18 views

Uploaded by Mpho

Ecos and Stats Study Guide

- 14 - Sasmal 2011
- 12 Forex Markets
- Economic Growth
- 101898344 Informe de Laboratorio de Fisica Ley de Hooke
- Foreign Exchange
- The Role of Human Capital in Economic Development
- Economic Growth and the Role.pdf
- Group 4 Economic Theory
- Trade
- IB Unit-III
- 662487702.pdf
- analyses.doc
- ch07
- Banking Exchange Rates and Forex Business
- Foreign Exchange Market
- International pricing
- Forex ppt
- PESTLE Analysis
- Spoerer85
- DOC-20170604-WA0001[1392]

You are on page 1of 94

ECOS01-08

Cape Town

Milpark Education

Tel: 021 673 9100

Fax: 021 673 9111

Address: Milpark Education

2nd Floor, Sunclare

Cnr Dreyer and Protea Roads

Claremont, 7700

Johannesburg

Milpark Education

Tel: 011 718 4000

Fax: 011 718 4001

Address: Milpark Education

Cnr Main Road and Landau Terrace

Melville Ext 2

Johannesburg, 2007

Durban

Milpark Education

Tel: 031 266 0444

Fax: 031 266 0466

Address: Westville Office Park

54 Norfolk Terrace

(off Rodger Sishi Rd)

Westville, 3630

No part of this publication may be reproduced, stored in a retrieval system or transmitted in

any form or by any means electronic, electrostatic, magnetic tape, mechanical,

photocopying, recording or otherwise

Information

communications and to check critical dates (for example, assignment due dates,

exams and results release dates). Go to www.milpark.ac.za and click on

myMilpark.

Librarian: librarian@milpark.ac.za (recommended reading and other resources)

The content in Milpark study guides and teaching documents is not intended to

be sold for commercial purposes. Such content is in essence part of tuition and

constitutes an integral part of the learning experience in the classroom and at a

distance.

iii

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Table of contents

Information iii

Table of contents iv

Module purpose and outcomes vii

Glossary of terms viii

1.1 Introduction 9

1.2 Sources of economic growth 9

1.3 Theories of economic growth 13

1.4 Potential GDP and the investment decision 21

Summary 23

Self-Assessment Questions 23

FORECASTING 24

2.1 Introduction 24

2.2 The forex market: a brief history 25

2.3 Bid/ask spread 26

2.4 Direct/indirect quotation 26

2.5 Forward market 27

2.6 Exchange-rate determination 28

2.7 Exchange-rate forecasting 36

Summary 38

Self-Assessment Questions 38

MODELLING 39

3.1 Introduction 39

3.2 Probability 39

3.3 Addition and multiplication rule of probability 40

3.4 What are probability distributions? 41

3.5 Different types of probability distributions 42

3.6 Statistical inferences 45

3.7 Properties of estimators 48

iv

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Summary 49

Self-Assessment Questions 49

4.1 Introduction 50

4.2 Methodology of econometrics 50

4.3 The structure and organisation of data 52

4.4 What is regression analysis? 53

4.5 Regression versus correlation 57

Summary 58

Self-Assessment Questions 58

5.1 Introduction 59

5.2 Multiple regression model 60

5.3 Statistical inference 61

5.4 How to interpret the coefficients in a regression 62

5.5 Partial correlations AND multiple correlation 63

5.6 Analysis of variance AND hypotheses testing 63

5.7 Omit irrelevant variables AND include important ones 64

5.8 Heteroscedasticity 65

5.9 Autocorrelation 67

5.10 Multicollinearity 69

Summary 71

Self-Assessment Questions 72

6.1 Introduction 73

6.2 What is a stochastic process? 73

6.3 Trend stationary versus difference stationary 75

6.4 How to test for stationarity 76

6.5 Unit root testing 77

6.6 Forecasting with time-series processes 78

6.7 Modelling volatility (arch/garch) 81

Summary 81

Self-Assessment Questions 82

CASE STUDY 2: POTENTIAL GDP AND INVESTMENT DECISION 85

CASE STUDY 3: SOUTH AFRICAN RAND MODELLING AND FORECASTING 87

v

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Answers to Self-Assessment Questions 89

Topic 1 Self-Assessment Answers 89

Topic 2 Self-Assessment Answers 90

Topic 3 Self-Assessment Answers 91

Topic 4 Self-Assessment Answers 92

Topic 5 Self-Assessment Answers 92

Topic 6 Self-Assessment Answers 93

References 94

vi

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Module purpose and outcomes

Module purpose

indicators and addresses how the economy influences investment decisions. It

also covers regression and time-series analysis and provides students with an

introduction to econometrics/statistical modelling.

Module outcomes

influence on investment decisions.

2. Explain how to determine and forecast currency exchange rates in a

given scenario.

3. Describe how correlation, regression and multiple regression models

function, how they are used in practice situations in the investment

industry, and what their limitations are.

4. Display knowledge of time-series analysis by applying the concept to a

given case scenario.

5. Demonstrate a basic understanding of what econometrics and statistical

modelling entails.

Note: The equations in this study guide are provided to aid understanding of the

concepts. They are not meant to be known, unless stated otherwise.

Note: Any reference to masculine gender may also imply the feminine. Singular

may also refer to plural and vice versa.

Maddala, G.S. 2001. Introduction to Econometrics. 4th ed. West Sussex: John

Wiley and Sons.

vii

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Glossary of terms

historical values.

Bid/ask spread: the difference between the bid (buy) and the ask (sell) quotes.

economy over time.

currency over another. In other words, it is a value of one currency over another.

that a hypothesis will hold.

Interest-rate parity (IRP): the concept that explains that the difference in the

market interest rates of two countries should be equal to the difference between

the spot-exchange rate and the forward-exchange rate.

variable (the dependent variable) with one or more other variables (the

independent variable/s).

Stationary process: has a mean, variance and autocorrelation that do not change

over time.

time.

Triangular arbitrage: the arbitrage opportunity that occurs when there is a pricing

discrepancy among three currencies in the foreign-exchange market.

Variance: a measure of how a set of numbers is spread out from the mean

(average).

economy changes. It is usually used as a measure of risk.

viii

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Topic 1

Economic growth and the investment decision

1.1 INTRODUCTION

influence on investment decisions.

of equity is partly derived from future corporate earnings, which are dependent

on future economic growth. In addition, future economic growth provides an

indication of future movements in real interest rates, and this offers an indication

of expected real returns. Consequently, in order to formulate portfolio strategies,

investors should identify and understand the sources for long-run economic

growth. Using the long-run economic outlook, an investor can evaluate the

investment opportunity and risk of a particular economy specifically if he is

advising clients who are holding portfolios in that particular country.

After reading this topic, you should have gained knowledge in the following

areas:

2. Sources and determinants of economic growth

3. The different theories of economic growth

4. Potential GDP and the investment decision.

understand the different sources and factors that underpin economic growth in

an economy. From an investors perspective, understanding the sources and

factors of economic growth will make it easier to interpret and report on

macroeconomic indicators when conducting stock and bond valuations.

9

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

1.2.1 Savings and investment

The level of saving and investment in the economy determines how quickly or

slowly an economy will expand. If savings are low (or even negative, in that

there is dissaving), then one may find that, in general, the citizens in the

domestic economy are living beyond their means. 1 In this case, there may not

be enough savings that can be used for domestic investment and, with minimal

investment in capital stock, the rate at which the economy grows will tend to be

low. This is typical of developing economies, such as South Africa. South Africa

is a net borrower to the rest of the world; it runs a current account deficit that is

financed by capital inflows. 2 These capital inflows serve as supplementary

sources of investment in the South African economy.

The opposite is where the savings rate in the domestic economy is high. China

is an example of an economy where the high savings rate has steered the

economy to achieve high growth rates over the past few decades.

Stable and regulated financial markets are integral to stable economic growth.

Financial markets and intermediaries, such as banks, allow for liquidity in the

economy. The more liquid an economy is, the more resources are made

available. One way to think of this is that financial markets and intermediaries

provide well-organised channels through which savers can allocate funds to

investments.

Financial markets provide the platform from which firms can obtain the funding

needed to expand. Typically, firms listed on equity markets will be high-growth

companies and the employers of a significant portion of the countrys population.

Commercial or investment banks, on the other hand, can be instrumental in

providing financial assistance where information asymmetries exist. For instance,

if a firm is unable to raise capital through the equity market, it may opt for a

loan from a commercial bank.

1 Consumption (private and/or public) exceeds the amount of output (and therefore revenue)

produced in the country.

2 Capital inflows can be direct, such as foreign direct investment, or indirect in the form of investment

in domestic equity or bond markets.

10

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

1.2.3 Political stability, legal institutions and property rights

The political status and the effectiveness of the legal institutions of a country can

have an impact on the overall performance of that countrys economy. It is widely

documented that countries battling with political instability often suffer from

economic uncertainty, as future prospects of a flourishing economy are gradually

if not immediately diminished by the continuing political instability. Closely

related to this are weak or ineffective legal institutions. This is especially

problematic for private-sector investment where a negative relationship might

exist between private-sector investment and weak legal institutions.

Entrepreneurship may therefore be discouraged by the lack of legal regulations

in place.

It should therefore be ensured that the political status of the country remains

stable for both domestic and foreign investors and entrepreneurs. In addition,

legal institutions may need to be strengthened if they appear to be weak.

Economic growth should be boosted by the encouragement of entrepreneurship

and by the fact that strong legal institutions and stable government will lead to

greater foreign investment that will supplement domestic investment, and spur

economic growth.

Education and good healthcare are instrumental in ensuring that the countrys

labour force, or human capital, functions as expected. With the growing need to

become more innovative and to produce more efficiently, education has also

become more important. The current and expected capital stock still requires

intelligence in order to be employed more efficiently and effectively.

Furthermore, good healthcare improves the life expectancy in a country, which

will improve the economic prospects of the country (unfortunately, Africa has a

high incidence of AIDS and other diseases). Apart from private and public

investment, and political instabilities and unrest, inadequate health systems have

impeded economic growth.

Significant progress has been made by developing countries to mitigate the lack

of access to healthcare and to improve the level of education. 3 This is also evident

in the improved and sustained economic growth rates of the Sub-Saharan Africa

region. 4

4 IMF Regional Outlook.

11

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

1.2.5 Tax and regulatory systems

The type of tax and regulatory systems put in place in a country can either

discourage or promote private investment and entrepreneurship. Countries with

a significant amount of red tape tend to discourage entrepreneurship, as it

proves to be difficult to start up and establish a business if an entrepreneur is

faced with challenges of excessive red tape. A worst-case scenario is where both

the regulatory systems and taxation are not conducive to start-up businesses.

High taxes also limit the amount of foreign direct investment (FDI) from

multinational companies that may have identified an opportunity to operate in a

specific country.

The level of openness of the economy can be advantageous for economic growth.

South Africa has a low savings rate and, as a result, one would expect a low level

of domestic investment. However, on account of the fact that South Africa is a

small open economy, 5 it relies heavily on FDI to help boost much-needed

economic growth.

The level of openness of an economy to the rest of the world will boost economic

growth through the increase in capital stock and infrastructure development. The

increased capital stock should lead to higher productivity in the domestic

economy and, as higher productivity leads to greater output, unemployment in

the economy is reduced. This leads to higher wages, which increase the living

standards in the overall economy. Conversely, the level of openness of the

domestic economy to the rest of the economy may also makes it susceptible to

any exogenous shocks 6 from the rest of the world. This is especially true if the

domestic economy cannot generate enough output to sustain its economy and

therefore has to rely on foreign investment as a source of sustaining economic

growth.

According to the growth accounting equation, output that cannot be linked to the

contribution of labour or capital stock in the economy will be assumed to originate

from technical progress. As we will see in the theories of growth in section 1.3,

technical progress is a significant contributor to economic growth.

6 An exogenous shock is an unexpected shock to the economy.

12

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Economies that constantly innovate and focus on research and development tend

to achieve high growth rates. Developed countries tend to fit this description,

whereas developing countries tend to imitate the technological progress made

by the developed countries.

Activity

Analyse the graph below and look back at the factors presented in the preceding

sections to see which ones, in your mind, were the biggest drivers of the GDP

development below. Research the web for information to back up your findings.

There are many sources of economic growth and, on account of this, different

theories relating to economic growth have resulted. These are covered below for

information purposes. Investment analysts and portfolio managers should not be

concerned about knowing every detail and each formula of every theory, but

rather with how growth affects the investment decision.

13

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Table 1.1 Theories related to economic growth

Classical theory Adjust either of the factors of

production (capital or labour);

population growth key to growth;

technical progress held constant.

Neoclassical theory Investment key to growth;

short-term growth achieved through

savings and investment;

long-term growth achieved through

technical progress.

New growth theory Investment key to growth;

capital accumulation (investment)

redefined to also include human capital.

such as Thomas Malthus and David Ricardo. We will focus on the theory proposed

by Thomas Malthus in 1798.

population. The theory, which was pessimistic in its outlook, held that the

growing population will eventually surpass the ability of labour to produce output.

If one assumes that population increases as income per capita increases above

the minimum income needed to maintain life, and with the notion that technical

progress and the amount of land available increases the productivity of labour,

then the increase in productivity would feed into higher growth rates of the

population.

However, if decreasing returns to scale to labour are assumed, then the more

the population increases, the more additional labour is added to the workforce.

Only so much labour will be needed for optimal output generation before

diminishing returns settle in and output begins to grow at a decreasing rate.

Consequently, labour productivity would fall, which would lead to a decrease in

income per capita. The income per capita will eventually converge towards the

minimum level of income required to maintain life.

