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Multicollinearity and Measurement Error in Econometric Financial Modelling

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  • Green, Christopher J
  • Kiernan, Eric

Abstract

Econometric financial modeling has produced a range of counterintuitive results. Estimated interest elasticities are invariably smaller than intuition would suggest and, in many cases, have the opposite sign to that predicted by theory. This paper considers the possibility that such results may be due in part to the interaction between multicollinearity and measurement error involving the interest rates in asset demand functions. Usng a two variable example, we focus on inconsistencies in the estimation of the own rate and cross rate coefficients. For the own rate coefficient, the sign of the inconsistency conforms with intuition, producing an estimated elasticity which is "too small." For the cross rate coefficient the sign of the inconsistency is related to the underlying parameters of the model. We also show that sign reversal may occur in the estimation of the cross rate effect; this is not however possible in estimation of the own rate effect. Copyright 1989 by Blackwell Publishers Ltd and The Victoria University of Manchester

Suggested Citation

  • Green, Christopher J & Kiernan, Eric, 1989. "Multicollinearity and Measurement Error in Econometric Financial Modelling," The Manchester School of Economic & Social Studies, University of Manchester, vol. 57(4), pages 357-369, December.
    • Handle: RePEc:bla:manch2:v:57:y:1989:i:4:p:357-69
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    Cited by:

    1. Arturs Kalnins, 2022. "When does multicollinearity bias coefficients and cause type 1 errors? A reconciliation of Lindner, Puck, and Verbeke (2020) with Kalnins (2018)," Journal of International Business Studies, Palgrave Macmillan;Academy of International Business, vol. 53(7), pages 1536-1548, September.
    2. Raphael Markellos & Terence Mills, 2003. "Asset pricing dynamics," The European Journal of Finance, Taylor & Francis Journals, vol. 9(6), pages 533-556.
    3. Christopher J. Green & Victor Murinde, 2003. "Flow of funds: implications for research on financial sector development and the real economy," Journal of International Development, John Wiley & Sons, Ltd., vol. 15(8), pages 1015-1036.
    4. Moore, Tomoe & Green, Christopher J. & Murinde, Victor, 2006. "Financial sector reforms and stochastic policy simulations: A flow of funds model for India," Journal of Policy Modeling, Elsevier, vol. 28(3), pages 319-333, April.
    5. Tomoe Moore & Christopher Green & Victor Murinde, 2005. "Portfolio Behaviour in a Flow of Funds Model for the Household Sector in India," Journal of Development Studies, Taylor & Francis Journals, vol. 41(4), pages 675-702.

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