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Economics and Statistics

ECOS01-08
Cape Town
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Table of contents

Heading Page number

Information iii
Table of contents iv
Module purpose and outcomes vii
Glossary of terms viii

TOPIC 1 ECONOMIC GROWTH AND THE INVESTMENT DECISION 9


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

TOPIC 2 CURRENCY EXCHANGE RATES: DETERMINATION AND


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

TOPIC 3 INTRODUCTION INTO ECONOMETRICS AND STATISTICAL


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

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Summary 49
Self-Assessment Questions 49

TOPIC 4 REGRESSION ANALYSIS AND CORRELATION 50


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

TOPIC 5 MULTIPLE REGRESSION ANALYSIS 59


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

TOPIC 6 TIME-SERIES ANALYSIS 73


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 1: DECOMPOSING LONG-TERM GROWTH IN SOUTH AFRICA 83


CASE STUDY 2: POTENTIAL GDP AND INVESTMENT DECISION 85
CASE STUDY 3: SOUTH AFRICAN RAND MODELLING AND FORECASTING 87

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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

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Module purpose and outcomes

Module purpose

This module introduces students to the practice of forecasting economic


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

1. Explain different influencing factors for economic growth and their


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.

Please refer to the following textbook, where indicated in the text:

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

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Glossary of terms

Autocorrelation: occurs when time-series data are influenced by their own


historical values.

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

Covariance: the measure of how two random variables move together.

Economic growth: the increase in the production of goods and services in an


economy over time.

Foreign-exchange rates: these rates are determined by the exchange of one


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

Hypothesis testing: a method used in statistics that determines the probability


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.

Probability: the likelihood or chance that an event will occur.

Regression analysis: this involves estimating the relationship between one


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.

Stochastic processes: a collection of random variables usually collected over


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).

Volatility: refers to how often, quickly and randomly a security, market or


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

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Topic 1
Economic growth and the investment decision

1.1 INTRODUCTION

This topic focuses on the following module outcome:

1. Explain different influencing factors for economic growth and their


influence on investment decisions.

For investors, understanding and measuring economic growth is useful. Pricing


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:

1. Understanding and utilising economic growth for investment decisions


2. Sources and determinants of economic growth
3. The different theories of economic growth
4. Potential GDP and the investment decision.

1.2 SOURCES OF ECONOMIC GROWTH

To gain an understanding of what economic growth is, it is beneficial to


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.

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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.

1.2.2 Financial markets and intermediaries

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.

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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.

1.2.4 Education and healthcare

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

3 See Millennium Development Goals (2013).


4 IMF Regional Outlook.

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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.

1.2.6 The level of openness of the economy

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.

1.2.7 Technical progress

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.

5 An economy that cannot influence world interest rates.


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

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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.

1.3 THEORIES OF ECONOMIC GROWTH

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.

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Table 1.1 Theories related to economic growth

Growth theories Differentiating factors


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.

1.3.1 Classical growth theory

The classical theory of economic growth was proposed by classical economists,


such as Thomas Malthus and David Ricardo. We will focus on the theory proposed
by Thomas Malthus in 1798.

This theory focused on how limited resources could be used by a growing


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

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income per capita would converge back to the minimum income per capita
required, even if technology progressed.

1.3.2 Neoclassical growth theory

The neoclassical growth theory followed on from the classical theory. There are
two famous neoclassical theories: the Harrod-Domar model and the Solow
model.

The Harrod-Domar 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.

For this to occur, the model is based on three assumptions:

1. There are constant returns to scale.


2. Both the population and the savings rate are exogenous.
3. Technological progress is constant.

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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 Solow model

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)

The reason that knowledge is included multiplicatively into the production


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:

7 Savings realised from income earned.


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

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Figure 1.1 Production relation

Source: Romer (2006) Advanced Macroeconomics

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.

Source: Adapted in part from Musa (2012)

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Figure 1.2 Steady state in the economy

Source: Romer (2006) Advanced Macroeconomics

is where there is a balanced growth path or a 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.

