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Applied Financial
Econometrics
Theory, Method and
Applications

Moinak Maiti
Applied Financial Econometrics
 Moinak Maiti

Applied Financial
Econometrics
Theory, Method and Applications
Moinak Maiti
Department of Finance
National Research University
Higher School of Economics
St. Petersburg, Russia

ISBN 978-981-16-4062-9 ISBN 978-981-16-4063-6 (eBook)

https://doi.org/10.1007/978-981-16-4063-6

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer
Nature Singapore Pte Ltd. 2021
This work is subject to copyright. All rights are solely and exclusively licensed by the
Publisher, whether the whole or part of the material is concerned, specifically the rights
of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on
microfilms or in any other physical way, and transmission or information storage and
retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology
now known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc.
in this publication does not imply, even in the absence of a specific statement, that such
names are exempt from the relevant protective laws and regulations and therefore free for
general use.
The publisher, the authors and the editors are safe to assume that the advice and informa-
tion in this book are believed to be true and accurate at the date of publication. Neither
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This Palgrave Macmillan imprint is published by the registered company Springer Nature
Singapore Pte Ltd.
The registered company address is: 152 Beach Road, #21-01/04 Gateway East, Singapore
189721, Singapore
To my parents: Mr. Lakshmi Kanta Maiti and Mrs. Sandhya Maiti.
—Moinak Maiti
 Preface

Every year while teaching Financial Econometrics course at the Master

level. I find that most of the candidates are quite interested to take up the
Financial econometrics course but many of them do not dare to take up
the course primarily due to the fear of complex mathematics and nota-
tions. Candidates do come from different backgrounds and for most of
them mathematics is just a night mare. Most of the candidates those who
have taken advance econometrics course earlier is usually get enrolled
for my financial econometrics course. Most of such candidates share that
advanced econometrics courses are usually based on mathematical deriva-
tions, notations and at the end any how they just manage to clear the
subject. That makes it really a challenging task for any instructor to deliver
the course in a very simple way (without much complex mathematical
notations). Next issue arises due to the reason that many of them have
no background in the programming. Altogether it makes somewhat more
difficult to deliver a course successfully. Financial econometrics course that
I teach, the syllabus is built in such a way that it starts with some basics
but ends with advanced concepts. The primary aim of the course is to
give students an updated knowledge of the econometrics techniques so
that they can implement it with confident in solving the real-world prob-
lems. After completion of my course, some of the comments that students
share are as follows:

vii
viii PREFACE

Thanks for all the helps you given to me during the lecture. And all the
lecture materials we used in the class are associated with most current
researches and study, that are very useful and practical. I personally
benefited from this.
I would like to continue my studies for both the subjects because I
learned a lot, it would be great. In any case, I want to say thank to you
for your passion and teaching.
I would want to take this opportunity to express my heartfelt apprecia-
tion for your contribution to the publication of my term paper and other
assistance you have given me. It was a great beginning for my research
career.
Thank you professor for the course! It was very useful and practical
oriented.

What’s next? Student says it is very difficult to find an econometrics book

that covers all important topics that you teach altogether. Then most
of the books available either talks too much on theory or mathematical
modelling. In such case there is real demand for a financial econometrics
book that is written from the students point of view that makes plea-
sure in learning. A book that explains theory in the simplest way. My
students ask me “professor why do not you write a book that will help
the learning community in a greater extent”. I am very encouraged by my
beloved students’ statements. So, I decided to write a book that will fulfil
all such needs. This book has real-world examples with software execu-
tion and finally clear cut explanation of the obtained results. All examples
are executed either by EViews or R programming with stepwise explana-
tion in a visual format wherever necessary. EViews and R programming
both are chosen due to two reasons: (1) EViews is simple to use and even
though it is a paid software but both student and tutor versions are avail-
able for free. (2) On the other hand, R is free and programming oriented.
By this students will learn both the techniques together and they can
choose either of them for applications as required. This book will be bene-
ficial for both students and instructors who are associated with econo-
metrics subjects at the undergraduate and postgraduate levels. Finally, I
appreciate all comments and suggestions for further improvement of the
book. As nothing is perfect in this world.

St. Petersburg, Russia Moinak Maiti

 Acknowledgements

First of all I would like to express my sincere gratitude to my family

and friends for their support, directly or indirectly in making this book
a reality. I am thankful to the commissioning and production team at the
Palgrave Macmillan publications for their sincere support and considera-
tion. I am also grateful to the three anonymous reviewers for their valuable
comments and suggestions for establishment of this book. I give thanks
to the almighty god for protection and ability to do work.
Special thanks to the learners, students, and colleagues. Lastly I am
thankful to everyone who are directly or indirectly associated in making
this book a reality.

Moinak Maiti

ix
 About This Book

The title of the book is “Applied Financial Econometrics”. The content of

the book is put to practical use as opposed to being just theoretical. The
present edition of this book is intended to cover different topics related
to the financial econometrics ranging from basic to advanced spectrums.
The organization and chapter-wise distribution includes up to date topics.
This book is written keeping in mind to ease the problem of students and
most importantly practical examples are included throughout from the
financial backgrounds. It discusses not only about the financial econo-
metric applications in the real world but it also conveys how one should
approach practical problem solving in finance. Throughout the book, I
have made all sincere efforts introducing the complex topics in a very
simplistic manner and keeping the language too simple. This book has
nine chapters as mentioned below.

1. Introduction
2. Random Walk Hypothesis
3. Geometric Brownian Motion
4. Efficient Frontier & Portfolio Optimization
5. Introduction to Asset Pricing Factor Models
6. Risk Analysis
7. Introduction to Fat Tails
8. Threshold Autoregression
9. Introduction to Wavelets

xi
xii ABOUT THIS BOOK

Every chapter starts with a detailed background of the topic followed

by stepwise software implementation of the real-world problems with
comprehensive interpretations. Then every chapter has “Finance in
Action” and “Analyst/Investor Corners” sections. At the end of each
chapter, numerous practise exercises are included namely MCQs, fill in the
blanks, long answer questions, real-world tasks, and case studies. More-
over the scope of this book is not only limited to the financial econo-
metric course but many of these chapters listed above could also be useful
in other courses such as asset pricing, theory of finance, risk management,
and others. Last few decades have seen significant increase in the interest
for econometrics in allied fields as well, especially in the management and
technological fields apart from the regular economics or finance. There
are no prerequisites for reading this book. Though a basic knowledge of
finance, statistics, or any programming language is a plus. This book will
be useful for both the students and instructors who are associated with
econometrics courses at the undergraduate and postgraduate levels.

