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Modelling, Forecasting and Trading Power Futures Spread
PAUL AMENYAWU
This dissertation is submitted in partial fulfilment of the requirement for the degree
of Master of Science in International Banking and Finance in the Isle of Man
International School, Liverpool John Moore’s University.
September 2007
2
Declaration
“This is to certify that this dissertation is the result of an original investigation. The
material has not been used in the submission of any other qualification. Full
acknowledgement has been given to all sources used”
Signed: Paul Amenyawu …………………………………..
Signed: Dr Andreas Nabor ………………………………………
3
Modelling, Forecasting and Trading Power Futures Spread
By PAUL AMENYAWU
Dissertation Supervisor: Dr Andreas Nabor
4
Acknowledgements
I would like to show an appreciation to my supervisor Dr. Andreas Nabor for his
suggestion, ideas and feed back. His guidance helped me a lot.
The content of this dissertation was inspired from articles, journal and books; I
am indebted to the authors and wish to express my appreciation to all of them.
In addition I would like to thank Nord Pool for granting me the permission to use
their data, which made my work possible.
Finally, I would like to thank all IBS staff in general and Melanie Jones in
particular; she was always there for us and for providing me with most of the
articles and books that I needed; especially for the literature review. She is great!
5
Table of Content
MODELLING, FORECASTING AND TRADING POWER FUTURES SPREAD .................. 1
PAUL AMENYAWU .................................................................................................................... 1
DECLARATION............................................................................................................................... 2
MODELLING, FORECASTING AND TRADING POWER FUTURES SPREAD .................. 3
Acknowledgements .................................................................................................................... 4
ABSTRACT..................................................................................................................................... 12
CHAPTER 1 INTRODUCTION.............................................................................................. 13
CHAPTER 2 LITERATURE REVIEW................................................................................. 16
EUROPEAN ELECTRICITY MARKETS: ANOVERVIEW...................................................................... 25
ECONOMIC FACTORS..................................................................................................................... 26
WEATHER AND TEMPERATURE CONDITION ................................................................................... 26
COMMODITY PRICES ..................................................................................................................... 27
THE FINANCIAL MARKETS............................................................................................................ 27
OPTION CONTRACTS ..................................................................................................................... 28
CONTRACTS FOR DIFFERENCE(CFD) ........................................................................................... 28
GROWTH....................................................................................................................................... 28
S&P500 INDEX ............................................................................................................................. 29
TECHNICAL ANALYSIS: AN OVERVIEW.............................................................................. 30
CHAPTER 3 METHODOLOGY & METHODS................................................................... 32
BOXJENKINS OR ARIMAMETHODOLOGY.................................................................................... 32
ARMA (P, Q) AND ARIMA(P, D, P) MODELS................................................................................ 32
ARIMA(P, D, Q)........................................................................................................................... 33
VECTOR ERROR CORRECTION MODEL (VECM) & VECTOR AUTO REGRESSION(VAR)
METHODOLOGY............................................................................................................................. 34
GENERAL VECEM (P) .................................................................................................................. 35
COINTEGRATION METHOD............................................................................................................. 35
COINTEGRATION “FAIR VALUE” APPROACHPAIRS TRADING MODELLING ................................. 36
VOLATILITY MODEL METHODOLOGY............................................................................................ 38
INTRODUCTION ............................................................................................................................. 38
GARCH (1, 1) Model............................................................................................................... 38
6
TARCH Model with seasonal dummies............................................................................................. 39
SUMMARY..................................................................................................................................... 40
SPREAD SERIES ............................................................................................................................. 40
DATADESCRIPTION ...................................................................................................................... 42
MEANREVERTING MODELS WITH JUMPS...................................................................................... 43
PARAMETER ESTIMATION.............................................................................................................. 46
MEANREVERTING MODELS WITH TIME VARYING MEAN............................................................... 46
SIMULATION OF ELECTRICITY PRICES RETURNS.......................................................... 47
INTRODUCTION ............................................................................................................................. 47
MODELLING.................................................................................................................................. 49
MEANREVERSION PARAMETER ESTIMATION................................................................................ 51
SIMULATION OF MEANREVERSION WITH JUMPS........................................................................... 52
SINGLEFACTOR MODEL WITH SEASONALITY ........................................................................... 54
SIMPLEMOVING AVERAGE (SMA)............................................................................................... 55
TRADING RULES: .......................................................................................................................... 55
EXPONENTIAL SMOOTHED MOVING AVERAGE ............................................................................. 55
DOUBLE EXPONENTIALMOVING AVERAGE (DEMA)................................................................... 56
MOVING AVERAGE CONVERGENCE – DIVERGENCE (MACD)....................................................... 57
TRADING RULES WITH MACD...................................................................................................... 58
BOLLINGERBANDS (BB) .............................................................................................................. 58
TRADING RULES: .......................................................................................................................... 59
RELATIVE STRENGTH INDICATOR (RSI)........................................................................................ 59
ADX DIRECTIONAL MOVEMENT INDEX ....................................................................................... 59
ADX ALGORITHM......................................................................................................................... 60
TRADING RULES............................................................................................................................ 61
MOVING AVERAGE METHODOLOGY.............................................................................................. 61
TRADING RULES FOR THE EMAAND MA: .................................................................................... 62
REVIEW OF PERFORMANCE MEASURES............................................................................ 63
INTRODUCTION ............................................................................................................................. 63
FORECASTING MEASURES............................................................................................................. 63
ROOT MEAN SQUARE ERROR (RMSE).................................................................................. 63
PROFITMEASURES........................................................................................................................ 64
RISKMEASURES ........................................................................................................................... 65
THE CORRELATION FILTER............................................................................................................ 66
TRADING RULES: .......................................................................................................................... 67
EQUITY CURVE ............................................................................................................................. 67
UNDER WATER CURVE............................................................................................................. 68
7
SUMMARY..................................................................................................................................... 68
CHAPTER 4 FINDINGS .......................................................................................................... 70
INTRODUCTION ............................................................................................................................. 70
RESULTS OF FORECASTING PERFORMANCE................................................................... 70
ASUMMARY OF MODELLING PROCESS OF ARMA TIME SERIES..................................................... 72
RESULT OF THE TRADING STRATEGY USING S&P500 .................................................................... 72
SYSTEM PRICE AND MACD .......................................................................................................... 76
CHAPTER 5 CONCLUSION................................................................................................... 78
REFERENCES................................................................................................................................ 82
APPENDIX 1................................................................................................................................... 86
COINTEGRATION JOHANSEN METHODOLOGY ................................................................................ 86
APPENDIX 2................................................................................................................................... 88
APPENDIX 3................................................................................................................................. 101
FORECASTING WITH ORDINARY LEAST SQUARE AS APPLIED TO POWER DATA
(CDF) ............................................................................................................................................. 105
APPENDIX 4................................................................................................................................. 109
FORECASTING WITH ARIMAMODEL.......................................................................................... 111
VECTOR ERRORCORRECTION MODEL (VECM) ......................................................................... 120
FIGURE 47: MODELLING OF S&P500 SERIES.................................................................... 134
8
List of Tables
TABLE 1: SOURCE: HTTP://WWW.FUTURESANDOPTIONSTRADER.COM............................................... 57
TABLE 2: A COMPARISON OF FORECASTING TOOLS......................................................................... 71
TABLE 3: SUMMARY OF RATIOS OF THE TRADING STRATEGYOLSQAPPLIED TO CDF...................... 71
TABLE 4: SUMMARY OF TRADINGSTRATEGY ANALYSIS OF S&P500 INDEX (WITHOUT FORECASTING
TOOL) ....................................................................................................................................... 73
TABLE 5: SUMMARY OF RATIOS OF THE RESULT OF S&P500 TRADING STRATEGY WITH ARMA....... 74
TABLE 6: SUMMARY RATIOS OF PAIRS TRADING STRATEGY............................................................... 75
TABLE 7: SUMMARY OF THE RATIOS OF MACD TRADING STRATEGY APPLIED TO YEARLY SYSTEM
INDEX....................................................................................................................................... 76
TABLE 8: SUMMARY OF THE RATIOS OF MACD TRADING STRATEGY APPLIED TO YEARLY S&P500
INDEX....................................................................................................................................... 77
TABLE 9: SUMMARY RATIOS OF THE TRADING STRATEGY AS APPLIED TO THREE DIFFERENT DATA
SET. .......................................................................................................................................... 78
TABLE 10: A SUMMARY OF ADF TEST ............................................................................................. 90
TABLE 11: A SUMMARY OF PHILIPSPERON TEST ........................................................................... 92
TABLE 12: A CORRELOGRAM OF CDF SERIES................................................................................. 95
TABLE 13: FORECASTING WITH OLSQ........................................................................................... 109
TABLE 14: UNIT ROOT TEST............................................................................................................ 112
TABLE 15: SUMMARY OF ESTIMATION OF ARMA (10, 10) .............................................................. 114
TABLE 16: GARCHM MODEL........................................................................................................ 116
TABLE 17 RESULT FROM COINTEGRATION TEST USING JOHANSEN COINTEGRATION TEST......... 120
TABLE 18: RESULTS FROM THE UNIT ROOT TEST.......................................................................... 123
TABLE 19: OUTPUT OF THE ESTIMATION OF THE SHORTRUN DYNAMICS...................................... 126
TABLE 20: SUMMARY OF COINTEGRATION TEST............................................................................ 131
TABLE 21: OUTPUT OF THE UNIT ROOT TEST FOR STATIONARITY..................................................... 135
TABLE 22: OUTPUT OF AUTOCORRELATION TEST ......................................................................... 137
TABLE 23: OUTPUT OF AR AND MA TEST...................................................................................... 138
TABLE 24: FORECAST OUTPUT (STATIC FORECASTUSING THE ARMA) ......................................... 140
TABLE 25: LIST OF RATIOS .............................................................................................................. 141
9
List of Figures
FIGURE 1: A COMBINATION OF 30DAY VOLATILITY AND SKEW OF RETURNS OF THE
SYSTEM PRICE...................................................................................................... 49
FIGURE 2: ACOMPARISON OF A SIMULATE PATH OF A MEAN REVERSION MODEL PATH
AND THE ORIGINAL PATH. .................................................................................... 52
FIGURE 3 JUMP DIFFUSION MODEL ............................................................................... 53
FIGURE 4 AMOVING AVERAGE STRATEGY................................................................. 62
FIGURE 5 AN EXAMPLE OF A SUMMARY OF THE RESULTS OF A TYPICAL TRADING
STRATEGY. SOURCE: FUTURES & OPTIONS MAGAZINE ........................................ 66
FIGURE 6: EQUITY CURVE FOR A TRADING STRATEGY SHOWING FEW PAUSES. ............ 67
FIGURE 7: THE DIAGRAM SHOWS THE DRAWDOWN OF THE OUTPUT OF A TRADING
STRATEGY. ........................................................................................................... 68
FIGURE 8: SYSTEM PRICE DETERMINATIONS................................................................ 29
FIGURE 9: ADAILY DATA OF RANGE PRICE SERIES OR THE CDF .................................. 88
FIGURE 10: ADATA COMPARISON OF SYSTEM AND HELSINKI DAILY PRICES ............... 89
FIGURE 11: ASUMMARY STATISTICS OF THE CDF....................................................... 89
FIGURE 12: ALOG TRANSFORMATION OF THE RANGE SERIES. ...................................... 90
FIGURE 13: ASUMMARY STATISTICS OF LOG TRANSFORMATION OF THE CDF SERIES. . 90
FIGURE 14: QUANTILEQUANTILE PLOT OF THE LOGRETURNS .................................... 99
FIGURE 15: ALOG TRANSFORMATION OF HELSINKI PRICES ........................................ 99
FIGURE 16: LOG TRANSFORMATION OF SYSTEM PRICES ............................................... 99
FIGURE 17: S&P500 INDEX. ....................................................................................... 100
FIGURE 18: LOGARITHMS RETURNS OF THE SYSTEM PRICE ....................................... 100
FIGURE 19: APLOT OF NUMBER OF JUMPS AGAINST RETURNS................................... 101
10
FIGURE 20: ACOMBINATIONS OF 30DAY VOLATILITY AND LOGARITHMS RETURNS
OF THE SYSTEM PRICE........................................................................................ 101
FIGURE 21: MAXIMUM DRAWDOWN OF S&P500 WITHOUT FORECASTING ................ 102
FIGURE 22: RETURNS AND 9DAY EMAAND 20DAY MA SERIES ........................... 102
FIGURE 23: MAXIMUM DRAWDOWN FOR S&P500 WITH ARMA FORECAST .............. 103
FIGURE 24: DAILY PROFIT FOR S&P500 WITH ARMAFORECAST ............................. 103
FIGURE 25: DAILY CUMULATIVE PROFIT FORS&P500 WITH ARMAFORECAST........ 104
FIGURE 26: COMPARING PRICE, MOVING AVERAGE, EXPONENTIAL MOVING AVERAGE104
FIGURE 27: EQUITY CURVE OF S&P500 WITHOUT FORECASTING............................... 105
FIGURE 28: GRAPH OF MAXIMUM DRAWDOWN OF OLSQ APPLIED TO CDF ............. 106
FIGURE 29: GRAPH OF EQUITY CURVE ...................................................................... 106
FIGURE 30: 30DAY VOLATILITY ............................................................................... 107
FIGURE 31: GRAPH OF MAXIMUM DRAWDOWN .......................................................... 107
FIGURE 32: GRAPH OF CUMULATIVE PROFIT .............................................................. 108
FIGURE 33: ERROR SQUARE ...................................................................................... 109
FIGURE 34: RESULT OF FORECAST USING OLSQ........................................................ 111
FIGURE 35:................................................................................................................. 112
FIGURE 36: ASUMMARY OF FORECASTING RESULT OF BOXJENKINS METHOD.......... 116
FIGURE 37: ASUMMARY OF RESULT OF A DYNAMIC GARCHM FORECAST.............. 119
FIGURE 38: ASUMMARY OF RESULT OF A STATIC GARCHM FORECAST.................. 119
FIGURE 39: ERROR CORRECTION TERMSERIES ....................................................... 123
FIGURE 40: RESULTS OF DYNAMIC FORECAST OF VECMMODEL............................ 128
FIGURE 41: RESULTS OF STATIC FORECAST OF VECMMODEL ............................... 128
FIGURE 42: ACOMPARISONS OF A SYSTEM PRICE AND SIMULATED PRICE WITH A
MEAN SPEED OF 0.47 AND A LONG RUN MEAN OF 949.27 WITH A HALFLIFE 1.46129
FIGURE 43: ESTIMATING PARAMETER OF A MEAN REVERSION MODEL USINGLEAST
11
SQUARE ESTIMATION. ........................................................................................ 129
FIGURE 44: SUMMARY STATISTICS OFRETURNS SERIES OF GARCH(1, 1)
ESTIMATION OF THE SYSTEM PRICE .................................................................... 130
FIGURE 45: VARIANCE OF THE SERIES RETURNS ........................................................ 131
FIGURE 46:................................................................................................................. 134
FIGURE 47: THE LOG SERIES OF THE S&P INDEX........................................................ 135
FIGURE 48: OUTPUT FORECAST (DYNAMIC FORECAST)........................................... 140
12
Abstract
The main aim of this dissertation is to forecast shortterm electricity price spread
and to apply a correlation filter to the forecasted returns with the aim of finding
initially the best forecasting tool. A MACD trading strategy is then applied to the
forecasted returns of the best tool, profitability and volatility ratios are then
calculated using Microsoft excel spread sheet set up. This set up consists of an
input data serieswhich can be varied with set of ratios generating different values.
The is an adaptation of Jason al et, (2002) spread sheet models. The applicability of
the models to trading is thus evaluated and conclusions drawn based on the values
of the various ratios.
It is concluded that forecasting tools can be used by traders in their daily trading
activities. Similarly market inefficacies do exist and trading strategies can generate
modest or reasonable amount of profits and losses from these markets.
13
Chapter 1 Introduction
The main objective of the dissertation is to apply academic forecasting tools to
stock market trading. Williams (2003) investigated the above and come out with
the following conclusion: “Regression model…, do have the ability to forecast
EUR/USD returns…, and to add value as a forecasting and quantitative tool “. The
dissertation set out to verify this, but with different data, with different
characteristics and from different markets.
The aim of the topic is to test the usefulness of academic forecasting tools, such as
ARMA to stock market traders. Market traders use two main tools: Fundamental
and Technical analysis. Fundamental analysis is based on their views of the market;
the trading decisions they make are based on for example; on the financial
statement of a particular company or a group of companies. Another example
includes US Federal monetary policies, especially with regard to interest rates.
Whilst technical analysis on the other hand uses day to day price movements as
their means of forecasting price trends which can be upwards of downwards.
Some of their tools include moving average, range trading trading between low
price and high price; other indicators are used to reach some of these decisions.
Two different data sources will be used. These are Nord Pool electricity and US
S&P500 index prices. These markets are entirely different, one is power based,
which exhibits peculiar characteristics such as: seasonal cycles, price spikes and
high volatility, whilst the other mainly based on equities of 500 companies from
wide range of backgrounds. In this regard S&P500 will be used as proxy for the
perfect market. Firstly each of these will be forecasted, with the aim of using the
ratios to compare the forecasting ability of these tools. Secondly, a moving average
14
trading strategy will applied using the outofsample data to measure the risk and
profit of the forecasting tools. Finally the moving average strategy will be applied
directly to the prices of both markets as a means of testing whether traders can
profit without the use of the academic forecasting tools. An Excel spread sheet will
be set up to do the moving average strategy calculations – which include ratios,
graphs and charts.
400 prices from 01January2002 to 31December2002 will be used. 250 of this
will be used insample for estimation of the various models; the rest will be used as
outofsample data mainly for forecasting and testing moving average strategy.
Four main forecasting tools will be use to forecast the Nord Pool and S&P 500
prices. The insample data will be used for estimation and optimization purposes,
whilst the out of sample data will be used for the forecasting. The various ratios
will be rank and compared with the aim of finding the best forecasting methods.
Secondly a moving average trading strategy will be tested using the forecasted data
values, with the various risk and profitability ratios computed. The result of the
strategy will be then compared to find out which of the forecasted tools provided is
the best. Dissertation is divided into five chapters. Chapter 2, Literature Review
examines previous articles, books and other works that have been studies by
several researches. Their approach and methodologies will examine with the aim of
identifying strength or weakness in each of them and if possible extend and
improve on them.
Chapter 3: “Methodology & Method”describes the various research
methodologies, tools and ratios that are going to be used in the dissertation. Some
of these includes, forecasting tools, technical analysis ratios. Simulation of
electricity prices will be examined with the aim of identifying, prices hikes,
15
volatility and any other characteristics. A review of the Nord Pool as well as
S&P500 markets will also be examined. Data analysis and dynamic of each of the
price data will be look at. Finally, in addition to comparing forecasting techniques
as applied to electricity, the relationship between Spot/System price, Futures,
Forwards and CDF of Nord Pool will be examine using simulation techniques and
looking for evidence of unique characteristics. Chapter 4: “Findings” – discuss on
the basis of data analysis the usefulness and limitation of “academic” forecasting
tools to market participants. A general summary of the output of the results which
includes description of statistics of the various test will be in this section.
Chapter 5: “Conclusion”This section provides a summary of the observation of
price developments, estimation, procedures and the relevance of the forecasting
tools and their usefulness to market traders in the two markets.
16
Chapter 2 Literature Review
Introduction
Futures sport price exhibit features such as: mean reversion, seasonal effects,
time varying volatility and volatility clustering, extreme values/spikes, time of the
day effects i.e. price variation during the day, week days, weekends and the
beginning of the week. Couple with the fact the electricity is nonstorable in other
words cannot be use to arbitrage price. However, Clewlow al et, (2000), argued
that inputs such as coal, gas, nuclear fuels, are in fact storable, therefore cost
associated with transmission, purchases, storages, tolling and other charges, must
be taking into account in the arbitrage pricing model. This introduces complexities
of power data and modelling must be therefore be understood and embraced by the
modeller. In addition the demand and supply shocks introduce regimeswitches.
There is therefore the need to obtain an accurate forecast of the electricity spot
prices and to take into account the feature listed above. The next section examines
some of the main research which has been done. In addition the various
methodologies and conclusion drawn will also be looked at.
Jason et al. (2004) studied the use of correlation filter as a measurement of
performance of the spread trading models. They used a data which consist of daily
closing prices for the period 1995 till 2004 of WTI Light, sweet crude oil futures
contract and Brent Crude oil futures contract. Neural network Regression was used
as a bench mark model against other methods of forecasting such as Moving
Average, ARMA, Cointegrating ”fair value” model. The forecasted sample was
then exported to excel and both a standard and a correlation filter were applied.
Their findings suggested that ARMA model is the best. The ideas and concepts
from this paper inspired the dissertation. They concluded that “the correlation
17
filter can provide traders with a useful way of improving the performance of
spread trading and subsequently should be studied further”. However, their
conclusions were based on single market. In other words data from different market
such as electricity which has features like volatility clustering, jumps, seasonal and
regional variation are likely to give different results if theses are not taken into
consideration. Their research was from an academic view point which is usually
frowned upon by market traders. In addition part of their research was based on
moving average which is trend recognition and unidirectional which has a
disadvantage of lag in the data. This is usually resolve by practitioners using
countertrend systems such as Bollinger bands which takes into consideration
volatility, peaks and trough within a certain range. This also includes protective
stops which minimises unlimited losses. I would therefore like to extend this
research by making this relevant to market by using tools used by traders on a daily
basis. The other aspect of Evans et, al; that is of interest is the extension of Holmes
et, al (2003) “Fair Value” approach. In their conclusion they stated that the fair
