to reject the null hypothesis (Ho).
(
…cont’d
 In this course, we cover a hypothesis tests:
 Tests for individual significance(Standard error test Z & t-test)
 Global significance tests: (Fisher or F-test)
Question 1: How informative is (are) an explanatory variable (the

independent variables) for the dependent variable?
I. Standard error test

This test helps us to decide whether the estimates and are
significantly different from zero,

Steps to conduct SE test
1) State the null and alternative hypotheses (two-tail)
(
..cont’d
 2) Compute the sample estimates and it standard error

, , and
3) Decision rule
Compare the standard errors with half of the numerical values of

and .
As rule of thumb
 If , reject the null hypothesis and accept the alternative
hypothesis. We conclude that is statistically significant.

 If , accept the null hypothesis and reject the alternative
hypothesis. We conclude
( that is statistically
) insignificant.
April 4, 2024
Econometric for finance by Teshome H. MSc in Econometrics
..cont’d
In other words, fail to reject H0 implies that the
relationship between Y and X is in fact , i.e. there is no

relationship between X and Y.
Numerical example:
Suppose that from a sample of size n=30, we estimate the
following consumption function function.
A) Test the significance of the slope parameter at 5% level

of significance using the standard error test?
Solution:
Steps:
1) State the null and alternative hypotheses
( April 4, 2024
Econometric for finance by Teshome H. MSc in Econometrics )
..cont’d
2) Compute the sample estimates and it standard error
, , Hence
3) Decision rule
In this case, we reject the null since . The implication is is
statistically significant at 5% level of significance.

Note: The standard error test is an approximated test
(which is approximated from the z-test and t-test) and

implies a two tail test conducted at 5% level of
significance.
(
..cont’d
II. Z – test (Z-statistic)
 We use Z- test for & the population is assuming to have standard normal distribution.
 Then the standard normal random variable, Z is given by:
Numerical example:
 Suppose that from a sample of size n=30, we estimate the following consumption function.
 A) Test the significance of the slope parameter at 5% level of significance using the Z-tset?
Solution
 1) State the null and alternative
(
..cont’d
 2) The Z-value for the test statistic is:
From the z-table (critical) value ‘’ at 0.025 level of significance

 3) Decision rule
 If , reject the null (.
 Thus, 24 > 1.96, we reject the null. Meaning is statistically
significant ( the sample estimate derives from the population)

(
III. Student’s t-test
 Student's t-test is widely used when the sample size is

reasonably small (less than approximately 30).
 T-tests are used in linear regression to determine if a
particular variable is statistically significant in the
model
 The student’s t-test statistic is given by:
where SE = is standard error, k is the number of unknown

parameters .
(
…cont’d
Suppose that from a sample size n=20 we estimate the

following consumption function (C) on disposable
income(Yd):
The values in the brackets are standard errors.

A). Test whether the coefficient (=0.7) is statistically
significant or not at 5% level of significance?
Solutions
1) State the null and alternative hypotheses
(
…cont’d
=
2) Calculate the t-value for the test statistic is:
 
 0 1 0.70
 3.3
t*  1    0.21
SE (  1 ) SE (  1 )
=
3) Find the two side 5% critical value ?
Since it is a two tail test, we divide to obtain the critical

value of ‘t’ at =0.025 and 18 degree of freedom (df), i.e.
(n-2=20-2).
From the t-table ‘’ at 0.025 level of significance and 18 DF is

2.10.
(
…cont’d
4) Decision rule

Using Test Statistic Approach: if the absolute value of the test
statistic (t*=3.3 ) is greater than the t- critical value(=2.1), we

reject Ho.
Hence, t*=3.3 > =2.1,. It implies that is statistically significant((
the sample estimate derives from the population),

In economics, as the disposable(net) income of individual
increases by birr 1, then consumption also increases by

0.7 cents.
(
…cont’d
II. Global significance tests: (Fisher or F-test)

 F-test: it is used to test the overall significance of a regression
model.
 It assesses whether at least one of the independent variables
has a non-zero coefficient, indicating that there is a significant

relationship between the set of independent variables as a
whole and the dependent variable.
 The null hypothesis for the F-test is that all coefficients in the
model are equal to zero.
(
…cont’d
The F-test involves estimating 2 regressions.
The unrestricted regression is the one in which the
coefficients are freely determined by the data.
Where y= consumption expenditure, is income &

Then unrestricted residual is ,
 The unrestricted residual sum of square (URSS) w/c is equal
to error sum of square is given by
𝑛
2
෍ 𝜀Ƹ𝑖2 = ෍ ෠
൫𝑌𝑖 − 𝑌𝑖 ൯
 The restricted regression is the one in which the
𝑖=1
coefficients are jointly zero.
(
…cont’d
 Then the Restricted Residual Sum of Square (RRSS) is given by:

𝑛
෍ 𝜀Ƹ𝑖2 = ෍ ሺ𝑌𝑖 − 𝑌ത𝑖 ሻ2

𝑖=1
where if no explanatory variables in the model, the Restricted Residual Sum of Square (RRSS)
is equal to the total sum of square (TSS) which is equal to the difference between the actual
value () and the mean value().
 Then, Fisher test-statistic( F-test) is given by:
ሺRRSS − URSSሻΤሺ𝐾 − 1ሻ ሺTSS − URSSሻΤk − 1

𝑭= =
URSSΤሺn − kሻ URSSΤn − k
which is equivalent to:

(ESS)Τk − 1
𝑭= ~ 𝐹k−1,n−k
RSSΤn − k
Where is explained sum of square and RSS is residual sum of square.

