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1 Distributions
2 Return
Simple Returns
Pt − Pt−1
Rt = (1)
Pt−1
Continuously Compounded Returns
Pt
Yt = log(1 + Rt ) = log( ) = log(Pt ) − log(Pt−1 ) (2)
Pt−1
2.0.2 Autocorrelations
Autocorrelations measure how returns on one day are correlated with returns on previous days. The coeffi-
cients of an autocorrelation function (ACF) give the correlation between returns and its lags:
1. Volatility clustering
2. Fat tails
3. Nonlinear dependence
The function of the normal distribution is given by the following function:
1 (x−µ)2
f (x) = √ e− 2σ2 (5)
σ 2π
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T T
Skewness2 + (Kurtosis − 3)2 ∼ X 2 (6)
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(b) KS test, based on minimum distance estimation comparing sample with reference probability
distribution (t-dist). Advantage is that it is distribution free and non-parametric
2. QQ-plots
Γ( v+1 ) x2 v+1
f (x) = √ 2 v (1 + )− 2 (8)
vπΓ( 2 ) v
*
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3 Factor Models
A factor model estimates risk and return on the basis of other variables such as macroeconomic effects or
other stocks. The general form of factor model (RGP) is:
• The fi ’s are common factors that affect most securities. Examples are economic growth, interest rates,
and inflation. It is given as the deviation from what we expect. (E[fi ]= 0)
• bi,j denotes the loading of the i’th asset on the j’th factor. This tells you how much the asset’s return
goes up when the factor is one unit higher than expected.
• Portfolio selection
• When one assumes relation between assets in prototype, the amount of input variables is drastically
decreased
• Easy to specialize along certain factors
Cons
• Some factor models are purely statistical, does not explain whether a low price is because of risk or
becasuse of mispricing
• Relies on past data and assumes stationarity of volatility
3.1 CAPM
CAPM is a single factor model, based on an equilibrium model. Specifying a relation between expected rates
of return and covariances for all assets. The most commonly quoted equation for the CAPM is:
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3.2 APT
The APT specifies a pricing relationship with a number of “systematic” factors.The idea behind the APT
is that investors require different rates of return from different securities, depending on the riskiness of the
securities. If, however, risk is priced inconsistently across securities, then there will be arbitrage opportuni-
ties.
E(e
ri ) = λ0 + λ1 bb,1 + ... + λK bi,k (13)
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1. We treat the factors as observable and specify the fej directly. Loadings can be estimated using
regressions.
(a) In this case, the factors can be macroeconomic variables like inflation, output.
(b) We can estimate the loadings via regression.
(c) We think that these variables will be sufficient to capture the systematic risk in the economy.
2. We treat the loadings as observable and obtain these from fundamental information. e.g. value firms
have higher returns than growth firms, or similar firms move together.
3. Treat both factors and loadings as unobservable, use just regressions to get loadings of statistically
determined factors. (Fama-French)
Ri,t = α0,t + α1,t βi,t + α2,t M Vi,t + α3,t BT Mi,t + ui,t (14)
where Ri,t are again the monthly returns, βi,t are the CAPM betas, M Vi,t are the market capitalisa-
tions, and BT Mi,t are the book-to-price ratios, each for firm i and month t. Similar stuff can be done
with SMB (small minus big) and HML (high minus low). SMB is the difference in return between a
protfolio of small stocks and a portfolio of large stocks. HML is the difference in return between a
portfolio of value stocks and a portfolio of growth stocks.
• Carhart, It has become customary to add a fourth factor to the equations above based on momentum.
This is measured as the difference between the returns on the best performing stocks over the past
year and the worst performing stocks
3.4 Tests
3.4.1 Pearson’s Correlation Coefficient
Pearson’s correlation coefficient measures the strength of linear dependence, it is scale independent and
defined as:
σX,Y
ρX,Y = (15)
σX σY
’
ρ is always less than or equal to 1 in magnitude. If ρ is greater than 0 it implies that Y tends to be above
average when X is above average, and if ρ is less than 0 then Y tends to be below average when X is above
average. If ρ is 0 then there is no linear relationship between X and Y.