value principle is an example of a test in market efficiency. In which both arms of
the spread contracts are “efficiently priced”. Based on this they tested the predicted
value of the spread using Technical analysis models. The data on which their
research was based is oil futures which are considered as a commodity and whose
price follows a random walk. The general acceptance of their conclusion could be
stronger if they had used data from other sources or markets. Their approach will
be used but with different data and productelectricity.
Hadsel (2006) uses TARCH to examine the returns in electricity futures volatility.
Evidence from his study confirmed; “asymmetric reaction of traders to new
information”. Traders reacted by “increasing trading volume and adjusting prices
to a new equilibrium”.
18
Weber et, al (2007) extended ARMA models by using it to forecast dayahead in
electricity markets. The combination of Gaussianmixtures and switchingregime is
similar to the ARMA models. They concluded that GARCH approach captures the
fat tail in the price distribution. In other words “high volatility coincides with
strong price change”.
Mark et, al (2003) used EUR/USD returns to investigate regression models as a
tool for trading and investment. Neural network (NNR) was used as a bench mark
model against BoxJenkins type of regression models. They concluded that,”
regression models and in particular NNR do have forecasting abilities and an
added tool for quantitative trading”. The literature above assumes deterministic
price volatility, but evidence from electricity markets suggest otherwise. It is
therefore appropriate for the modeller to use models which incorporate loads,
weather and plant variables. In other words, cyclical patterns that dominate electric
spot markets must be considered. This includes the socalled: hourof theday
effects, dayoftheweek as well as seasonal effects. These will be included in
models by the use of dummy variables. The various models used by previous
researchers for forecasting commodity or electricity will be discussed in this
section. Both linear and nonlinear series will be considered. Each of these will be
derived and discussed. In addition the suitability of the model to the data will also
be looked at.
The dissertation will also examine and apply a paper by Bachelor, et, al, 2007.
They examine sport and forward rates in freight rate assuming shipping is a non
storable service; using the Forward Freight Agreement (FFA) market using
forecasting methods such as vector equilibrium correction (VECM), ARIMA and
VAR. They found out that the ARIMA or VAR provided a better forecast of spot
rate. The test was based on the following assumptions: firstly the FFA market is
19
small and new; secondly they regarded the forward rate as a services which is not
storable, suggesting that there is no arbitrage between the spot and futures rates –
non existence of cost and arbitrage relationship; finally, the FFA market is made up
of hedges rather than speculators – as speculation often leads to biased with regard
to forecasting. They concluded that the spot and forward rate do not cointegrate
which was contrary to their expectation.
TaiLeng (2006) studied the profitability of directional indicators such as
Directional Movement Index (DMI) trading rule. Their aim was to test DMI trading
strategy to Hang Seng, KOSPI, Nikkei 255 and TWSE then compare this with the
UK and US stock market. Their result concluded that the strategy performed well
with the Asian market with the DMI. In addition they found that buyandhold
strategy did provide more positive returns for the Asian, UK and US data. In effect
their research was to test market efficiency; they found out that the US/UK markets
are more efficient than the Asian markets. If that is the case then one will be forced
to conclude that, technical analysis does not have any predictable ability. However,
their result was inconclusive in this regard.
Weber (2007) applied ARMA in conjunction with GARCH, Gaussianmixtures to
model electricity price German data. Their conclusion was that the “extended
model” did actually capture the characteristics often exhibited by power data, and
hence recommended the forecasting abilities of theses models in general and
ARMA in particular.
Williams M (2003) investigated the predictability of regression models for the
forex markets. Their results confirmed the forecasting ability of these tools;
however their study did not test the suitability of these tools to different markets or
data.
20
Burgess (2003) used daily closing price of the STOXX 50 index to examine the
potential of Cointegration techniques to hedging and trading international equities.
He used the properties of Cointegration, which assumes that if Cointegration exist
between two of more variables, it is possible to establish a longterm equilibrium
relationship, which included an error correcting (ECT). This error term can be
classified as mispriced which opens up opportunities for arbitrage. I addition the
ECT can used in statistical arbitrage trading strategy in general and pairs trading in
particular. Since the ECT model is an equilibrium model; which tend to revert to its
long term mean; it is this property which enables it to be used for hedging and
trading purposes. The result from his study provided a further proof of the
usefulness of, statistical forecasting tools to trading.
Chaun et al. 2001 applied two technical trading rules moving average (MA) and
Channel rules (CR). They applied this to 13 Latin American currencies. In addition,
the use of their research is to find out whether theses markets are efficient. They
found out that four of the currencies showed positive returns for MA and only three
for CR. The four countries include: Brazil, Mexico, Peru and Venezuela and the
remaining three, Brazil, Mexico and Venezuela. Their result suggested that the
difference in the returns of the trading rules was due to statistical properties
peculiar to the various currencies, which calls for further research.
Bracj et al. 92, tested technical rules namely moving average (MA) and Trading
range break (TRB), using Dow Jones Industrial index data from 1897 to 1980.
Their result proved highly positive returns from these technical rules. However the
returns from “academic” tools such as AR(1), GARCHM, random walk and
Exponential GARCH models, were not consistent with the trading rules. Their
studies focused on simple trading rules we the hope that it can be further extended.
Their result proved that technical analysis does have predictable ability over the
21
academic ones. In addition the found out that technical analysis do account for the
patterns in stock prices which cannot be accounted for by AR models. These
patterns include returns for long signals are larger than that for short.
Marshal et al. 2006 used CRISMA a technical trading system, which is a
combination of momentum, volume and relative index indicators to examine the
profitability of trading system. They used CRSP stock from 1976 to 2003. Their
funding suggested that the system did not provide consistence returns. Previous
researcher however used small samples which provided consistent returns. Thus in
their final conclusion they suggested that profitability of any trading system
depends on the sample size.
Burgess (1990) in his thesis examines the Statistical Arbitrage (StatArb) model as a
low risk trading tool. A StatArb is an application of statistical and computational
techniques to exploit the short term fluctuations or mispricing of stock prices. A
simpler form is pairs trading; which involve buying one share and selling the other,
unlike pairs trading, StatArb exploits the mispricing of more than two shares in a
portfolio, by buying one set and selling the other. Neil Burgess used Cointegration
as the main statistical tool for his thesis. He selected series of cointegrated stocks
and then modelled the mispricing using the Error Correction model concept, with
the aim of capturing the mispricing of the stock in the portfolio. Finally he used a
risk minimizing techniques to select the best stock for the portfolio. The closing
prices of the FTSE 100 index and other indices were the main source of data. He
concluded that statistical and computational methods do have practical application.
Furthermore the model ensured profitability with or without transaction cost under
certain risk limits. However in his views the result was inconclusive, since the data
used were historical, which did not take into consideration, real data in a trading
environment. In spite of this, he concluded that computational and statistical tools
22
do in his own words, ”demonstrate significant potential”, hence calls for further
research.The next section gives a brief description of the models that are widely
used by researchers.
Autoregressive moving average
The ARMA model assumes a set of data with an error term that normally
distributed. The general model is of the form:
t
Y =
t i t
q
i
i i t
p
i
i
Y c c 0 p u
~
0 1
+ + +
÷
=
÷
=
¯ ¯
.
Where: c
~
is a random error component with zero mean and variance
2
~
o ; with p
denoting the maximum number of lags on
t
Y .This model is made up of two
components, autoregressive (AR): Y =
t i t
p
i
i
Y c p u
~
1
+ +
÷
=
¯
and moving average
(MA): Y =
i t
q
i
i ÷
=
¯
c 0
0
. The observations are usually calculated based on previous
values. An extended form of the ARMA model is ARIMA (p, d, q)
q t q t t p t
d
p t
d
t
d
Y Y Y
÷ ÷ ÷ ÷
+ ÷ ÷ + A + + A + = A c u c u c p p u ... ...
1 1 1 1 0
Where:
1 ÷
÷ = A
t t t
Y Y Y . The parameters are estimated by applying the maximum
likely hood estimation procedure to the density function of the distribution.
The generalizedautoregressiveconditional heteroscedasticity (GARCH)
This GARCH(r, p) model is as follows:
t t t
r ¸ o + =
¯ ¯
=
÷
=
÷ ÷
+ + =
p
i
i t i
r
i
i t r t i t
d
0
2
0
2 2
o  c ì e o . The parameters of this model are usually
estimated using the maximum likelihood principles. The error terms are assumed to
be random and follow a normal distribution. There are different types of GARCH
23
models; which are distinguished by their parameters and most are suitable for
electricity price modelling; as they tend to capture the extreme volatilities. The
simple GARCH (1, 1) is sufficient in most hence it is going to be used in this
dissertation; however different parameters can be used to determine an appropriate
model.
Naïve methodology
The Naïve or random walk model is of the form:
1
ˆ
÷
=
t t
Y Y +
t
c , where
t
c , is a
random error. Random walk is not meanreverting, in other words the price does
not return to the mean of the prices. Its trend cannot therefore be predictable. The
Naïve model is simple and enables us compare actual values with forecasted ones.
It does not take into considerations factors such as trends, seasons and in addition
requires a minimal amount of data.
Error Correction Model (ECM) methodology
The ECM assumes that if variables
t
Y and X
t
are nonstationary it is possible to
find a linear combination of both variables which will be stationary. A combination
of first difference and lagged levels of cointegrated variables forms equilibrium
model:
t t t t o t
X Y X Y u u   + ÷ + A = A
÷ ÷
) (
1 1 1
or three variable
version:
t t t t t t o t
X Y X Y u u u    + Z ÷ ÷ + AZ + A = A
÷ ÷ ÷
) (
1 1 1 0 1 3 1
, were
1 1 ÷ ÷
÷
t t
X Y u is
the error correction term (ECT). Furthermore provided that
t
Y and X
t
are co
integrated with cointegration coefficient u , the
1 1 ÷ ÷
÷
t t
X Y u , will be I (0) even
though the constituents are I (1). ECT is a short term deviation from the longrun
equilibrium position. If such deviation exist, then it is possible to exploit it for
speculative profit. Burgess (2003) examined this technique in his thesis. Similarly
Law et al (2004) used the above techniques to test for market efficiency of futures
market. They used a simplify version of the model:
24
Y=a +bX +e
According to them for the requirement of market efficiency the following four
conditions must hold:
i. Y and X must be of the same order
ii. Y and X must cointegrate
iii. B the slope equation must be equal to 1, with the constant a=0
iv. The forecasted error must not be correlated.
In other words for a short term efficiency, ECT must exist. They held the view
shared by other researchers, by stating that for inefficient market traders can take
advantage of this to make profits. Their final conclusion stated that a fair amount of
profit and losses could be made by using trading strategies. This conclusion will be
tested using different trading strategies and data. The trading strategy will be tested
whether the market is efficient or not.
The recent growth of energy exchange such as Nord Pool has generated a lot of
interest in modelling and pricing electric futures. The next section gives an
overview of markets associated with this exchange.
25
European Electricity markets: an Overview
Nord Pool power markets embraces Finland, Sweden, Denmark and Norway,
emerge as a result of deregulation that is sweeping throughout Europe and the rest
of the world. Deregulation broke government monopoly over power generation,
paving the way for private sector participating in the sector thereby increasing
generating capacity and transmission efficiency. Power is now considered to be a
tradable competitive commodity  it can be index like any other commodity;
making it an important tool in a free market economy. This has made Nord Pool a
multi billion market which is rapidly evolving and developing. Risk management
practices which are common with financial assets such as stokes and bonds in the
new market. The Nord Pool sports market is called Espot Market. It is an auction
based for trading in physical power, which uses bid for buying and selling. There
three types of bids: hourly, block and flexible. Market participants after submitting
their bids a spot price usually called system Price is calculated by using aggregate
supply and demand curves. The intersection of these two curves forms the system
Price. The system price is a reference price for all contracts traded in the derivate
markets. It takes into consideration consumptions variations – plans closure, fuel
prices, seasonal variation, reservoir levels and other bottlenecks that affect the four
Nord Pool members. To be able to model power prices effectively there is the need
to understand factors influencing power prices. There is a general view held by
researchers about the unique features exhibited by electric prices. These views
include: non storability of electricity; seasonality; price spikes; transmission
bottlenecks. Nord Pool specific reasons for power prices various are not so much
different. Their annual report of 2006 provided reasons for theses price fluctuations
26
excerpts of which follows:
Economic Factors
The main economic factors which influences prices was identified in the report
these are: Level of economic activity; currency movements and generating
capacity. Increasing generating capacity brings into its wake increase in supply
with its attendant low prices, depending of other relating cost. Business cycles with
Europe and the rest of the world affects power generating inputs such as coal, any
fluctuation in prices of any of theses do affect power prices in the Nord Pool
generating area. Most of the raw materials used in power generation are priced
using the US dollar which is subjected to fluctuations. Nord Pool benefits if the
exchange rate is low but loses if it is high.
Weather and temperature condition
Nord pool electricity is generated from sources such as hydro, nuclear and coal;
any factor the affect theses source is likely to affect the supply and consequently
the prices. Similarly, rain, snow tends to raises the level of the rivers that feed the
turbines consequently increasing supply thereby reducing prices. Thus, periods of
high precipitation leads to high supply and lower prices; while a low precipitation
means lower supply and high prices.
Finally temperature trends within the year do affect prices. For instance colder
temperatures in winter month’s results I high demand for electric and consequently
high prices.
Electricity transmission bottle necks affect prices in two ways; firstly limited
capacity in the networks tends to affect supply and demand. If the demand exceeds
supply in such areas, prices would tend to rise. Secondly, other nonNordic markets
27
trade with Nord Pool with recorded inflows and outflows, power supply and
demand in these markets also affects prices.
Commodity Prices
The cost of commodities such as coal, raw which serves as inputs or raw
materials for power generation affects prices significantly. Regional generation
stations in European rely on identical inputs  these two markets compete for this
essential commodity, thus pressures due to supply and demand have an enormous
influence in price determination in the entire region.
Carbon dioxide emission allowance (EUA), a recent phenomenon is a tradable.
Inputs such as coal, gas do emit carbon dioxide, thus generating stations are
required to buy EUA and the cost is therefore incorporated in pricing of power.
Nuclear power stations account for 30% of the power supply, any factor the affects
the power stations will also affects power prices.
Thus the key factor listed above explains, seasonality, cyclical pattern and
occasional dramatic price change – spikes followed by return to normal levels
explains the System Price path. These unique features of power markets present a
challenge and thus call for new models development and study.
The Financial Markets
The Nord pool ASA is one of the third arms of the Nord Group; this financial
Market is made up power producers, retailers and stock brokers. The aim of theses
participants is to use the contracts traded in this market to manager their risks.
Contracts traded includes: base load futures, forwards, options and contracts for
difference (CFD).The futures contracts consist of: day contracts base load for the
period of 24 hours; weekly contracts; base load for a period of 7 days. The
28
Contracts period ranges from eight to twelve months. The future settlement uses a
daily marktomarket settlement and a final settlement of cash which is a difference
between final closing prices and the System Price. Daily gains and losses are
reflected in the marktomarket settlement. The Forward on the other hand consist
of three seasonal contracts, which is also contract marktomarket; however any
profit and loss is accumulated and realised at the end of the trading period.
Option Contracts
Options contracts are one of the derivatives traded at Nord Pool ASA which offers
risk management strategies. Option traded is mainly European in nature, which is
exercisable only at the exercise date. Most of the contracts consist of quarterly and
yearly forward contracts. New contracts are listed at the expiration of the old ones.
Exercise day is usually the third Thursday of the month before delivery. Strike are
normally set buy the pool, with a price which is usually quoted in EUR/MWH and
a tick size of 0.01 EUR. Well know option strategies such as straddles; strangle
which combines calls and puts are used by traders wanting to make profit.
Contracts for Difference (CFD)
An alternative to futures and forwards contract is the CFD, which is the difference
between and area price ant Nord Pool System Price. CFD is considered to be a
forward contract that is used to exploit prices differential in the System price.
Growth
According to the 2006 Account Statement, Nord Pool is the largest Power
Exchange in Europe with volume of trade amounting to 2220 with market value of
Euro 79.2 billion traded in the Financial (OTC) trades alone an increase of 3% and
51.35% in the previous year. Similarly contracts in the financial market in 2006
29
amounted at a value of 766Twh with a corresponding value of Euro 36.3 billion
and a total transaction of 89147 and increase of 2.55%, 52.57% and 16.81%
respective love the previous years. Thus the market has seen a phenomenon growth
over the reporting period.
S&P500 Index
The S&P 500 index is made up of 500 leading companies in the US, with about
70% of all US stocks/equities. It has a market capitalization of 12,867 billion
dollars. Some of the sectors include energy, industries, information technology,
telecommunication services, consumer staples, health care and banks. Theses
companies include world renowned ones such as: Microsoft, Cisco Systems,
General Electric, AT&T, just to mention a few. Thus the S&P500 can be used as
proxy of a perfect market; it also has an added advantage of reflecting the common
risk and returns of the various sectors as enumerated above.
Figure 1: System Price determinations
Source: Nord Pool
30
A few researchers has research into mainly modelling and pricing of electric
futures; but little in terms of modelling and forecasting an important product such
as Contract of Difference(CDF), which is actively traded in that exchange and
other exchanges. The aim of this dissertation is to apply the methodologies and
tools enumerated in the literature review, to power price data. Common statistical
and forecasting tools which are available to most researchers will be used to model
and forecast the price data with the aim of finding out any predictability power and
whether the results can be exploited by market traders in identifying opportunities
presented by these tools.
Technical Analysis: An overview
Technical analysis is a method used to analyse past data with the intention taking
investment and trading decision. Techniques have been developed to determine for
example: trends, cycles commonly found in market data. Market traders generate
profits by following the market trend which can be an uptrend, downtrend or range
bound. Chapter 3 introduces some of theses trend measures and the signals they
often generate and finally the main strategies often associated with them. The
indicators are constructed by using a formula to transform a price data series into
another. Theses indicators are of graphical nature usually plotted on the price data
or in most cases below it.
The measures that are going to be considered includes: Relative Strength
Indicator, Moving Averages, Exponential Moving Averages, Moving Average
ConvergenceDivergence and Bollinger Bands, since these are the commonest
tools used by market practitioners for analysing these trends.
31
Figure 2: Graph showing moving average on the price data; Volume and MACD
indicators at the bottom, traders use these indicators for short term forecasting.
32
Chapter 3 Methodology & Methods
Introduction
This chapter examines the forecasting models in detail, their properties, method of
constructing, evaluating and comparison. The final section briefly examines models
of some of the technical indicators and a list of trading rules often used in
conjunction with them. The remainder of the section provides a list of some of the
profitability as well as volatility measures which is used to compare the forecasting
abilities of the trading strategies.
Box Jenkins or ARIMA methodology
Box Jenkins classical methods are one of the best econometric forecasting tools. It
embodies model identification, evaluating or estimating and model validating. Box
Jenkins methods unlike random walk model are mean reverting and stationary.
They have other properties such as, trending, deterministic, which makes them
useful forecasting tools. This section examines some of these models.
ARMA (p, q) and ARIMA (p, d, p) models
The autoregressive (AR) model is a class of time series denoted by AR (p) and of
the form:
t p t p t t
Y Y Y c p p
~
...
1 1
+ + + =
÷ ÷
t =1, 2… T. 3. 1
=
t i t
p
i
i
Y c p u
~
1
+ +
÷
=
¯
3. 2
Where: c
~
is a random error component with zero mean and variance
2
~
o ; with p
denoting the maximum number of lags on
t
Y .
33
Similarly the Moving average (MA) model is of the form:
q t q t t t
Y
÷ ÷
+ + + = c 0 c 0 c ...
1 1
3. 3
=
i t
q
i
i ÷
=
¯
c 0
0
ARMA (p, q) model is a combination of moving average (MA) and autoregressive
(AR) process. It is unvaried in nature and therefore suitable for modelling spread
series. It is capable of predicting futures values using past values of a data,
provided an appropriate values for p and q are chosen, it also has the capability of
mimicking any stationary series of interest without an economic theory. ARMA
models are traditional method of modelling electricity prices. The ARMA (p, q)
model is of the form:
t
Y =
t i t
q
i
i i t
p
i
i
Y c c 0 p u
~
0 1
+ + +
÷
=
÷
=
¯ ¯
3. 4
ARIMA (p, d, q)
ARIMA (p, d, and p) model is and extension of ARIMA (p, q) model with an
additional parameter d which is the difference factor responsible for transferring
nonstationary series to a stationary one. It is of the form:
q t q t t p t
d
p t
d
t
d
Y Y Y
÷ ÷ ÷ ÷
+ ÷ ÷ + A + + A + = A c u c u c p p u ... ...
1 1 1 1 0
3. 5
Where:
1 ÷
÷ = A
t t t
Y Y Y .
Fitting an ARMA model to a data involves: model identification or test for
stationary; estimation of parameters; finally a diagnostics test which includes
checking for the significance of the parameters.
34
Vector error correction model (VECM) & Vector Auto regression
(VAR) methodology
VAR can be used to forecast electricity prices since it does not need any theoretical
justification for its use. It is capable of explaining the random disturbances that
influences the spreads, since it treats the two arms of the spread as endogenous
variable. In addition is also enables the impact of demand and supply as well as
regimeswitches between static and dynamic volatile periods to be incorporated
into the model. The model for Spot(S) and Forward (F) are:
VAR (p);
t j t
p
j
i i t
p
i
i o t
F S S c o c c
+ + A + = A
÷
=
÷
=
¯ ¯
1 1
. 3. 6
t j t
p
j
i i t
p
i
i o t
F S F c o c c
+ + A + = A
÷
=
÷
=
¯ ¯
1 1
3. 7
VECM (p)
t t t j t
p
j
i i t
p
i
i o t
F S F S S c   k o c c
+ ÷ ÷ + + A + = A
÷ ÷ ÷
=
÷
=
¯ ¯
) (
1 1 0 1 1
1 1
3. 8
t t t j t
p
j
i i t
p
i
i o t
F S F S F c   k o c c
+ ÷ ÷ + + A + = A
÷ ÷ ÷
=
÷
=
¯ ¯
) (
1 1 0 1 2
1 1
3. 9
35
General VECEM (p)
t t t t l t t t o t
G F P G F P P u ¸ ì o     ˆ ) (
1 1 1 0 1 3 1 2 1 1
+ ÷ ÷ ÷ A + A + A + = A
÷ ÷ ÷ ÷ ÷ ÷
; 3. 10
With error correction model term (ECT):
ECT=
1 1 1 0 1 ÷ ÷ ÷
÷ ÷
t t t
G F P ¸ ì or
R
t
=
t t
R c p o + +
÷1
where:
t
c ~N (0, ) o 3. 11
The error correction term defines the long term relationship between variables
and the speed of adjustment is denoted by the parameters:
1
k ,
2
k , a value of zero
reduces the VECM to VAR.
Cointegration method
Long term relationship between variables can be modelled using cointegration.
If variables are cointegrated then the spread deviation will not depart from the
long equilibrium position in the longrun. Trading strategies can then be set up if
the variable cointegrated otherwise the spread will deviate without bounds thereby
making the spread a risky one.
Testing for cointegration requires the series to be nonstationary at the prices
level with the same order of integration. A stationary series has the additional
property of a constant mean and a constant variance and independent of time. We
are going to test for cointegration using Johansen approach. Let consider the
following equation:
t t t
Y Y c p + =
÷1
3. 12
If 1 = p , equation (1) is said to be integrated of order 1 I(1) and nonstationary and
of unit root. A unit root can be tested by using augmented Dickey Fuller (ADF) and
Phillips Peron tests. The test uses the following model:
36
3. 13
Where, Y indicates the various prices and
1 ÷
÷ = A
t t t
Y Y Y with n the number of
lags. The test will examine whether the coefficient
1
 is < 0, an indication of
stationary series. The null hypothesis to be tested is: H 0 : = 
o
against an
alternative of: H 0 :
1
<  . A rejection of the null hypothesis indicates the presence
of a unit root. If the first difference of the series is stationary, ADF and Phillip
Peron test will suggest, the presence of unit root.
In addition a test of the presence of auto correlation is to be conducted using LM
test. If the test suggests the presence of autocorrelation, further test should be done
by adding lags variables until autocorrelation was removed.
The first difference rejected the null hypothesis of a unit root at levels, 1%, 5% and
10% respectively. This is an indication that System and Helsinki spread series are
stationary and thus can be modelled in a cointegration relationship.
The next section introduces pairs trading; an application of ECT concept; which is
a Statistical Arbitrage method in its simplest form. The System and Helsinki prices
will be used to model a portfolio which will be tested later using a moving average
strategy.
Cointegration “Fair Value” ApproachPairs Trading modelling
Cointegration test enable us find whether an economic relationship exit between
the two variables in the spread. If, it indeed exits, then there must be a temporary
widening of the spread in either direction and in addition the two arms of the
spread must be capable of reverting to the long term mean. This will enable traders
to short (buy) the spread. This amounts to testing for statistical arbitrage. Johansson
i t
n
i
i t t
Y Y Y c    + A + + = A
÷
=
÷ ÷ ¯ 1
3
2 1 1 0
37
cointegration test is use to find a longterm spread equilibrium. Firstly an in
sample is used to find the co integration vector (ECT):
ECT =PP
t