In summary, this theory stated that in the long run, if there is technical progress,

then the population of a nation would increase, but the population would be less

wealthy. The standard of living of nations would remain constant over time as

14

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

income per capita would converge back to the minimum income per capita

required, even if technology progressed.

The neoclassical growth theory followed on from the classical theory. There are

two famous neoclassical theories: the Harrod-Domar model and the Solow

model.

This model states that there is a direct link between the rate of economic growth

and the level of investment in the economy. The model breaks the connection

into two components; that is, from the demand side of the economy and from

the supply side of the economy. From the demand side, it states that investment

is a component of gross domestic product (GDP). More specifically:

= + + + ( ) (1.1)

From the above equation, we can see that GDP is determined by:

consumption (C).

investment (I).

government purchases (G).

net exports ( ).

From the supply side of the economy, the model states that capital stock is one

of the factors of production. The amount of investment capital accumulation

is the difference between gross new investment and the depreciation of existing

capital. In other words, if gross new investment exceeds the depreciation of

existing capital, then one may find that the investment has increased as more

capital has been accumulated.

The model also puts forward the idea that long-run growth can only be achieved

through the supply side of the economy: as firms produce more and reinvest

back into their capital stock, the more economic growth will be realised. As such,

economic growth will increase in the long run.

2. Both the population and the savings rate are exogenous.

3. Technological progress is constant.

15

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

The limitations of the model is that endogenous savings 7 (savings as a function

of income) are ignored. All else being constant, the more an individual earns, the

more he should be able to save. Endogenous population 8 to income is also

ignored. There may be cases of diminishing returns to scale and the model

ignores that as well.

The Harrod-Domar model is based on the belief that increasing savings will lead

to higher economic growth, and the Solow model is opposed to this. Instead,

according to the Solow model, increasing savings will not lead to long-run

economic growth. An increase in savings will only lead to short-term economic

growth. In other words, the impact on economic growth will be short-lived and

the only way that long-run economic growth can be sustained would be through

technical progress. If there are no movements in technical progress, then an

economy will not be able to achieve long-run economic growth.

The same assumption of exogenous savings still holds for the Solow model and

the model considers three inputs of economic growth: capital (K), labour (L) and

knowledge (A). The production function of the model is as follows:

= ( , ) (1.2)

function is that labour is assumed to be effective labour. Equation 1.2 implies

constant returns to scale. Using the assumption of constant returns to scale,

equation 1.2 can be reduced to the following intensive form equation: 9

= ( ) (1.3)

Equation 1.3 is output per unit of effective labour and is a function of capital per

unit of effective labour.

Since the following conditions hold: f (k) = 0 and f (k) < 0, equation 1.3 will

allow for diminishing returns to scale for capital per unit of effective labour. In

other words, the marginal benefit of adding an additional unit of capital fades

away as more units of capital are added into production. Graphically, the above

can be depicted as follows:

8 Population growth as a result of output.

9 Multiply equation 1.2 on both sides by a non-negative constant c and set c = 1/AL. Divide both

sides 1/AL to obtain equation 1.3

16

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Figure 1.1 Production relation

Since the focus of the model is to look at capital per unit of effective labour, we

may be inclined to look at the dynamics of capital; that is, how capital per unit

of effective labour moves over time. Consider the equation below:

k t = sf(k t ) (n + g + )k t (1.4)

Equation 1.4 states that the growth rate of capital per unit of effective labour is

determined by the difference between actual investment per unit of effective

labour, sf(k t ), and break-even investment, (n + g + )k t .

Actual investment is output per unit of effective labour and the amount saved

from output produced (s). Break-even investment is the level of investment that

must be carried out to maintain the current level of capital per unit of effective

labour. The manner in which capital is modelled over time is similar to the

Harrod-Domar model, with the exception that the rate of growth of population

and the rate of growth of technology are added to the depreciation of existing

capital.

17

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Figure 1.2 Steady state in the economy

This means that actual investment is just enough to meet the needs of growing

effective labour, the rate of technical growth, and the depreciating capital. When

the outputcapital ratio is high (when k is below ), then actual investment

exceeds break-even investment and capital stock rises. However, due to the

diminishing returns to scale to capital, capital will increase at a decreasing rate

until it settles at the steady state.

The opposite happens when k is above and the outputcapital ratio is low;

capital stock expands more slowly than labour growth. Therefore, capital per unit

of effective labour will fall until it settles at the steady state.

In summary, no matter where the starting point of capital per unit of effective

labour is, output per unit of effective labour will always converge to the steady

state.

The Solow model considers savings to be exogenous and that increasing savings

will not have a long-run impact on economic growth. However, it still remains

that increasing savings in the economy can be useful for policy formulation and

for investing heavily in research and development so that there is sufficient long-

run economic growth. Countries like China have done well, based on the fact that

the savings rate in the country has been high and because there has been

technical progress.

18

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Growth accounting

According to the equation, the output of goods and services in an economy

depends on the available inputs and their productivity. The relationship between

the output produced and the inputs going into production can be explained by

the following production function:

= (, ) (1.5)

Equation 1.5 above tells us that output (Y) is explained by the employment of

capital (K), labour (L) and productivity (A). For output to grow, it means that

either labour (L) must grow, capital (K) must grow, or productivity (A) in the

economy must advance. To analyse the relationship between the growth rate of

output and growth rate of inputs and the growth rate of productivity, equation

1.5 can be rewritten as follows:

= + + (1.6)

The above equation is called the growth accounting equation and it was

developed by Robert Solow. is the elasticity of output with respect to capital

and is the elasticity of output with respect to labour. In other words, is the

percentage increase in output from a 1% increase in the capital stock. The same

holds for . Additionally, both and are between 0 and 1.

Lastly, if we were to subtract from both sides, keeping in mind that + =

1, it would give us the following:

= + (1.7)

The above equation is the growth rate of output per unit of labour which is

obtained from the growth rate of capital per unit of labour, and whatever is left

over is what is known as the Solow Residual. 10 The Solow Residual would

normally be associated with technical progress in the economy. Whatever labour

and capital stock cannot contribute to the final output produced in the economy

will be assumed to be technical progress or advances in technology.

19

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Activity

We have covered the neoclassical growth theories. Draw your own mindmap,

showing differences and commonalities between the different models. Share your

mindmap on the tutor forum on MyCourses.

One of the major limitations of the Solow model is that technical progress is

assumed to be exogenous and constant. However, that is not always the case.

It has been found that increasing technical progress though innovation, research

and development leads to higher economic growth. Technical progress should

therefore be treated as endogenous to economic growth. In other words,

technical progress will not just occur arbitrarily; education needs to be

addressed, together with research and development.

New growth theory attempts to model and quantify how technical progress can

boost economic growth. The Solow model states that long-run economic growth

can only be achieved through technical progress, and not through the increase

in savings, which feeds into greater capital accumulation or investment. New

growth theory states that long-run economic growth can be achieved through

capital accumulation only if capital is redefined to also include human capital or

effective labour, and research and development. The inclusion of human capital

may have implications of increased returns to scale11 to capital, as opposed to

the constant returns to scale to capital and the diminishing returns to scale to

capital per unit of effective labour that the Solow model assumes.

Activity

Visit MyCourses and discuss with your fellow students how the Solow model and

the new growth theory believe economic growth can be determined.

20

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

1.4 POTENTIAL GDP AND THE INVESTMENT DECISION

of how well an economy can perform without putting upward pressure on the

inflation rate (i.e. how an economy can perform at full capacity).

Stock and bond valuations are based on how the economy is performing. For

instance, if the economy is performing well and is also projected to perform well,

then it can be assumed that projected corporate earnings will be high, and that

normally translates into greater performance of the equity market. To better

understand the relationship between potential GDP and share prices, consider

the following equation:

= (1.8)

Equation 1.8 relates to the aggregate value of equity as the product of GDP, the

share of corporate earnings to GDP, and the pricetoearnings (PE) ratio. Over

time, the equation can be interpreted as that the aggregate value of equity is a

function of a percentage change of GDP, plus a percentage change in corporate

earnings as a share of GDP, plus the percentage change in the PE multiple. In

the short to medium term, all three factors may contribute to the aggregate

value of equity. In the long term, however, only the percentage change of GDP

will have a significant effect. This is because both the percentage change of

corporate earnings and PE will disappear in the long term.12 Therefore,

understanding where the economy is heading should provide an indication of the

performance of the equity markets.

bonds. If actual GDP is above potential GDP, it will put upward pressure on

inflation. An increase in inflation leads to higher interest rates and, as a result,

bond prices drop.

12 Corporate profit cannot rise forever and loss-making firms will not survive. At the same time, PE

will not rise forever because investors will not pay a large price for a unit of earnings and they will

also not pay for a firm with low expectations of earnings.

21

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Activity

Have a look at the Executive Summary of the IMF regional outlook to gain an

understanding of the economic prospects for the Sub-Saharan African region.

Are they positive or negative? Would they help one to make an investment

decision?

http://www.imf.org/external/pubs/ft/reo/2015/afr/eng/pdf/sreo0415.pdf.

In conjunction with the above activity, look at the following table and interpret

the various forecasts. Would you invest in the stock market or in bonds short

term and long term given the numbers below? Is your recommendation in line

with economic growth?

(28.01.16)

GDP growth rate 0.70 0.3 0.5 1.3 2.75 2.1 percent

Balance of trade 1 771.96 -5 767 -5 966 -5 626 -5 342 -5 062 ZAR Million

Government Bond 10Y 10.16 10.36 10.67 11.18 11.68 15.24 percent

Stock market (JSE ALSI) 48 571.45 46 800 45 400 43 900 43 000 59 700 points

Source: http://www.tradingeconomics.com/south-africa/forecast

returns, it might be beneficial to read the following article on PIMCOs website.

PIMCO is one of the biggest asset management companies in the world:

http://global.pimco.com/EN/Insights/Pages/Forecasting-Bond-Returns-in-the-

New-Normal.aspx.

22

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Summary

This topic covered economic growth and looked at how investment decisions can

be made through the analysis of economic growth. Sources of economic growth

were identified and the way that they determine economic growth was

investigated. Thereafter, the different theories that attempt to model economic

growth were discussed. These theories were developed and formulated to

formally identify and model the sources of economic growth. A description of the

sources of economic growth highlighted how potential economic growth can

influence investors decisions.

Self-Assessment Questions

3. Consider Figure 1.2 (in Topic 1). What happens to the actual investment

and break-even investment schedule if the developments listed below

occur?

b) The technical progress rate falls.

c) The output per unit of effective labour increases.

decision-making.

fixed-income investments.

23

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Topic 2

Currency exchange rates: determination and

forecasting

2.1 INTRODUCTION

given scenario.

The foreign exchange (forex) market is a market that allows for the formal

trading of currencies. As the world economy grows and more economies open up

to international trade, international financial markets become more

interconnected, highlighting why it is important to understand foreign-exchange

markets.

After reading this topic, you should have gained knowledge in the following

areas:

2. Direct/indirect quotations

3. Cross rates and how mispricing of cross rates can lead to triangular

arbitrage opportunities

4. Forward rates, calculating forward premiums or discounts

5. International parity conditions and how the conditions determine

exchange rates

6. The impact of balance of payments on exchange-rate determination

7. How fiscal policy and monetary policy impact on exchange-rate

determination.

24

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

2.2 THE FOREX MARKET: A BRIEF HISTORY

The forex market has evolved over the years and it is helpful to understand how

it began.

The Gold Standard was operative between 1876 and 1913. Prior to 1876,

countries traded informally. In order to facilitate formal trade between nations,

a standard had to be established. At that time, gold was the only commodity that

was valued by all nations and it was therefore used as a means to determine the

exchange rate between two currencies, as each currency was convertible to gold

at a specified rate.

The fall of the Gold Standard began with the first and second world wars.

Countries started spending money to finance their militaries for war. Since each

country needed gold to convert their currencies, and on account of the fact that

there was overspending to finance the war, there was not enough gold for the

amount of currency supplied.

When the Gold Standard failed, a new method for determining exchange rates

needed to be established for nations to trade. After the Bretton Woods

agreement, it was decided that the United States (US) dollar would be used to

convert currencies. The US fixed the price of gold at $35 for an ounce of gold. All

other currencies pegged to the US dollar, indirectly fixing all currencies. Only the

US dollar was backed against the value of gold.

domestic spending and an increase in military spending to finance the Vietnam

War. This caused a greater demand for the dollar, and once again there was not

enough gold.

Following the fall of the Bretton Woods system, countries started to adopt the

floating exchange-rate system. More liquid currencies were allowed to float and

to fluctuate at around 2.25% of their true value.

25

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

2.3 BID/ASK SPREAD

commercial banks where the commercial banks hold reserves of currencies, and

buy and sell currency. The commercial bank functions as the market-maker and

charges two-way prices: a bid (buy) quote and an ask (sell) quote. The difference

between the bid and ask quotes is the bid/ask spread. Bid quotes will generally

be smaller than ask quotes, which ensures profitability for the market-maker.

Furthermore, the spread will be a function of liquidity in the market, inventory

and order costs, and market volatility.

Example:

Assume you are travelling from South Africa to Botswana and at the bank they

quote the Pula to the Rand as P1:R1.20/R1.50. You would need R7 500 if you

wanted to buy P5 000.

If, for some reason, the trip was cancelled and you needed to sell your Pula

(P5 000/R1.20=R6 000), the difference (P6 000 P5 000) is due to spread.