(
…cont’d
F-test Example: Suppose a researcher wants to test whether the
consumption expenditure of 144 household(Y) is determined by their

income (x1) and family size (x2 ). The regression is carried out on:
and the RRSS is 436.1 and URSS is 397.2.
A) Check whether the two variables (x1 & x2 ) are jointly determined (Y)
at 5% significance level?
Solutions
Given , n=144, k(number of parameters) =3, RRSS = 436.1 & URSS =
397.2
(
…cont’d
1) State the null & alternative hypotheses:
, no joint effect
At least one of the is non-zero

2) Calculate F-statistic/F-calculated value:
ሺRRSS − URSSሻΤሺ𝐾 − 1ሻ ሺ436.1 − 397.2ሻΤ3 − 1
𝑭= = = 6.9
URSSΤሺn − kሻ 397.2Τ144 − 3
 3) Then find the F-critical(tabulated) value at k-1 &n-k degree of freedom at 5%
significance level..
F(3-1,144-3)= F(2, 141) = 3.08

 4) Decision Rule: If compare F-statistic > F-critical, reject .
 Since F-statistic(6.9)>F-critical value(3.08), we reject the null hypothesis . This means

Econometric
incomeforand
finance by Teshome
family (
H. MSc
size jointly affect )
household
in Econometrics April 4, 2024
consumption expenditure.
3.2. Goodness of Fit Test()
 After estimating the regression parameters, we need to develop a measure of how
well our regression model actually fits the data.

 The measures that indicate how well the regression line fit the data is referred to as
goodness of fit measures.

 The most common goodness of fit statistic is known as the coefficient of
determination (R2).
 R2 shows the proportion of total variation of the dependent variable that can be
explained by the changes in the explanatory variable(s) included in the model.

 The total variation in the regression model is given by the variation from explanatory
variable and error term.
(
…cont’d
where is the total variation or total sum of square (TSS)
is explained variation or Explained sum of square (ESS)
is the unexplained variation or Residual sum of squared (RSS)
Overall fitting criterion of the fitted model:

 Coefficient of determination
 Adjusted coefficient of determination
The coefficient of determination is the ratio of the (empirical)
variance explained by model to the (empirical) variance of yt :

(
…cont’d
 Thus, is defined by:
Note:
 R2 should be bounded between 0 and 1 .
 It is applicable mostly in regression model.
 It is descriptive analysis/ no distributional rule
 R2 never falls if more regressors are added to the regression.
 In order to get around for more variables problems, Adjusted R2
will be derived as: (

…cont’d
Example: Recall an example used in F- statistic.
We know that RRSS is equal to the total sum of square (TSS=( and URSS
is equal to
 The adjusted is given by:
(1-0.089)=0.0748
 As we observed from the result, the value of is very low around 8.9%,
so the model is not good.

 So the the statistical model couldn’t well predicts an outcome.
This may be due to the existence of high unexplainable

variation(variance of the residual is still very large)
(
Econometric for finance by Teshome H. MSc in Econometrics )
April 4, 2024

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CH-3: Statistical Inferences(First Order criteria)

 Global significance tests: (Fisher or F-test) with application

St. Mary's University

Statistical inference is traditionally divided into two main

sample drawn from the population.

 An estimate is a numerical value of the unknown parameter obtained by

applying a rule or a formula called an estimator.

There are two kinds of estimates:

parameter is expressed by a single value.

Hypothesis Testing: is a fundamental framework in

involves testing the null hypothesis that there is no

The formal testing procedure involves a statement of

the hypothesis, usually in terms of a null. and an

 State the null and alternative hypotheses

 Choose the test statistic and level of significance

 Find the tabulated(critical) value from their distribution

 But, there are three decision making approach:

 The Confidence Interval Approach: If the confidence interval contains

 In this course, we cover a hypothesis tests:

 Tests for individual significance(Standard error test Z & t-test)

 Global significance tests: (Fisher or F-test)

Question 1: How informative is (are) an explanatory variable (the

I. Standard error test

significantly different from zero,

 2) Compute the sample estimates and it standard error

Compare the standard errors with half of the numerical values of

hypothesis. We conclude that is statistically significant.

relationship between Y and X is in fact , i.e. there is no

A) Test the significance of the slope parameter at 5% level

In this case, we reject the null since . The implication is is

statistically significant at 5% level of significance.

(which is approximated from the z-test and t-test) and

 Then the standard normal random variable, Z is given by:

 1) State the null and alternative

 2) The Z-value for the test statistic is:

From the z-table (critical) value ‘’ at 0.025 level of significance

 If , reject the null (.

 Thus, 24 > 1.96, we reject the null. Meaning is statistically

significant ( the sample estimate derives from the population)

 Student's t-test is widely used when the sample size is

where SE = is standard error, k is the number of unknown

Suppose that from a sample size n=20 we estimate the

The values in the brackets are standard errors.

Since it is a two tail test, we divide to obtain the critical

From the t-table ‘’ at 0.025 level of significance and 18 DF is

4) Decision rule

statistic (t*=3.3 ) is greater than the t- critical value(=2.1), we

the sample estimate derives from the population),

increases by birr 1, then consumption also increases by

II. Global significance tests: (Fisher or F-test)

has a non-zero coefficient, indicating that there is a significant

model are equal to zero.

Where y= consumption expenditure, is income &

 Then the Restricted Residual Sum of Square (RRSS) is given by:

෍ 𝜀Ƹ𝑖2 = ෍ ሺ𝑌𝑖 − 𝑌ത𝑖 ሻ2

ሺRRSS − URSSሻΤሺ𝐾 − 1ሻ ሺTSS − URSSሻΤk − 1

which is equivalent to:

Where is explained sum of square and RSS is residual sum of square.

F-test Example: Suppose a researcher wants to test whether the

consumption expenditure of 144 household(Y) is determined by their

and the RRSS is 436.1 and URSS is 397.2.

1) State the null & alternative hypotheses:

At least one of the is non-zero