Moinak Maiti
 Praise For Applied Financial
Econometrics

“Moinak Maiti’s book “Applied Financial Econometrics” provides a great

introduction to a couple of highly relevant topics in empirical finance.
The hands-on approach is a particular strength and guides students how
to DO econometrics rather than just to know the concepts. While the
book focuses on under- and postgraduate students, also young empir-
ical researchers will benefit from it. A superb book for students and
instructors.”
—Professor Michael Frömmel, Finance Professor, Ghent University

“The present book in Applied Financial Econometrics introduces relevant

topics using econometrics to deal with financial problems. It is practi-
cally oriented and includes practical examples in every chapter showing
the reader how to solve in a stepwise manner real cases. For all that I
highly recommend it.”
—Professor Angel Barajas, Head, Department of Finance, Higher School
of Economics

xiii
xiv PRAISE FOR APPLIED FINANCIAL ECONOMETRICS

“This is a must-read for anyone interested in entering the world of finance

with quantitative focus. The author explains the theories with practical
examples. Furthermore, I see very little need for any prerequisites. I
recommend everyone interested in financial analytics in general to benefit
from this book.”
—Dr. Badri Narayanan Gopalakrishnan, Consultant Economists, McKinsey
& Company

“Moinak always had a knack of simplifying the most complex of problems,

and that is exactly what he has very successfully done through this book.
This is a must read for anyone wanting to understand the application of
Econometrics to everyday problems.”
—Kartik Palaniappan, South Asia Head, Buyside Order Management
Solution, Bloomberg LP

“Author in his book titled “Applied Financial Econometrics” presents a

new way of thinking about machine learning that gives its own place in the
econometric toolbox through appropriate examples. The detailed deliber-
ation on “Fat tailed distribution” will immensely help and guide investors
in the money market, business entrepreneurs of all sectors. I recommend
this book as a must read for all students aspiring to pursue Finance &
Management Courses. I wish! Many more editions of this book will be
published with the latest updates in years to come.”
—Dilip Kumar Bardhan, Additional General Manager (Retd.), NTPC
Limited, Ministry of Power, Government of India

“The book “Applied Financial Econometrics” will be aimed for theorists,

practitioner, as well as for advanced students, from a wide range of econo-
metrics, financial markets and institutions, corporate finance, and digital
finance. This book develops insights on an innovative approach, in order
to underpin practice and research in the area of financial econometrics.”
—Dr. Darko Vukovic, Head, International Laboratory for Finance and
Financial Markets, People’s Friendship University of Russia “RUDN”

“In “Applied financial econometrics”, this fantastic author guides us

through the financial econometrics, a relative complicated issue even with
finance students and lecturers, in a very simplistic but helpful manner. I
enjoy reading his wonderful approach to include practical examples, soft-
ware implementation, real world tasks, and also case studies. Notably, I
 PRAISE FOR APPLIED FINANCIAL ECONOMETRICS xv

am surprising with the update of this book as it has included current latest
development in financial econometrics such as fat tails, threshold regres-
sion, and Wavelets analysis. I confidently recommend “Applied financial
econometrics” and I trust that it would provide huge benefits for finance
students but also promoting their future development.”
—Dr. Canh Phuc Nguyen, Senior Lecturer, University of Economics Ho
Chi Minh City

“Dr. Maiti’s “Applied Financial Econometrics” is an interesting read for

students and professionals alike. The topics, although difficult, are nicely
described and deal with real word applications.”
—Dr. Cornel Nesseler, Postdoctoral Fellow, University of Zurich, &
NTNU Business School

“This book is a sophisticated beautiful integration of Econometrics and

real world use of it…written in plain English, based on simplified notation
and full of case studies. An important and practical combination for both
academic and professionals. Highly recommended.”
—Sattwik Das, CFA, FRM, Independent Model Review Manager, HSBC

“This book is a complete balance between the theory and the practice. It
is a comprehensive book with excellent features.”
—Dr. Saakshi, Assistant Professor, Indian Institute of Management
Ranchi

“Today health economics is emerging as one of the challenging and inter-

esting field to deal with especially for the applied econometricians. The
COVID-19 pandemic raises several questions on the risk management
related to healthcare, social insurance, spatial health econometrics and
others. The author in this book has covered several important topics such
as how to deal with the nonlinearity, fat tails, and heterogeneity existing
in the data using the highly sophisticated techniques. Overall I find this
book is very helpful and highly recommended in the field of applied health
econometrics.”
—Dr. Mousam Maiti, MS-Otorhinolaryngology, Head & Neck Surgery,
Resident Doctor, All India Institute of Medical Sciences Bhopal
xvi PRAISE FOR APPLIED FINANCIAL ECONOMETRICS

“Dr. Maiti’s reader-friendly illustrations provide an amazing insight and

wonderful learning platform on the real world applications in Financial
Econometrics. Definitely, this book is going to inspire many students not
only to enhance their technical knowhow but also foster a desire to pursue
it as a career to work in the finance industry.”
—Mihir Kumar Parial, Director (Retd.), Directorate General of Training,
Ministry of Skill Development and Entrepreneurship, Government of India

“This book on “Applied Financial Econometrics” enables students with

real life problem solving skills in financial markets while giving intuitive
grasp on the underlying concepts. The author has put in sincere efforts to
keep the content practical, industry oriented and data driven to keep the
students involved.”
—Satya Venkata Chalapathi, Former Vice President of Singapore
Mercantile Exchange

“Prof. Maiti’s well-written textbook represents a novel and refreshing

treatment of financial econometrics and should have be seen as bridge
between theoretical econometrics and applied financial econometrics.
Moreover, it is a practitioner friendly textbook. Even so complicated
topics such as Wavelet analysis are treated at an accessible level. I consider
it as a gift to graduate students in terms of discussing the terms, presenting
topics and showing how to apply each method to real life data. Thus, I
strongly advice the adaptation of Maiti’s book to my colleagues.”
—Professor Mustafa Özer, Economics Professor, Anadolu University

“I have not seen a more thorough resource dedicated specifically to the

practical aspects of financial econometrics. It will transform your under-
standing of topics related to financial econometrics ranging from basic to
advanced spectrums. I would recommend this book to both the students
and instructors of econometrics at different levels and for anyone looking
to advance their knowledge and expand their scope of practice.”
—Professor B. Charumathi, Head, Department of Management studies,
Pondicherry University
 PRAISE FOR APPLIED FINANCIAL ECONOMETRICS xvii

“Dr. Maiti has written a must-read primer for anyone considering financial
econometrics… This book has several real world examples that take us
towards the data sciences ... such as examples on forecasting, non-linear
data series, predictive modelling etc…”
—Dr. Amrit Mukherjee, Postdoctoral Fellow, Zhejiang University

“I have had the pleasure of knowing Moinak since his student days when
he was an offsite intern for Bloomberg LP at Pondicherry University. He
consistently impressed me with his rigor and tenacity. He brings the same
spirit to the title “Applied Financial Econometrics”. His work considers
existing econometric theory and aspires to juxtapose it against emerging
research and practice.”
—Joel Pannikot, Head, India at CMT Association; Former Head of
Asia-Pacific Strategy-Education, Bloomberg LP