The exchange rate between two currencies may be directly quoted or indirectly

quoted. To understand this better, one can use the quoting convention A/B,

where currency A is the quote currency and B is the base currency. The base

currency is always set to be a quantity of 1. To obtain a direct quote, the domestic

currency is taken to be the quote currency and the foreign currency to be the

base currency. For example, for a South African resident, the South African rand

will be the quote currency and the US dollar will be the base currency to obtain

the direct quotation of the rand-dollar exchange rate. Similarly, to obtain the

indirect quote, the US dollar would be the quote currency and the rand would be

the base currency. In other words, the indirect quote is the reciprocal of the

direct quote:

1

= (2.1)

From the direct and indirect quotations, one can determine the exchange rate

between two currencies that are directly and indirectly quoted against a third

26

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

currency. Say, for example, there are three currencies and we are given the

direct quote of the randdollar exchange rate and the indirect quote of the dollar

euro. To obtain the cross rate for the rand and the euro, the randdollar

exchange rate must be multiplied by the dollareuro exchange rate. Specifically:

= (2.2)

Triangular arbitrage may arise when there is mispricing of cross rates. Cross

rates are listed on the foreign-exchange-rate market and if it so happens that

the cross rate between any two currencies is mispriced, then triangular arbitrage

exists.

Example:

Assume the EURUSD exchange rate is $1.3257 and the USDZAR is R5.7895. In

order to express the EURZAR, you need to express both currencies in terms of

dollars. First, convert the indirect quotation of ZAR into a direct quotation as

follows: ZARUSD = 1/USDZAR = 1/5.7895 = $0.17273. Since we have both

currencies in terms of dollars, we then calculate the EURZAR cross rate: EURZAR

= EURUSD/ZARUSD = 1.3257 /0.17273 = R7.6750.

In the case of triangular arbitrage, if we were to assume that the observed rate

of the EURZAR is R7.60, then we could sell the euro against the rand at R7.6750

and buy it back at R7.60 generating a risk-free return of R0.0750.

Forward contracts can be agreed upon today for a forward rate determined to

hedge against currency volatility risk. A forward rate can either be priced at a

premium or at a discount to the spot-exchange rate. If the forward rate is greater

than the spot-exchange rate, then the forward rate is quoted at a premium.

Conversely, if the forward rate is lower than the spot-exchange rate, then the

forward rate is quoted at a discount.

Since forward rates are mostly used to hedge against currency volatility when

foreign assets are being invested in, it is important that investors are aware of

interest-rate parity conditions. According to this condition, the gain that would

27

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

have been realised from a foreign investment should be equal to the gain realised

from the domestic investment, if the interest-rate differential is equal to the

forward-exchange rate. If this condition does not hold, then an arbitrage

opportunity would exist. The time that the arbitrage opportunity would exist may

vary, however the opportunity tends to fade away relatively quickly.

For the condition to hold, transaction costs are normally assumed to be zero. The

forward premium/discount can also be determined from the covered interest-

rate parity (CIP) condition. The premium of the domestic currency would be

obtained if the risk-free foreign-interest rate is greater than the domestic risk-

free interest rate.

We have seen what constitutes a forex market and the kind of transactions that

are conducted in a forex market. Now we can assess how the different exchange

rates across the world are determined. This will provide further insight into

investment decision-making. Being able to forecast exchange rates will enhance

your ability to handle portfolios that are made up of foreign assets.

exchange rates. These conditions are normally employed when one is trying to

determine an exchange rate in real terms. Therefore, it is important to know the

different conditions and their relevance in exchange-rate determination. These

conditions are listed as follows:

Uncovered interest-rate parity

Purchasing power parity

The Fisher Effect

Real interest-rate parity

Note: the covered interest-rate parity condition has been discussed already; the

condition is primarily relevant when forward contracts are used.

28

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Uncovered interest-rate parity

The uncovered interest-rate parity (UIP) condition is closely related to the CIP

condition in that the interest-rate differential between two assets in two countries

should be equal to the expected change in the spot-exchange rate. The main

difference between the UIP and CIP conditions is that the UIP condition is tied to

the expected change in the spot-exchange rate, whereas the CIP is tied to the

forward-exchange rate.

The UIP condition will hold if the expected appreciation (depreciation) of the spot-

exchange rate is equal to the expected loss (gain) over the period of the interest-

rate differential.

Example:

Assume that we have one-year government bonds, and that the interest rate in

South Africa is 5% and in the UK it is 3.5%. At face value, it seems that holding

South African bonds will yield a return that is greater by 1.5%.

will be a greater demand for rands as foreign investors will be attracted to the

higher return of the South African bonds as opposed to the UK bonds. The rand

will therefore appreciate in value. However, if the UIP condition holds, foreign

investors will need to believe that, though the rand may appreciate in value when

the demand for it increases, the expected depreciation of the rand will have to

be equal to the 1.5% interest-rate differential between the bonds of the different

countries.

The purchasing power parity (PPP) condition talks to how exchange rates relate

to inflation differentials the difference in prices of goods and services between

two economies. The PPP condition is based on the Law of One Price (LOP), which

follows the logic that opening up to international trade should equalise prices

across the economies for the same good, as it will be profitable to buy the good

from an economy where it is cheap and sell it where it is expensive. Therefore,

if the LOP holds, the same basket of goods should cost the same across the

different economies if that basket of goods is valued at a common currency.

If the exchange rate between the rand and the pound is R18.50 then, according

to the LOP, a good that costs 100 in the UK should cost R1 850 in South Africa.

29

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

If we were to expand this to include services and to measure a broad range of

goods and services, then the broad price level (inflation) in the foreign economy

must be equal to the currency adjusted broad price level (inflation) in the

domestic economy. This is known as the absolute PPP condition.

The indices that track the broad price levels in the different economies

will include the same basket of goods and services, and each good will

be equally weighted.

To determine nominal exchange rates using the absolute PPP condition, the price

level of the foreign economy will be divided by the domestic price level.

/ = (2.3)

costs that exist in real life and the fact that not all goods and services are

tradable. The relative PPP condition talks about the change in the exchange rate

and the change in the price level. According to the relative PPP condition, the

percentage change in the exchange rate will be determined by the differential

between the inflation rates (change in price levels) of foreign and domestic

economies.

%/ = (2.4)

The ex ante version of the PPP condition follows from the relative PPP condition

and it can be used to say that if a country is expected to continue to run a higher

inflation rate, then it should be expected that its currency will depreciate.

Conversely, if the inflation rate is low then it should be expected that the

economys currency will appreciate.

The Fisher Effect combines both the purchasing power parity and the interest-

rate parity conditions, in that it decomposes nominal interest rates into real

interest rates and the expected inflation rate:

= + (2.4)

30

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Where i = nominal interest rate

r = real interest rate

= expected inflation rate.

In terms of tying this relationship to exchange rates, the Fisher equation can be

written out for both domestic and foreign countries as follows:

= + (2.5)

= + (2.6)

Subtracting equation 2.5 from equation 2.6 will show the yield of the nominal

yield between the domestic country and the foreign country, and the nominal

yield spread will be equal to the foreigndomestic real yield spread and the

foreign-domestic expected inflation differential. Algebraically, the above should

be as follows:

= + ( ) (2.7)

Equation 2.7 can be rearranged to solve for the real yield spread, instead of the

nominal yield spread, as follows:

= ( ) ( ) (2.8)

If we were to employ both the UIP and the ex ante PPP conditions, and assume

that they both hold, equation 2.8 will be as follows:

= %/ %/ =0 (2.9)

According to equation 2.9, the real yield spread will only be equal to zero if both

the UIP and the ex ante PPP conditions hold. Therefore, real interest rates in the

domestic country will be equal to the real interest rate of the foreign country

thereby leaving the investor with no incentive to choose the domestic country

over the foreign country or vice versa. The notion that the real interest rates will

be identical across countries is known as the real interest-rate parity condition.

31

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Activity

Using equations 2.5 and 2.6, derive equation 2.9, which shows the real yield

when both the UIP and PPP conditions hold. Using myCourses, briefly discuss

what the implications are if the UIP and the ex-ante PPP conditions do not hold.

What does it mean for the investor?

Lastly, if the real interest-rate parity condition holds, then the foreigndomestic

nominal yield spread will be equal to the expected foreigndomestic inflation

differential. In other words, the foreigndomestic nominal yield spread will be

determined by the expected foreigndomestic inflation differential:

( ) = ( ) (2.10)

The balance of payments (BOP) is made up of the current account (CA) and the

capital account 13 (KA). The current account will include the trade balance, which

is the difference between exports and imports, and the net interest receipts. The

capital account will consist of capital inflows and capital outflows. The BOP must

always sum to zero meaning that whatever transaction is inputted in the CA

should be offset by a transaction within the CA or in the KA. Countries running a

CA deficit tend to have a depreciating currency and countries running a CA

surplus tend to have an appreciating currency.

the vertical axis is the dollarrand exchange rate and on the horizontal axis is

the quantity of rands. If the demand increases, there is a shift in the demand

schedule, and vice versa if the demand decreases. The same will apply for an

increase and decrease in the supply of rands.

32

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

SR

$/R

R 12.50

DR

QR

The impact of the CA on the path of the exchange rate can be explained through

three main different channels:

2. The portfolio balance channel

3. The debt sustainability channel.

The flow supply/demand channel is based on the fact that there will always be

trade amongst the nations and the nations respective currencies will be

demanded and supplied in order to facilitate international trade. If a country

exports more goods and services than imports, that countrys particular currency

will be demanded more on the forex market and consequently the currency is

likely to appreciate. The opposite will occur if a country imports more than it

exports.

The portfolio balance channel is based on a theory that wealth will be shifted

from countries running a CA deficit to countries running a CA surplus. Through

this channel, it is assumed that financial assets (such as bonds) are imperfect

substitutes, 14 as investors will perceive foreign-exchange risk to be related to

foreign currency-denominated assets.

33

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Lastly, there is what is referred to as the debt sustainability channel, which is

based on whether there should be a ceiling for running CA deficits. In other

words, countries should not be allowed to run CA deficits beyond a certain

threshold. This is because current account deficits are followed by a rise in

sovereign debt. If a country has a negative trade balance, it means that it cannot

generate enough revenue. It will therefore need additional funding, through

borrowing, to finance investment and production in the domestic economy. If

there is a reason for investors to believe that a country is reaching unsustainable

debt levels and is likely to default, then the investors will most likely pull their

investment out of that particular country and, as a result of reduced demand for

its currency (and greater supply due to domestic investors moving money into

international markets), that particular country will experience a currency

depreciation, which will have a negative impact on exchange rates where that

currency is included.

responsiveness of capital flows to interest-rate differentials, risk premiums, and

the expectation that exchange rates do fluctuate. Interest-rate differentials can

lead to a greater demand of a currency that has higher yields leading to a

currency appreciation. Capital flows may also be driven by the risk premiums. If

the debt-to-GDP for a country is low and is expected to remain low, then the risk

premium attached to that particular country will be low. Consequently, investor

outlook will remain positive and that will result in a higher influx of capital into

the safe haven country. There may be a relationship 15 between how the equity

markets are performing and the exchange rates. If the Johannesburg Stock

Exchange (JSE) rate is constantly performing well and the London Stock

Exchange (LSE) is not performing well, then assuming all else is constant, it

might make the case for foreign investors to want to invest in South Africa.

Higher demand for the rand will cause the rand to appreciate.

Monetary and fiscal policies can affect the path of the exchange rate in a number

of ways and through different channels.

34

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

The Mundell-Fleming 16 model

This model talks to how a change in monetary or fiscal policy will have an impact

on the level of interest rates and economic output, and that will feed into

international competitiveness, which will translate into positive/negative

movements of the exchange rate. The Mundell-Fleming model conveniently

applies to both flexible and fixed exchange-rate regimes, so there are four

possible outcomes:

exchange rate

2. The effect of an expansionary monetary policy on a fixed-exchange rate

3. The effect of an expansionary fiscal policy on a flexible/floating-exchange

rate

4. The effect of an expansionary fiscal policy on a fixed-exchange rate.

An expansion in monetary policy will reduce the domestic interest rate and

increase investment and consumption, thereby increasing aggregate demand in

the overall economy. As a result, capital outflows will increase in the search for

a higher yield in foreign markets. The currency will depreciate and that will have

an impact on net export, as exports will become cheaper. This will increase the

international trade competitiveness of the domestic economy. If the domestic

currency is allowed to fluctuate, then the effects of monetary policy will be

evident in the depreciation of the currency. However, if the currency is fixed,

then the monetary authorities will have to intervene and ensure that the currency

will not depreciate. They will do so by buying their own currency in an attempt

to maintain its demand and therefore its value. The best-case scenario is that

the effect of monetary policy will be insignificant.

Expanding fiscal policy will mean increasing spending in the economy, thereby

boosting economic output. However, as opposed to the decrease in interest rate

with the monetary policy expansion, the interest rates will be higher because the

increase in government spending will need to be financed though borrowing. The

increase in interest rate will lead to higher capital inflows. The higher capital

inflows will cause the currency to appreciate and, as the currency appreciates,

the competitiveness of the domestic economy will become weaker. The same

35

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

argument applies when the exchange rate is fixed: the monetary authorities will

intervene to curb the appreciation of the currency.

Activity

Look at the current stance of fiscal policy and monetary policy in South Africa.

What do you think the impact is on the long-run path of the rand?

https://www.resbank.co.za/Lists/News%20and%20Publications/Attach

ments/6746/MPRJun2015.pdf

http://www.treasury.gov.za/documents/national%20budget/2015/revie

w/chapter%203.pdf.

important to understand how to predict or forecast the future movements of a

currency exchange, especially in the short term. Accurately predicting or

forecasting currency exchange rates assists investment analysts and fund

managers to mitigate risk for their respective portfolios.