t
GP o 
t
PF  = PP
t

t
S . 3. 14
“The fair value of the spread is then calculated”, based on the above relation
The trading signals are as follows:
If PP
t
<
t
S . , then go long the spread until fail value is gained, similarly
If PP
t
>
t
S . then go short the spread, until a fail value is regained.”
Evans & Laws (2004), the standard and correlation filters are then applied. The
result of the Cointegration test of the System and Helsinki prices proved that they
cointegrated with [1,0.019635] as the Cointegration vector. As a result it is
possible to form a portfolio, V of the two asserts of the form: V (t) =100S
t

1.9635H
t
.The trading strategy is: buy if V>0(mean), sell otherwise. The mean in
this regard can be the moving average of the portfolio values. If transaction cost k
is included; the new trading rule becomes: Buy if K MV V > ÷ , sell otherwise;
with the moving average, MV=
¯
÷
=
÷
1
0
1
m
i
i m
V
m
.
The next section examines the two main volatility models which are going to be
used in the forecasting processes.
38
Volatility Model methodology
Introduction
On examination of the System price reveal that they are very high during winter
and summer months. Other period tended to be relatively stable but price spikes
appear to be evenly distributed throughout the period under study. This behaviour
patterns suggest a nonconstant variance or time dependence, which is an
indication of a random volatility. This particular behaviour is commonly seen in
commodities prices such as crude oil, interest rates and equities. The best model
which explains this phenomenon is Autoregressive Conditional Heteroscedasticity
(ARCH), they have been shown to model leptokurtic distribution effectively. Some
of these models will be considered in next section.
Comparing simulated futures price volatility and GARCH (1, 1)
The Schwartz single factor model can be used to simulate the System Price:
The following model is going to be used: t t X X X
t t t t
A + A ÷ + =
÷ ÷
c o u o ) ˆ (
ˆ
1 1
GARCH (1, 1) Model
GARCH (1, 1) is one of the stochastic volatility models. It models data with
varying volatility it is of the form: r
t
= c +
t
c with,
2
1 2
2
1 1 0
2
÷ ÷
+ + =
t t t
w w w o c o .
Where;
2
t
o is the conditional variance of the returns and
2
1 ÷ t
c ; the squared random
error component, r
t
is the logarithm of the returns, define as: r
t
=log ) (
1 ÷ t
t
S
S
; and
S
t
is the System Price.
39
TARCH Model with seasonal dummies
Electricity prices have been observer to exhibit a period of static volatility
followed by period of dynamic or large volatility of volatility clustering due to
seasonal patterns. There is therefore the need to use a model which captures
theses features. In addition the assumption of constant variance no longer
appropriate in this situation. A GARCH model which allows the variances to be
conditioned on the past errors is the most is the best in this situation. TARCH or
Threshold ARCH is one variant of GARCH models has additional property of
capturing asymmetric response in electricity futures prices. In addition it
captures persistence and meanreversion. The following model will be used:
t t t
r ¸ o + =
¯ ¯ ¯ ¯
+ + + + =
=
÷
=
÷ ÷
=
÷ i
p
i
i t i
r
i
i t r t i
q
j
j t j t
D d o o  c ì c o e o
0
2
0
2
1
2 2
. 3. 15
Where d
t
=1 if 0 <
t
c and 0 otherwise; where: D
i
represents the various
monthly dummies. According to Eviews 5
TM
:
“Good news means , 0 >
÷i t
c and bad news
0 < ÷i t
c , have differential effects on
the conditional variance; good news has impact on
i
o , while bad news has
impact of
i i
ì o + . If , 0 >
i
ì bad news increases volatility, and we say that there is a
leverage effect for the ith order. If 0 =
i
ì , the news impact is asymmetric”
TARCH (1, 1) model is of the form: + + + + =
÷ ÷ ÷ ÷
2
1 1
2 2
1
2
t t l t t t
d o ìc oc e o Seasonal
dummy variables and a mean equation:
t t t
r ¸ o + = .Longterm variance =
ì  o
e
o
5 . 0 1
2
÷ ÷ ÷
= 3. 16
40
The GARCHM volatility model has been found to incorporate the mean equation,
and therefore provides a good forecast, thus it will be used as the main forecasting
tool for volatility.
Summary
We have examined the properties of the main forecasting tools, which include
Random walk, Box Jenkins and GARH volatility models. The strength and
limitation and the context under which they can be applied was also explained.
Finally the concept of Cointegration was also examined. In the next section the
actual series will be model, examine, with an additional aim of finding properties
such as: stationarity and meanreverting. The existence of these properties will lead
to a possible model for the data.
Spread Series
This section will examine the suitability of the meanreversion model as applied to
electricity futures prices, using test for normality and mean reversion. The
logarithms returns are going to be examined for leptokurtic behaviours using
quintile plots, kurtosis and skewness. If the statistics indicate a small negative
skewness and high kurtosis the jump diffusion process is appropriate for modelling
the future price. Finally, a clear understanding of sport futures price dynamics will
be explored in this section. The data to be used consist of closing prices of the
following futures: System Price (SP), Helsinki Price (HP). The period of the data
is from 29/12/03 to 31/12/04, with all data coming from Nord Pool (NP).
41
The following formula show how the spread series R
t
 CFD is defined as:
“R
t
=
÷
÷
t
t t
HP
HP HP
1