“The author’s proactive approach implies the active participation of the

reader through solving tasks and various case studies. The multidisci-
plinary of the books is reflected in the usefulness that this material
provides for risk analysis, asset management options, and financial theory
in general. The book has significant use value at all levels of study in areas
related to econometrics.”
—Dr. Duško Ranisavljević, Assistant Professor, Health and Business
Studies, Singidunum University

“This book has a lucid representation and relevant content for the 21st
century financial econometrician. Highly recommended to all students,
academicians and working professionals in this area as the book provides
both theoretical as well as pragmatist insights.”
—Dr. Abhijeet Lele, Assistant Professor, Symbiosis Institute of Business
Management Pune

“An indefatigable effort has been taken by the author to provide prac-
tical knowledge on trending topics of finance. This book going to make
a difference.”
—Srividya Mortha, Data Management Consultant, Wells Fargo
xviii PRAISE FOR APPLIED FINANCIAL ECONOMETRICS

“The book “Applied Financial Econometrics” deals with relevant and

contemporary topics related to financial econometrics. The author gave a
detailed and satisfactory literature dealing with this subject. The objective
of the book sets the tone and expectations. This book guides thinking.”
—Dr. Marko D. Petrović, Honorary Fellow, University of
Wisconsin–Madison
 Contents

1 Introduction 1
2 Random Walk Hypothesis 47
3 Geometric Brownian Motion 67
4 Efficient Frontier and Portfolio Optimization 89
5 Introduction to Asset Pricing Factor Models 113
6 Risk Analysis 153
7 Introduction to Fat Tails 203
8 Threshold Autoregression 223
9 Introduction to Wavelets 255

Index 281

xix
 About the Author

Dr. Moinak Maiti is Associate Professor in the Department of Finance,

National Research University-Higher School of Economics, Saint Peters-
burg. He is an Active Speaker and invited to share the World renowned
platforms of World Bank, United Nations, World Trade Organisation
(WTO Studies), SAS®, Bloomberg LP, Max Plank Society, PEP Canada,
Ivy League Universities, and many others. He holds university Gold
Medal along with several other notable awards throughout in his time-
line. Several eminent research grants from World renowned institutions
like World Bank, Max Plank Society Germany, PEP Canada, World Trade
Organisation (WTO Studies), Ivy League Universities, and others are
added to his account.
He is in the editorial board members of several International Jour-
nals published by Elsevier, Emerald, Wiley, and other reputed publishing
house. His article regularly published as Research articles, Book chap-
ters, Cases, Blogs, Newspapers and Reviews, etc., by renowned publishing
house.
His area of interest and expertise is Finance, more specifically in Asset
Pricing, Financial Econometrics, Fintech, IoT, and Neuroscience. He is
open to collaborate and discuss interesting consultancy projects.

xxi
 Abbreviations

ACF Autocorrelation Function

ADF Test Augmented Dickey-Fuller Test
APT Arbitrage Pricing Theory
AR Auto-Regressive
ARCH Autoregressive Conditional Heteroskedasticity
ARIMA Auto-Regressive Integrated Moving Average
ARMA Autoregressive Moving Average
BDS Independence Test Brock, Dechert, and Scheinkman Independence Test
BE/ME Book to Market ratio
BSE Bombay Stock Exchange
CAPM Capital Asset Pricing Model
CCAPM Consumption Capital Asset Pricing Model
CCM Constant Coefficients Model
CMA Conservative Minus Aggressive
CML Capital Market Line
CWT Continuous Wavelet Transform
DJIA Dow Jones Industrial Average
DWT Discrete Wavelet Transform
EMH Efficient Market Hypothesis
ESTAR Exponential Smooth Transition Autoregressive
GARCH Generalized Autoregressive Conditional
Heteroskedasticity
GBM Geometric Brownian Motion
GMM Generalized Method of Moments
GRS Test Gibbons, Ross, & Shanken Test
HML High Minus Low

xxiii
xxiv ABBREVIATIONS

HPR Holding Period Returns

ICAPM Intertemporal Capital Asset Pricing Model
IDE Integrated Development Environment
IID Independently and Identically distributed
KPSS Test Kwiatkowski–Phillips–Schmidt–Shin Test
LOESS Locally Estimated Scatterplot Smoothing
LP Linear Programming
LSTAR Logistic Smooth Threshold Autoregression
MA Moving Average
MMV Multifactor Mean Variance
MODWT Maximal Overlap Discrete Wavelet Transform
NSE National Stock Exchange of India
NYSE New York Stock Exchange
OLS Ordinary Least Square
PACF Partial Autocorrelation Function
P/B Price to Book ratio
PDL Program Design Language
PP Test Phillips-Perron test
RBI Reserve Bank of India
RMW Robust Minus Weak
RWH Random Walk Hypothesis
SETAR Self-Exciting Threshold Autoregressive
SMB Small Minus Big
SML Security Market Line
SoFiE Society for Financial Econometrics
SSR Sum of Squared Residuals
STAR Smooth Threshold Autoregression
STL Seasonal and Trend decomposition using LOESS
TAR Threshold Autoregression
VAR Vector autoregression
VECM Vector Error Correction Model
VIX Volatility Index
WML Winners Minus Losers
 List of Figures

Fig. 1.1 Evolution of various econometrics software packages 3

Fig. 1.2 EViews 11 Student Lite Main Window 13
Fig. 1.3 Workfile create window 14
Fig. 1.4 Imported data in the workfile window 15
Fig. 1.5 Graph options window 16
Fig. 1.6 Multi and single series output 16
Fig. 1.7 Descriptive statistics estimates 17
Fig. 1.8 Histogram and descriptive statistics output 17
Fig. 1.9 Covariance Analysis window 18
Fig. 1.10 Correlation analysis estimates 19
Fig. 1.11 Unit root test window 19
Fig. 1.12 Unit root test estimates for the original series and first
differentiation 20
Fig. 1.13 Equation Estimation window 21
Fig. 1.14 Generate series by equation window 22
Fig. 1.15 RStudio interface with R console 24
Fig. 1.16 Dot plot for EUR_USD series 29
Fig. 1.17 Line and dot overlapped graph for EUR_USD series 30
Fig. 1.18 Combination of either line and dot graph for EUR_USD
series 30
Fig. 1.19 Histogram plot for the EUR_USD series 31
Fig. 2.1 Paths taken by random walk model with a fixed drift 52
Fig. 2.2 Price movements follow random walk model with a fixed
drift 53