The use of technical analysis stems from the belief that the past behaviour in

currency exchange-rate movement will determine the likely path going forward.

Specifically, this refers to when the past behaviour occurred in a systematic

manner. There are different forms for technical analysis some are for

determining market trends and some are for the determination of market

reversals; while some help to determine (a) conditions where an overbought or

an oversold can occur, (b) the currencys relative strength, and (c) support and

resistance levels.

This has to do with the customer flow data. Typically, with equity markets

trading, information is readily available to investors there is full information on

the trading activity and prices reflect that. On the other hand, the forex market

will not necessarily release information on the trading activity instantly. It

becomes increasingly important for the investor to source and obtain that

36

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

information if that information is proven to be predictive in the short term. If the

relationship between the order book and the exchange-rate path is found to be

positively correlated, then there is immense value in sourcing the information.

The use of currency risk reversals 17 are usually used as a gauge of how the

market anticipates or attaches a higher likelihood of a large currency appreciation

as opposed to a large currency depreciation. If the risk reversal is positive (+3),

this could indicate that the market is attaching a higher probability of an

appreciation, rather than a depreciation.

The net positions of speculative accounts in the forex futures market are

monitored to gain an indication of whether speculative flows are flowing towards

or out of a currency. If they do, then it could mean that the flows are applying

significant upward or downward pressure on a currency. Net positions are also

monitored if they are overbought. Overbought net positions could increase the

probability that an adverse shock might cause a sharp downturn in currency

trends.

Activity

Now that you have familiarised yourself with the theory, read the following article

and the summary contained on the CFA website:

http://www.economist.com/news/special-report/21668719-china-shakes-

worldbut-not-way-it-hoped-longer-march

http://www.cfapubs.org/doi/full/10.2469/dig.v46.n1.1.

When looking at the determinants of exchange rates, which of those would China

have taken into account to devalue their currency last year?

put.

37

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Summary

This topic covered currency exchange rates, with a specific focus on how

exchange rates are determined. A brief history of exchange-rate systems was

discussed, as well as how each system evolved from the other.

The participants determine the supply and demand of currencies. The economic

and/or political factors also determine the supply and demand of currencies and,

as a result, exchange rates between currencies are determined.

Self-Assessment Questions

determination of exchange rates.

Explain what is likely to happen to the rand if the countrys current

account deficit continues to widen.

inflation rate in the United Kingdom. What will happen to demand and

supply of the pound? What will happen to the pounddollar exchange

rate?

38

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Topic 3

Introduction into econometrics and statistical

modelling

3.1 INTRODUCTION

function, how they are used in practice situations in the investment

industry, and what their limitations are.

After reading this topic, you should have gained knowledge in the following

areas:

2. Probability

3. Random variables

4. Probability distributions

5. The properties of estimators

6. The problem of estimation

7. The problem of testing of hypotheses.

3.2 PROBABILITY

likelihood of an event occurring. It is usually quantified to be between 0 and 1

(or equivalently between 0% and 100%). The higher the probability, the higher

the likelihood of an event occurring. The classical view of probability is that of a

number of favourable outcomes. For example, the number of possible outcomes

of rolling a six with a die will be one. Given this, we know that the total number

of outcomes is six, and therefore the probability of rolling a six will be one over

six (or 1/6) or 17%.

of an event out of a large number of repetitions. This involves looking at the

39

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

relative frequency of the occurrence. Using the same example of the die, one

would count the proportional times a six appears on a number of times the die

is rolled.

individuals will have their own probability distribution.

have different events (A1, A2, A3) and each of these events occur such that if one

event occurs then the other events do not occur, then one can infer that such

events are mutually exclusive. If the occurrences of the events expend all the

possible outcomes, then such events are exhaustive.

The intersection and union of events can be shown by writing P(AB) and P(A+B)

respectively. P(AB) means that event A and B jointly occur or they occur

together. P(A+B) means that either A or B will occur. Using the example of rolling

a die, if we define A as rolling 2, 3, or 5 and B as rolling 1 or 5, the P(AB) would

equal 5 and P(A+B) would equal 1, 2, 3, 5.

( + ) = () + () () (3.1)

For mutually exclusive events, P(AB) = 0, meaning that event A and event B

cannot occur together. Therefore, equation 3.1 can be modified as follows:

( + ) = () + () (3.2)

If the occurrences of the events are exhaustive, then we have the case of

P(A)+P(B) = 1. In addition, the multiplication rule is dependent on the

independence assumption of the events. If one event can occur without the other

event occurring, then P(AB) = P(A) + P(B).

40

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Activity

Go onto ScholarText and read through the Bayes theorem of probability, as well

as the summation and product operators. This will be found on pages 15, 16 and

17 of the following textbook: Maddala, G. S. 2001. Introduction to Econometrics.

3rd ed. West Sussex: John Wiley & Sons.

random variable X is a random variable if, for every real number b, there is a

probability P(Xb) that X will take on a value less than or equal to b. A discrete

random variable can assume only a finite set of values. Conversely, a continuous

random variable will assume any value in a certain range.

A probability distribution will give you probabilities of different values for discrete

random variables. When dealing with continuous random variables, a probability

density function will give you probabilities for different values of continuous

random variables. The probability density function is denoted by (). Usually,

probabilities of continuous random variables are given in a certain range. If we

need to find out the probability of X being any value between a and b, we can

find this by writing it out in the following manner:

P(a X b) = () (3.3)

The cumulative distribution function will be found when, for different values of c,

the different probabilities are added together. For this function, equation 3.3 is

modified to look as follows:

F(x) = P(X c) = () (3.4)

Graphically, both the cumulative distribution function and the probability density

function would be depicted as follows:

41

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Figure 3.1 Cumulative distribution and probability density functions

variables. We can look at joint probability density functions between two random

variables X and Y, written out as (, ); the marginal probability density

functions, () (); the conditional probability density function,

(|) (|). If (, ) = ()() for all x and y, then x and y are independent,

meaning that it does not matter whether y happened or not; the probability of x

will remain the same.

While many distributions do exist, the most popular ones are discussed below.

follows:

1 1

() = exp ( )2 + (3.5)

2 2 2

where and 2 are the mean and the variance respectively. The distribution has

three main properties:

42

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

1. The distribution is symmetrical around its mean.

2. Roughly 68% of the area under the normal curve will lie between values

of or one standard deviation away from the mean. About 95% of

the area will lie between values of 2 or two standard deviations away

from the mean. Lastly, roughly 99.7% of the area will lie between values

of 3 or three standard deviations away from the mean.

3. The normal distribution is dependent on both and 2 . If both are

specified, then the probability that X will be in a certain interval will be

found. The probability will be found by the employment of the probability

density function of the normal distribution.

If we have Z1, Z2, Z3 to Zn as normal variables with zero mean and constant

variance, then the summation of Z= =1 2 will possess a distribution with n

degrees of freedom. The properties of the chi-squared distribution are listed as

follows:

depends on the degrees of freedom. If the degrees of freedom are few,

then the distribution is skewed to the right. By having more degrees of

freedom, the distribution becomes more symmetrical.

The mean is represented as k and the variance as 2k.

The summation of independent chi-square variables means a summation

of each variables degrees of freedom.

follows a distribution of a zero mean and a constant variance and a chi-square

variable, which is distributed independently from Z1.

Source: www.coursehero.com

1

= (3.6)

2

43

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

The properties of the distribution are as follows:

As the degrees of freedom increase, the t distribution becomes more like

the normal distribution.

The mean of the distribution is zero and the variance is k/(k-2).

of freedom are k1 and k2 respectively, then the variable

1 /1

= (3.7)

2 /2

right. As the degrees of freedom increase, the F distribution becomes

more like the normal distribution.

222 (1 +2 2)

The mean is 2/(2 - 2), where 2 > 2 and the variance is .

1 (2 2)2 (2 4)

distribution has k degrees of freedom, then we would obtain a random

variable following an F distribution with 1, k degrees of freedom.

Example:

assist with a small sample, in that the left tail will represent losses. The flatter

the tail, the larger the losses. Normal distributions are often used in portfolio

theory and risk management to obtain approximated returns and/or losses.

44

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Activity

On the following webpage you will find additional explanations of different types

of distributions:

http://www.itl.nist.gov/div898/handbook/eda/section3/eda36.htm.

Look at the gallery of distributions and find the ones that have been explained in

this guide. Write down reasons why you think the graph looks the way that it

does for the distributions.

not, however, know the parameters of the distribution (such as the mean and

variance). Therefore, it might be necessary to estimate these parameters. This

is known as the problem of estimation. The problem of estimation can be divided

into two parts: point estimation and interval estimation. In addition, there is the

problem of testing of statistical hypotheses.

parameter. If we have a random variable with a known probability density

function and a parameter of the distribution, f(x,) where is the parameter, we

can estimate the value of the parameter. How do we proceed? We can draw a

random sample from the probability density function and build a function based

on the sample that will provide an estimate of the true . The estimate will be

given by the estimator, .

which the true parameter will lie. Instead of building one function, we can have

two functions which will provide two estimators, 1 and 2. Based on the two

estimators, we can infer that the true parameter lies within the two estimators,

such that:

Pr(1 2) = 1 0 1 (3.8)

45

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

where is known as the significance level. If the significance is stated to be 0.05

then we can infer, with the probability =1 = 0.95, that the true parameter lies

within the two estimators. In other words, with the confidence level of 1 , we

are 95% sure that the true estimator will lie within the interval of the two

estimators.

Example:

Generally, the point estimate would be the sample mean of the population. If the

population is firms stock prices and you want to model the volatility (risk) of

your portfolio, you can take the stock prices for a period (sample) and obtain a

mean return. The mean return of the each stock price in the sample would be a

point estimate.

To affirm the point estimate, we could use a range of values that will be above

and below the point estimate. With normal distribution, we can state the level of

confidence of the estimate. The level of confidence will be represented by the .

This = 5% means a confidence level of 95%, and = 1% means a confidence

level of 99%.

significance or not. In other words, does the estimator provide an estimate equal

to the true parameter or not? In hypothesis testing, there is a null hypothesis,

0, which states that the . There is also the alternative hypothesis, which

states that = . In testing the null hypothesis, one has to obtain the test statistic

from the sample information and employ either the confidence interval approach

or the test of significance approach.

true parameter, the sample mean should be equal to the population mean.

Hence, ~(, 2 /) , which is similar to ~(, 2 ) where is a random variable

for the population and is for the sample and n is the sample size. Therefore, if

the probability distribution is known, we can use a confidence interval for the

estimated parameter to see if that confidence interval will include the true

parameter being an approximate of the estimated parameter. If it does, then the

null hypothesis will be rejected.

46

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Example:

A sample of 100 monthly returns on a stock fund has a mean return of 1.5% and

a standard deviation of returns of 0.5%. We can build a 95% confidence interval

for the following months returns.

Using a t-distribution, knowing that the level of confidence is 5%, and having 99

degrees of freedom (100 1), we can determine that the critical t-value is 2.000.

Our confidence interval would be:

( 2, + 2)

= (1.5% 2.000, 1.5% + 2.000)

= (1.5% 2.000 0.5%, 1.5% + 2.000 0.5%)

= (1.5% 2.000 0.5%, 1.5% + 2.000 0.5%)

= (0.5%, 2.5%)

We can therefore determine that there is a 95% chance that the following

months return will be between 0.5% and 2.5%.

The sample mean and size can be found (if it is not known, it can be estimated).

However, the mean and the variance of the population are not known. If we could

specify the variance and make the assumption that under the null hypothesis the

sample mean is equal to the population mean (or = ), then Zi can be

computed. By using the normal distribution table, we can find the probability of

attaining the computed Z value. If the probability is less than 5% or 1%, then

the null hypothesis will be rejected. Conversely, the null hypothesis can be

accepted if the probability is high enough. The important thing is that the test

statistic is the Z statistic and its probability distribution is under the assumption

of = .

Note

47

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

3.7 PROPERTIES OF ESTIMATORS

analysis. These properties form the basis for econometric analysis to be carried

out. If these properties are not specified, or at least controlled for, then

commencing the analysis proves meaningless as the inferences made from the

result might be inaccurate. These properties are as follows and the first two are

for small samples:

Properties of estimators

Unbiased

Efficiency

Consistency.

3.7.1 Unbiased

the sampling distribution of that statistic can be shown to be equal to the

parameter being estimated. If we have s2 as the variance of the sample and we

also have as the mean of the sample, then, if the estimator is unbiased, both

the variance and the mean of the sampling distribution will be equal to those of

the parameters being estimated.

the least biased estimator will be chosen over the more biased estimator.

3.7.2 Efficiency

estimator is unbiased and its variance is the smallest in a class of unbiased

estimators, then the estimator is an efficient estimator. The estimator will be a

minimum-variance unbiased estimator (MVUE). Additionally, if we were dealing

with linear estimators, then the estimators would be known as the best linear

unbiased estimator (BLUE).

3.7.3 Consistency

A consistent estimator is one in which as the sample size increases, the estimator

values tend towards the true value of the parameter that is being estimated.

48

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Activity

textbook: Maddala, G. S. 2001. Introduction to Econometrics. 3rd ed. West

Sussex: John Wiley & Sons.

Summary

This topic introduced the concept and use of econometrics and statistical

modelling. The concepts of probability, probability distributions, and statistical

inferences were discussed. These concepts provide the foundation for Topic 4.

Write down some of the most important points that you took away from this

topic. Share with your fellow students on myCourses.

Self-Assessment Questions

1. Define probability.

of discrete and continuous variables.