÷
÷
÷
1
1
t
t t
SP
SP SP
3. 17
Where:
SP
t
= System spot price at time t
SP
1 ÷ t
=System spot price at t1
HP
t
= Helsinki spot price at time t
HP
1 ÷ t
= Helsinki at time t1
Laws et, al (2004).
42
Data Description
Daily closing settlement price from the Nord Pool Power Exchange, with data
period spanning between 01/06/200529/12/2006 will be used. This data will be
split into two samples. The first is insample and the second is outofsample. The
insample is used for initial test and modelling. The insample will consist of the
first 250 sample. Whilst the outofsample is going to be use to evaluate the
forecasting accuracy and testing the trading strategies, the last 150 prices will be
used as the outof the sample data. On the examination of CDF daily prices, it was
found to exhibit characteristics already identify by Swider (2006), where they
listed: “daily, weekly and seasonal cycles; high volatility; meanreversion;
frequent prices spikes”. They attributed this short term fluctuations to non
storability of electricity which leads to peak supply and demand not being able to
match. Furthermore a summary statistics of the range series, suggested a non
normal nature of the data, this was confirmed by the JarqueBera statistics. The
data is highly skewed with very high kurtosis which also suggests nonstationarity.
Theses evidences calls for the data to be transformed to make it stationary. A log
difference of the CDF series also showed the spiky nature of the series. The
summary statistics showed an improvement with JarqueBera statistics still
indicating a nonnormal series with very low skew, which is a characteristic of
stock market prices. Swider (2006) and others viewed this characteristic as fat
tails, hence call for a new form of modelling which incorporates conditional
heteroscedasticity modelling. Hence they suggested using ARCH test to the
presence of heteroscedasticity.
On examination of the system price, the JarqueBera Statistics gave a value of
20596.20 which lead to the rejection of the normality of the price distribution. The
43
data was transformed by taking the logarithms of each of the prices. A log
transformation of the data suggested stationarity. A test of unit root to confirm
stationarity using Dickey Fuller (ADF) test and PhilipsPeron test statistics rejected
unit root at significant level of 1%, 5% and 10% respectively. Thus the logreturns
are stationary. The summary for the logreturns showed a very large kurtosis and
skewed data. The JarqueBera statistics rejected the normality of the returns. It
exhibits leptokurtosis and volatility clustering which is a common feature of
financial data. A close examination of the QuantileQuantile plots proved that the
logreturns is not normal, as there were some data at the extreme ends of the
reference line a clear departure from normality. Thus the log returns is leptokurtic
and hence follows a jump diffusion mean reverting process.
Mean Reverting Models with jumps
Merton (1970) initiated the idea of jumps in financial models and subsequently a
lot of researches followed suite. However, the approach used in this section is
based on the one developed by Lumberton et, al (1995). They argued that Black
Scholes model assumes complete market scenarios; rare events such as earthquakes
cannot be modelled using BlackScholes. They proposed discontinuous stochastic
model that in their view captures this jumps as they called it. Thus financial data
with jumps can be modelled by extending the BlackScholes model to cater for
jumps, which a modelled using the Poisson process.
Let N
t
be a sequence of nonnegative independent and identical distributed
random variables, the random variable N
t
is said to follow a Poisson process with
parameter ì with the following probability distribution:
P(
!
) (
)
x
t
e x N
x
t
t
ì
ì ÷
= = x=0, 1 …n
44
With the following properties:
E (N
t
) =ì t, Var (N
t
) =ì t
Let begin the derivation of the jump process by using a risk less asset define by S
(t) =e
rt
Where, r is the interest rate and t the time. Let define the proportion of jumps by
consideration the following random variables: ... ... ,
2 1 k
t t t at the within jumps
times’ define by: .. ,.... ,
2 1 k
t t t and assuming each of the jumps follows a Poisson
process.
Let assume the variables: ,... ,
2 1
w w for t>0 follows a Brownian motion. Finally let
assume the price of the asset is X
t
for t> 0. According to D. Lumberton, B Lapeyre
“
In the interval [
1
,
+ k k
t t ]
dX
t
=X
t t t
dW X dt o u +
At time
k
t the jump of X
t
is given by:
,
k
U X X X X
k k k k
÷ = ÷ = A
÷
t t t t
Thus X
j
t
=X
k
U
k
+
÷
1 (
t
)
So we have for t ] , 0 [
1
t e
t
t
o t
w e X X o
o u
+ =
÷ ) 2 / (
2
Consequently the lefthand limit of
1
t is given by:
1
2
1
) 2 / (
t
o u
t
ow e X X
t
o
+ =
÷
and
1
2
1
) 2 / (
1
) 1 (
t
o u
t
ow e U X X
t
o
+ + =
÷
Then for t ] , [
2 1
t t e
45
) (
1 1
1
2
1
) )( 2 / (
t t
t
t
w w e X X
t
t o u
t
o ÷ + =
÷ ÷
The above process is repeated till we obtain:
t
t
n
J
J t
w e u X X
T
o
o u
+ + =
÷
=
I
) 2 / (
1
) 0
2
1 ( (
With the convention 1
0
0
I
=
=
j
The solution of the deferential equation satisfies the equation:
¯
í
=
÷ + + + =
f
j
N
j
j s
t
t
U X dw ds X X X
1
0
0 0
) (
t
o u
“
Mean reversion is the ability of energy or electricity spot prices to return to a
long term level. Theses are models base on OrnsteinUhlenbeck process and are of
the form:
dP
t
= ( )
t t t t
dW P dt P P o u o + ÷ ln (2)
The model can be amended by adding another term with takes care of jump
diffusion or spikes. This model is the Clewlow & Strickland (2000) jumpdiffusion
meanreversion SDE
dP
t
= ( )
t t t t
dW P dt P P K o o u o + + ÷ ln +P
t t
dQ ì (14)
Where, Q
t
is a Poisson process with intensity k, and jump size ì that is distributed
normally with mean
j
u and standard deviation
j
o . The forecast model is:
j t t
P P ìu  o + + =
÷1 1
ˆ ˆ
. (15)
Clewland & Strickland (2000) estimated these parameters using a Recursive Filter
Which caters for autocorrelation, where,
t
P is the price at time t, the long term
mean is
u
u e =
ˆ
, the speed of reversion rate o and W
t
a Wiener process.
46
Integrating the equation gives:
P
t
=
s
t
t
t s t
o
t
dW e e S e o u
o o o
í
÷
+ ÷ +
0
) (
) 1 (
(3)
The discrete version is:
t
P =c +
t t
P c  +
÷1
(4)
Where c= ) 1 (
o
u
÷
÷ e ,
o