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Growth accounting

An empirical application of the Solow model is the growth accounting equation.


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.

10 Sometimes referred to as Total Factor Productivity.

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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.

1.3.3 New growth theory

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.

Note: both of them talk about technical progress.

11 The case where an increase in inputs more than doubles output.

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1.4 POTENTIAL GDP AND THE INVESTMENT DECISION

Potential GDP evaluations are important because potential GDP is an indication


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.

Potential GDP may also be important for fixed-income investments, such as


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.

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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?

Table 1.2 Economic forecasts South Africa (20162020 outlook)

Overview Actual Q1/16 Q2/16 Q3/16 Q4/16 2020


(28.01.16)

GDP growth rate 0.70 0.3 0.5 1.3 2.75 2.1 percent

Unemployment rate 25.50 25.96 26 25.55 25.97 25.25 percent

Inflation rate 5.20 5.2 5.3 5.5 5.1 4.7 percent

Interest rate 6.25 6.5 6.5 6.75 6.75 7 percent

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

Government debt to GDP 39.00 42 42 42 42 47 percent

Currency (R/$) 16.31 15.96 16.27 16.43 16.59 12.64

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

To get a better understanding of the influencing factors in forecasting bond


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.

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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

1. List all the sources of economic growth.

2. Explain how the theories of economic growth build on each other.

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?

a) The depreciation rate falls.


b) The technical progress rate falls.
c) The output per unit of effective labour increases.

4. Explain the importance of determining potential GDP for investment


decision-making.

5. Explain the importance of potential GDP in determining the value of


fixed-income investments.

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Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b
Topic 2
Currency exchange rates: determination and
forecasting

2.1 INTRODUCTION

This topic focuses on the following module outcome:

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


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:

1. Understanding the foreign-exchange market


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.

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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.

2.2.1 The Gold Standard

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.

2.2.2 Fixed exchange rates

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.

Around the 1960s, the US dollar became overvalued on account of increased


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.

2.2.3 Floating/flexible exchange rates

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.

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Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b
2.3 BID/ASK SPREAD

The foreign-exchange market is made up mainly of large corporations and large


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.

2.4 DIRECT/INDIRECT QUOTATION

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

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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.

2.5 FORWARD MARKET

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.

2.5.1 Covered interest-rate parity

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

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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.

2.6 EXCHANGE-RATE DETERMINATION

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.

2.6.1 International parity conditions

International parity conditions are usually included in the determination of


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:

International parity conditions

Covered interest-rate parity


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.

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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%.

Due to the transparency and integration of international financial markets, there


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.

Purchasing power parity

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.

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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 critical assumptions of the absolute PPP are as follows:

The broad range of goods and services are tradable.


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)

The relative PPP condition was formulated in an attempt to control transaction


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 and real interest-rate parity

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)

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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.

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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 above equation is known as the International Fisher Effect.

The impact of balance of payments on exchange-rate determination

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.

Below is a graphical representation of how the exchange rate is determined. On


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.

13 Or the financial account.

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Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b
SR
$/R

R 12.50

DR

QR

Figure 2.1 Determining the exchange rate

Changes in current account and determination of exchange rates

The impact of the CA on the path of the exchange rate can be explained through
three main different channels:

1. The flow supply/demand channel


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.

14 When you cannot easily substitute one good for another.

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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.

Impact of capital flows on the determination of exchange rates

The long-run equilibrium of exchange rates can be determined by the


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 policy and fiscal policy effects

Monetary and fiscal policies can affect the path of the exchange rate in a number
of ways and through different channels.

15 This relationship has not been empirically proven.

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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:

1. The effect of an expansionary monetary policy on a flexible/floating-


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.

The effect of an expansion in monetary policy

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.

The effect of an expansion in fiscal policy

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

16 Mundell (1962, 1963) and Fleming (1962)

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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.

2.7 EXCHANGE-RATE FORECASTING

With the determinants of currency exchange rates discussed above, it is


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.

2.7.1 Technical analysis

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.

2.7.2 The use of order flow

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

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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.

2.7.3 The use of sentiment

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.