49

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Topic 4

Regression analysis and correlation

4.1 INTRODUCTION

given case scenario.

of econometric analysis and modelling, the concept of regression analysis is

introduced in this topic. Regression analysis looks at the relationships between

variables; in other words, their dependence. Correlation is a similar concept,

which also explains the relationship between variables.

After reading this topic, you should have gained knowledge in the following

areas:

2. Different structures of data

3. The simple regression

4. An understanding of what correlation is

5. The interpretation of regression results

6. Limitations of regression analysis.

an econometric analysis. There are certain variations, but the core method

remains the same.

model that needs to be tested. This economic model is often founded on a

hypothesis. The econometric model needs to be correctly specified so that the

model can effectively model the economic problem.

50

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Secondly, the estimation of the econometric model is done, where inferences can

be made from the model. Lastly, if the models results make economic sense

according to economic theory, then the model can be used for forecasting and

prediction and, more importantly, for policy formulation. To provide more detail,

the steps in an econometric analysis can be tabulated as follows:

Steps Description

Economic theory Using economic theory, a hypothesis is made about a

relationship between economic factors or indicators.

This hypothesis needs to be tested.

Mathematical model Economic theory may suggest that a relationship

exists; however it may not specify the functional form

of the relationship. This functional form is usually

formulated by a mathematical economist.

Econometric model The mathematical model may mean that an exact

relationship exists between two economic indicators.

However, that may not be the case; the

econometrician may modify the mathematical model

to include a disturbance term that will cater for factors

that are not explicitly measurable.

Data Collection of data needs to be done for model

estimation.

Estimation The parameters will need to be estimated.

Testing of hypothesis After the estimation of the model, tests are conducted

to verify the results and whether to reject or accept

the hypothesis stated. In other words, are the results

of (statistical) significance?

Forecasting/prediction Once the model has been confirmed to be reliable and

can efficiently describe an economic relationship, the

model can be used for forecasting.

Policy implications Policy can be changed and/or re-adjusted according

to the results found.

Activity

Go to myCourses and look at the PowerPoint presentation that has been loaded.

Do you think the steps above were followed in this model?

51

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

4.3 THE STRUCTURE AND ORGANISATION OF DATA

It is important to understand the different kinds of data that are available. The

type and nature of data will ultimately determine the level of accuracy and the

success of an econometric analysis.

There are three different types of data, namely time-series, cross-section, and

pooled data.

Cross-section data One can assess how average returns change across

different stock or portfolios.

Time-series data Modelling of stock returns or exchange-rate volatility

over time.

Pooled data Analysing the returns of stocks across different

sectors.

Cross-section data talks to a point in time and refers to data of one or more

variables collected at a single point in time. A typical example of cross-section

data is a population census where individuals in an economy are counted. The

collection of data is carried out at a point in time and each individual or citizen

will have their age, demographics and employment indicated. The potential

problems that an econometrician may encounter when they are conducting an

econometric analysis using cross-section data is the problem of heterogeneity.

In other words, there may be cases of cross-section data lacking uniqueness,

which may lead to biased or inaccurate estimates and results.

Time-series data is different from cross-section data. This kind of data will be a

collection of a variable over a period of time. There are different frequencies of

such data ranging from daily to decennially (every ten years). A typical example

of time-series data is GDP figures for an economy. These data are usually stored

over a period of time. As with cross-section data, there are problems that need

to be dealt with when using time-series data. One major problem is that of

stationarity. Typically, time-series data might need to be converted to be

stationary before they are used for economic or econometric analysis. This is

because the use of non-stationary time series might lead to inaccurate results.

52

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

4.3.3 Pooled data

data that covers more than one variable over a period of time. An example of

pooled data is CPI for different countries (cross section) over a period of time

(time series). Within pooled data, there is panel or longitudinal data. This data

relates to an individual unit over time. Panel data can be balanced or unbalanced.

If the data is balanced, it means that the cross-section unit has the same amount

of observations. When the panel data is unbalanced, it means that the cross-

section unit may have unequal amounts of observations.

Regression analysis has to do with the explanation and evaluation of one chosen

variable, Y, by one or more other variables, Xi .The Y variable is called the

dependent variable, while the X variable(s) is called the independent variable.

When we are dealing with one independent variable, we have what is called a

simple regression. When the number of independent variables becomes more

than one, we have what is called a multiple regression analysis.

In this topic, we deal with simple regression where the dependent variable is

described or explained by one independent variable. The relationship between

the Y and the X variable can be explained by a simple function: y= f(x). However,

it should be understood that the relationship is probabilistic, which means that

the values of y cannot be determined exactly for different values of x, but can

only be determined probabilistically. Therefore, we assume that the X is a linear

function of Y:

() = + (4.1)

= + + (4.2)

represents the stochastic component. and are the regression parameters

and are estimated from Y and X. Additionally, u is the error or the disturbance

term. The term captures all that could be not explained by the variable. This

could be something unpredictable in human behaviour or omitted variables that

could explain Y, or could be a simple measurement error where Y cannot be

measured accurately. The disturbance term has some assumptions:

53

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

1. A mean of zero

2. A constant variance

3. It is independent, meaning that the previous error will have no influence

on the current error.

4. It is also independent of the variable.

5. The error term is normally distributed.

Lastly, since the error term has a mean of zero, or () = 0, we can have:

( ) = + (4.3)

Equation 4.3 is often termed the population regression function (PRF), which is

then called the sample regression function (SRF) when the estimates of the

parameters are substituted.

It is useful to know how the estimates of the parameters are obtained. There are

three different ways: the method of moments; the method of least squares; and

the method of maximum likelihood. In this topic, we only cover the method of

least squares, which is the most common method.

Activity

Go to myCourses and look at the PowerPoint presentation loaded there. Can you

follow how the regression was approached in this case?

The method of least squares 18 needs one to select the estimates of the

parameters, and , in that we have the following:

= ( )2 4.4

prediction errors when yi is predicted given xi. To understand the intuition behind

the method, we can use Figure 4.1 below.

Figure 4.1 is a graph of the yi and xi points. A regression line is passed through

the points in a manner that the line is as close as possible to the points. In other

54

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

words, the method minimises the distances between the line and the points. The

smaller the distance, the more accurate the estimates.

x

Figure 4.1 The classical linear regression model

In addition to finding estimates for the parameters, we must also be able to make

inferences based on the estimates about the true parameters. It would be ideal

to find out how close the estimates are to the true parameters. We should

therefore make some assumptions about the Yi in the PRF and, as a result, also

make assumptions on Xi and ui because Yi is dependent on them. If we do not

know how they are generated, then we cannot make accurate statistical

inferences on Yi. The assumptions made on the ui have been mentioned above.

The classical linear regression model (CLRM) makes seven assumptions. These

are as follows:

linear with regard to its variables. In other words, the model may be

non-linear between the dependent variable (Y) and the independent

variable (X), but the parameters alpha and beta must not be raised to

any power > 1. This assumption forms the basis for CLRM.

2. The independent variables must be independent from the error term.

3. The disturbance term has a zero mean value. To comprehend this

assumption, the error term will generate both negative and positive

values when the estimation is done. The intuition behind this is that the

negative and positive values of the error term will cancel each other out,

and therefore the mean or average effect on Y will be zero.

4. The error term has a constant variance. This assumption is otherwise

known as homoscedasticity. The variance of the error term will be the

same, regardless of the X value inputted. The opposite of

55

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

homoscedasticity is heteroscedasticity, where the variance of the error

term is not constant.

5. There must be no autocorrelation between the error terms. If we have

two X values, xi and xj, then the two error terms, ui and uj should not be

correlated.

6. The number of observations used must be greater than the number of

parameters that will be estimated.

7. The nature of X variables must be different. This assumption states that

the x values of any given sample must not all be the same. They must

be positive and there must be outliers. Intuitively, if there is not much

variation in the independent variables, then it will become impossible to

explain the variation in the dependent variable.

Activity

following link (in addition to the information provided above):

https://www.youtube.com/watch?v=zRklTsY9w9c.

line in Figure 4.1. If all the points lie inside the line, then we would have a perfect

fit; however, this is seldom the case. In the case of a two-variable or simple

regression model, we have the coefficient of determination as r2, and in the case

of a multiple regression model, we have it as R2.

1. It is non-negative.

2. It is bounded (inclusively) between 0 and 1 or 0 r 1. A coefficient of

1 means a perfect fit and a coefficient of 0 means no fit at all (that is,

there is no relationship between the dependent variable and the

independent variable).

The limitations of regression analysis are based on the assumptions made in the

models. The CLRM has seven assumptions and all these assumptions should be

fulfilled when the model is used. If one of the assumptions is violated, especially

56

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

the autocorrelation, homoscedasticity and linearity in the parameters, then

inferences cannot be made from the results. The relationship found may not hold

for future periods.

distribution.

The two terms are closely related, but they are not the same. In regression

analysis, the assumption is that the dependent variable is random and has a

probability distribution. The independent variables are not considered to be

random; in fact, they are fixed in repeated sampling. With correlation analysis,

there is no distinct difference between the dependent variable and the

independent variable. Both variables will be assumed to be random.

57

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Summary

and organisation of data, as the collection of data is part of the methodology.

With the simple regression model, we discussed how the sample regression

function is derived from the population regression function by substituting the

estimates of the parameters. The estimates can be found by using three different

methods of estimation; of which we discussed the method of linear squares.

analysis.

Self-Assessment Questions

estimator and the best linear unbiased estimator.

explain.

data. How is each type used in financial or investment analysis?

limitations with real-life investment analysis.

58

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Topic 5

Multiple regression analysis

5.1 INTRODUCTION

function, how they are used in practice situations in the investment

industry, and what their limitations are.

analysis. Multiple regression analysis deals with more than one independent

variable. It is important to be aware of issues such as including irrelevant

variables and excluding important variables in the analysis. Issues of correlation

among the variables are also something that one needs to be cautious about.

Additionally, there are also problems with multiple regression analysis, such as

heteroscedasticity, multicollinearity and autocorrelation. The analysis of

variance, whether there is joint significance of all independent variables, is

covered in this topic.

After reading this topic, you should have gained knowledge in the following

areas:

1. Statistical inference

2. Interpretation of results from multiple regression

3. Measuring partial correlations and multiple correlation

4. Analysis of variance

5. Omitting of important variables and including of irrelevant variables

6. Testing for heteroscedasticity, multicollinearity, and autocorrelation

7. Prediction with multiple regression.

59

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

5.2 MULTIPLE REGRESSION MODEL

variable and the independent variable. Multiple regression analysis is an

extension of this, in that the relationship studied is between the dependent

variable and more than one independent variable. Although there are multiple

independent variables included in the model, it does not mean that there will not

be any measurement errors (where there is something unquantifiable or non-

measureable in the analysis). There was a disturbance term in the simple

regression and there is also one in multiple regression analysis. The model is as

follows:

= + 1 1 + 2 2 + = 1,2, (5.1)

The disturbance term must have assumptions similar to those made in Topic 4.

The assumptions are as follows:

2. The variance must be constant or ( ) = 2 .

3. There must be independence between .

4. There must be independence between .

5. must be normally distributed .

With the first four assumptions, it is clear that the estimators are unbiased and

have a minimum variance amongst a class of linear unbiased estimators (similar

to Topic 4). The last assumption is crucial for hypothesis testing and confidence

interval testing. The additional assumption that there is no collinear relationship

amongst the independent variable is important. If there is a perfect relationship,

then it becomes impossible to separate the effects of each variable from the

dependent variable. The relationship may exist, however it should not be large

and/or perfect. This will be covered later in the topic.

To provide more detail about multiple regression analysis, we can take equation

5.1 and the above five assumptions, which are for the population or the economic

theory we want to test. To proceed with the analysis, we need to use a sample

to test for the entire population. Therefore, the notation used in the assumptions

will need to be replaced for the sample. Also, we want to estimate , 1 , and 2.

Thus, the estimators will be , 1 , 2 . Below is the sample disturbance term:

60

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

= 1 1 2 2 (5.2)

equations) will be used and they can be obtained by means of the least squares

method. The derivation need not be done every single time an analysis is

conducted, as there are computational applications available to compute the

estimators.

Important to note is that as in the simple regression, the residual sum of squares

(RSS), the regression sum of squares, and the coefficient of multiple

2

determination, .12 are also obtained.

2

.12 .

Activity

Maddala, G. S. 2001. Introduction to Econometrics. 3rd ed. West Sussex: John

Wiley & Sons.

Once the estimators are obtained, it is important that results are derived and

inferences are made. The estimators obtained have normal distributions with

means equal to those of the population means. The correlation between the

independent variables is given by , and the variances and covariances are as

follows:

2

1 = 2 (5.3)

11 (1 12 )

2

2 = 2 (5.4)

22 (1 12 )

2

2 12

1 , 2 = 2 (5.6)

12 (1 12 )

2

() = + 12 1 + 212 22 1 , 2 + 22 2 (5.7)

61

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

, 1 = 1 1 + 2 1 , 2 (5.8)

, 2 = 2 2 + 1 1 , 2 (5.9)

With higher values of 12 , there will be less precision in the estimation of the

parameters. Therefore, it is important to understand that the correlation between

the independent variables should be minimised. 19 Also, we know that if the

expectation of the estimated variance is equal to a constant variance,

equivalently, if ( 2 ) = 2 , then 2 is an unbiased estimator for 2 . If we then

substitute the estimated variance for the actual variance in the above

expressions, then we have estimated variances and covariances; and the square

roots of the estimated variances will be called the standard errors (SE). The

higher the standard errors, the greater the difference between the actual and the

predicted parameter (recall Figure 4.1 in Topic 4). Lastly, with multiple

regression, we can use an F-distribution and build a confidence region for all the

parameters (i.e. 1 and 2 ), and test their joint significance in the analysis.

dependent variable. With simple regression, the effect is measured by 20. In the

case of a multiple regression model, the regression equation 5.1 can be rewritten

as follows:

= 1 (1 1 ) + 2 (2 2 ) + (5.10)

The effect is given by . In multiple regression, the effects of both 1 and 2 can

be measured together. This is known as a joint effect. Alternatively, we can

measure partial effects when we only look at the effect on 1 alone, holding the

effect of 2 constant and vice versa for 2 .