÷
= e
(5)
This equation is an autoregressive process of order 1 i.e. AR (1).
The spread is going to be modelled to include seasonal trend:
R
t
=
t
t
t
AR D c  o + + + +
¯
=
) 1 (
12
1
(6)
Seasonal dummies are included in the model to capture the effect of weather
and to explain the impact of the demand side effects.
Parameter estimation
The parameters that are going to be estimated include: Mean reversion rate, jump
rate, standard deviation of jumps, and average number of jumps. Finally diagnostic
tests will be conducted on all the equations for parameter breaks, outliers and
ARCH effects.
Mean Reverting models with time varying mean
These models incorporate seasonal variation found in electricity prices
dP
t
= ( )
t t t t t
dW P dt P P o u o + ÷ ln (7)
47
Where:
t
u =
¯ t
Day +
¯ t
Month +
¯ t
Hour +Trend
t
(8)
This model has a discrete form:
t
P =
t
o +
t t t
P c  +
÷1
. (9)
This is an ARMA (1, 0) model with dummy exogenous variable which takes
into consideration an hour, day of a week, month of a year.
t
R = ARMA (0, 1) + seasonal dummies.
Simulation of Electricity Prices Returns
Introduction
Monte Carlo method is going to be used to simulate future price using its historic
parameters, since the simulated returns are realistic and closer to the market data.
The parameters to be estimated from the actual market data includes: mean,
deviation, mean reversion rate, jump rates. This is an aid to choosing the right
model. Figure 3.0 shows the logarithms returns of the system price. Theses returns
do fluctuates around zero, which must be due to supply and demand, weather and
market related information.
48
30Day Volatility
0.000
0.010
0.020
0.030
0.040
0.050
0.060
0.070
0.080
0 50 100 150 200 250 300 350 400
time
v
o
l
a
t
i
l
t
y
Figure 1: 30day volatility of logarithms returns of the System price
Figure 1 shows the system price volatility using a 30day rolling returns. The
simulated path appears to capture seasonal patterns due to weather fluctuations,
which is prevalent in most electricity markets
Figure 3.15 show a comparison of the logarithm of the system prices and 30day
rolling standard deviation. An inspection of these two paths show that prices are
much higher in summers and winter as shown by the peaks or spikes. Theses peaks
are spread throughout the whole year.
49
30day volatility & skew
3.00
2.00
1.00
0.00
1.00
2.00
3.00
4.00
5.00
6.00
1 39 77 115 153 191 229 267 305
Time
R
e
t
u
r
n
s
30day skew
30day volatility
Figure 3: A combination of 30day volatility and skew of returns of the
System price
Figure 3.3 shows a plot of 30day volatility and skew. There appears to be a
relationship between skew and volatility, if the volatility is positive skew tends to
be the same, however if the volatility decreases the skew decreases and sometimes
with a negative value. In other words there is a correlation between volatility and
the skew; this is an interesting finding which needs to be investigated further.
Modelling
Schwartz, E (1997) describes a one factor model of the logarithm of
Spot price of commodity prices assuming the prices follows OrnsteinUhlenbeck
mean. The reverting process of the form: dS= Sdz Sdt S o u o + ÷ ) ln
ˆ
( .Equation (3.1)
can be written if a different format by letting X =lnS:
dX = dz dt X o o k + ÷ )
ˆ
(
3.2
With
k
o
u o
2
ˆ
2
÷ =
3.3
50
The speed of adjustment a nonnegative constant k , which measures the rate at
which the mean reverts to its long term mean ofoˆ . If a market risk ì is
introduced, equation (3.1) now becomes:
dX = dz dt X o o k + ÷
' ' '
) ( 3.4
Where: ì o o ÷ =
' ' '
The model is and extension of Geometric Brownian Motion(GM) by incorporating
mean reversion, which takes into consideration the convergence of the spot prices
to its long term mean, thus balancing the supply and demand fluctuations. S is the
spot prices, u
ˆ
is the mean and o the volatility and dz is a Wiener process; o is the
mean reversion rate, which is always positive. The long term mean of the spot price
is e
u
. The drift is given by ) ln ˆ ( S ÷ u o , which is a measure of how the spot price
will drift to its long term mean.
The halflife is
o
) 2 ln(
this measures the time taken for the series to revert to its long
term position.
Equation 3.2 can be stated in the form:
t t t
dW dt X dX + ÷ = p 3.5
It can be show to have a solution of the form:
X
z
t
z t t
t
dW e e xe
í
÷ ÷
+ =
0
p p p
o 3.6
With expectation and variance of:
E(X
t
) =X
o
e
t p ÷
3.7
Var(X
t
) =E ((X
t
[E ( ) )]
2
t
X =
2
o
p
p
2
1
2 t
e
÷
÷
3.8
51
For the purpose of simulation a discretised form of equation (3.1)
X
i
=
1 ÷ i
X + t t X
i i
A + A ÷
÷
oc u o ) ˆ (
1
With S (t) =exp(X
i
) 3.9
Mean Reversion parameter estimation
The various parameters of the mean reversion model can be estimated using a
linear regression. Clewlow & Strickland (2000), method is simple yet robust means
of estimating the parameters of the model, we are therefore going to employed it.
The estimation procedures use discrete form of the continuous model:
t t o t
Y Y c ¸ ì + + = A
1
By plotting
t
Y A against Y
t
the main parameters
o
¸ (intercept) and
1
¸ (slope) can
be from historical price change
t
Y A ; using Excel function STDEV and annualised
assuming a 252 trading days, with the annualised standard deviation taking the
form:
252 o
.
Similarly excel function STEYX  returns the standard error of the predicted y
value for each x in the regression, was also calculated. The remaining parameters
were calculated using the following equations:
o = speed = slope
Log Run mean =uˆ = Intercept/speed
Volatility =STEYS/log run mean
Halflife =ln2/speed
The path is simulated using Monte Carlo method in combination with variance
reduction techniques. This methodology involves using another path which is
negatively correlated with the first one; one additional equation will be needed:
52
X
j
=X
1 ÷ j
+
1
ˆ
(
÷
÷
j
X u o ) t t
j
A ÷ + A ) ( c o 3.3
The average of the two paths is then calculated using the following relation:
X =
k
0.5*(X
i
+ X
j
). The following estimated parameters of o u o , , :
0024 . 0 ˆ , 054 . 447 ˆ , 04 . 0
ˆ
= = = o u o . The following equation was used to simulate
the path: t t X X X
i i i
A + A + + =
÷ ÷
c 0024 . 0 ) 054 . 447 ( 04 .
1 1
.Where ) 1 , 0 ( ~ N c
t A is defined as T/N where T is the time and N the number of intervals. The path is
generated by generating c randomly from a normal distribution.
0.00
200.00
400.00
600.00
800.00
1000.00
1200.00
1400.00
1600.00
1 36 71 106 141 176 211 246 281 316 351
simulate values
Original values
Figure 4: A comparison of a simulate path of a mean reversion model path
and the original path.
Figure 3.0 shows the simulated path and the original, clearly this are similar, thus
show that the original system price is mean reverting.
Simulation of Mean Reversion with jumps
The model to be used in simulation of the jumps is the Merton diffusion Model:
kSdq Sdz SdS dS + + = o u
A discrete form of the model is:
53
) )( ( )
ˆ
(
ˆ
1 1
t t t X X X
i j i i k i i
uA > + + A + A ÷ u ÷ + =
÷ ÷
u ¸c k oc u u o
Where:
k
u = average number of jumps
¸ = standard deviation of the number of jumps
k = average number of jumps
u = number of jumps return/time of jumps
i
u a random variable from a normal distribution
Jump Diffusion
0.00
200.00
400.00
600.00
800.00
1000.00
1200.00
1400.00
1600.00
1 46 91 136 181 226 271 316 361
Time
S
y
s
t
e
m
P
r
i
c
e
Jump_dif fusion
Non_jump path
Figure 5: Jump diffusion model
3.1 Two factor model
The twofactor model was developed by Gibson and Schwartz. It consisted of
two models; with the first following Geometric Brownian Motion (GBM):
1 1
) ( dz Sdt dS o ¸ u + ÷ = (1)
and the second is the instantaneous convenience yield model which is mean
reverting OrensteinUhlenbeck equation:
2 2
) ( dz Sdt dS o 0 o k + ÷ = (2)
54
where: dz
1
and dz
2
following a Browning Motion and correlated with correlation
coefficient p .
If we let X =ln(S) equation (1) can be written as:
1 1
) ( dz Sdt dS o ¸ u + ÷ =
1 1
2
1
)
2
1
( dz dt dX o o ¸ u + ÷ ÷ = (3)
Where: ¸ is the dividend rate with risk adjustment factor r¸ , thus the electricity
price, this factor incorporate the storability of assert. Both equations can be
expressed as:
1 1
) ( dz Sdt dS o ¸ u + ÷ =
2 2
) ) ( ( dz Sdt dS o ì 0 o k + ÷ ÷ =
With dz dt dz p =
2 1
*
A discretised form of both equations can be written in the form:
t t r X X
i i i
A + A ÷ ÷ + =
+ 1
2
1
)
2
1
( oc o ¸
Single Factor Model with Seasonality
A Schwartz model can be used to simulate prices by incorporating seasonal
volatility. A single model is of the form:
dz dt X dX
t t t
o u o + ÷ = ) ˆ ( ˆ
With z discretised form used by Clewlow and Strickland:
t t t t t
t t X X X c o u o A + A ÷ + =
÷ ÷
)
ˆ
(
1 1
The time varying volatility is estimated using a 30day standard deviation with the
55
sole aim of including the seasonal cycles.
Simple Moving Average (SMA)
A simple moving average technique involves adding a market price a of a nperiod
and diving the result by n. SMA always lags behind the market, however it is
useful visual aid as well as determining market trend.
SMA can be used to indicate a buy or a sell signal. For example if the market price
falls below the SMA at time t gives a sell signal and the reversal indicates a sell
signal.
Trading Rules:
SMA n P
n
i
i n
/
1
¯
=
= ; where P
t
is the stock price at time t.
Rate of return is defined as: R
1 ÷
B =
t t t
X , where:
B
1 ÷ t
=
)
`
¹
¹
´
¦
> >
< <
long go 70% RSI if and SMA P If 1 
short go 30% RSI if and , SMA P If 1
t t t
t t t
Exponential Smoothed Moving Average
The Exponential Moving Average (EMA) is a method of moving averaged
developed out of the short comings of the ordinary moving average (MA). EMA
incorporates older data often discarded by MA. The deletion of earliest trading data
according to Dahlquist (2007) leads to significant false signals, since information
on recent prices is often ignored. Thus EMA was developed to address these by
generating more buy and sell signals.
The formula for EMA is calculated as follows:
Smoothing factor (weight) = =
t
w 2/(umber of days in moving average +1)
56
For example a 26day EMA, the weight: w
26
=2/26+1 =7.4%
The general weight is calculated as follows: EMA
t t
w ÷ = % 100
Similarly the formula for calculating the EMA for a particular t is:
1
* *
÷
+ =
t weight t t t
MA EMA P w EMA , Where; P
t
= today’s closing price.
1 ÷ t
MA =simple moving average of the previous day.
Double Exponential Moving Average (DEMA)
The Double Exponential Moving Average is a techniques initially developed by G
Mullory in 1994. Fot Staff applied this in the December (2007) of Futures &
Options Trader Journal. According to him DEMA is a “responsive indicator”,
which aims at reducing lag which is commonly found in all moving average
indicators such as SMA and EMA. DEMA formula incorporates a smoothing
constant or factor which provides an advantage of adding weight to the price. Thus
the formula is:
EMA
t
= w
t
*P
t
+ (1w )
t
*EMA
1 ÷ t
Where: 0<w 1 <
t
and w 1 / 2 + = n
t
, with n representing the number of periods.
DEMA=2*EMA(x)EMA(EMA(x) ).
According to Fot Staff:
“The DEMA calculates the difference between two components: a doubling of the
basic EMA value and “double smoothing” of the EMA valuean EMA smoothed by
a second EMA”
Fot Staff computed DEMA and EMA using two MACD systems. The main
difference between the two was the components. The first system used DEMA and
the second EMA, was used as the standard. A summary of the result of the two
57
systems is shown below:
Table 1: Source: http://www.futuresandoptionstrader.com
The net profit for the DEMA system appeared to be much better than the standard.
This trading system can be improved by an addition of Bollinger Bands with the
aim of including price volatility.
Moving Average Convergence – Divergence (MACD)
The Moving Average ConvergenceDivergence (MACD) is widely used by
technical analyst as a trending tool. It is an application of the EMA methodology. It
uses initially a 12day and 26day EMA; however it can be adjusted for short or
longer periods. The 26day EMA is subtracted from the 12day EMA:
MACD
t
=EMA
26 12
EMA ÷
In addition to the MACD line there is another line often referred to as the signal
line, which is a nineperiod EMA. MCAD oscillates about zero; if it is above the
signal line (SL) then a buy signal is generated; similarly if it is below zero a sell
signal is generated. In other words a buy signal is generated if the MACD line
crosses the signal line from below. Similarly a buy signal is generated if the
MACD crosses the signal line from above. However downward signals are not
58
always reliable therefore other measures such as RSI are used in conjunction with
the above strategy.
Trading Rules with MACD
Rate of return is defines as: R
1 ÷
B =
t t t
X , where
B
1 ÷ t
=
)
`
¹
¹
´
¦
>
>
short SL and 0, < MACD If 1 
, SL and 0, > MACD If 1
t
t
long
In addition to MACD line, there is one other line which represents the signal line a
9day period EMA. This is also plotted on the same chart. The difference between
these two lines is often depicted below the main charts. The histogram trend is
similar to the MACD line.
In situations where the MACD is above zero or below zero for the entire period;
an upward trend with buy signals should be followed. Buy signals are located
where the upward trend starts and the intersection of the EM
9
signal linebuy
signals are above this line. Downward trend in this situation are not profitable
therefore ignored.
Finally, the peaks and troughs as illustrated in the histogram can provide bits and
pieces of information regarding divergence analysis which identifies directional
changes over both long and short periods.
Bollinger Bands (BB)
A Bollinger is made up of two lines one above and one below a moving average
Line. Each line is calculated based upon a certain number of standard deviation
from the moving average. Market
Traders use 20period simple moving average. Two standard deviation added to
plot the upper band similarly two standard deviation are subtracted to plot the
59
lower band. The bands are adjusted automatically with regard to the price changes
or volatility.
Trading Rules:
Rate of return is defines as: R
1 ÷
B =
t t t
X , where:
B
1 ÷ t
=
)
`
¹
¹
´
¦
.
Buy 70% > RSI if 2 + SMA < P if 1 
Sell 30% < RSI if and 2 + SMA > P if 1
t 20
t 20
o
o
Relative Strength Indicator (RSI)
RSI measures the strength of the market by removing erratic price movements.
Furthermore, it has the advantage of detecting market reversal. RSI scale range
from 0% to 100%.If 30 %< RSI< 70% indicates a warning signal. If RSI > 70%
indicate an overbought provides an opportunity for buying of selling. If RSI <
30% indicate an oversold. A RSI value of 80% and 20% are preferred by market
practitioners. In addition if RSI >70% sell signal is indicated similarly if RSI<30%
a buy signal is generated. In other words RSI compares “up days” to “down days”
of a stock price and generates signals as a result. RSI is calculated as follows:
Up = (Sum of gain over N periods)/N
Down= (sum of losses over n periods)/N
RS=Up/Down
RSI =100(
RS + 1
100
); with 0<RSI<100. Traders normally use a 14day period.
ADX Directional Movement Index
Introduction
ADX system was created by Wells Wilder Jr. It can be used as a stand alone
filter or in conjunction with a trend following system like moving average. The
60
Directional Movement Index (DMI) indicates trend and in addition measures it.
DMI is made up of three lines:
+DM measures an upward trend
 DM measures a downward trend
ADX signals the presence of a trend.
DMI is on a scale of 0100, the higher the better for a potential tread.
ADX is used together with +DI and –DI. A signal is generated when +DI and
–DI crosses each other.
ADX Algorithm
Let Y
h
, Y
l
denotes previous day high and low prices similarly T
h
T
l
denotes today’s high and low values respectively. Using these values +DM and
–DM are calculated as follows:
+DM =
)
`
¹
¹
´
¦
÷ > ÷ ÷
otherwise
T Y Y ifT Y T
l l h h h
h
, 0
) 0 , max(
DM =
)
`
¹
¹
´
¦
÷ > ÷
otherwise 0
i 0) , T  max(Y
l l l l h h
T Y Y fT
Another measure is the True Range (TR) which is defined as follows:
TR=max (T
h
–T
l
,  T
h
 Y
c
, T
l
Y
c
)
Where Y
c
, is the previous day closing price.
The Nday Directional Indicators are defined as follows:
+DI (N)
t
=
¯
¯
+ ÷ =
+ ÷ =
+
t
N t i
i
t
N t i
i
TR
DM
1
1
61
DI (N)
t
=
¯
¯
+ ÷ =
+ ÷ =
÷
t
N t i
i
t
N t i
i
TR
DM
1
1
the Nday Directional Movement Index(DX) at time t is defines as follows:
DX (N)
t
= 100 *
) ) ( ( ) (
) ) ( ( ) (
t t
t t
N DI N DI
N DI N DI
÷ + +
÷ ÷ +
The Nday Average Directional Movement Index (ADX) is similarly defined
at a time t as follows:
ADX (N)
t
=
N
N DX
t
N t i
i ¯
+ ÷ = 1
) (
Trading rules
Rate of return is defines as: R
1 ÷
B =
t t t
X , where:
B
1 ÷ t
=
¦
¦
¦
¦
¦
¦
)
¦
¦
¦
¦
¦
¦
`
¹
¦
¦
¦
¦
¦
¦
¹
¦
¦
¦
¦
¦
¦
´
¦
>
+ > ÷ + < ÷
>
÷ > + < +
20 ) (
and
) ( DI(N) and DI(N) DI(N) if 1 
20 ) (
) ( DI(N) and DI(N)  DI(N) if 1
t 1  t t
t 1  t t
Sell
N ADX
N DI
Buy
N ADX
and
N DI
t
t
t
t
Moving Average methodology
For the purpose of this research, a combination of two moving averagean
exponential (EMA) and a standard (MA) will be used to identify the trend and to
reduce lag thereby providing a robust trading system. Both of the moving average
has the advantage of smoothing out data with EMA being the more aggressive and
hence tracking price effectively, however both of them lag the data.
62
Moving Average
90.00
90.20
90.40
90.60
90.80
91.00
91.20
91.40
0 5 10 15 20 25 30
Time
Prices
10Day MA
10Day EMa
sell buy
Figure 6: AMoving Average strategy
The system will be traded on the buy side only. A buy signal is generated if the
EMA cross the MAthe signal line and above the price curve. All other buy signals
are ignored until an exit signal is triggered; this is when the EMA line crosses
below the signal line. However, traders usually wait for confirmation from the
price movement and other indicators such as stochastic, relative index, before
entering the trade. This is a simplest trading strategy that can be executed by any
trader, and are found in almost all trading software systems.
Trading Rules for the EMA and MA:
Rate of return is defines as: R
1 ÷
B =
t t t
X , where:
B
1 ÷ t
=
)
`
¹
¹
´
¦
.
Buy EMA & MA < P if 1 
Sell EMA & MA > P if 1
10 10
10 10
63
Review of Performance measures
Introduction
In this section we list some of the performances measures statistics and the
information they captures. We are going to look at three main groups of measures:
Forecasting, Profit and Risk measures.
Forecasting Measures
There are three main ratios which are use in practice to compare the forecasting
abilities of the various models. The ratio measures the difference of the forecasted
values and the original observations. Theses ratios are:
Root Mean Square Error (RMSE)
RMSE=
2
1
)
ˆ
(
1
¯
=
÷
N
t
t t
y y
N
Mean Absolute Error (MAE)
MAE=
2
1
)
ˆ
(
1
t
N
t
t
y y
N
÷
¯
=
.
Where n is the number of observations; y
t
the actual observation and
t
y
ˆ
is the
forecast value a t time t.
RMSE and MAE according to Eviews 5
TM
are used to compare the “forecast for
the same series across different models; the smaller the error, the better the
forecasting ability of that model according to that criterion”.
Mean Absolute Percentage Error (MAPE)
MAPE= t y y
N
t N
N t
t t
/
1
1
¯
+
+ =
÷
64
Theil Inequality Coefficient (TIC)
TIC=
( )
h y h y
h y y
N
t t
t t
/
ˆ
/
ˆ
/
ˆ
1
2
2
¯ ¯
¯
+
÷
Where n is the number of observations; y
t
the actual observation and
t
yˆ is the
forecast value a t time t.
MAPE and TIC are similarly, according to Eviews 5; “lies between zero and one,
where zero indicates a perfect fit”. There three other ratio statistics: Bias
Proportion, Variance proportion and Covariance Proportion. For a good forecast
theses ratio should add up to one.
Profit Measures
Profit statistics are used to indicate the profitability of a strategy. Any rule based
strategy are meant to generate profit, therefore an appropriate rule must be put in
place to ensure profitability, which must stand the test of time. The following
statistics are used to measure the profitability of a strategy. The ratios will be used
in the spread sheet.
Profit Factor (PF) =
TotalLoss
