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Multivariate models
Correlation
Causality
Granger Causality
Solving for Q,
P S u P T v
(6)
Solving for P,
Q S u Q T v
(7)
Rearranging (6),
P P T S v u
( ) P ( ) T S ( v u )
P
vu
T
S
(8)
u v
T
S
(9)
(8) and (9) are the reduced form equations for P and Q.
But what would happen if we had estimated equations (4) and (5), i.e. the
structural form equations, separately using OLS?
Both equations depend on P. One of the CLRM assumptions was that
E(Xu) = 0, where X is a matrix containing all the variables on the RHS of
the equation.
It is clear from (8) that P is related to the errors in (4) and (5) - i.e. it is
stochastic.
What would be the consequences for the OLS estimator, , if we ignore
the simultaneity?
(
X
'
X
)
X ' ( X u )
So that
( X ' X ) 1 X ' X ( X ' X ) 1 X ' u
( X ' X ) 1 X ' u
Taking expectations, E ( ) E ( ) E (( X ' X ) 1 X ' u)
( X ' X ) 1 E ( X ' u )
10
P 10 11T 12 S 1
(10)
Q 20 21T 22 S 2
(11)
We CAN estimate equations (10) & (11) using OLS since all the RHS
variables are exogenous.
But ... we probably dont care what the values of the coefficients are;
what we wanted were the original parameters in the structural
equations - , , , , , .
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12
13
14
Example
In the following system of equations, the Ys are endogenous, while the
Xs are exogenous. Determine whether each equation is over-, under-, or
just-identified.Y1 0 1Y2 3Y3 4 X 1 5 X 2 u1
Y2 0 1Y3 2 X 1 u2
(14)-(16)
Y3 0 1Y2 u3
Introductory Econometrics for Finance Chris Brooks 2013
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16
Y1 10 11 X 1 12 X 2 v1
Y2 20 21 X 1
v2
Estimate the reduced
OLS, and obtain the fitted
Y3 form
30equations
31 X 1 (17)-(19)
vusing
3
values,
(17)-(19)
Y1 , Y2 , Y3
Introductory Econometrics for Finance Chris Brooks 2013
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(20)
18
Recursive Systems
Consider the following system of equations:
(21-23)
Y1 10
11 X 1 12 X 2 u1
Y2 20 21Y1
21 X 1 22 X 2 u2
Y3 30 31Y1 32Y2 31 X 1 32 X 2 u3
Assume that the error terms are not correlated with each other. Can we estimate the
equations individually using OLS?
Equation 21: Contains no endogenous variables, so X1 and X2 are not correlated with
u1. So we can use OLS on (21).
Equation 22: Contains endogenous Y1 together with exogenous X1 and X2. We can use
OLS on (22) if all the RHS variables in (22) are uncorrelated with that equations
error term. In fact, Y1 is not correlated with u2 because there is no Y2 term in equation
(21). So we can use OLS on (22).
Introductory Econometrics for Finance Chris Brooks 2013
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20
21
Estimation of Systems
Using Two-Stage Least Squares
In fact, we can use this technique for just-identified and over-identified systems.
Two stage least squares (2SLS or TSLS) is done in two stages:
Stage 1:
Obtain and estimate the reduced form equations using OLS. Save the fitted
values for the dependent variables.
Stage 2:
Estimate the structural equations, but replace any RHS endogenous variables
with their stage 1 fitted values.
22
Estimation of Systems
Using Two-Stage Least Squares (contd)
Example: Say equations (14)-(16) are required.
Stage 1:
Estimate the reduced form equations (17)-(19) individually by OLS and obtain the
fitted values,
.
Y1 , Y2 , Y3
Stage 2:
Replace the RHS endogenous variables with their stage 1 estimated values:
23
Estimation of Systems
Using Two-Stage Least Squares (contd)
24
Instrumental Variables
Recall that the reason we cannot use OLS directly on the structural equations is that the
endogenous variables are correlated with the errors.
One solution to this would be not to use Y2 or Y3 , but rather to use some other variables
instead.
We want these other variables to be (highly) correlated with Y2 and Y3, but not correlated
with the errors - they are called INSTRUMENTS.
