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financial econometrics

1. The assignment must be word-processed.
2. The whole assignment must be no more than 1250 words in length including any, GRAPHICS BUT NOT REFERENCES. The word count must be stated at the end of the assignment.
3. Your Word file MUST be submitted to Turnitin via Blackboard.
4. The assessment criteria detailed overleaf will be used to mark your assignment. Please bear the criteria in mind when preparing your assignment.
5. The assignment is worth 60% of the total module mark.

The purpose of this assignment is to make students familiar with some contemporary econometric techniques used to examine finance theories. You are required to make proper use of both financial theory and empirical practice using EViews.

You are a Junior Analyst for F& H Investment with the responsibility of tracking stock in the FTSE-100 index. Your boss proposes to upgrade the financial risk management methodology the company uses. Your boss further proposes that, after several successful years of operation in the UK, the company is now considering expanding its operation to cover other European countries.

As the financial analyst, you are required to select any one FTSE-100 stocks from a relevant database (e.g., Eikon/DataStream, Bloomberg, Yahoo Finance) and estimate their excess return series.

Use monthly observations from the last 15 years unless your firm is listed on the stock market after the start date.

[Hint: Use the selected firm and return series from Assignment 1]


Part 1.
For each of the series:
(a) Perform the ADF and KPSS tests of stationarity in EViews, clearly stating your hypotheses. Comment on your results in line with relevant financial theory. [15 marks]

(b) Estimate the best fitting ARMA/ARIMA model, following the Box-Jenkins methodology. Assess the adequacy of your results and formulate appropriate diagnostic procedures. Produce dynamic “out-of-sample” forecasts for the returns and discuss your findings about their accuracy. [30 marks]

(c) Your boss suggests using ARCH(1) process to model the returns volatility. You disagree and wish to convince your boss that a GARC(1,1) process is better. Estimate both models and try to convince your boss about the preferability of the model you are proposing. [25 marks]

Part 2.
Pair the FTSE-100 index with any other two (2) country stock indices (posted on Blackboard) and test for cointegration among the pairs of variables by applying the Engle-Granger (EG) approach. Critically comment on your results. [20 marks]

A well laid-out structure and presentation (executive summary, referencing, layout) [10 marks]

The written report should be 1,250 words (plus or minus 10%) in length (including, plots and pictures but not the reference list), word-processed and should be of a professional format suitable for the audience. You should also attach all relevant tables with summaries of results as an appendix to your report. In the report you should:
• Explain the rationale behind your empirical tests and the methodology adopted. This part has to be concise and precise. No marks will be given for clutter.
• You must use the appropriate scientific rhetoric. Therefore, you should define clearly your null and alternative hypotheses tested in each stage of the analysis.
• Provide a clear definition of the techniques/econometric tests used and WHY they are used.
• Be precise in the underlying theory and relate this to your results and discussion.

The majority of the marks will be given to students that produce evidence of:
• Good understanding of the underlying theory and concepts.
• Good understanding of econometric analysis.
• Ability to link properly the first two points above
• Critical thinking in the interpretation of the findings.

The grade you achieve for this part will depend entirely on the level of understanding demonstrated in your report and your sound empirical backing.

In terms of referencing, you are required to use the Harvard system of citation. Also, beware of the academic regulations regarding plagiarism.

I strongly recommend that you get a copy of the EViews manuals as soon as possible to familiarise yourself with elementary statistics and hypothesis testing procedures. Use your lecture notes and relevant sources to grasp the theory behind efficient markets and basic financial econometrics.
Think about potential problems of financial time series such as those of heteroscedasticity, autocorrelation and non-stationarity. You should correct and comment on any possibility of these errors affecting your analysis.

Brooks, C. (2008). Introductory Econometrics for Finance, 2nd Edition (2011). Cambridge University Press.

Asterious, D., & Hall, S. G. (2015). Applied econometrics. Macmillan International Higher Education.

Gujarati, D. (1995). Basic Econometrics. 3rd Edition. McGraw-Hill.
Maddala, G.S. (2001). Introduction to Econometrics. 3rd Edition. John Wiley & Sons.

Literature review:

Barari, M. (2004). Equity market integration in Latin America: A time-varying integration score analysis. International Review of Financial Analysis, 13(5), 649-668.

Caporale, G. M., & Pittis, N. (1998). Cointegration and predictability of asset prices1. Journal of International Money and Finance, 17(3), 441-453.

Demian, C. V. (2011). Cointegration in Central and East European markets in light of EU accession. Journal of International Financial Markets, Institutions and Money, 21(1), 144-155.

Fama, E. F. (1991). Efficient capital markets: II. The journal of finance, 46(5), 1575-1617.

Granger, C. J. (1986). Developments in the study of cointegrated economic variables. Oxford Bulletin of economics and statistics, 48(3), 213-228.

Gregory, A. W. and Hansen, B. E. (1996). “Residual-Based Tests for Cointegration in Models with Regime Shifts”, Journal of Econometrics, Vol. 70, pp. 99-126.

Johansen, S. (1988). Statistical analysis of cointegration vectors. Journal of economic dynamics and control, 12(2-3), 231-254.