2.7.4 The use of positioning

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?

Share your thoughts on myCourses with your fellow students.

17 Currency option positions have a simultaneous out-of-the-money call and an out-of-the-money


put.

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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

1. Compare futures contracts and forward contracts.

2. Discuss the importance of the international parity conditions in the


determination of exchange rates.

3. South Africa has an economy that is dependent on capital inflows.


Explain what is likely to happen to the rand if the countrys current
account deficit continues to widen.

4. Assume that the inflation rate in America increases relative to the


inflation rate in the United Kingdom. What will happen to demand and
supply of the pound? What will happen to the pounddollar exchange
rate?

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Milpark Education (Pty) Ltd Economics and Statistics ECOS01-08 16b
Topic 3
Introduction into econometrics and statistical
modelling

3.1 INTRODUCTION

This topic focuses on the following module outcome:

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.

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

1. The purpose of econometrics and statistical modelling


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

Probability is a quantitative measure of uncertainty; it is a measure of the


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%.

Alternatively, probability can be viewed by counting the number of occurrences


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

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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.

There is also a subjective view of probability based on personal beliefs;


individuals will have their own probability distribution.

3.3 ADDITION AND MULTIPLICATION RULE OF PROBABILITY

Before discussing the rules of probability, a few terms need to be defined. If we


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.

The addition rule of probability is stated as follows:

( + ) = () + () () (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).

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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.

3.4 WHAT ARE PROBABILITY DISTRIBUTIONS?

Probability distributions are made up of different values of random variables. A


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:

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Figure 3.1 Cumulative distribution and probability density functions

In some cases, it would make sense to look at relationships between random


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.

3.5 DIFFERENT TYPES OF PROBABILITY DISTRIBUTIONS

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

3.5.1 Normal distribution

This is a bell-shaped distribution and the probability density function is given as


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:

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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.

3.5.2 Chi-squared 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:

A chi-squared distribution is skewed. The skewness of the distribution


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.

3.5.3 The t distribution

A t distribution is a combination of a standardised normal variable (Z1) that


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

The variable is defined as:

1
= (3.6)
2

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The properties of the distribution are as follows:

The t distribution is symmetrical, but flatter than the normal distribution.


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).

3.5.4 The F distribution

If Z1 and Z2 are independently distributed chi-square variables, and the degrees


of freedom are k1 and k2 respectively, then the variable

1 /1
= (3.7)
2 /2

follows an F distribution with the k1 and k2 degrees of freedom.

The properties of the distribution:

Similar to the chi-square distribution, the F distribution is skewed to the


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)

If we were to square a random variable following a t distribution and that


distribution has k degrees of freedom, then we would obtain a random
variable following an F distribution with 1, k degrees of freedom.

Example:

In finance, one would be concerned with identifying losses. A t distribution can


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.

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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.

3.6 STATISTICAL INFERENCES

A random variable is often assumed to follow a particular distribution. One may


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.

3.6.1 Point estimation and interval estimation

Point estimation is the estimation of a single-point estimate of the true


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, .

As opposed to the point estimate, interval estimation will provide a range in


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)

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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%.

3.6.2 Hypotheses testing

Whatever is estimated should be tested to analyse whether there is statistical


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.

The confidence interval approach

In order for the estimated parameter to be equal to or sufficiently explain the


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.

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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 test of significance approach

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

See Case Study 1 for an example of how hypothesis testing is done.

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3.7 PROPERTIES OF ESTIMATORS

There are properties of estimators that are mentioned extensively in econometric


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

A statistic is an unbiased estimate of a particular parameter when the mean of


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.

Obtaining unbiased estimators is important, although there will be times when


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

3.7.2 Efficiency

The efficiency of an estimator has to do with the variance of the 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. 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.

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Activity

Work through the properties of estimators on pages 2024 in the following


textbook: Maddala, G. S. 2001. Introduction to Econometrics. 3rd ed. West
Sussex: John Wiley & Sons.

Discuss the implications of not meeting these properties on myCourses.

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.