ofit Total Pr
If PF>1, this indicates the system is making profit otherwise it is losing.
1. Percentage winning tradesusually between 30%50%. For a winning
system this ration must be greater the 60%.
2. Annualized rate of return compare with a market benchmark
3. Payoff ratio (PR) =
gTrade AverageLos
de AverageTra
sin
. A PR greater the 5 is
preferable.
65
4. Efficiency Factor =
t Grossprofi
Netprofit
a value between 38% and 69% is
preferable.
Risk Measures
Risk is usually inherent in any trading strategy. Therefore any rule put in
place must be able to account for risk. This section looks at some of theses
measures.
1. The maximum cumulative drawdown a correction from the maximum
curve, or a deviation of the equity curve from a peak and is a measure of
risk.
2. Net profit drawdown ratio =
own imumDrawnd
Netprofit
max
.
Where Maximum drawn down = min [ ) (
1
¯
=
÷
n
t
t t
r Max R ]
This ratio is also referred to as a recovery ratio and a value greater than two is
preferable.
3. Sharp ratio=
iation SandardDev
turns Re
4. Calmar Ratio (CR) – A measure of downside risk which provide an
added advantage over Sharpe ratio which measures both downward and
upside volatility.
CR=
 max  drawdown imum
retrun of rate Anuualised
÷
÷ ÷ ÷
5. Profit factor=gross profit/gross loss
Where gross profit is the profit from profitable trades and gross loss is the
total of all losses.
66
6. Percentage winning trades= Average of winning trade.
7. Cumulative profit=sum of daily profit.
8. Annualised volatility =Standard deviation of daily trading profit/square
root of number of trading days.
9. Maximum Daily profit =maximum of daily trading profit
10. Maximum daily loss= Minimum of daily trading profit.
11. Maximum drawdown Minimum of maximum drawdown.
Figure 7: An example of a summary of the results of a typical trading strategy.
Source: Futures & options Magazine
The Correlation filter
The aim of this method is to separate dynamic spread from static spread based on
the correlation of the spread. Dynamic spread corresponds to a decreasing
correlation whilst a static one corresponds to a decreasing correlation. Correlation
filter can be used instead of moving average technique.
67
Trading Rules:
Rate of return is defines as: R
1 ÷
=
t t t
B X , where:
1 ÷
÷
t
DRC N , is the Nday rolling correlation, which is obtained by assign the
correlation of the two spreads and dividing by N.
1 ÷ t
B =
)
`
¹
¹
´
¦
>
.
Buy 70% > RSI and Spread DRC  N if 1 
Sell 30% < RSI and Spread < DRC  N if 1
t t 1  t
t 1  t
Equity Curve
The Equity curve is a plot of cumulative profit over time. It provides a visual
representation of profit and losses over the testing period. A perfect equity line is a
straight line through the origin. Any deviation from this is usually due to
drawdown and pauses.
Equity Curve
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
1 40 79 118 157 196 235 274 313 352
Time
A
c
c
o
u
n
t
B
a
l
a
n
c
e
Account
Figure 8: Equity curve for a trading strategy showing few pauses.
68
Under Water Curve
Drawdowns
180%
160%
140%
120%
100%
80%
60%
40%
20%
0%
Time
%
D
r
a
w
d
o
w
n
s
Drawdown
Figure 9: The diagram shows the drawdown of the output of a trading strategy.
The Under Water Curve is a plot of percentage drawdown. It provides a visual
representation of the draw downs over time. The percentage draw downs measure
the maximum percentage of decline of equity from the highest value. The smaller
the ratio, the better the system or strategy. A value less than 20% is effective in
minimizing risk. The output of a trading strategy show on the diagram gives a
summary of the draw downs, which shows several draw downs greater 20% with
most of them longlived relatively.
Summary
Kirkpatrick, CD and others [2006] sums up what a good trading system is:
“In his book, Beyond Technical Analysis, Tushar Chande discusses the
characteristics of a good trading system. Chand’s Cardinal Rules for a trading
system are the following:
 Positive expectationGreater than 13% annually
 Small number of robust trading rulesLess than ten each is best for
entry and exit rules
69
 Able to trade in multiple markets Can use baskets fro determining
parameters, but rules should work across similar markets, different
stocks, different commodities futures , and so on
 Incorporates good risk control – Minimum risk as defied by
drawdown should not be mores than 20% and should not last more
than nine months
 Fully mechanicalNo secondguessing during operation of the
system”.
The next section discusses results of the application of the outofsample prices to
the moving average trading strategy. The S&P500 price index will be compared
with Nord pool electricity prices. Since these indexes are similarly influenced by
factors such as demand and supply, changes in prices of commodities such as gas,
oil, carbon, short and long term weather forecast.
Chapter 4 Findings
Introduction
This section summary the results of the forecasting tools, and the application to the
moving average strategy. On the examination of the electricity prices, it was observed
that they do indeed exhibit volatility clustering. This was confirmed by JarqueBera
statistics, which rejected normality. In addition the quintiles distribution showed a
few outliers, a further confirmation of the departures from normality. Thus the data
fat tailed which called for a model which would incorporate this property. Finally, the
results of the GARCH test showed that all the terms including the asymmetric ones
proved significant. The coefficient of the asymmetric terms was negative, thus
pointing to a high variance in the following period. In addition the sum of the
coefficients was less that one, which provided the evidence of the persistence of the
conditional variance.
Results of forecasting performance
Each of the forecasting tools was tested with regard to their forecasting ability using
RMSE. The one with the least RMSE was then chosen. The moving average trading
strategy is then applied using the outofsample from the best forecasting tool. The
performance of the forecasting model models is compared using the outofsample
period, the reason being that market participants use a day–ahead forecast which
consist of 24 hour auctions, where orders are bid until demand are met. Outof–
sample periods are chosen with or without regards to jumps.
Ordinary least square forecast was found to have the least RMSE with Naïve method
the worse; Table 4.1 shows a summary of the results. Hence it was made the model of
choices for the trading strategy. Table 4.2 similarly shows the ratios of the trading
71
strategy.
Table 2: A comparison of forecasting tools
Tool RMSE Rank
Naïve 45.0633 6
GARCHM(dynamic) 4.854295 3
BoxJenkins 7.971633 4
VECM(dynamic) 20.418411 5
VECM(static) 4.631233 2
OLSQ 2.5788 1
Table 3: Summary of ratios of the trading strategyOLSQ applied to CDF
Ratios
Cumulative Profit 11201.9% Number of Periods Daily returns Rise 52.00
Annualised Volatility 16740.0% Number of Periods Daily returns Fall 30.00
Max. Daily Profit 8.4 Number of Winning Up Periods 35
Max. Daily Loss 7.8 Number of Winning Down Periods 12
Maximum Drawdown 17.0 % Winning Up Periods 67%
% Winning Trades 18.2% % Winning Down Periods 23%
Number of Up Periods 35 Correct Directional Change 0.24
Number of Down Periods 35 Average Gain in Up Periods 86.69
Number of Transactions 23 Average Loss in Down Periods 83.3
A summary of modelling process of ARMA time series
A graph of the time series of the S&P500 suggested the presence of cycles and
some trends. This was however transformed into a stationary one using logarithms
and first differences. ADF test on the data confirmed stationarity. Similarly, the
sample correlation and partial sample autocorrelation suggested an ARMA (p, q)
model. Model estimation was carried out, with the result indicating significance of
the model parameters. An ARMA (6, 6) model was then used to produce an outof
sample forecast. The mean square error of forecast indicated that, the static forecast
was better than the dynamic forecast, since it provided the smallest MSE. In the
next section the forecasted outofsample data will be used as an input for the
moving average trading strategy.
Result of the trading strategy using S&P500
The trading strategy was applied to the S&P500 index; without the use of any
forecasting tool. These section summaries this result with the aim of using this to
compare the output from other data where academic tools have been applied to,
different data from different environment. The equity curve shows some losses
initially but was increase in a passage of time with a steady trend. There was
however reversal which was due to drawdown’s. The trade system had a low
cumulative profit of 44.7%. This provides an indication of a good trading system,
since it is far greater the 13%the standard. There were a lot of drawdowns which
was lower than 20% recommended for a robust system. In particular there were
several drawdown’s in excess of 100%, but were shortlived. The maximum
drawdown reported by the system was about 2.5% which is less than 20%
recommended. From the statistical ratios the trading system befitted from both
73
direction, however the system could minimize loss due to potential reversals if
protection offered in the form of protective stops.
Table 4: Summary of Trading Strategy Analysis of S&P500 Index (without
forecasting tool)
Ratios
Cumulative Profit 19.4% Number of Periods Daily returns Rise 32
Annualised Volatility 4.6% Number of Periods Daily returns Fall 45
Max. Daily Profit 0.9% Number of Winning Up Periods 62
Max. Daily Loss 0.5% Number of Winning Down Periods 36
Maximum Drawdown 0.5% % Winning Up Periods 193.75%
% Winning Trades 71.4% % Winning Down Periods 113%
Number of Up Periods 33 Correct Directional Change 12.25%
Number of Down Periods 36 Average Gain in Up Periods 20.95%
Number of Transactions 8 Average Loss in Down Periods 1.55%
74
Table 5: Summary of ratios of the result of S&P500 trading strategy with ARMA
Ratios
Cumulative Profit 16.4% Number of Periods Daily returns Rise 34.00
Annualised Volatility 13.9% Number of Periods Daily returns Fall 44.00
Max. Daily Profit 1.9% Number of Winning Up Periods 23
Max. Daily Loss 2.5% Number of Winning Down Periods 28
Maximum Drawdown 7.3% % Winning Up Periods 68%
% Winning Trades 27.8% % Winning Down Periods 82%
Number of Up Periods 37 Correct Directional Change 0.18
Number of Down Periods 34 Average Gain in Up Periods 34.03%
Number of Transactions 19 Average Loss in Down Periods 17.6%
75
Summary of Trading Strategy Analysis of Pairs trading
Table 6: Summary ratios of pairs trading strategy
Ratios
Cumulative Profit 0.1% Number of Periods Daily returns Rise 110
Annualised Volatility 297590.7% Number of Periods Daily returns Fall 143.00
Max. Daily Profit 29.0% Number of Winning Up Periods 105
Max. Daily Loss 34.2% Number of Winning Down Periods 0
Maximum Drawdown 65.5% % Winning Up Periods 95.45%
% Winning Trades 5.7% % Winning Down Periods 0%
Number of Up Periods 36 Correct Directional Change 11.86%
Number of Down Periods 34 Average Gain in Up Periods 68.63%
Number of Transactions 24 Average Loss in Down Periods 42.08%
76
System price and MACD
Table 7: Summary of the ratios of MACD trading strategy applied to yearly System
index
Ratios
Cumulative Profit 2.0% Number of Periods Daily returns Rise 100
Annualised Volatility 125842.4% Number of Periods Daily returns Fall 148.00
Max. Daily Profit 20.7% Number of Winning Up Periods 94
Max. Daily Loss 13.9% Number of Winning Down Periods 0
Maximum Drawdown 34.6% % Winning Up Periods 94.00%
% Winning Trades 2.9% % Winning Down Periods 0%
Number of Up Periods 33 Correct Directional Change 16.21%
Number of Down Periods 37 Average Gain in Up Periods 234.81%
Number of Transactions 16 Average Loss in Down Periods 48.25%
77
Table 8: Summary of the ratios of MACD trading strategy applied to yearly
S&P500 index
Ratios
Cumulative Profit 2.8% Number of Periods Daily returns Rise 108
Annualised Volatility 48918.7% Number of Periods Daily returns Fall 145.00
Max. Daily Profit 88.9% Number of Winning Up Periods 102
Max. Daily Loss 120.4% Number of Winning Down Periods 0
Maximum Drawdown 356.6% % Winning Up Periods 94.44%
% Winning Trades 5.7% % Winning Down Periods 0%
Number of Up Periods 34 Correct Directional Change 11.46%
Number of Down Periods 36 Average Gain in Up Periods 1424.14%
Number of Transactions 21 Average Loss in Down Periods 867.68%
78
Chapter 5 Conclusion
In this dissertation the forecasting ability of a series of forecasting tools was tested
with the aim of finding their use in a trading environment. The returns from
forecasting using outofsample data was applied to a moving average trading
strategy (MACD) the various forecasting, profitability and other ratios was then
generated. The CDF series was modelled using ordinary least square, the out of
sample forecast was then simulated by the MACD strategy. Similarly S&P500
prices were modelled by ARMA and the out–ofsample was simulated using the
MACD. The trading strategy was simulated using S&P500 price without the use of
any tool. Finally, the usefulness of pairs trading concepts was tested using MACD.
A summary of the ratios generated by trading strategy is shown in the Table 5.1
below.
Table 9: Summary ratios of the trading strategy as applied to three different
data set.
Ratios Nord CDF with OLSQ S&P500 S&P500 ARMA
Cumulative Profit 11201.9% 13095.0% 16.4%
Annualised Volatility 16740.0% 9230.7% 13.9%
Max. Daily Profit 8.4 0.9% 1.9%
Max. Daily Loss 7.8 0.5% 2.5%
Maximum Drawdown 17.0 0.5% 7.3%
% Winning Trades 18.2% 71.4% 27.8%
Number of Up Periods 35 33 37
79
Number of Down Periods 35 36 34
Number of Transactions 23 8 19
Number of Periods Daily returns Rise 52.00 32 34.00
Number of Periods Daily returns Fall 30.00 45 44.00
Number of Winning Up Periods 35 62 23
Number of Winning Down Periods 12 36 28
% Winning Up Periods 67% 193.75% 68%
% Winning Down Periods 23% 113% 82%
Correct Directional Change 0.24 12.25% 0.18
Average Gain in Up Periods 86.69 20.95% 34.03%
Average Loss in Down Periods 83.3 1.55% 17.6%
Maximum drawdown is a measure risk that needs to be taken into consideration
before the strategy starts making profit. For the purpose of comparison we assume a
maximum drawdown of 20% or less, any other ratio represents a risk to the trader.
The table suggest all the drawdown ratios are reasonable, since they are all less than
20% the limit. However the best drawdown has a value of 0.17%; this was from
the OLSQ technique. The worse was from the trading pair’s strategy which gave a
value of 65.5% The best maximum daily profit was 29%, which was from the pairs
trading strategy, followed by 20.7% when the MACD was applied to the System
price. The two ratios were more than the minimum of 16% suggested by analyst.
The OLSQ ratio was 8.4%, with the rest generating lesser ratios. Thus this result
suggested that the more risky a strategy is, the better the returns.
The Correct Direction Index (CDI) is an additional tool used in conjunction with
80
RMSE to measure the direction ability of the forecasted variable; a positive CDI
indicates an increase price value. All the types produce positive values, with OLSQ
generating the biggest ratio of 0.24; the pairs trading strategy produce a least value
of 0.1186.
We conclude based on the above a ratio that OLSQ is the best forecasting tool for
electricity prices and can be used in all markets. However the ratios used were
calculated from past data, with different sample size. The applicability of these
ratios in a trading environment cannot be relied on, since it did not take into
consideration the dynamic nature of the trading environment. In addition
transactions cost was not taken into consideration. The losses generated by the
strategies were very huge, thus any future research in this area should take into
consideration the risk premium.
Thus in spite of the above weakness, “academic tools” are relevant in any trading
environment and this cannot be over emphasised. This conclusion seems to agree
with the finding of Jason et, al (2004). The simulation of the CDF process using
OrnsteinUhlenbeck method; also provided evidence of the use of stochastic
process in the modelling and pricing of CDF similarity which, which suggest its
consideration for future research.
Future Research
This dissertation was meant to point out some of the weakness of previous studies;
however there were some limitations which future research could consider. For
example the, both the short side and the long of the trades can be considered in
future since only the long side was used.
The usefulness of this study can be more relevant if the number of portfolios is
81
increased, this is in regard to the pairs trading strategy, which is very relevant to
today’s live trading environment. Similarly the period for the moving average can
be varied and adapted to different trading styles, such as weighted moving average.
Data from other major exchanges in the rest of Europe, Japan could also be
considered in the future, since the price data behaviours varies for instance,
currencies data behaves differently from commodities such as oil and gas.
The reliability of the conclusions drawn could question on the basis of the one year
data which was used. It is a well known fact that long term data captures all kinds of
important information such as interest rate cuts, business cycles which is relevant to
both short and long term traders.
82
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86
APPENDIX1
Cointegration Johansen methodology
If a set of variables are cointegrated, then there is an error correction model
(ECM) that links all the variables. In other words if there is a long term relationship
between two cointegration variables, it is possible to find a linear combination of
theses variable in a vector representation format. Engle and Grange [1987] method
is often applied but by far the most superior is the method used by Johansen [1988]
is going to be employed in the study. Johansen used a maximum likelihood
approach using vector auto regression representation (VAR) which is specified in
the following form:
X
t
=
i k t k t i
X X c u + + H + + H
÷ ÷
...
1
(1)
Where, X
i
is a pdimensional vector of price; with k lags and
i
c an independent
identical distributed random variable, with mean zero and variance 1.
For p=3, equation (1) becomes:
t t t i
X X X c u + + H + H =
÷ ÷ 2 2 1 1
(2)
¯
=
÷
+ + H =
2
1 i
t i t i i
X X c u
(3)
The tow variables are chosen because of the two spread variables. According to
Johansson if, the X
t
variable is nonstationary, it is possible to find a variable
t
X A
which is stationary. As a result of this, equation (1) can be transformed into its
87
EMT by using the L operator defined by: ÷ = A 1 L
t i t
1 k
1 i
i t
ε μ X ΔX Γ ΔX + + u + =
÷ ÷
÷
=
¯ k t
(4)
Where: ), Π ... Π (1 Γ
i 1 i
÷ ÷ ÷ ÷ = I=1... K1,
Is n x n coefficients matrix which includes information about the variable Y
t
) Π .. Π (I Φ
k 1
÷ ÷ ÷ ÷ = i=1 ... k1 (5)
Both
t
X A and
k i÷
u tends to zero in the long run according to Johansson.
The matrix His an nxp and can be expressed as:
'
ˆ
β α Π = , with both α and β
ˆ
representing a p x r matrices with α representing
the speed of adjustment of the coefficients. If the variables are cointegrated then
there exists a stationary relation of the form
t
X β
ˆ
even though
t
X is non stationary.
The rank of Π is r < p depending on the number of cointegrating vectors. The
rank determines the number of cointegrating equations. A rank of two suggests that
the variables are jointly stationary. The hypothesis of interest is:
β α Π : (r) H
ˆ
=
o
If the hypothesis is significant, a rank r is found then there is likely to be a linear
combination of the stationary variables. The α vector is the speed of adjustment
with β
ˆ
representing the cointegrating vector. The estimation of the parameters of
Π is determined by regressing
t
X A and
k t
X
÷
on lagged difference 
1 1
,...,
+ ÷ ÷
A A
k t t
X X . Johansson formed a product of residual of the
form:
jt ij
1
ij
T S c c
'
=
¯
÷
, i, j =0, k
The estimates of β is found by equating the determinant of the Eigen value to zero:
88

