Jul 30

What is econometrics? (Quant: Econometrics)

by David Harper, CFA, FRM, CIPM

Econometrics is a social science that applies tools (economic theory, mathematics and statistical inference) to the analysis of economic phenomena. Econometrics consists of "the application of mathematical statistics to economic data to lend empirical support to the models constructed by mathematical economics."

An eight-step methodology:

Create a statement of theory or hypothesis
Collect data: time-series, cross-sectional, or pooled (combination of time-series and cross-sectional)
Specify the (pure) mathematical model: a linear function with parameters (but without an error term)
Specify the statistical model: adds the random error term
Estimate the parameters of the chosen econometric model: we are likely to use ordinary least squares (OLS) approach to estimate parameters
Check for model adequacy: model specification testing
Test the model's hypothesis
Use the model for prediction or forecasting

Key points for the FRM candidate

The pure mathematical model "although of prime interest to the mathematical economist, is of limited appeal to the econometrician, for such a model assumes an exact, or deterministic, relationship between the two variables." The mathematical model is deterministic: it is not realistic.
The difference between the mathematical and statistical model is the random error term. The addition of the error term is not trivial: is incorporates the inadequacy of the model which reveals as randomness.