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What is Financial Econometrics?

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  • Written By: Jason C. Chavis
  • Edited By: Bronwyn Harris
  • Last Modified Date: 28 September 2016
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Financial econometrics is the discipline that studies the quantitative and statistical aspects of economic principles. As different facets of the smaller economy are interrelated, a certain analysis of these relationships are necessary to understand the different individual components and their effects on the full economy at large. This data is observable from the normal practices of the various market forces, making experimentation unnecessary in financial econometrics. In addition, a number of different models are used in order to find the economic data that benefits the finance industry and investment research in general. The most beneficial aspect of this discipline can be seen in the fields of portfolio management and risk management.

Econometricians, the people that study financial econometrics, primarily use a principle known as regression analysis to model and analyze the components of the economy. Statistical analysis and the targeting of different variables gives researchers the information necessary to make a conclusion about a certain aspect of the market and its connection to another market's features. Specifically, regression analysis identifies a variable that is dependent on the target feature, while at the same time identifying the various independent variables of the market. This helps determine what is called the conditional mean, a way of finding the likely value of a random factor within the economy.

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Data sets are another important tool in determining econometric factors. Econometricians can utilize observable data and compile it into usable formats which provide information. Time-series data sets are one example, in which certain aspects of the economy, such as the cost of a good or service, are compiled over the course of a specific time frame. As the price fluctuates, the data will allow a researcher to observe other factors that may be responsible for the changes. For example, if the cost of paper goes down over the course of ten years, one can make a determination based on outside influences. An econometrician can correlate the data by analyzing the impact of increased household recycling or implementing the effects of the lowering cost of trees with the price changes that occurred.

Financial econometrics was developed in the early 20th century primarily through the work of Nobel Prize-winner Ragnar Frisch. He developed the methods of both data sets and regression analysis in the 1920s and 1930s respectively. Frisch also helped establish the Econometric Society, an organization that helps establish the relationship between mathematics and the economy. Modern researchers, such as University of Pennsylvania professor Lawrence Klein, built upon these concepts in the 1980s to move financial econometrics into the computer age with advanced modeling techniques.

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