i0
1
ko kk
S S S λS
÷
÷  =0
Johansson normalised this equation and applied the maximum likelihood principle
to obtain a likelihood function or a likelihood ration test statistics of the form:
)
ˆ
1 ln( ) ln( 2
1
¯
+ =
÷ ÷ = ÷ =
p
r i
i trace
T Q ì ì
With T, the sample size and
p
ì ì ì
ˆ
,...,
ˆ
,
ˆ
2 1
representing the Eigen values.
This statistics is a chisquared distribution with Nr degree of freedom, where N is
the number of variables and r the rank of the matrixΠ. The null hypothesis of at
most r cointegrating vector is tested against an alternative of r grater than r.
Similarly the maximum likelihood Eigen value for the null hypothesis with exactly r
cointegrating equations against r+1 is:
)
ˆ
1 ln(
1 max +
÷ ÷ =
r
T ì ì , with
p r
ì ì
ˆ
...
ˆ
1
> >
+
APPENDIX2
0
10
20
30
40
50
60
70
80
90
50 100 150 200 250 300 350 400
CDF
Figure 10: A daily data of range price series or the CDF
89
50
100
150
200
250
300
350
50 100 150 200 250 300 350 400
SYSTEM HELSINKI
Figure 11: A data comparison of System and Helsinki daily prices
0
20
40
60
80
100
12.5 25.0 37.5 50.0 62.5 75.0 87.5
Series: CDF
Sample 1 400
Observati ons 370
Mean 13.42475
Median 11.46933
Maximum 86.13453
Minimum 3.334269
Std. Dev. 7.355829
Skewness 3.535252
Kurtosis 28.96757
JarqueBera 11166.39
Probability 0.000000
Figure 12: A summary statistics of the CDF
80
60
40
20
0
20
40
60
50 100 150 200 250 300 350 400
DCDF
90
Figure 13: A log transformation of the range series.
0
20
40
60
80
100
120
140
160
60 40 20 0 20 40 60
Series: DCDF
Sample 1 400
Observations 369
Mean 0.005930
Median 0.032009
Maximum 55.67898
Minimum 68.52856
Std. Dev. 6.925025
Skewness 1.331122
Kurtosis 39.50347
JarqueBera 20596.20
Probability 0.000000
Figure 14: A summary statistics of log transformation of the CDF series.
Table 10: A summary of ADF test
Null Hypothesis: D(DCDF) has a unit root
Exogenous: Constant
Lag Length: 7 (Automatic based on SIC, MAXLAG=16)
tStatistic Prob.*
Augmented DickeyFuller test statistic 15.42240 0.0000
Test critical values: 1% level 3.448312
5% level 2.869351
10%
level 2.570999
*MacKinnon (1996) onesided pvalues.
91
Augmented DickeyFuller Test Equation
Dependent Variable: D(DCDF,2)
Method: Least Squares
Date: 02/18/08 Time: 14:00
Sample (adjusted): 12 371
Included observations: 360 after adjustments
Variable
Coefficie
nt Std. Error tStatistic Prob.
D(DCDF(1))