xxv
xxvi LIST OF FIGURES

Fig. 2.3 Price movements follow random walk model with random
drift (holding period return) 54
Fig. 2.4 Variance ratio test window 56
Fig. 2.5 Test for random walk assuming no heteroskedasticity 57
Fig. 2.6 Test for Exponential Random walk assuming
no heteroskedasticity 58
Fig. 2.7 Test for Martingale 58
Fig. 3.1 Brownian Motion path plot 70
Fig. 3.2 Geometric Brownian Motion paths plots with 20
stimulations 71
Fig. 3.3 Geometric Brownian Motion paths plots with 40 and 400
stimulations 72
Fig. 3.4 A, B: American call option price estimates using Binomial
Option Pricing 74
Fig. 3.5 A, B: American put option price estimates using Binomial
Option Pricing 75
Fig. 3.6 A, B: Plain Vanilla call option price estimates using
Monte Carlo Simulation 78
Fig. 3.7 A, B: Asian Arithmetic put option price estimates using
Monte Carlo Simulation 80
Fig. 4.1 Portfolio diversification 91
Fig. 4.2 Mean variance efficient frontier 96
Fig. 4.3 Multifactor Mean Variance (MMV) efficient frontier 97
Fig. 4.4 Capital market line and mean variance efficient frontier 99
Fig. 4.5 Security market line 100
Fig. 4.6 Mean Variance Efficient Frontier and 5000 portfolios plot 102
Fig. 4.7 Mean Variance Frontier 104
Fig. 5.1 Graphical representation of the linear asset pricing model 120
Fig. 5.2 Graphical representation of the implied cross-sectional
relationship 121
Fig. 5.3 Scenario 1 scatter plots of the data 126
Fig. 5.4 Scenario 2 scatter plots of the data 126
Fig. 5.5 Regression Equation Estimation window 129
Fig. 5.6 CAPM estimates for Portfolio 1 and Portfolio 25 130
Fig. 5.7 Fama–French three factor model estimates for Portfolio 1
and Portfolio 25 131
Fig. 5.8 VIF estimates of Fama–French three factor model
for Portfolio 25 132
Fig. 5.9 GRS test estimates for CAPM and Fama–French three
factor model 133
Fig. 5.10 Panel Regression Equation Estimation window 134
Fig. 5.11 Constant coefficients model estimates 135
 LIST OF FIGURES xxvii

Fig. 5.12 Fixed effects Panel Regression Equation Estimation

window 136
Fig. 5.13 Fixed effects model estimates 137
Fig. 5.14 Cross section fixed effects estimates 137
Fig. 5.15 Random effects Panel Regression Equation Estimation
window 138
Fig. 5.16 Random effects model estimates 139
Fig. 5.17 Cross section random effects estimates 139
Fig. 5.18 Correlated Random Effects-Hausman Test estimates 140
Fig. 6.1 STL decomposition Window 160
Fig. 6.2 STL decomposition of S&P 500 daily returns 161
Fig. 6.3 Unit root test estimates 162
Fig. 6.4 Correlogram Specification 162
Fig. 6.5 Correlogram Estimates 163
Fig. 6.6 Equation Estimation Window 164
Fig. 6.7 ARIMA Estimates 165
Fig. 6.8 Inverted AR and MA roots plot 166
Fig. 6.9 Q Statistics Estimates 167
Fig. 6.10 Forecast Window Specification 168
Fig. 6.11 (a) Static method and (b) Dynamic method 169
Fig. 6.12 S&P daily return plot 169
Fig. 6.13 Equation Estimation Window 170
Fig. 6.14 Estimation output 171
Fig. 6.15 ARCH Test estimates 172
Fig. 6.16 Equation Estimation Window 173
Fig. 6.17 GARCH Estimates 174
Fig. 6.18 Generate Series by Equation Window 175
Fig. 6.19 VAR specification Window 176
Fig. 6.20 VAR Estimates 177
Fig. 6.21 VAR Granger Causality Test estimates 178
Fig. 6.22 VAR Stability Estimates 179
Fig. 6.23 Lag Length Selection Estimates 179
Fig. 6.24 Autocorrelation LM Test Estimates 180
Fig. 6.25 Impulse Responses Specification Window 181
Fig. 6.26 Impulse response analysis 182
Fig. 6.27 Variance Decomposition Specification Window 183
Fig. 6.28 Variance Decomposition Analysis 184
Fig. 7.1 Skewness 204
Fig. 7.2 Kurtosis 205
Fig. 7.3 Fat tails 206
Fig. 7.4 Conditional quantile function 208
Fig. 7.5 OLS Regression Equation Estimation window 210
xxviii LIST OF FIGURES

Fig. 7.6 Fama–French three factor model OLS estimates

for Portfolios 1 and 25 210
Fig. 7.7 Quantile Regression Equation Estimation window 211
Fig. 7.8 Fama–French three factor model Quantile (0.05 & 0.95)
estimates for Portfolios 1 and 25 212
Fig. 7.9 OLS and quantile regression residuals graph 213
Fig. 8.1 Descriptive statistics 228
Fig. 8.2 Correlation estimates 228
Fig. 8.3 Plot of daily average return pattern of gold, silver
and crude oil 229
Fig. 8.4 EViews Unit Root Test estimates 230
Fig. 8.5 EViews BDS Independence Test statistic estimation
window 231
Fig. 8.6 EViews BDS independence Test estimates 232
Fig. 8.7 TAR equation specification tab (Equation Estimation) 233
Fig. 8.8 TAR equation options tab (Equation Estimation) 234
Fig. 8.9 EViews TAR Estimates 235
Fig. 8.10 TAR sum squares of residuals plot 236
Fig. 8.11 STAR Equation Estimation in EViews 238
Fig. 8.12 EViews STAR estimates 239
Fig. 8.13 Threshold weights view and shape of the smoothing
function 240
Fig. 8.14 STAR sum of squared residuals plot 241
Fig. 8.15 STAR linearity test estimates 242
Fig. 8.16 STAR Encapsulated non-linearity test estimates 243
Fig. 9.1 Illustration of the time and frequency domain localized
characteristics of the Fourier and Windowed Fourier
Transforms 256
Fig. 9.2 Time series transform using the Fourier, Windowed
Fourier, and Wavelet transform 258
Fig. 9.3 Multi Scale Wavelet Decomposition 261
Fig. 9.4 Periodogram Plot for Stellar 264
Fig. 9.5 MODWT decomposition of the Stellar daily returns 265
Fig. 9.6 Wavelet Coherence diagram between Stellar and Monero
daily returns 267
Fig. 9.7 Wavelet Clustering diagram for four cryptocurrencies
(Note 1. Stellar, 2. Monero, 3. XBP, and 4. Bitcoin) 268
 List of Tables

Table 1.1 Illustration of cross-sectional data 9

Table 1.2 Illustration of time series data 10
Table 1.3 Illustration of pooled data 10
Table 1.4 Illustration of balanced panel data 11
Table 4.1 Variances and covariances matrix 95
Table 5.1 Fama and French portfolio construction techniques 117
Table 9.1 Wavelet scaling factor and equivalent frequency 258

xxix
 CHAPTER 1

Introduction

Key Topics Covered

• What is Applied Financial Econometrics?
• The essential steps to conduct the applied financial econometrics study
• Type I and Type II errors
• Importance of Stochastic specification (ε) in the model
• Basic data types that are used in financial econometrics study
• Introduction to Econometric software packages: EViews and R
programming

1.1 Background
The term “econometrics” was emphasized by Ragnar Frisch in the inau-
gural issue of the Journal of the Econometric Society (Econometrica)
editorial note1 published in the year 1933. Even though Pawel Ciompa
have used the term “Oekonometrie” (Econometrics in German) in the
year 1910, almost two decades beforehand Frisch. Modern economists
favour Frisch version of econometrics that “aims at a unification of
the theoretical quantitative and the empirical-quantitative approach to

1 Frisch, R. (1933). Editor’s note. Econometrica, 1(1), 1–4. Retrieved March 20, 2021,
from http://www.jstor.org/stable/1912224.

