Econometrics in Finance

Econometrics refers to developing quantitative methods to analyze economic principles. Theoretical econometrics uses statistical properties while applied econometrics usually applies econometric methods to the various theories. Finance domain is increasingly using the technique like risk management, portfolio management etc.

Econometrics is used in finance to evaluate quantitative problems and uses various techniques like financial models, volatility estimation, capital asset pricing, risk adjusted returns etc. Financial econometrics is viewed as a merger of economics, finance, statistics and applied mathematics. For the various issues in financial world, economics renders theoretical foundation while statistics and applied mathematics using quantitative techniques are used to solve quantitatively. The vast amount of data generated in financial markets on asset returns, volatility usually requires study over a period of time using techniques like time series. Econometrics is widely used for derivative products like options, futures etc.

Regression analysis is one of the primary methods. It usually involves modeling and analyzing various variables to establish a relationship between dependent variable and many independent variables. This technique is useful to understand the changes in the dependent variable to any changes in independent variable. Methods of Moments, Bayesian methods, Generalized Method of Moment etc are other important methods used in econometrics.

The general steps involved in developing an econometric model are:

• Understanding the problem – It involves formulation of a theoretical model to relate two or more variables.

• Collecting data – It involves accumulating relevant data from public domain like Reuters or any published information and also from surveys.

• Selection of method – This step involves choosing an appropriate estimation method like single or multiple equation technique.

• Statistical evaluation – It involves framing assumptions for estimating parameters of the model and analyzing the aptness of the estimates in relation to the data.

• Evaluating the model – The model is then assessed from theoretical perspective.

• Implementation of the model – the model is then used for the identified issue and also for making forecasts. The step also results in courses of action needed.

Econometrics is being widely used in fields including finance and knowledge of its various techniques helps investors manage their portfolios well.