2. Define both discrete and continuous variables. Compare the distributions


of discrete and continuous variables.

3. List and explain various probability distributions.

4. List and describe different properties of estimators.

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Topic 4
Regression analysis and correlation

4.1 INTRODUCTION

This topic focuses on the following module outcome:

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


given case scenario.

Topic 3 introduced the concept of econometric and statistical modelling. As part


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:

1. The methodology of econometrics


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.

4.2 METHODOLOGY OF ECONOMETRICS

There is a methodology that is followed by econometricians when they conduct


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

The first step is to formulate an econometric model, based on the economic


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.

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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:

Table 4.1 Econometric methodology

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?

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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.

Data structures Practical use


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.

4.3.1 Cross-section data

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.

4.3.2 Time-series data

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.

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4.3.3 Pooled data

Pooled data is a combination of both time-series and cross-section data. It is


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.

4.4 WHAT IS REGRESSION ANALYSIS?

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)

Assuming that the relationship is a stochastic relationship, 4.1 becomes:

= + + (4.2)

The term + represents the deterministic component, whereas the


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:

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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?

4.4.1 The method of least squares

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

Equation 4.4 is to be minimised. The equation is a sum of squares of the


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

18 Here we focus on Ordinary Least Square (OLS).

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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:

1. The regression model is linear in its parameters. It may or may not be


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

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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

Compare the concepts of homoscedasticity and heteroscedasticity. Use the


following link (in addition to the information provided above):

https://www.youtube.com/watch?v=zRklTsY9w9c.

The coefficient of determination, r2

The coefficient of determination measures the accuracy of the fitted regression


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.

The coefficient of determination has two properties:

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).

4.4.2 The limitations of linear regression analysis

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

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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.

Lastly, the model requires independence and the assumption of a normal


distribution.

4.5 REGRESSION VERSUS CORRELATION

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.

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Summary

In this topic we covered the methodology of econometrics, followed by the types


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.

Finally, we compared the concepts of regression analysis and correlation


analysis.

Self-Assessment Questions

1. Briefly discuss the difference between the minimum-variance unbiased


estimator and the best linear unbiased estimator.

2. Is homoscedasticity an issue in financial or investment analysis? Briefly


explain.

3. Data can be organised as cross-section data, time-series data, or pooled


data. How is each type used in financial or investment analysis?

4. Describe how the properties of linear regression can turn out to be


limitations with real-life investment analysis.

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Topic 5
Multiple regression analysis

5.1 INTRODUCTION

This topic focuses on the following module outcome:

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.

In this topic, we expand on regression analysis and cover multiple regression


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.

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5.2 MULTIPLE REGRESSION MODEL

Topic 4 covered simple regression the relationship between the dependent


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:

1. The expectation of the term is zero or ( ) = 0.


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:

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= 1 1 2 2 (5.2)

In order to obtain the different estimators, three equations (called normal


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

Go through the derivation of the normal equations in the following textbook:


Maddala, G. S. 2001. Introduction to Econometrics. 3rd ed. West Sussex: John
Wiley & Sons.

The derivation and illustrative example is on pages 132134.

5.3 STATISTICAL INFERENCE

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)

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, 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.

5.4 HOW TO INTERPRET THE COEFFICIENTS IN A REGRESSION

In regression analysis, we test the effect of the independent variable on the


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 =
()

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5.5 PARTIAL CORRELATIONS AND MULTIPLE CORRELATION

The partial effects discussed above can be referred to as partial correlations,


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.

5.6 ANALYSIS OF VARIANCE AND HYPOTHESES TESTING

In regression analysis, partial effects are often considered, as opposed to the


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)

where n is the number of observations and k is the number of variables. The F


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

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the hypothesis is not rejected, it means that the independent variables do not
explain the dependent at all.

Activity

Watch the following video:

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.

5.7 OMIT IRRELEVANT VARIABLES AND INCLUDE IMPORTANT


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.

Omitting relevant variables may have the following implications:

The coefficients of the regression will be biased and inconsistent. Even if


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.