© The Author(s), under exclusive license to Springer Nature 1

Singapore Pte Ltd. 2021
M. Maiti, Applied Financial Econometrics,
https://doi.org/10.1007/978-981-16-4063-6_1
2 M. MAITI

economic problem” in contrast to the Pawel’s conception of economet-

rics which is entirely descriptive. Frisch stressed that to understand the
quantitative relationships of the real complex economic environment,
only single viewpoint of statistics, economic theory, or mathematic is
not sufficient rather it demands the union of three. Hereafter economet-
rics as a distinct branch of economics began to emerge and it further
gains momentum with the foundation of entities namely “Cowles Commis-
sion for Research in Economics ” and others. Foremost methodological
debate in econometrics initiated with the article titled “The Probability
Approach in Econometrics” by Trygve Haavelmo (1944)2 and hereafter
other areas of econometrics seen significant developments. Subsequently,
notably Gerhard Tintner (1953)3 defines origin of the word “economet-
rics” as the neology of two Greek words, “oikonomia” (administration
or economics) and “metron” (measure). Hence, factually meaning of the
term econometrics appears to be as the “measurement in economics”.
Gerhard made an attempts to provide an expressive definition for: what is
econometrics? To do so, Gerhard in his study quoted several viewpoints
of “econometrics” as defined by the several noteworthy researchers. In
conclusion Gerhard argues that the definition of econometrics as defined
by the earlier studies is somewhat sketchy in nature. It is really a difficult
and challenging task to define econometrics with just a single char-
acterization as the space of econometrics is very vast. It is true that
“measurement” is one of the important component of econometrics but
likewise nowadays the scope of econometrics is much wider than that.
Thereafter, in a relatively short period of time studies in the field of
econometrics have seen significant development holistically. To support
the increase in demand for the econometrics studies development of
several supportive econometrics software packages began to progress.
Some of the notable econometrics software packages that are developed
over a period of time is represented in Fig. 1.1.
Studies in econometrics could be grouped into two groups: theoretical
and applied econometrics. Theoretical econometrics explore the proper-
ties of existing statistical tests and procedures for estimating unknown

2 Haavelmo, T. (1944). The probability approach in econometrics. Econometrica:

Journal of the Econometric Society, iii–115.
3 Tintner, G. (1953). The definition of econometrics. Econometrica, 21(1), 31–40.
https://doi.org/10.2307/1906941
 1 INTRODUCTION 3

Fig. 1.1 Evolution of various econometrics software packages

variables in the model. Whereas applied econometrics combines the theo-

retical econometrics and real-world data for evaluating economic theories,
constructing innovative econometric models, and forecasting models.
Today the applications of econometrics are just not only limited to the
field of economics but it is well adapted in the other allied fields such as
business and management. Sir Clive William John Granger during in his
noble prize speech quoted the following.

We econometricians love numbers… which I view as a healthy local

trend.4 —Clive W.J. Granger

In practice, there exists the ambiguities and overlaps between “econo-

metrics, data science, machine learning and others” in the way different
people see these terms. The fundamental difference between econometrics
and other terms such as data science and machine learning lies with the
different approaches for problem solving. Econometrics focuses more on
the casual relationship between the variables under study. In contrast data
science and machine learning focuses more on the reverse engineering and
curve fitting problems. Nonetheless knowledge of econometrics would
be a treat for the data scientists as both shares a lot of common interests,
such as Regressions, ARIMA & VAR models, and others. Having a strong
foundation of econometrics, data scientists would be able to interpret the
obtained results and understand the causality better among the variables.
That is how the knowledge of econometrics could make the data scientists
influential.
Financial econometrics is a subset of the financial economics (subset
of economics) that deals with the application of statistical methods to
financial market data. The field of financial econometrics has seen signif-
icant developments in the last few decades. Today financial econometrics

4 Granger, C. W. (2004). Time series analysis, cointegration, and applications. American

Economic Review, 94(3), 421–425.
4 M. MAITI

is considered being one among the fast growing fields in economics.

To promote the global network of academics and practitioners dedi-
cated to sharing research and ideas in the field of financial econometrics,
Society for Financial Econometrics (SoFiE)5 is co-founded by Robert F.
Engle and Eric Ghysels. Top academic journals namely Journal of Finance,
Econometrica, Journal of Econometrics, Journal of Financial Economics,
Journal of Financial Econometrics, and others publish studies on financial
economics frequently. Studies in applied financial econometrics typically
include the following topics but are not limited to

• Analysis of high-frequency time series

• Asset pricing dynamics
• Optimal asset allocation
• Non-linear time series
• Fund performance analysis
• Derivative structuring
• Volatility estimation techniques
• Risk analysis
• Coherence and co-movements
• Forecasting models
• Portfolio optimisation and theory
• Test of market efficiency
• Causation and effect
• Identification of shocks and thresholds estimation
• Random walk models
• Fixed Income, equities, commodities, currencies & others asset
classes
• Intraday trading
• Modelling financial markets.

1.2 Steps to Be Followed in Applied

Financial Econometrics Study
Seven key steps that have to be followed to conduct applied financial
econometrics study successfully are as follows:

5 http://sofie.stern.nyu.edu/.
 1 INTRODUCTION 5

• Problem definition or statement

• Selection of variables
• Model description
• Selection of methods or techniques
• Result Estimation
• Interpretation and Validation
• Conclusion and research implications.

1.2.1 Problem Definition or Statement

Problem definition or statement is the very first step for conducting any
financial econometrics study. It is very important to identify the clear-cut
research problem or what study is going to address? For an instant let’s
define the study statement as “To examine the performance of Capital
Asset Pricing Model (CAPM) in Indian context”. Based on the study
problem following hypotheses are framed:

Null Hypothesis (Ho): CAPM regression intercept is equal to

zero.
Alternative Hypothesis (Ha): CAPM regression intercept is not equal
to zero.