Say we found suitable instruments for Y2 and Y3, z2 and z3 respectively. We do not use the
instruments directly, but run regressions of the form
(27) & (28)
Y2 1 2 z2 1
Y3 3 4 z3 2
25
Obtain the fitted values from (27) & (28), Y2 and Y3 , and replace Y2 and
Y3 with these in the structural equation.
If the instruments are the variables in the reduced form equations, then
IV is equivalent to 2SLS.
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27
28
The S&P 100 Index has been traded on the CBOE since 1983 on a
continuous open-outcry auction basis.
29
30
31
The Data
The average bid & ask prices are calculated for each option during the
time 2:00pm 2:15pm Central Standard time.
The following are then dropped from the sample for that day:
1. Any options that do not have bid / ask quotes reported during the hour.
2. Any options with fewer than 10 trades during the day.
The option price is defined as the average of the bid & the ask.
32
The Models
For the calls:
CBAi 0 1CDUMi 2 Ci 3CLi 4 Ti 5CRi ei
(1)
(2)
(4)
where PRi & CRi are the squared deltas of the options
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34
Results 1
(6.55)
(6.56)
0
0.08362
(16.80)
0
-3.8542
(-10.50)
1
0.06114
(8.63)
1
46.592
(30.49)
2
0.01679
(15.49)
2
-0.12412
(-6.01)
3
0.00902
(14.01)
3
0.00406
(14.43)
4
-0.00228
(-12.31)
4
0.00866
(4.76)
5
-0.15378
(-12.52)
Adj. R2
0.688
Adj. R2
0.618
Note: t-ratios in parentheses. Source: George and Longstaff (1993). Reprinted with the permission of
the School of Business Administration, University of Washington.
Introductory Econometrics for Finance Chris Brooks 2013
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Results 2
0
0.05707
(15.19)
0
-2.8932
(-8.42)
1
0.03258
(5.35)
1
46.460
(34.06)
2
0.01726
(15.90)
2
-0.15151
(-7.74)
3
0.00839
(12.56)
3
0.00339
(12.90)
4
-0.00120
(-7.13)
4
0.01347
(10.86)
(6.57)
(6.58)
Adj. R2
5
-0.08662
0.675
(-7.15)
Adj. R2
0.517
Note: t-ratios in parentheses. Source: George and Longstaff (1993). Reprinted with the permission of
the School of Business Administration, University of Washington.
36
Comments:
Adjusted R2 60%
etc.
37
The paper argues that calls and puts might be viewed as substitutes
since they are all written on the same underlying.
So call trading activity might depend on the put spread and put trading
activity might depend on the call spread.
38
Conclusions
Bid - Ask spread variations between options can be explained by reference to the
level of trading activity, deltas, time to maturity etc. There is a 2 way relationship
between volume and the spread.
The authors argue that in the second part of the paper, they did indeed find
evidence of substitutability between calls & puts.
Comments
- No diagnostics.
- Why do the CL and PL equations not contain the CR and PR variables?
- The authors could have tested for endogeneity of CBA and CL.
- Why are the squared terms in maturity and moneyness only in the
liquidity regressions?
- Wrong sign on the squared deltas.
Introductory Econometrics for Finance Chris Brooks 2013
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A VAR is in a sense a systems regression model i.e. there is more than one
dependent variable.
40
or
y1t
10 11 11 y1t 1 u1t
y2 t
20 21 21 y2 t 1 u2 t
+ 1 yt-1
gg g1
+ ut
g1
41
This model can be extended to the case where there are k lags of each
variable in each equation:
yt = 0
g1
g1
+ 1 yt-1
gg g1
+ 2 yt-2
gg g1
+...+
k yt-k + ut
gg g1 g1
We can also extend this to the case where the model includes first
difference terms and cointegrating relationships (a VECM).