19 One way to control the problem of high correlation between independent variables is to use

instrumental variables.

(,)

20 Where =

()

62

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

5.5 PARTIAL CORRELATIONS AND MULTIPLE CORRELATION

given by 2 1 and 2 2 for a regression model of dependent variable y and

independent variable X1, and another model with y and X2. These correlations

measure the proportion or the extent of the variation in y or the dependent

variable that the X or the independent variable can explain. Additionally, partial

correlations are helpful when one needs to know if the effect of the current

independent variables will increase or decrease when an additional independent

variable is included or excluded.

Conversely, you will also have a case where the effect of more than one

independent variable can be measured. This correlation is called multiple

correlation. It measures the proportion of the variation in y that all the

independent variables can explain.

entire effect of all the independent variables in the regression model. When we

consider partial effects and their significance, the t distribution is often used

where a t statistic is used to determine if the coefficient of a specific independent

variable is (statistically) significant or not. There are, however, times when the

overall effect of the independent variables is needed. In such cases, the F

distribution is used and the F statistic is used. The following equations are for the

t-test and F-test, respectively:

= ( ) (5.11)

2 1

= 12 (5.12)

test is usually included in an analysis of variance where the variance of the

dependent variable is broken down into the variation that can be explained by

the independent variables and the variation which cannot be explained, and

hence variation from the residual or disturbance term. With the F value and the

F-table, the hypothesis of whether there is joint significance of the independent

variables can be accepted (not rejected), or the hypothesis can be rejected. If

63

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

the hypothesis is not rejected, it means that the independent variables do not

explain the dependent at all.

Activity

https://www.youtube.com/watch?v=OzGuXV_qZHg

On MyCourses, discuss with your fellow students when to use a t-test and when

to use an F-test. Also discuss when both would be needed.

ONES

In regression analysis, there are sometimes cases when one is not sure if certain

factors (quantifiable) have been omitted from the analysis. Perhaps it is possible

that including those factors will improve the quality of the model. The converse

is the case where there are factors that simply do not add any value to the

analysis, and removing them will not impact the precision and quality of the

model.

the sample size is increased, the coefficients will remain biased if there

is a correlation between the included variable and the excluded variable,

thereby compromising the precision of the model in explaining the

population group.

The sample variance will be a biased estimator.

Hypothesis and confidence interval testing will be misleading.

Forecasting and prediction based on the model will be compromised.

Hypothesis and confident interval testing may still be valid.

The variances of the estimators may generally be larger than those of

the true model, thereby impacting the efficiency of the model.

64

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Activity

www.gwilympryce.co.uk/teach/miich5ommittedvars.doc.

Glasgow in the UK. Make sure that you focus on the text, and not on the

mathematical and statistical detail of the document. Write a summary that

compares this document with Topic 5.7 above.

5.8 HETEROSCEDASTICITY

One of the assumptions made in both Topic 4 and Topic 5 is that in regression

analysis the variance of the disturbance term should be constant (in other words,

the variance should not change over time). This assumption can be termed as

homoscedasticity, where homo means equal and scedasticity means spread or

variation. In contrast, heteroscedasticity will be an unequal spread. Some of the

reasons why the variance of the disturbance term may vary are as follows:

Sources of heteroscedasticity

There are cases when the factor in question improves over time, thereby

decreasing its level of error over time with improved techniques of data

collection.

If the data used have outliers.

The variance may also vary over time due to misspecification of the

regression model (that is, when relevant variables are excluded).

The model may have an incorrect functional form (i.e. a linear model is

used when the relationship that needs to tested requires a log-linear

functional form).

If the data are not transformed correctly.

One may question what impact the presence of heteroscedasticity will have on

the most common method of regression analysis the least squares method.

Under this method, the estimators are assumed to be unbiased, BLUE (Best

Linear Unbiased Estimator), and consistent.

65

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Note:

(ii) It should be unbiased, such that its expected value should converge to

the real value of 1.

(iii) It should have the least variance in the class of such linear unbiased

estimators.

The good news is that the presence of heteroscedasticity will have no impact on

the assumption of the estimator being unbiased and consistent. However, the

estimator may not be BLUE when heteroscedasticity is present. In other words,

it may be best (have the smallest variance) in a class of unbiased estimators. 21

The impact on the confidence interval and hypothesis testing is that the presence

of heteroscedasticity will make the variance of the estimator larger. A larger

variance leads to smaller t-statistics, which means that a coefficient will be shown

to be insignificant; though without heteroscedasticity, the coefficient would have

been significant. In other words, the inferences made from confidence interval

and hypothesis testing may end up being misleading.

There are multiple ways to detect the presence of heteroscedasticity. Some are

formal and some are informal. It is advisable that more than one method is used

at a time. Some of the informal methods are as follows:

regression test, plot the residuals against the predicted dependent

variable and observe if there is a systematic pattern. If a pattern exists,

then it could be taken that heteroscedasticity is present.

In finance, the presence of heteroscedasticity is taken as given for many

investment variables, such as stock prices. As such, heteroscedasticity

goes on to be modelled.

that the variance is some function of the independent variable. Because

21 The switch from OLS to Generalised Least Squares may control this problem.

66

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

the variance cannot be estimated, the Park Test makes use of the

estimated residuals obtained after running the regression model. These

residuals are then run on the independent variable according to the

following regression model:

2 = + + (5.13)

The White General Heteroscedasticity Test involves three steps. The first

step is to run the model and obtain the residuals. The second step is to

run the residuals on the independent variables, their squared values, and

the products of the independent variables and obtain the R-squared. In

the third step, it can be shown that the product of the sample size and

the R-squared follows a chi-square distribution. The last step is to

compare the chi-square statistic and the critical value from the chi-

square distribution table. If the statistic exceeds the critical value then

the null hypothesis that there is no heteroscedasticity can be rejected.

There are two approaches to control for heteroscedasticity: when the variance is

known and when it is not known.

When the variance is known, the method of weighted least squares can be used.

When the variance is unknown, the use of Whites Heteroscedasticity-Consistent

Variances and Standard Errors can be used.

5.9 AUTOCORRELATION

Autocorrelation, also known as serial correlation, is the correlation of the error

or disturbance terms. It may be present for either cross-sectional data or time-

series data. For cross-sectional data, the correlation between the error term of

one firm and an error term of another firm may occur. In such cases,

autocorrelation is defined as spatial autocorrelation as the correlation is not

across time, but correlation in space. For time-series data, the correlation can be

over time. For instance, the movement of stock prices over time varies and the

67

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

variation can be successive for a specific period; and hence the error term can

exhibit autocorrelation.

If there are variables that are excluded from the model (in other words,

the misspecification of a model)

If the function form is incorrect

The manipulation of data, such as interpolation or extrapolation

Transforming data

In the case of time-series data, if the data is non-stationary.

OLS (Ordinary Least Squares) estimator is no longer BLUE. Hence, the

consequences of using OLS with the presence of autocorrelation is that the

confidence interval and hypothesis testing will yield unreliable results.

Firstly, the residuals may be plotted against time. This plot is known as the time

sequence plot. If there is a systematic pattern in the plot, then autocorrelation

may exist.

Secondly, a runs test may be used. The intuition behind the test is that we can

observe the transition between one symbol and another or between a positive

sign and a negative sign. We also count how long the residuals are negative and

how long the residuals are positive. There can be a run of two negatives followed

by a run of four positives, and so forth. Thereafter, an examination can be

carried out on how runs work in a random sequence of events. If the runs occur

too often, it could be indicative of autocorrelation.

Thirdly, one could use the Durbin-Watson d test, which makes use of the d

statistic. There are assumptions that need to be provided for when running this

test. They are as follows:

The independent variables must not be stochastic.

The disturbances follow a first-order autoregressive 22 (AR) process.

All observations must be included in the data.

The regression model does not include a lagged dependent variable.

68

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Unlike t, F, or chi square distributions, the Durbin-Watson d test has no unique

critical value. Instead, there is a lower bound d value and an upper d value. If

the d statistic lies outside the bound, then there can be either positive or negative

autocorrelation.

a model misspecification.

2. The use of GLS instead of OLS.

3. The use of the Feasible Generalised Least Squares.

Activity

https://www.youtube.com/watch?v=jt5nl2VEpwg.

5.10 MULTICOLLINEARITY

regression model. The presence of multicollinearity is another violation of the

assumptions made earlier for the CLRM. The correlation between the independent

variables may be perfect or imperfect.

Sources of multicollinearity

population.

When there are constraints in the population from which the sample is

drawn. In other words, there are cases where richer investors buy

expensive stocks. Expensive stocks tend to have similarities or

correlation between themselves.

If the model is incorrectly specified.

When a model is overdetermined or when there are more independent

variables than the number of observations.

69

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

One should be cautious of the fact that in the presence of multicollinearity, the

OLS estimators may remain efficient; however the variances and covariances

may be large and therefore affect the precision of the model estimation. Also,

there could be a wider confidence interval, forcing one to accept a null hypothesis

that would have otherwise been rejected if there were no issues of

multicollinearity. The R-squared can be high with too few significant coefficients.

There are a number of ways in which one can spot or detect the presence of

multicollinearity:

1. When the R-squared is high, but there are too few significant coefficients.

2. If the pair-wise or the zero-order correlations are high between the

regressors. These correlations may not be used alone as the existence

of a high correlation may not necessarily mean multicollinearity exists.

Conversely, the correlation may be low, but multicollinearity may be

present.

3. One can also examine partial correlations.

4. Through the use of auxilliary regressions. There could be cases where

some independent variables are linear combinations of other

independent variables. One way of testing is to run each independent

variable on the remaining independent variables, observe the R-squared

and compute the F statistic. If the computed F value exceeds that of the

critical value found in the F table, then a particular independent variable

is collinear with other independent variables.

5. As a rule of thumb, one can compare the R-squared of the auxiliary

regression to that of the R-squared of the overall regression model.

There are two approaches: simply do nothing or use some of the rules of thumb.

solid understanding of the economic theory that speaks to the problem

statement.

A variable could end up being dropped from the model. One just needs

to be careful in that dropping a certain variable will not cause any

specification bias.

The use of instrumental variables (IV).

70

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Activity

Watch the following video from YouTube:

https://www.youtube.com/watch?v=O4jDva9B3fw.

Activity

We have discussed heteroscedasticity, multicollinearity and autocorrelation,

which are violations of the assumptions made in Topics 4 and 5.

http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91320859.

Make an attempt to follow the questions and answers that are posted on this

forum. You might want to think about registering on the site.

Summary

In this topic, multiple regression analysis was covered. The topic is an extension

of the simple regression model that was covered in Topic 4; and the same

assumptions made in Topic 4 were also made in Topic 5.

This topic addressed the inclusion of more than one independent variable in the

regression. Hence, there was a need to cover partial correlations and multiple

correlation. Issues related to including irrelevant variables or excluding important

variables in the analysis were also discussed.

multicollinearity tend to be present when the econometrician is conducting

multiple regression analysis.

71

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Self-Assessment Questions

rejected? Do the independent variables explain the dependent variable?

cross-sectional data and time-series data.

3. What happens when some of the assumptions are not met when running

the DurbinWatson d test?

4. Explain why the zero-order correlation test may not always translate into

concrete inferences about multicollinearity.

72

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Topic 6

Time-series analysis

6.1 INTRODUCTION

given case scenario.

Typically, these concepts work with cross-section and/or pooled data. In this

topic, we discuss the time-series econometrics, which will deal with time-series

data.

After reading this topic, you should have gained knowledge in the following

areas:

2. Stationarity and tests of stationarity

3. Non-stationary processes

4. Co-integration and tests of co-integration

5. Analysis of variance

6. The different approaches to forecasting

7. Modelling volatility.

Over time, there could be random variables which, when ordered in time, will

form a stochastic process. We can let Y denote a random variable. If it is

continuous, we can denote it as Y(t) or if it is discrete, it can be denoted as Yt.

The collection of economic data is done at a discrete point in time. For our

purposes we can denote the random variable as Yt. In other words, we can have

Y1, Y2 to Y10, where Y1 will be the first observation and Y10 will the last

observation.

73

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

For example, nominal GDP can be reported to be R3 550 000 000 in the first

quarter of 2000. Theoretically, the figure reported for GDP could have been any

number, due to political and/or economic factors. Hence, GDP can be a random

variable. Stochastic processes can be further decomposed into stationary

stochastic processes and non-stationary stochastic processes.

Stochastic processes will be stationary if the mean and the variance are constant

over time and the covariance between two time periods is dependent only on the

gap between the time periods, and not on the time when the covariance is

worked out. A stochastic process of this nature is said to be weakly stationary

and such a condition is usually enough for most analyses.

Source: www.coursehero.com

When dealing with non-stationary time series, a random walk is often spoken of.

In investment theory, it is postulated that stock prices or exchange rates follow

a random walk. In other words, a time series of stock prices will be non-

stationary. In terms of random walks, there are random walks with drift (an

intercept term is present) and there are random walks without drift (no intercept

term is present).