As the entire study centres around the framed hypotheses and a minor
mistake in framing the hypotheses could result into an absolute disaster.
So, any financial econometrics study requires in-depth understanding of
the hypotheses testing for the different statistical methods and economet-
rics models used. Testing of hypothesis concludes either with rejection
of the null hypothesis or acceptance of the alternative hypothesis. Rejec-
tion of the null hypothesis indicates that the null hypothesis is not true
and alternative hypothesis could be accepted or vice versa. Decision of
acceptance or rejection of the null hypothesis is based on the obtained
p-values or t-values.
Wrongly rejecting the null or alternative hypothesis could give rise to
the circumstances of Type I (alpha) and Type II (beta) errors. Rejec-
tion of null hypothesis even when that’s true would result into Type I
error. Likewise fail to reject the null hypothesis even when that’s false
would result into Type II error. Type I errors largely arise due to scepti-
cisms and by selecting the correct critical values it could be eliminated to
6 M. MAITI

a greater degree. In practice depending on the type of datasets different

critical values that are being used are based on the 1, 5 or 10% statistical
significance level. In contrast Type II errors could be prevented mostly
using large sample size. Second approach might be the choosing higher
level of significance. The impact of Type I and Type II errors ruling
can be accessed through determining the appropriate level of statistical
significance. This is how the appropriate level of statistical significance is
powerful. Next crucial question is “Which type of the errors are the worst:
Type I or II”? Well, both Type I and II errors could be worst depending
upon the context. By and large Type I errors are more serious than Type
II errors.

1.2.2 Selection of Variables

Based on the study statement wisely selects the study variables. Selec-
tion of variables is the another important task in financial econometrics
study. Most of the financial econometrics study deals with the closest
proxy variables available as it is very difficult to obtained the real vari-
ables data. For example, it is very difficult to obtain the real estimates
for the market returns. Influential Stock Index benchmarks (S&P 500;
BSE 30; NSE 50, and others) are often used as the proxy for market
returns. For the study statement “To examine the performance of Capital
Asset Pricing Model (CAPM) in Indian context”, study variables could be
as follows: individual stocks or portfolio excess returns (dependent vari-
able); risk free rate (91 days T-bills); market returns (BSE 30 or BSE-200
index monthly excess returns). For financial econometrics studies, data
could be obtained from both paid and unpaid databases or data sources.
Bloomberg, Thomson Reuters Eikon, Capitaline, Compustat, Datas-
tream, CMIE Prowess, and others are some of the leading providers of
financial data or databases based on subscriptions. Likewise Yahoo finance,
central banks, World bank, IMF, Stock exchanges, Google finance, SEC,
CoinMarketCap (Cryptocurrency), and others are some of the leading
providers of public or free financial data or databases. Once variables are
chosen next study period and frequency of data (daily, weekly, monthly,
yearly or others) has to be specified.
 1 INTRODUCTION 7

1.2.3 Model Description

Once the study variables are identified based on it develop the finan-
cial econometric model. Mathematically represent the developed financial
econometric model taking into account all possible factors or variables
that could affect the dependent variable(s). For example, the CAPM
illustrates the relationship between market (systematic risk) and expected
return for assets. Here the relationship between market (systematic risk)
and expected return for assets is not exact and deterministic, rather a
typical or stochastic one. Moreover in financial econometrics study the
relationship between the variables often has two way causality. These
types of situations demand for a stochastic specification in the model.
And that is possible by inserting “stochastic terms” or “Error terms” or
“noise terms” or “disturbance terms” or “residuals terms” in the model.
Other justification for inclusion of the stochastic specification (ε) in the
model could take into account the erratic human behaviour, influence of
omitted variables, measurement errors if any and others. To examine the
performance of CAPM in Indian context following model is developed as
shown below in Eq. 1.1:

Rpit −Rft = α + β(Rmt − Rft ) + εit (1.1)

where
Rpit −Rft = Individual stocks or excess portfolio returns
Rmt − Rft = excess market returns
Rft = Risk free rate
α = alpha
β = beta coefficient
ε = “Error terms” or “noise terms” or “disturbance terms” or
“residuals terms”.
Stochastic specification (ε) in the above model is not readily observable
like the other variables. Often study in applied financial econometrics
makes some reasonable assumptions about the shape of the distribution
of each (ε).
Which are as follows:

• Error terms (ε) are normally distributed

• Mean of the error terms (ε) is zero
• Error terms (ε) have uniform variance (σ2 ) or homoscedastic
• Error terms (ε) are independent or uncorrelated to each other.
8 M. MAITI

1.2.4 Selection of Methods or Techniques

Once the model has been described based on it appropriate econometric
method or techniques selection should be carried out. For an instant
performance of CAPM in Indian context could be tested using the linear
regression.

1.2.5 Result Estimation

Before running the developed financial econometric model (regression or
others), it is worthwhile to look into the details characteristics of the study
variables. Preliminarily plot different graphs of the chosen study vari-
ables to look at glance the nature of the variables. Look for the unusual
spikes and try to find out the cause-and-effect of it. Check to see for
the descriptive statistics of the study variables whether they follow central
limit theorem or not? Thereafter check for covariances and correlations
among the explanatory variables. Financial econometrics study generally
deals with the different time series, and it is always necessary to verify
whether the time series is stationary or not. Besides unit root test, several
other tests are available to check the quality and reliability of the data.
For any financial econometrics study quality and reliability of the data
is essential as all estimated outputs are based on the selected data. All
possible necessary checks should be done to justify quality and reliability
of the study data. When all of the above-mentioned necessary checks
are performed then run the above regression model (or other chosen
models) using available econometrics software packages and obtained the
results from it. Commonly all available econometrics software packages
provide much details of the estimated results. Include only the necessary
information of the estimated results as obtained from the econometrics
software packages such as values of the coefficients, t statistics, R 2 value
and others.

1.2.6 Interpretation and Validation

It is worthwhile to begin the discussion with the explanatory variables.
Include a short interpretation on all of the necessary information obtained
from the graphical plots, descriptive statistics, covariance and correlation
analysis, unit root testing, and other necessary estimations. Subsequently
critically interpret the estimated outputs obtained from the developed
 1 INTRODUCTION 9

financial econometric model. Further it is desirable to check the robust-

ness of the developed financial econometric model. For robustness check
of the financial econometric model different tests are available such as
GRS, GMM, Boot strapping, and others could be implemented. Even
one could go one step ahead later with the forecasting models.

1.2.7 Conclusion and Research Implications

Although it is the last step it is very important in terms of real contribu-
tion of the study/research taken. Study results or findings should convey
about the direct policy implications or key message for the future studies.

1.3 Fundamental Data Types Used

in Financial Econometrics Study
Financial econometrics study primarily deals with the four data types
namely cross sectional, time series, pooled, and panel data. Usually based
on the data types different methods or techniques are selected for the
financial econometrics study/research. Hence, it is very important to
have the knowledge of these various data types used in the financial
econometrics study/research.

1.3.1 Cross-Sectional Data

Cross-sectional data consists of data gathered from the multiple subjects
(individuals, firms, countries, or regions) at the one particular point or
period of time. Table 1.1 shows cross-sectional data of country wise
chosen by the largest banks interest incomes for the year 2006. In this
illustration of the cross-sectional data, period is fixed (Year is 2006)
whereas remaining factors (Country and Interest Incomes) changes.

