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Using Neural Networks and Genetic Algorithms to Predict Stock Market Returns

Using Neural Networks and Genetic Algorithms to Predict Stock Market Returns

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Published by Dang Trong Duc

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Published by: Dang Trong Duc on Nov 11, 2012
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The effectiveness of the AR model will be measured on a set of unseen data (~10% of

all available data). The issue that arises is the choice of metrics we will use to evaluate

its performance. Two types of metrics will be used in this study: the mean absolute

prediction error, and benchmarks that will compare the predictive power of our model

with the Random Walk Model. Both metrics are widely used in econometrics to describe

the effectiveness of prediction models.

The mae is described by equation (4.4). It is quite clear that the closest to zero the mae

is the better our model or else the closest our predictions −

t

y to the actual values yt.

In order to use the second metric and compare the AR model with the Random Walk

(RW) model we will use a coefficient suggested by Henry Theil (1966), the Theil

coefficient. Theil coefficient (or inequality coefficient) is defined as [31]:

59

Theil=

=

=

N

t

t

N

t

t

t

y

y

y

1

2

1

2

_

)

(

(4.8)

It is the fraction of the mse of our model in respect to the mse of the RW. The prediction

of the RW model for day t is in terms of returns 0% (the same price as day t-1). That is

why the mse of the RW equals to the denominator of the fraction above. In case that

Theil is less than one we have a model that outperforms the RW, while in case that

Theil is close to one our model is as good as the RW.

Equation (4.8) is proposed for series of returns but in our case does not manage to

depict properly the RW on the excess returns series we use, which is:

yt = ln(

1−t

t

p

p

) − ln(

360

1−t

c

+1)

If we want to be precise and depict the mse of the RW model on the actual prices of the

market, then we would have that the prediction of the price of the market for day t (pt) is

equal to the price of day t-1 (pt-1):

=

t

p= pt-1, where =

t

pis the prediction of the RW for day t.

From the last two equations we have that the prediction of the excess returns on day t

according to the RW on prices is:

=

t

y = − ln(

360

1−t

c

+1) (4.9)

Using (4.9) the Theil Coefficient would be:

Theil=

=

=

+

N

t

t

t

N

t

t

t

c

y

y

y

1

2

1

1

2

_

))

1

360

ln(

(

)

(

(4.10)

60

A third approach is to assume that the excess returns time series itself follows a random

walk. In this case the Theil that would compare our model with this type of RW would

be:

Theil=

=

=

N

t

t

t

N

t

t

t

y

y

y

y

1

2

1

1

2

_

)

(

)

(

(4.11)

The RW on the denominator this time indicates that the prediction of the return on day t

is going to be equal with the return on day t-1.

In conclusion the metrics we will use to evaluate the AR model are:

Metric Equation

Description

Mae

(4.4)

Mean absolute error

Theil A (4.10)

Comparison of the AR model with the RW on prices pt

Theil B (4.11)

Comparison of the AR model with the RW on excess returns yt

Theil C (4.8)

Comparison of the AR model with the model which states that
the price of the market tomorrow will be such that will allow us
to have the same profits that we would have by investing in
bonds.
Table 4.1: The metrics we will use to evaluate the AR models.

For simplicity reasons we will refer to equations (4.10), (4.11) and (4.8) as TheilA,

TheilB and TheilC respectively.

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