The Basics of Financial Econometrics: Tools, Concepts, and Asset Management Applications

CHAPTER 1

Introduction

After reading this chapter you will understand:

• What the field of financial econometrics covers.
• The three steps in applying financial econometrics: model selection, model estimation, and model testing.
• What is meant by the data generating process.
• How financial econometrics is used in the various phases of investment management.

Financial econometrics is the science of modeling and forecasting financial data such as asset prices, asset returns, interest rates, financial ratios, defaults and recovery rates on debt obligations, and risk exposure. Some have described financial econometrics as the econometrics of financial markets. The development of financial econometrics was made possible by three fundamental enabling factors: (1) the availability of data at any desired frequency, including at the transaction level; (2) the availability of powerful desktop computers at an affordable cost; and (3) the availability of off-the-shelf econometric software. The combination of these three factors put advanced econometrics within the reach of most financial firms such as banks and asset management firms.

In this chapter, we describe the process and the application of financial econometrics. Financial econometrics is applied to either time series data, such as the returns of a stock, or cross-sectional data such as the market capitalization¹ of all stocks in a given universe at a given moment. With the progressive diffusion of high-frequency financial data and ultra ...