Table 1.1 Illustration

Country Year Interest income (in millions, EUR)
of cross-sectional data
Romania 2006 209.44
Serbia 2006 43.85
Slovenia 2006 129.65
10 M. MAITI

Table 1.2 Illustration

Year Interest income (in millions, EUR)
of time series data
2006 209.44
2007 218.13
2008 283.85
2009 318.00
2010 360.07

Table 1.3 Illustration

Country Year Interest income (in millions, EUR)
of pooled data
Romania 2006 209.44
Serbia 2006 43.85
Romania 2007 218.13
Serbia 2007 77.28
Slovenia 2007 148.10

1.3.2 Time Series Data

Time series data consists of data points of the single subject (individuals,
firms, countries, or regions) over a period of time or at regular inter-
vals. Table 1.2 shows time series yearly data of chosen by the Romanian
largest banks interest incomes for a period of five years (2006–2010). In
this illustration of the time series sectional data period, country is fixed
(Romania) whereas time period (Year) varies between 2006 and 2010.

1.3.3 Pooled Data

Pooled data is combination of the both cross-sectional and time series
data. It is sometimes referred to as “time series of cross sections” in which
the data points contained in each of the cross section necessarily do not
refer to the same subject(s). Table 1.3 shows pooled data of country wise
chosen by the largest banks interest incomes for the year 2006 and 2007.
In this illustration of the pooled data the number of subject elements in
cross section is not identical for the year 2006 and 2007. In the year
2007, Slovenia is in addition to the Romania and Serbia. Pooled data
is used often to see how the key relationship between the variables has
altered over a period.
 1 INTRODUCTION 11

1.3.4 Panel Data

Panel data is often referred as the longitudinal data. Panel data consists
of the repeated data points of the same multiple subjects over the short
or long periods of time. Panel data is of two types namely balanced and
unbalanced panel data. Table 1.4a shows balanced panel data of country
wise chosen by the largest banks interest incomes for the year 2006 and
2007. In this illustration of the balanced panel data number of period
(2006 and 2007) are identical for the each cross-sectional units.
Likewise Table 1.4b shows unbalanced panel data of country wise
chosen by the largest banks interest incomes for the year 2006, 2007,
and 2008. In this illustration of the unbalanced panel data number of
period (2006, 2007, and 2008) are not identical for Romania and Serbia.

1.4 Software Packages

Today various econometrics software packages are available to users for
carrying out studies in financial econometrics. Here in this section two
commonly used econometrics software packages are discussed namely
EViews and R programming. All the discussions and interpretations that
are made either with the EViews 11 (Student Version Lite) or R program-
ming outputs in this text book are merely for knowledge sharing purposes
of greater interest.

Table 1.4 Illustration

Country Year Interest income (in millions, EUR)
of balanced panel data
(a)
Romania 2006 209.44
Romania 2007 218.13
Serbia 2006 43.85
Serbia 2007 77.28
(b)
Romania 2006 209.44
Romania 2007 218.13
Serbia 2006 43.85
Serbia 2007 77.28
Serbia 2008 83.6
12 M. MAITI

1.4.1 EViews
EViews econometrics software is currently being promoted by the IHS
Markit. It is a window based and user friendly econometrics software
that offers basics to advanced statistical forecasting and modelling tools
for interaction. Today EViews is well accepted by the practitioners and
academics in practice. Users include 600+ central banks, financial insti-
tutions, IMF, Federal reserves, United Nations, World bank, 1,600+
university’s economics and business departments, over 50% of Fortune’s
Top 100 Companies, and others. EViews provides user with three choices
for the interface: first graphical user interface, second single commands,
and third program files.
EViews offers several product and pricing options for the users
namely Standard, Enterprise, University Edition, Student Version Lite,
and others. EViews Student Version Lite is a free version available to the
students and faculty members for usage. EViews Student Version comes
with various limitations such as length of use (1 year), image only copy
paste options, limit in total observations (15,000), only available for 64-
bit devices, and many others. Presently EViews 11 Student Version Lite
version is available to download in their official website.6 First down-
load the EViews 11 Student Version Lite software. Then register yourself
with EViews by providing basic information (such as name, university,
email, and others) to request a serial number. Upon successful registra-
tion EViews will send the 24-character serial number to the registered
email. This 24-character serial number is required as a part of the instal-
lation and product activation/registration. Then get installed the EViews
11 Student Version Lite software in your system to use. EViews also
provides several useful resources for knowledge purpose under the section
“Learning Resources” could be accessed from their official websites.

1.4.1.1 EViews in Action

Graphical user interface is the most preferred interface by the users to
work with the EViews. By clicking on the EViews 11 Student Version Lite
(Hereafter EViews) shortcut icon, EViews interface will open as shown
in Fig. 1.2. Here some of the basic estimations that could be performed
using EViews software are discussed. To do so following datasets are used:

6 http://www.eviews.com/home.html.
 1 INTRODUCTION 13

Fig. 1.2 EViews 11 Student Lite Main Window

EUR_USD, and GBP_USD exchange rates daily closing price between 1

January 2020 and 31 March 2020 (Data source: Yahoo Finance).
Importing Data

EViews can read several types of available data formats such as MS Excel,
SPSS, SAS, txt, csv, and many others. Basically there are two ways by
which data that can be imported into the EViews.
First approach:
File → Import → select the file → Finish
Second approach:
File → New → Workfile → The “Workfile Create” new window will
appear as shown in Fig. 1.3.
It provides users with three choices of workfile structure and thirteen
choices of data frequency. Once details are chosen then click OK button,
and a new “workfile” window will be displayed. Right click on the work-
file window, then select paste and finish. Final output after importing
the data (EUR_USD, and GBP_USD exchange rates daily closing price)
14 M. MAITI

Fig. 1.3 Workfile create window

into the EViews interface following any one of the above-mentioned two
approaches is shown in Fig. 1.4.
Plotting Graphs
User can plot several type of graphs using EViews.
For plotting the multiple series into a single graph: select the series
variables (eur_usd and gbp_usd) and open as “Group”. A new workfile
window will be displayed with the titled “Group”. Then click on the View
→ Graph → A new window with “Graph Options” will appear as shown
in Fig. 1.5.
After selecting the details and clicking OK button in the Graph
Options window. Likewise, to plot the individual series graph simply
click on any of the series variables (eur_usd) in the workfile window
and follow the remaining steps as stated above. Final output for both
cases (group and individual) is displayed in Fig. 1.6. The sharp decline
pattern of EUR_USD & GBP_USD pairs in the figure is during the
global lockdown period of the COVID pandemic.
 1 INTRODUCTION 15

Fig. 1.4 Imported data in the workfile window

Descriptive Statistics
To estimate the descriptive statistics of the two series variables eur_usd
and gbp_usd, perform the following steps: Open Group workfile window
→ View → Descriptive Stats → Individual Samples.
Then the final output with descriptive statistics looks as illustrated in
Fig. 1.7. Jarque-Bera test statistics indicate that EUR_USD series follows
normal distribution among the two series. GBP_USD series is more
volatile (Standard deviation value is higher) and have heavy tails (Kurtosis
value is higher) as compared to the EUR_USD series.
Histogram and descriptive statistics of the individual series variables
(eur_usd) may also be plotted as shown in Fig. 1.8 by doing the following:
Open EUR_USD workfile window → Descriptive Statistics & Tests →
Histogram and Stats.
Exploring the Variety of Random
Documents with Different Content
THE EVENING STAR.
Beneath a weight of glistening snow each bough was bent,
Ice-glued the crystal cushions took strange form,
Like ghosts of prehistoric ferns whose palour blent
With earth and sky—the aftermath of storm.