Including irrelevant variables may have the following implications:

The estimators may still be unbiased and consistent.


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.

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Activity

Download the following document from the internet:

www.gwilympryce.co.uk/teach/miich5ommittedvars.doc.

It is the personal webpage of Professor Gwilym Pryce from the University of


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

5.8.1 What is 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.

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Note:

For an estimator to be BLUE, the following should hold:

(i) It should be linear.


(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.

5.8.2 How to identify heteroscedasticity

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:

Assume that there is no heteroscedasticity and run the model. As a post-


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.

Some of the formal methods include the following:

The Park Test is a formalisation of the graphical method above. It states


that the variance is some function of the independent variable. Because

21 The switch from OLS to Generalised Least Squares may control this problem.

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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)

If it is found that is significant, then heteroscedasticity is present.

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.

5.8.3 Controlling for heteroscedasticity

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

5.9.1 What is autocorrelation?

Another violation of the assumptions made earlier is that of 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

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variation can be successive for a specific period; and hence the error term can
exhibit autocorrelation.

Some of the sources of autocorrelation are as follows:

Economic variables often follow trends over business cycles


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.

Similar to the presence of heteroscedasticity, when there is autocorrelation the


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.

5.9.2 How to identify autocorrelation

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:

There must be an intercept term in the regression model.


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.

22 ARs will be covered in Topic 6.

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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.

5.9.3 Controlling for autocorrelation

Some of the options include:

1. You should be able to identify if the autocorrelation is not as a result of


a model misspecification.
2. The use of GLS instead of OLS.
3. The use of the Feasible Generalised Least Squares.

Activity

Watch the following video, and summarise the main points:

https://www.youtube.com/watch?v=jt5nl2VEpwg.

5.10 MULTICOLLINEARITY

5.10.1 What is multicollinearity?

Multicollinearity refers to the correlation between the independent variables in a


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

Using a sample that was made up of a limited range of values in the


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.

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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.

5.10.2 How to identify multicollinearity

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.

5.10.3 Controlling for multicollinearity

There are two approaches: simply do nothing or use some of the rules of thumb.

The rules of thumb are as follows:

Having a priori information about the problem statement or having a


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).

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Activity
Watch the following video from YouTube:

https://www.youtube.com/watch?v=O4jDva9B3fw.

Make a summary of the most salient points.

Activity
We have discussed heteroscedasticity, multicollinearity and autocorrelation,
which are violations of the assumptions made in Topics 4 and 5.

Go to the following webpage:

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.

Lastly, we saw that the issues of heteroscedasticity, autocorrelation and


multicollinearity tend to be present when the econometrician is conducting
multiple regression analysis.

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Self-Assessment Questions

1. What does it mean when the hypothesis of joint significance is not


rejected? Do the independent variables explain the dependent variable?

2. Think of examples of where autocorrelation could be present for both


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.

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Topic 6
Time-series analysis

6.1 INTRODUCTION

This topic focuses on the following module outcome:

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


given case scenario.

In Topic 5, we discussed the concept of simple and multiple regression analysis.


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:

1. Defining a stochastic process


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.

6.2 WHAT IS A STOCHASTIC PROCESS?

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.

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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.

6.2.1 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

6.2.2 Non-stationary stochastic processes

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)

Equation 6.1 can also be viewed as an Autoregressive or AR (1) model, as the


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)

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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.

A random walk with drift can be illustrated by a simple modification of equation


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.

6.3 TREND STATIONARY VERSUS DIFFERENCE STATIONARY

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 = +

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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

Source: South African Reserve Bank

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.

For further exposure to econometrics, please refer to pages 514519, Chapter


13, Maddala, G.S. 2001. Introduction to Econometrics, 3rd ed. West Sussex: John
Wiley and Sons.

6.4 HOW TO TEST FOR STATIONARITY

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.

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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.

The main difference between a correlogram of a stationary process and a non-


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?

How do we know that the autocorrelation coefficient is statistically significant at


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.

6.5 UNIT ROOT TESTING

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.