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43
Cross-Equation Restrictions
Suppose that a bivariate VAR(8) estimated using quarterly data has 8 lags
of the two variables in each equation, and we want to examine a restriction
that the coefficients on lags 5 through 8 are jointly zero. This can be done
using a likelihood ratio test
LR T log r log u
Introductory Econometrics for Finance Chris Brooks 2013
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45
MAIC ln
2k / T
k
MSBIC ln ln(T)
T
2
k
ln(ln(T))
MHQIC ln
T
46
y2 t 20 21 y2 t 1 21 y1t 1 22 y1t u2 t
We can write this as
y1t
10 11 11 y1t 1 12 0 y2 t u1t
y
0
y
u
2t
20 21
21
2 t 1
22
1t
2t
This VAR is in primitive form.
Introductory Econometrics for Finance Chris Brooks 2013
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22 1 y2 t
20 21 21 y2 t 1 u2 t
or
A yt = 0 + 1 yt-1 + ut
48
y 2t 20 21 22 y 2t 1 21 22 y 2t 2 21 22 y 2t 3 u 2t
This VAR could be written out to express the individual equations as
49
Implied Restriction
21 = 0 and 21 = 0 and 21 = 0
11 = 0 and 11 = 0 and 11 = 0
12 = 0 and 12 = 0 and 12 = 0
22 = 0 and 22 = 0 and 22 = 0
Each of these four joint hypotheses can be tested within the F-test framework,
since each set of restrictions contains only parameters drawn from one
equation.
These tests could also be referred to as Granger causality tests.
Granger causality tests seek to answer questions such as Do changes in y1
cause changes in y2? If y1 causes y2, lags of y1 should be significant in the
equation for y2. If this is the case, we say that y1 Granger-causes y2.
If y2 causes y1, lags of y2 should be significant in the equation for y1.
If both sets of lags are significant, there is bi-directional causality
Introductory Econometrics for Finance Chris Brooks 2013
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Impulse Responses
y2 t 20 21 y2 t 1 21 y1t 1 u2 t
A change in u1t will immediately change y1. It will change change y2 and
also y1 during the next period.
We can examine how long and to what degree a shock to a given equation
has on all of the variables in the system.
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Variance Decompositions
This is done by determining how much of the s-step ahead forecast error
variance for each variable is explained innovations to each explanatory
variable (s = 1,2,).
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Brooks and Tsolacos (1999) employ a VAR methodology for investigating the
interaction between the UK property market and various macroeconomic variables.
Monthly data are used for the period December 1985 to January 1998.
It is assumed that stock returns are related to macroeconomic and business conditions.
The variables included in the VAR are
FTSE Property Total Return Index (with general stock market effects removed)
The rate of unemployment
Nominal interest rates
The spread between long and short term interest rates
Unanticipated inflation
The dividend yield.
The property index and unemployment are I(1) and hence are differenced.
Introductory Econometrics for Finance Chris Brooks 2013
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SPREAD
0.0242
0.6212
0.0000
0.1151
0.3420
0.5537
UNEM
0.0327
0.4217
0.4372
0.0000
0.4793
0.8922
UNINFL
0.2126
0.5654
0.6563
0.0758
0.0004
0.7222
PROPRES
0.0000
0.4033
0.0007
0.2765
0.3885
0.0000
55
DIVY
SPREAD
UNEM
UNINFL
PROPRES
Months ahead
II
II
II
II
II
II
0.0
0.8
0.0
38.2
0.0
9.1
0.0
0.7
0.0
0.2
100.0
51.0
0.2
0.8
0.2
35.1
0.2
12.3
0.4
1.4
1.6
2.9
97.5
47.5
3.8
2.5
0.4
29.4
0.2
17.8
1.0
1.5
2.3
3.0
92.3
45.8
3.7
2.1
5.3
22.3
1.4
18.5
1.6
1.1
4.8
4.4
83.3
51.5
12
2.8
3.1
15.5
8.7
15.3
19.5
3.3
5.1
17.0
13.5
46.1
50.0
24
8.2
6.3
6.8
3.9
38.0
36.2
5.5
14.7
18.1
16.9
23.4
22.0
56
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
-0.02
-0.04
-0.06
0.12
0.1
0.08
0.06
0.04
0.02
0
-0.02 1
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
-0.04
-0.06
-0.08
Steps Ahead
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