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R̄i = λ0 + λi βi + vi (16)
Then we should see that λ0 = Rf and λ1 = [Rm − Rf ]. You could do the same thing with squared beta’s
and inserting error terms, but you should always see that those λ’s should be zero.
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4 Event Studies
Event studies are extremely common in finance and in research projects! They represent an attempt to gauge
the effect of an identifiable event on a financial variable, usually stock returns So, for example, research has
investigated the impact of various types of announcements (e.g., dividends, stock splits, entry into or deletion
from a stock index) on the returns of the stocks concerned.
• Define the return for each firm i on each day t during the event window as Rit
• We need to be able to separate the impact of the event from other, unrelated movements in prices.
• So we construct abnormal returns, denoted ARit , which are calculated by subtracting an expected
return from the actual return ARit = Rit - E(Rit )
• The simplest method for constructing expected returns is to assume a constant mean return. More
complex methods include market regressions using indices like S&P500 or home-made indices
It could also be interesting to look at average returns in an event study across firms. Or over firms and
time.
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5.2 EWMA
The simplest volatility is the moving average model. Which is a very bad model.
WE
1 X
σ̂t2 = y2 (21)
WE i=1 t−i
Risk Metrics is a slightly more advanced model, it uses a weighted sum of past returns.
2
σ̂t2 = w1 yt−1 2
+ w2 yt−2 2
+ ... + wWE yt−W E
(22)
EWMA is even more advanced, exponentially declining the weights of past returns. This can also be
written as shown in the following formula, which is the standard notation of EWMA.
2
σ̂t2 = (1 − λ)yt−1 2
+ λσ̂t−1 (23)
5.3 ARCH
An econometric term used for observed time series. ARCH models are used to model financial time series
with time-varying volatility, such as stock prices. ARCH models assume that the variance of the current
error term is related to the size of the previous periods’ error terms, giving rise to volatility clustering.
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5.4 GARCH
The general process for a GARCH model involves three steps. The first is to estimate a best-fitting au-
toregressive model. The second is to compute autocorrelations of the error term. The third is to test for
significance. GARCH models are used by financial professionals in several areas including trading, investing,
hedging and dealing. A GARCH(1,1) model is shown below:
yt = µ + φyt−1 + ut (30)
2. Specify the log-likelihood function (LLF) to maximise under a normality assumption for the distur-
bances.
T T
T 1X 1X
L = − log(2π) − log(σt2 ) − (yt − µ − φyt−1 )2 /σt2 (32)
2 2 t=1 2 t=1
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6 Simulations
6.1 Monte Carlo Simulation
Simulations studies are usually used to investigate the properties and behaviour of various statistics of
interest. The technique is often used in econometrics when the properties of a particular estimation method
are not known. For example, it may be known from asymptotic theory how a particular test behaves with
an infinite sample size, but how will the test behave if only 50 observations are available?
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6.3 Bootstrapping
In finance, the bootstrap is often used instead of a pure simulation, this is mainly because financial asset
returns do not follow the standard statistical distributions that are used in simulations. Bootstrapping is
similar to pure simulation but the former involves sampling from real data rather than creating new data.
6.5 Derivatives
A derivative is a financial instruments whose value depends on (or is derived from) the value of other, more
basic, underlying variables, like stocks, bonds etc.
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7.2 Problems
• VaR is only a quantile on the P/L distribution, could be much worse than the VaR shows for one day
• VaR is not a coherent risk measure
• VaR is easy to manipulate by companies
2. The holding period, the time period over which losses may occur
3. Identification of the probability distribution of the P/L of the portfolio Empirical
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3. EWMA and MA, The MA model assumes that each day in the sample gets the same weight, but we
can improve volatility forecasts by applying more weight to the most recent dates. This can be done
using the EWMA model.
(a) MA is really bad at forecasting
(b) EWMA is only slightly worse than GARCH
(c) EWMA needs data set of at least 0.3/p observations
T
Y
Restricted Likelihood = LR (p) = (1 − p)1−ηt (p)ηt = (1 − p)v0 pv1 (42)
t=We +1
The likelihood ratio test, reject if LR>3.84, if a significance level was chosen of 5%.
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