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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 popular tests of stationarity include the following:

The Dickey-Fuller test


The Augmenting Dickey-Fuller test
The Phillips-Perron test.

Activity

Download the following document:

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.

6.6 FORECASTING WITH TIME-SERIES PROCESSES

In the previous sections, stationarity and the transformation of time-series data


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.

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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.

An ARMA will be a combination of both an AR and an MA process:

= + 1 1 + 0 + 1 1 (6.8)

Equation 6.8 is representative of an ARMA(1,1) process. The generalised process


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).

6.6.2 ARIMA: Box-Jenkins methodology

With the above-mentioned information, one may be confronted with a situation


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:

1. Identification. The identification step is the use of a correlogram to


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.

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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.

6.6.3 Vector Autoregressive (VAR)

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:

2001 = 1200.998 + 1.065762000 254.737652000


(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.

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6.7 MODELLING VOLATILITY (ARCH/GARCH)

In macroeconomics and finance, the measuring and modelling of volatility is


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.

Earlier it was mentioned that in the presence of a significant d statistic, it may


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

Download the following article about time-series analysis and forecasting:

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

In this topic, we covered time-series analysis. One of the most important


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.

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Self-Assessment Questions

1. Define a unit root.

2. List the three most popular tests of stationarity.

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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.

The organising principle of growth accounting is the Cobb Douglas Aggregate


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.

26 Please refer to equation 1.7 in Topic 1.

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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.

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CASE STUDY 2:
POTENTIAL GDP AND INVESTMENT DECISION

In Topic 1, we discussed the impact of potential GDP on the 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:

Hodrick-Prescott Filter (lambda=1600)


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

LRGDP Trend Cycle

Figure 2:

Fixed Length Sym m etric (Baxter-King) Filter


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

LRGDP Non-cycl i cal Cycl e

Source: South African Reserve Bank

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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.

Figure 3: RSA leading indicator

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

Source: South African Reserve Bank

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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

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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

Source: Standard Bank


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

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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

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


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

TOPIC 1 SELF-ASSESSMENT ANSWERS

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).

The neoclassical theories were based on the neoclassical school of


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.

3. a) The slope of the breakeven investment schedule will decrease if


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

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schedule. The actual investment curve will shift up, causing the
balanced growth path to increase.

4. Potential GDP evaluations are important because potential GDP is an


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.

5. GDP is an indicator of the health of the economy. Declining GDP, for


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.

An overheating economy an economy that is experiencing above-


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.

TOPIC 2 SELF-ASSESSMENT ANSWERS

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,

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the parity conditions are important in determining arbitrage
opportunities when there are price or interest-rate differentials.

3. The rand will continue to depreciate, as the widening of the current


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.

TOPIC 3 SELF-ASSESSMENT ANSWERS

1. Probability is a quantitative measure of uncertainty. It is a measure of


the likelihood of an event occurring. Alternatively, probability can be
viewed by counting the number of occurrences of an event in a large
repetition.

2. 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. 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.

4. Estimators should be unbiased, efficient and consistent.

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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.

TOPIC 4 SELF-ASSESSMENT ANSWERS

1. The efficiency of an estimator has to do with the variance of the


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.

2. No. Homoscedasticity does not need to be achieved when doing


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.

4. Economic variables do not always remain constant. There are


uncertainties involved and that may hinder a normal regression analysis.

TOPIC 5 SELF-ASSESSMENT ANSWERS

1. It means that all independent variables explain the dependent variable


collectively.

2. One example of the presence of autocorrelation in cross-section data is


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.

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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.

4. If the zero order correlation is higher between two variables, then


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.

TOPIC 6 SELF-ASSESSMENT ANSWERS

1. In the random walk model (below),

= 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.

2. In the random walk model below:

The Dickey-Fuller test


The Augmenting Dickey-Fuller test
The Phillips-Perron test.

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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.

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


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.

Musa, J. I. 2012. Technological change and economic transformation. Saudi


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.

Romer, D. 2006. Advanced Macroeconomics. 3rd ed. New York: McGraw-Hill.

www.coursehero.com

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