LESSON ONE: INTRODUCTION TO FINANCIAL ECONOMETRICSIntroductionLiterally interpreted, econometrics means “economic measurement.” Although measurement is animportant part of econometrics, the scope of econometrics is much broader. Econometrics, theresult of a certain outlook on the role of economics, consists of the application of mathematicalstatistics to economic data to lend empirical support to the models constructed by mathematicaleconomics and to obtain numerical results.Learning ObjectivesDefinitionImportance of econometricsMethodology in financial econometricsAssumptions of the linear regression modelTypes of econometricsWHAT IS ECONOMETRICSEconometrics may be defined as the quantitative analysis of actual economic phenomena based onthe concurrent development of theory and observation, related by appropriate methods ofinference.Econometrics may be defined as the social science in which the tools of economic theory,mathematics, and statistical inference are applied to the analysis of economic phenomena.Econometrics is concerned with the empirical determination of economic laws.Econometrics is based upon the development of statistical methods for estimating economicrelationships, testing economic theories, and evaluating and implementing government andbusiness policy. The most common application of econometrics is the forecasting of suchimportant macroeconomic variables as interest rates, inflation rates, and gross domestic product.While forecasts of economic indicators are highly visible and are often widely published,econometric methods can be used in economic areas that have nothing to do with macroeconomicforecasting. For example, we will study the effects of political campaign expenditures on votingoutcomes. We will consider the effect of school spending on student performance in the field ofeducation. In addition, we will learn how to use econometric methods for forecasting economictime series.The art of the econometrician consists in finding the set of assumptions that are both sufficientlyspecific and sufficiently realistic to allow him to take the best possible advantage of the dataavailable to him.WHY A SEPARATE DISCIPLINE?As the preceding definitions suggest, econometrics is an amalgam of economic theory,mathematical economics, economic statistics, and mathematical statistics. Yet the subject deservesto be studied in its own right for the following reasons.