The random walk without drift can be illustrated as follows: if a is a white noise

error term and its mean is zero and the variance is constant, then will be a

random walk if it is equal to lag and a random shock or:

= 1 + (6.1)

current price is dependent on the previous price plus some error term. Random

walk with drift models are non-stationary because the expectation of will be

equal to its initial value and the variance will increase over time, which violates

the assumptions of stationary where the variance should be constant. In order

to make the process stationary, a first difference can be taken.

Lastly, what is known as the unit root problem can be identified when equation

6.1 is modified to be:

= 1 + (6.2)

74

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

where will be equal to 1 when there is a unit root. Therefore, the terms unit

root, non-stationary, random walk can be used synonymously.

6.1 as follows:

= + 1 + (6.3)

is commonly known as the drift parameter and the name is derived from the

fact that when the first difference 23 of equation 6.2 is taken, then depending on

whether the drift parameter is positive or negative, will either drift upward or

downward. Similar to the random walk without drift, the assumptions of

stationarity are violated due to the non-constant mean and variance. Hence, a

random walk with drift is a non-stationary stochastic process.

There are cases where a non-stationary time series might need to be detrended,

as opposed to differencing (first or second or third, etc.), to be made stationary.

A distinction therefore needs to be made as to why the time series is non-

stationary. Is the trend exhibited in the nonstationary data deterministic or

stochastic?

The random walk without drift model can be said to be a difference stationary

process because time series can be made stationary by differencing. Also, the

random walk with drift model can be difference stationary. The only time when

the random walk with drift model can be trend stationary will be when equation

6.2 is modified to look as follows:

= 1 + 2 + (6.4)

is no longer dependent on its lag, but on some deterministic trend. The mean

or expectation of Y will be equal to ( ) = 1 + 2 and the variance will be

constant. Once the values of t, 1 and 2 are known, then the mean of can be

determined. To make the time series stationary would be to take away the mean

of from thus removing the deterministic trend. Hence, the series will be

trend stationary.

23 1 = +

75

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Example:

RGDP

2,000,000

1,800,000

1,600,000

1,400,000

1,200,000

1,000,000

90 92 94 96 98 00 02 04 06 08 10 12

The graph above shows a time series of South African real GDP, with a trending

mean (average). There are two models, namely trend stationary and difference

stationary, in which the time series can be made stationary.

One way is to estimate the trend and remove it from the data. Thereafter, the

data should be trend stationary.

Alternatively, the mean trend could be stochastic. Differencing the data will yield

a stationary series.

13, Maddala, G.S. 2001. Introduction to Econometrics, 3rd ed. West Sussex: John

Wiley and Sons.

There are multiple ways in which stationarity can be tested. However, we shall

only cover the two most common tests the graphical method and the

autocorrelation function/correlogram.

To have an intuitive feel about the nature of the time-series data is to first plot

out the data and see how they look. Typically, if the plot exhibits some form of

trend in the data, one could be more or less inclined to come to a conclusion that

the data are non-stationary. However, the graphical method should not be

carried out in isolation. Formal testing should be done to confirm the result from

the graphical analysis.

76

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

A more formal method would be the use of the autocorrelation function (ACF).

At lag n, the ACF can be defined as:

= (6.5)

0

where will be the covariance between Y and its lag. The covariance will lie

between 1 and +1. 0 is the variance of Y 24. To obtain the correlogram, the

covariance is plotted on the variance. To be more specific, since we deal with a

sample, the sample covariance will be plotted on the sample variance and the

sample correlogram will be obtained.

stationary process is that the correlogram of a stationary process will have

autocorrelations (positive or negative) that fluctuate around zero; whereas, for

the non-stationary process, the autocorrelations of high values will decrease as

the number of lags increase.

Practically, there are issues around which lag should be chosen to have

autocorrelations close to zero. Should the autocorrelations be close to zero after,

say, 10 lags? Or one lag? Or 100 lags? If so, should we then reject stationarity

if, after 10 lags, the autocorrelation coefficients are still high?

a certain lag? With statistical programmes available, the best practical advice for

lag-length selection is to start off with large lags and reduce by using a criterion,

such as the Akaike Information Criterion or Schwarz Information Criterion. There

are tests available that test for significance, such as the Q-statistic and the Ljung-

Box (LB) statistic.

For further reading, please refer to pages 514519, Chapter 13, Maddala, G.S.

2001. Introduction to Econometrics, 3rd ed. West Sussex: John Wiley and Sons.

As part of stationarity testing, the most common and popular form of testing has

been the use of the unit root test. The general idea behind unit root testing is

that Y is regressed on its lag and the coefficient of the estimated in equation

24 Note that 0 is the variance of Y as it is the covariance of the initial value of Y, which in itself is the

variance of Y as there is no lag for the initial value.

77

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

6.1 is tested for statistical significance. If it is statistically equal to 1, then series

of Y is stationary. However, that cannot be easily done with OLS because there

is a violation in one of the assumptions of OLS in the presence of a unit root.

Therefore, equation 6.1 is modified by subtracting the lag of Y on both sides and

the equation will look as follows:

= 1 + (6.6)

where ( 1) and is the first difference operator put in place for 1. Now

the test is on equation 6.4 with the null hypothesis that = 0, and the alternative

hypothesis that < 0. The logic is that if = 0 then = 1 meaning that there is

a unit root.

The Augmenting Dickey-Fuller test

The Phillips-Perron test.

Activity

http://www.econ.boun.edu.tr/hatipoglu/ef508/lecture1.pdf.

Go to pages 4753 and try to follow the example shown. Can you follow the steps

in the process and the result? Write down any questions that you might have and

post them on the tutor forum to ensure you receive clarification.

were discussed. In the following sections, the forecasting aspect of time-series

econometrics will be discussed. In particular, we will cover three popular

forecasting models the Autoregressive Moving Average (ARMA), the

Autoregressive Integrated Moving Average (ARIMA), and the Vector

Autoregressive (VAR) model.

78

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

6.6.1 ARMA and ARIMA

To understand the ARMA or ARIMA model, the model has to be broken down into

the two different components: the AR and the MA processes. The AR process can

be defined as a process in which the Y value at time t is equal to its lagged value

in addition to the disturbance term in time t. A clear example of an AR process

is equation 6.1, which exhibits an AR (1) model. A model with p lags will be an

AR (p) model. The MA component of an ARMA model will look as follows:

= + 0 + 1 1 (6.7)

c will be the constant and will be the white noise error term. According to

equation 6.4, the Y value is dependent on the constant and the moving average

of the error term, both at the current period and the previous period. The above

will be a MA (1), since we are dealing with one lag. The generalised MA process

will be a MA (q) for q lags.

= + 1 1 + 0 + 1 1 (6.8)

will be ARMA (p,q) where p represents autoregressive terms and q the moving

average terms. The relationship between the ARMA and the ARIMA is that ARMA

is dealing with a time series that is stationary, whereas ARIMA is dealing with a

non-stationary time series. A non-stationary time series process is said to be

integrated of order one and/or above. If it is integrated of order one, I(1), then

its first difference will be integrated of order zero, I(0). Generally, if a time series

is I(p), then it needs to be differenced p times to be I(0). Thus, if a time series

is non-stationary and needs to be differenced to make stationary to model an

ARIMA (p,q), then the original time series is ARIMA (p,d,q).

where a time series may follow multiple processes (for example, an AR process,

an MA process, an ARMA process, or an ARIMA process). In all cases, the values

of p, d, or q will need to be known. The Box-Jenkins methodology provides the

solution. The method follows four steps:

identify the values of p, d, and q.

2. Estimation. After the identification of the p and q values, the next step

is to estimate the parameters of the AR and the MA terms.

79

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

3. Diagnostic checking. Having done the estimation, the following step is to

assess whether the model estimated fits the data. It could be that

another ARIMA model fits the data better than the current model.

4. Forecasting. The last step is to use the chosen ARIMA model to conduct

forecasting.

VAR models are models in which there are only endogenous variables within a

system. In other words, the variables within the system have some relationship

with each other. The term autoregressive explains the fact that the dependent

variable will have a lagged value and the term vector explains the fact that there

will be a vector of more than one variable. To provide more detail on the above,

the theory lets us know that there is a relationship between money supply and

the interest rate. Therefore, the VAR can be applied to test the relationship as

follows:

1 = + + + 1 (6.9)

=1 =1

= + + + 2 (6.10)

=1 =1

The us are the error terms and they are called impulses, innovations or shocks.

Before estimating equations 6.9 and 6.10, the number of lags will need to be

determined. 25 So far, we have worked with k lags; however they will need to be

accurately determined as too many lags might lead to multicollinearity and too

few lags may lead to specification errors.

Once the appropriate VAR model has been chosen and estimated, forecasting

can be conducted. The forecasting can be done by replacing the estimated

coefficients in each equation. For example, we can have the money supply

equation as follows:

(6.11)

25 The lags can be chosen with the use of the Akaike or Schwarz information criterion. The model

chosen will be the one that gives the lowest values of each criterion.

80

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

6.7 MODELLING VOLATILITY (ARCH/GARCH)

important. We have learned that in order to estimate OLS, volatility has to be

constant or otherwise the data will need to be transformed so that we have

constant volatility (homoscedasticity). However, with time-series data, such as

stock prices or exchange rates, unequal volatility may not be a problem in that

we can end up modelling the volatility for forecasting and predicting purposes.

be that there is model misspecification. However, in the case of modelling

volatility, the significance of the d statistic may be due to the ARCH effect. It is

therefore advisable that the ARCH effect be tested before the significant d

statistic is interpreted to be indicative of model misspecification.

Lastly, there are multiple variations of the ARCH model. One of these is

generalised autoregressive conditional heteroscedasticity (GARCH). The GARCH

is an extension of the ARCH in that the conditional variance is dependent on the

lagged squared error term and also on its lagged conditional variance.

Activity

http://arxiv.org/ftp/arxiv/papers/1302/1302.6613.pdf.

Choose one of the practical examples and try to follow the approach. Summarise

the example and explain it to a family member or friend to ensure that you have

understood the concept.

Summary

concepts within time series analysis is stationarity. This, and how one can

overcome the problem of stationarity by differencing and detrending, was

covered. The tests that come with testing for stationarity were discussed. Lastly,

forecasting models in time series (such as ARIMA and VAR) were addressed.

81

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Self-Assessment Questions

82

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

CASE STUDY 1:

DECOMPOSING LONG-TERM GROWTH IN

SOUTH AFRICA

In Topic 1, we addressed the practical application of the Solow Model, and the

use of growth accounting. 26 This method has been used in this case study to

investigate the factors that determine long-term growth in South Africa. This was

done by decomposing or breaking down long-term economic growth in South

Africa.

Production Function, stated as:

Taking the logs and differentiating with respect to time, we can estimate the

function:

= + + +

where lnY, lnK and lnL are the growth rates of Output, Capital and Labour

respectively. is the growth rate of total factor productivity, represents the

share of capital, and is the share of labour. The above equation is then

estimated using the Ordinary Least Squares method of estimation. The data

(obtained from the World Bank and the South African Reserve Bank) used covers

the period 1962(q1)2012(q4).

The table below presents the results. All parameters are significant in explaining

the growth of output. The main driver of output growth in South Africa is the

growth in Total Factor Productivity (TFP) with a coefficient of 6.6; the share of

labour is negatively related to the growth of output in the South African Economy,

with the elasticity of labour () at -0.47. The share of capital is positively related

to the rate of growth of output and the elasticity of capital () is at 0.58 in the

South African economy.

83

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

Table:

Regression

Output.

Contributions to Growth of Output (Log real GDP)

1962-2012 (Quarterly data)

Coefficient t-stat

Share of labour 0.470 2.873068

Share of capital 0.586 4.296698

Total Factor Productivity 6.595 3.332544

Source: South African Reserve Bank

Diagnostic tests on the model showed that the model only suffered from

heteroscedasticity by the Breusch-Pagan heteroscekedasticity test. This was

corrected by re-estimating the above equation using white heteroscekedasticity-

consistent standard errors and covariance.

The main findings of the case study were that the dominant driver of economic

growth in the economy is the growth of technical progress. The share of labour

and the share of capital were also found to be significant. However, the share of

labour was negative and that could be as a result of high unskilled labour in

South Africa. Having unskilled labour in the economy does not add value to the

economy. This should also explain why capital stocks contribution to the

economy is positive. Investment could be biased towards capital-intensive

production, as there is a shortage of skilled labour in the economy.

84

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

CASE STUDY 2:

POTENTIAL GDP AND INVESTMENT DECISION

The investor or portfolio manager should know whether the economy is operating

above, below, or on par with its output potential. This is so that the potential

risks of huge losses to the portfolio can be minimised. There are two methods

that the investor can use to detect the position of the economy in its business

cycle. These are displayed in the Figure 1 and Figure 2 below.

Figure 1:

14.8

14.4

14.0

13.6

.06

.04 13.2

.02 12.8

.00

-.02

-.04

-.06

60 65 70 75 80 85 90 95 00 05 10

Figure 2:

1 4 .8

1 4 .4

1 4 .0

.0 6

1 3 .6

.0 4

1 3 .2

.0 2

1 2 .8

.0 0

-.0 2

-.0 4

60 65 70 75 80 85 90 95 00 05 10

85

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

The green graph is the business cycle, where if the graph is trending upwards

the economy is in an upswing, and it is experiencing a downswing when the

graph is trending downwards. According to the graph, South Africa is in a

downswing from 2013 onwards.

Looking at the blue (actual GDP) and red (potential) graphs, we can see that

from 2003 to 2008 the economy was performing above its potential. From 2009,

it is performing below its potential. As of 20132014, the economy has been in

a downswing. This means that due to weakening expectations (both consumer

and business), the economy has also declined in its potential to expand. Figure

3 shows the South African economys leading economic indicator. This indicator

has been trending downwards, which is indicative of a slowing economy.

