Professional Documents
Culture Documents
Solutions To The Review Questions at The End of Chapter 9: X) Matrix Will Be
Solutions To The Review Questions at The End of Chapter 9: X) Matrix Will Be
1. (a) This was a rather silly question since the answer is largely given away by
the question in part (b)! Nonetheless, although there are several methods that
could be used to determine whether there is evidence of daily seasonality in
stock returns, a simple method would be to obtain a sample of daily stock
returns and regress them on 5 day-of-the-week dummy variables. The
coefficient estimates would then be interpreted as the average return on each
day of the week, and if some of these were statistically significant but with
differing signs, this could be taken as evidence of daily seasonalities.
(b) The problem is one of perfect multicollinearity between the five daily
dummy variables and the constant term known as the dummy variable trap.
The sum of the five daily dummy variables will be one in every time period,
and this will be identical to the column of ones used for the constant. The
result is that the implicit assumption of the columns of the matrix of
explanatory variables being independent of one another has been violated,
and hence there is not enough separate information in the sample to be able
to calculate the values of all of the coefficients. The (XX) matrix will be
singular and therefore its inverse will not exist. The solution is simple: either
use all 5 daily dummy variables but no intercept term, or drop one of the
dummy variables and still include the intercept. These two methods of dealing
with the problem are equivalent with identical RSS, and only the
interpretation of the coefficient estimates will change.
(c) The first step is to calculate the t-ratios. These are 0.232, -2.691, 0.673,
-0.039, and 0.141 for the intercept, D1, D2, D3 and D4 respectively. The
interpretation of the intercept coefficient is the value of the return when all of
the variables (including the daily dummies) are zero, which in this case is the
average Friday return. The coefficients on the daily dummies can be
interpreted as the average deviation of that days return from the average
return for all days of the week. Only one of these dummy variables is
significant the dummy for Monday, and we would thus conclude that the
average return on Monday was significantly lower than the average return for
the whole week, but there is no statistically significant evidence of any other
daily seasonalities given these results.
(d) Intercept dummy variables work by changing the regression intercept
estimate if a certain set of conditions hold, while slope dummies work by
changing the slope(s). For example, suppose that the regression model under
study for a sample of daily returns is
yt = 1 + 2x2t + 3x3t + ut .
A model containing these variables but also including intercept dummy
variables would be
yt = 1 + 2x2t + 3x3t + 4D1t + 5D2t + 6D3t + 7D4t + ut .
1/6
2/6
3/6
it covers only a small number of observations. The upshot is that the use of
standard information criteria applied globally to the whole model would
typically be to lead to long lag lengths for all regimes that the series spends a
high proportion of time in and short lag lengths for regimes that it did not
enter very often. A solution is to define an information criterion that does not
penalise the whole model for additional parameters in one state, i.e. a
criterion that is a function of the separately calculated residual sums of
squares for both of the regimes and of the number of lags and of the number
of observations in each of those regimes. An algebraic example of such a
criterion was given in equation (9.26) on page 476.
(e) If there are transactions costs that are non-negligible, this can lead PPP
not to hold since there would be deviations from PPP, which may appear to
represent profitable trading opportunities since the law of one price is
violated, but that in practice are unprofitable once these costs are taken into
account. Thus, a threshold model may be useful for this, since it would allow
PPP not to hold if the deviations from PPP were sufficiently small that
transactions costs would imply that this situation could persist indefinitely,
while the PPP relationship would be restored if the deviations from it became
sufficiently large to warrant cross-border trading, which would restore
equilibrium. In the linear case with no thresholds, the PPP relationship is can
be estimated for the current example using France and Germany (before the
advent of the EURO currency!) by:
ln( fx F / G ,t ) 0 1 ln( p F ,t ) 2 ln( p G ,t ) u t
where ln( fx F / G ,t ) is the log of the exchange rate, expressed in French francs
per German mark, and ln( p F ,t ) and ln( p G ,t ) are the logs of the French and
German consumer price series respectively. We could define
ln( fx F / G ,t ) ln( p F ,t ) ln( p G ,t ) as the deviation from PPP (see Chapter 7). This
could be generalised to allow for a different relationship between the three
variables according to whether the deviation from PPP is larger than some
upper threshold value r, or smaller (more negative) than a lower threshold s:
ln( fx F / G ,t )
(f) The problem is essentially that the threshold no longer exists under the
null hypothesis that the SETAR model collapses to a linear model with the
same lag lengths as were in each part of the SETAR. This fact means that the
usual basis of asymptotic theory for testing hypotheses is not applicable, so
that the test statistics would not follow the distributions that we would have
assumed of them. There are procedures available for testing hypotheses such
4/6
as this in the context of TAR models, but these are quite complex see
Hansen (1996), for example.
(g) It is tempting to think that more complex models are bound to produce
more accurate forecasts than simpler models since the former should be able
to capture more of the relevant features of the data. However, this is certainly
not the case, for complex models may have a tendency to fit to sample-specific
features of the data that are not replicated during future (out of sample)
periods, and therefore lead to less accurate forecasts. This issue was discussed
in Chapter 5. However, the use of SETAR models for producing out of sample
prediction brings with it an additional problem, namely the possibility that
the regime that the variable will reside in during the forecasted observations
will be incorrectly predicted. If the SETAR model fits the data well, it is likely
that the behaviour will be quite different between the two regimes, and
therefore that the forecasts from each regime would also be different. This
being the case, forecasting the regime wrongly could cause a big source of
forecast inaccuracy for the series, and in practice it is often very difficult to
forecast the regime that the series will be in with any reasonable accuracy.
Thus, any improvement in forecast accuracy from accurate prediction of the
variable conditional upon a correct forecast of the regime that it will be in, is
likely to be more than outweighed by incorrectly forecasting the regime.
Overall, therefore, regime switching models have produced surprisingly poor
forecasts, even when they appear to fit the data very well see Dacco and
Satchell (1999).
3. Both of these questions concern volatility dynamics rather than dynamics
in the conditional mean therefore, in both cases the appropriate answer
would be to use a model for volatility dynamics but which also allowed for
varying behaviour over time. For (i), a plausible model would be a GARCH
with some daily dummy variables included in the conditional variance
equation, e.g.
yt = + yt-1 + ut , ut N(0,t2)
t2 = 0 + 1 ut21 +t-12 + 1D1t + 2D2t + 3D3t + 4D4t
where D1, .., D4 are Monday, .., Thursday dummy variables. A more
sophisticated model could also allow the coefficients on the lagged squared
error or lagged conditional variance terms to also vary across the days of the
week. If Monday volatility dynamics are different from other days of the week,
we would expect to see 1 significant.
For (ii), some sort of threshold model is required, and the question suggests
that the threshold variable is observable (and is the value of the previous days
volatility). Thus, an appropriate model would be a GARCH model with a
threshold in the conditional variance that switches, e.g.
yt = + yt-1 + ut , ut N(0,t2)
t2 = 0 + 1 ut21 +t-12 + 1It
5/6
where It = 1 if t-12 > 0.1, and zero otherwise. Note that the question does not
specify what is volatility, so it is assumed in this answer that it is equated
with conditional variance. Again, this dummy variable would only allow the
intercept in the conditional variance (i.e. the unconditional variance) to vary
according to the previous days volatility. A similar dummy variable could be
applied to the lagged squared error or lagged conditional variance terms to
allow them to vary with the size of the previous days volatility.
6/6