The splattering rain had stayed its noisy, windblown course

And now the padding flakes had ceased to come.
A silent world that stilled all passion and remorse,
Heart-throbbings, grief, thoughts dull and burthensome.

And in the shanty's warmth a child lay stretched at rest,

As delicate as winter tracery.
A mother's eyes sought hers in anxious, tender quest,
Then turned with prayerful light toward western sky,

As though to wrest the secret of the universe

From silver drapery and peeps beyond,
As though one added effort would avail to pierce
The cloaking space, that something must respond.

A something e'en more wonderful than branchlets sprayed

In weird fantastic tire 'gainst heaven's deep;
And lo the mystic blush of evening gently rayed,
Wee cloudlets strayed from mist like flocks of sheep.

A wind! or was't a cry? The infant gasped for breath.

Belike soft bleating lambs had wakened her,
Belike the new-born soul was lured toward lanes of death,
The rosy flush had held a messenger.

Ah woe that Mother's heart as close she pressed her child;

Poor quivering nameless thing and O so frail
To penetrate that void—her thoughts grew fierce and wild.
An infant unbaptised, what fears assail?

An erie wind had risen; hark its shrilling cry I

A flickering candle loosed deep shadows round
That emphasized despair and cruel misery;
The night had come, a sullen night that frowned.

And nought remained but burning love for help was far,
Nor remedies; and grief had surged and ebbed.
Again the Mother sought the sky and lo a star
Had forced the clouds; it peered through boughs close-webbed.

A bright and steadfast star that shot its friendly rays.

"O Evening Star," the woman softly sobbed,
"Be sponsor, shed celestial light through trackless haze."
Asudden within her heart the answer throbbed,

Or winds had drifted: "Innocence." She hearkened, yes

"Innocence," the Star had sanctioned it:
Her baby's name! Upon its brow with fond caress
And moistened touch the crossing sign was writ.

And Innocence looked up and smiled and caught the light

That streamed from Evening Star and breathed a sigh
That held content; a faint, sweet sigh that put to flight
A mother's fear, that hushed anxiety.

And so the Babe was named and Innocence still cheered

The lonely hut. A father heard the tale;
How Evening Star had given aid as he had steered
Through her his homeward course, obscured by gale.

And oft at sunset hour the parents sat and watched

Receding day with grave expectancy,
At times through lattice work of branches gaunt and notched,
At times through leafy boughs that swathed the sky.

And when the rosy prelude, orchestra of tint,

Had dimmed; with deep, upwelling thought that strives
And gladsome awe, they faced the Evening Star; whose print
Was on their baby's brow, had marked their lives.
Then Innocence would laugh and stretch her hands and prayer
Half-breathed would rise that happiness remain.
The Evening Star flung beams of trust and through the air
Oft "Innocence" was voiced by winds again.

And Innocence grew tall as passed the years; but frail

At times she seemed, still more when strangers neared.
Ah then she'd seek some ferny haunt, 'mid flowerlets pale
She'd cower, nor knew what dreaded ill she feared.

A lily-maid in homespun garb of softest white,

Her winter coat of silky rabbit skin
Or ermine brought by Indian guide. Her cheeks as white
Unless the flush to evening skies akin.

And so time passed, the nearby settlement became

A village, then a boastful town and road
And searching railway broke the still and helped defame
Sequestered charm that God, through Grace, bestowed.

And Innocence would shrink from noise and close her eyes
When drifting smoke showed progress near, like plant
That's sensitive, that shrivels from man's touch and lies
So piteous with tremulous leaves aslant.

Too weak for woodland stroll, a hammock-couch was strung

'Neath lofty pines and there the young girl lay
And watched a robin's second brood, or chipmunk swung
On sapling bent, or butterflies at play.

One heavy night she stayed without, till Evening Star

Had blown a kiss, then dipped beneath some clouds.
A silence crept, scarce broke by owlet's hoot afar,
While mists arose like ghosts in flaunting shrouds.

A rustling sound! but Innocence had dropped asleep;

Within her hand a dangling lily stem
 Within her hand a dangling lily stem,
Whose cool, white bud unfolded tales that willows weep
Where broad green leaves and starry petals gem,

Where waters pause from maddened rush to catch the calm

That slips through foliage, to rest awhile
In reedy bays as man fatigued might search for calm
'Neath roofing church, immunity from guile.

A rustling sound, a stealthy tread, some broken twigs,

And Guilt peeped low through scrubby briar growth,
Then pushed his ruthless way, nor cared that tender sprigs
Refused to bloom, once heard his muttered oath.

He plucked a burr that pulled his coat askew, then brushed

Aside some pollen dust, some larva-thread;
His outward garb so sleek and glossed, with step that hushed
He fast approached—above dark clouds had spread;

But through the gloom, the lily bud was visible,

The pallid curve of maiden's cheek; one stride,
He stood befogged, a something stayed against his will.
A something childlike, Godlike that defied.

For Innocence had wakened now and unabashed,

Unharmed she gazed at Guilt and pity lay
Within her eyes, a pity blent with pain that lashed,
Till Guilt one blinding moment felt its play.

He sank to earth beseeching what? He scarcely knew.

Respite? was pardon past? He felt a touch
As light as though from highest Heaven a Seraph blew
A kiss that floated downwards bringing much.

And on his heart he pressed the flower that Innocence

Had proferred him, the lily bud that erst
Had lain on waters cool and clear. It brought from thence
Some mirrored truth that Nature's self had nursed.
 So e o ed t ut t at atu e s se ad u sed

But Innocence had breathed her last, one gasp, 'twas all,
While Guilt affright, scarce pausing, fled; once more
The Evening Star shone forth, winds sobbed a lingering call,
The parents listened—useless to implore.

The grave awoke with crimson flowers; new birth attained,

The Evening Star had guided faithfully;
For ever since no grovelling soul has been so stained
But moments come that give some chance to free.

'Twas long ago, in our old Province of Quebec,

This tale at evenfall was whispered me.
One spoke—and was that one alive? or but a speck
Of spirit-world, of God's Eternity?

THE END.
 TRANSCRIBER'S NOTES
1. Silently corrected simple spelling, grammar, and
typographical errors.
2. Retained anachronistic and non-standard
spellings as printed.
*** END OF THE PROJECT GUTENBERG EBOOK THE ROMANCE OF
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