104

103

102

101

100

99

98

97

96

Jan, 2011

Jan, 2012

Jan, 2013

Jan, 2014

Jan, 2015

Nov, 2010

Nov, 2011

Nov, 2012

Nov, 2013

Nov, 2014

Jul, 2010

Mar, 2011

Jul, 2011

Mar, 2012

Jul, 2012

Mar, 2013

Jul, 2013

Mar, 2014

Jul, 2014

Sep, 2010

Sep, 2011

Sep, 2012

Sep, 2013

Sep, 2014

May, 2010

May, 2011

May, 2012

May, 2013

May, 2014

Leading Indicator

86

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

CASE STUDY 3:

SOUTH AFRICAN RAND MODELLING AND

FORECASTING

In this case study, we model the volatility of the dollar-rand exchange rate. The

exchange had to be transformed to logarithmic prices. The sample period was

from 4/01/2008 8/24/2015. To model the volatility, a sample period from

4/01/2008-8/04/2015 was used and a GARCH (1,1), GARCH (1,2) and GARCH

(2,1) model was used. In addition, the forecast was for the period from

8/05/2015 8/24/2015. This was done to compare and contrast which GARCH

model was the best (out of the three) in terms of modelling and forecasting

volatility.

From the results below, the GARCH (1,1) seems to possess better forecasting

power than the other models, indicating why it is the most commonly used model

in finance and in investment.

GARCH (1,1)

0.15

0.1

0.05

0

4/01/2

6/23/2

9/12/2

12/04/

2/25/2

5/19/2

8/10/2

10/30/

1/21/2

4/14/2

7/06/2

9/27/2

12/17/

3/10/2

6/01/2

8/23/2

11/14/

2/06/2

5/04/2

7/26/2

10/19/

1/16/2

4/12/2

7/08/2

10/01/

12/27/

3/20/2

6/23/2

9/12/2

12/05/

3/04/2

6/01/2

-0.05

-0.1

Forecast Actual

87

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

0.05

0.15

0.05

0.15

0.1

0.1

-0.05

0

-0.05

0

-0.1

-0.1

Date Date

6/23/2008 6/23/2008

9/15/2008 9/15/2008

12/08/20 12/08/2008

3/02/2009 3/02/2009

5/25/2009 5/25/2009

8/17/2009 8/17/2009

11/09/20 11/09/2009

2/01/2010 2/01/2010

4/26/2010 4/26/2010

7/19/2010 7/19/2010

10/11/20 10/11/2010

Actual

Actual

1/03/2011 1/03/2011

88

3/28/2011 3/28/2011

6/20/2011 6/20/2011

9/12/2011 9/12/2011

12/05/20 GARCH (2,1) 12/05/2011

GARCH (1,2)

2/28/2012 2/28/2012

Forecast

Forecast

5/29/2012 5/29/2012

8/22/2012 8/22/2012

11/15/20 11/15/2012

2/13/2013 2/13/2013

5/14/2013 5/14/2013

8/07/2013 8/07/2013

11/01/20 11/01/2013

1/31/2014 1/31/2014

5/02/2014 5/02/2014

7/29/2014 7/29/2014

10/22/20 10/22/2014

1/20/2015 1/20/2015

4/16/2015 4/16/2015

7/14/2015 7/14/2015

Answers to Self-Assessment Questions

1.

Savings and investment

Financial markets and intermediaries

Political stability, legal institutions and property rights

Education and healthcare

Tax and regulatory systems

The level of openness of the economy

Technical progress.

2. Each theory is built on the school of thought that dominated at the time.

The classical theory was based on the classical school of thought, and at

the time economies were opening up to free trade. Land was crucial,

along with other factors of production (i.e. labour and capital).

thought. The limitations of the classical theory were corrected for, in that

there could be constant returns to scale, as opposed to diminishing

returns to scale. Technical progress was also included into how long-term

economic growth could be achieved.

The new growth theory was built on the limitation of the neoclassical

theory of growth, which was that capital investment had a short-term

impact on long-term economic growth. The new growth theory stated

that investment could have long-term effects if capital stock was

redefined to include human capital.

there is a fall in depreciation. The actual investment curve is not

affected. From the figure, we see that the new balanced growth

path, k*, increases.

b) The slope of the break even investment schedule increases. The

actual investment curve is not affected. The balanced growth

path decreases.

c) The increase in the output per unit of capital will increase actual

investment and will not impact the break even investment

89

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

schedule. The actual investment curve will shift up, causing the

balanced growth path to increase.

indication of how well an economy can perform without putting upward

pressure on the inflation rate (in other words, how an economy can

perform at full capacity). With this in mind, the investor can better

manage a portfolio, and mitigate risk and maximise profits.

example, means that the economy is contracting. If the economy

contracts, it may be more risky and have a higher probability of

defaulting on its debts.

average GDP growth may be faced with higher interest rates in the

future, so as to control the growth rate. When interest rates are

increasing, market prices of existing fixed-income investments decline,

and the demand for new issue securities with higher rates will increase.

An economy that is faced with high growth rates is also likely to face a

rising inflation rate. If inflation is high, then the real rate of return on the

fixed income investments may go down.

1.

Futures Forward

Traded on an exchange market Private agreement

Standardised Customised for individual need

Exchange market will ensure default Credit risk

risk

Regulated at government level to Unregulated

ensure trading is reported timeously

2. The conditions are important as they can help determine exchange rates

in real terms; specifically when there is a need to compare prices for

goods and services that are sold across multiple countries. For investors,

90

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

the parity conditions are important in determining arbitrage

opportunities when there are price or interest-rate differentials.

account deficit implies that investors are mostly likely to pull out funds

to safer havens. The pulling out of funds will decrease the demand of the

Rand and therefore cause it to depreciate.

4. The increase in inflation in the USA will cause American investors to pull

funds out of the UK and to invest in the US. This will imply a decrease in

the demand of the pound. At the same time, British investors will also

start investing in the US and will pull finds out of the UK. As they sell

their investments, denominated in pounds in order to buy dollars, the

pound will increase in supply. This will cause the pound-dollar exchange

rate to depreciate.

the likelihood of an event occurring. Alternatively, probability can be

viewed by counting the number of occurrences of an event in a large

repetition.

Conversely, a continuous random variable will assume any value in a

certain range. If a variable is a discrete random variable, its probability

distribution will be called a discrete probability distribution, as it relates

to each variable with its probability. A probability density function will be

a continuous probability distribution. The distribution covers a

continuous range of values.

3.

Unbiased

Efficiency

Consistency.

91

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

A statistic is said to be unbiased when the mean of the sampling

distribution of that statistic can be shown to be equal to the

parameter being estimated.

If an estimator is unbiased and its variance is the smallest in a

class of unbiased estimators, then the estimator is an efficient

estimator.

An estimator is said to be consistent if the estimator value tends

towards the true value of the parameter as the sample size

increases.

estimator. If an estimator is unbiased and its variance is the smallest in

a class of unbiased estimators, then the estimator is an efficient

estimator. If we were dealing with linear estimators, then the estimators

would be known as the best linear unbiased estimator.

investment analysis. This is because heteroscedasticity allows for the

modelling of volatility of stock returns, exchange rates, etc.

3. Cross-section data: once can assess how average returns change across

different stocks or portfolios.

Time-series data: modelling of stick returns or exchange-rate volatility.

Pooled data: analysing the returns of stocks across different sectors.

uncertainties involved and that may hinder a normal regression analysis.

collectively.

when the return of one stock affects the return of another stock. For

time-series data, autocorrelation is present when there is a trend

(deterministic or stochastic) in the series.

92

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

3.

You should be able to identify if the autocorrelation is not as a

result of a model misspecification.

The use of GLS instead of OLS.

The use of the Feasible Generalised Least Squares.

multicollinearity might be a problem. If the independent variables are

more than two, then the zero-order correlation might not be enough.

This is especially the case when the third variable is a linear combination

between the other two independent variables.

= 1 + 1 1

if = 1, then we have a unit root problem, which means that the variance

of is not stationary and we have a situation of non-stationarity.

The Augmenting Dickey-Fuller test

The Phillips-Perron test.

93

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

References

Fleming, J. M. 1962. Domestic Financial Policies under Fixed and under Floating

Exchange Rates Staff Papers-International Monetary Fund, 369380.

Gujarati, N. D. & Porter, D.C. 2009. Basic Econometrics. 5th ed. New York:

McGraw-Hill.

Wiley & Sons.

Mundell, R. A. 1962. The appropriate use of monetary and fiscal policy for internal

and external stability. Staff Papers-International Monetary Fund, 7079.

Mundell, R. A. 1963. Capital mobility and stabilization policy under fixed and

flexible exchange rates. Canadian

Journal of Economics and Political

Science/Revue canadienne de economiques et science politique, 29(04), 475

485.

Arabia Economic Research and Policy Department, Islamic Development Bank,

Jeddah.

Piros, C.D. 2013. & Pinto, J.E. 2013. Economics for Investment Decision Makers.

New Jersey: John Wiley & Sons.

www.coursehero.com

94

Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b

- 14 - Sasmal 2011Uploaded byJuan Esteban Arratia Sandoval
- 12 Forex MarketsUploaded byYoga Adi
- Economic GrowthUploaded byezquey
- 101898344 Informe de Laboratorio de Fisica Ley de HookeUploaded byMEDALITH FANCY LOPEZ VEGA
- Foreign ExchangeUploaded bysaima
- The Role of Human Capital in Economic DevelopmentUploaded byioanamaf01
- Economic Growth and the Role.pdfUploaded byAndrew Lastrollo
- Group 4 Economic TheoryUploaded byThảo Nguyễn
- TradeUploaded byManu Mittra
- IB Unit-IIIUploaded byJitendra Kumar
- 662487702.pdfUploaded bysaketh
- analyses.docUploaded byimadebest
- ch07Uploaded byherueux
- Banking Exchange Rates and Forex BusinessUploaded byVaishali Jhaveri
- Foreign Exchange MarketUploaded bygoyalabhi
- International pricingUploaded bySelva Kumar Krishnan
- Forex pptUploaded byAbhishek Karekar
- PESTLE AnalysisUploaded byFarhana Romana
- Spoerer85Uploaded byMara Meli
- DOC-20170604-WA0001[1392]Uploaded byfranco alonso
- banking IndustryUploaded bySagar Damani
- Property Market ObservationUploaded bybharathanin
- Economic Growth and Female Labour Force Participation in India_Rahul LahotiUploaded byN. Elizondo
- World Economic OutlookUploaded byAditi Sharma
- Forex ( Foreign Exchange Market)Uploaded byM.Zuhair Altaf
- Petroquimica enfoque globalUploaded byejemplo1207
- convertibilityofindianrupee-110623060853-phpapp01Uploaded bytailboy477
- BP Plastic , AnalysisUploaded byChiaki Hidayah
- FundamentalDiwaliPicksOct2017.pdfUploaded bybinoy
- ManufacturingUploaded bySimran Singh Vohra

- French 2013Uploaded byAmanda Venturini Cortelezzi
- PG in IM ECOS01-8 Assignment Guidelines 2017v3Uploaded byMpho
- Post Graduate Diploma Financial Markets 2016Uploaded byMpho
- Diploma in Financial StrategyUploaded byMpho
- Programmes in FinanceUploaded byMpho
- Financial Strategies ProspectusUploaded byMpho
- PGDip Management PracticeUploaded byMpho
- Guide to MixingUploaded bynhomas

- knowledge-economy-and-society-9436Uploaded byabhitags
- An Estimated Monetary DSGE Model With UnEmployment and Staggered Nominal Wage Bargaining - GERTLER SALA TRIGARIUploaded byjc224
- 1Uploaded byAslina Azib
- Keynesian TheoryUploaded bysamrulezzz
- UnemploymentUploaded byLawrence Joseph Senupe Tremucha
- Chapter 10Uploaded bynikowawa
- EconomicalUploaded byllb123
- BANDAGES & SURGICAL COTTON PROJECT REPORTUploaded bysugaimpax
- US Federal Reserve: 199729papUploaded byThe Fed
- Argentine Economic DeclineUploaded byStephen Mariano Cabrera
- Digest Pool - Reg Holidays to SILUploaded byMarisseAnne Elaine J. Coquilla
- Week 2-2Uploaded byMarki Mendina
- imapact of it on global businessUploaded bySwapnil Vinod Nikam
- Topic 3 Solution of Short Answer Questions(3)Uploaded byTy Vo
- summer training report on employees welfare activities at GODREJUploaded byAnita Sharma
- C2311 Motor Vehicle Manufacturing in Australia Industry ReportUploaded bymenonmoon
- LabourUploaded bynimalinisansala
- Money or Ideas? A Field Experiment on Constraints to EntrepreneurshipUploaded byIrfy Beg
- MAS Reviewer - Relevant CostingUploaded byMarilou K. Espocia-Malquisto
- BRAZIL Stats TableUploaded byJayti Srivastava
- Grossman - Simonde de Sismondi and His Economic TheoriesUploaded bymichael4t
- Standard-Costing Ex Pr CasesUploaded byjohn condes
- c7 - costsUploaded byapi-241959879
- Department of Labor: 1081Uploaded byDepartment of Labor
- 3 Online Efficient Market 12 16 13Uploaded byZeJun Zhao
- OECD China Report FinalUploaded byjuanypato
- Estimating introductionUploaded byMax Shahin
- Learning Curves SupplementUploaded byDrShakeel Abasi
- Operations Management Key Terms flashcardsUploaded byddathaw
- Analyzing economies and diseconomies of scale.docxUploaded byr.wing0707