9.89547
5 0.641630 15.42240 0.0000
D(DCDF(1),2)
7.58449
8 0.608208 12.47024 0.0000
D(DCDF(2),2)
5.99664
6 0.540608 11.09242 0.0000
D(DCDF(3),2)
4.39986
6 0.448245 9.815769 0.0000
D(DCDF(4),2)
2.87512
9 0.339461 8.469694 0.0000
D(DCDF(5),2)
1.65367
8 0.228883 7.224993 0.0000
D(DCDF(6),2)
0.68970
7 0.129044 5.344728 0.0000
92
D(DCDF(7),2)
0.21152
5 0.052174 4.054205 0.0001
C
0.01435
5 0.339779 0.042247 0.9663
Rsquared
0.89302
6 Mean dependent var
0.02534
5
Adjusted R
squared
0.89058
8 S.D. dependent var
19.4900
0
S.E. of regression
6.44679
5 Akaike info criterion
6.58972
5
Sum squared resid
14587.9
7 Schwarz criterion
6.68687
8
Log likelihood

1177.15
1 Fstatistic
366.273
0
DurbinWatson stat
2.02061
3 Prob(Fstatistic)
0.00000
0
Table 11: A summary of PhilipsPeron test
Null Hypothesis: D(CDF) has a unit root
Exogenous: Constant
93
Bandwidth: 132 (NeweyWest using Bartlett kernel)
Adj. tStat Prob.*
PhillipsPerron test statistic 102.2090 0.0001
Test critical values: 1% level 3.447914
5% level 2.869176
10%
level 2.570905
*MacKinnon (1996) onesided pvalues.
Residual variance (no correction)
44.2693
0
HAC corrected variance (Bartlett kernel)
1.14383
3
PhillipsPerron Test Equation
Dependent Variable: D(CDF,2)
Method: Least Squares
Date: 02/18/08 Time: 14:05
Sample (adjusted): 4 371
Included observations: 368 after adjustments
Variable Coefficie Std. Error tStatistic Prob.
94
nt
D(CDF(1))

1.27629
4 0.050231 25.40849 0.0000
C

0.00092
2 0.347786 0.002650 0.9979
Rsquared
0.63819
4 Mean dependent var
0.01560
4
Adjusted R
squared
0.63720
5 S.D. dependent var
11.0765
4
S.E. of regression
6.67167
2 Akaike info criterion
6.63903
8
Sum squared resid
16291.1
0 Schwarz criterion
6.66027
8
Log likelihood

1219.58
3 Fstatistic
645.591
3
DurbinWatson stat
2.16825
8 Prob(Fstatistic)
0.00000
0
95
Table 12: A Correlogram of CDF series
Date: 02/18/08 Time: 14:11
Sample: 1 400
Included observations: 368
Autocorrelation
Partial
Correlation AC PAC
Q
Stat Prob
****.  ****.  1

0.528

0.528 103.49 0.000
..  ***.  2

0.045

0.450 104.26 0.000
.*  ***.  3 0.085

0.326 106.96 0.000
96
*.  ***.  4

0.060

0.363 108.32 0.000
.*  **.  5 0.116

0.194 113.39 0.000
*.  ***.  6

0.179

0.402 125.47 0.000
.**  **.  7 0.215

0.202 142.84 0.000
*.  **.  8

0.110

0.203 147.42 0.000
..  ..  9 0.021

0.043 147.59 0.000
*.  *.  10

0.071

0.166 149.53 0.000
.*  ..  11 0.102 0.011 153.46 0.000
..  ..  12

0.047

0.048 154.32 0.000
*.  *.  13

0.071

0.146 156.23 0.000
.*  *.  14 0.150

0.137 164.83 0.000
*.  *.  15

0.080

0.107 167.29 0.000
..  *.  16 0.007

0.129 167.31 0.000
97
..  *.  17

0.021

0.085 167.48 0.000
..  ..  18 0.045

0.007 168.26 0.000
..  .*  19

0.019 0.083 168.39 0.000
*.  ..  20

0.080

0.017 170.88 0.000
.*  *.  21 0.074

0.137 173.02 0.000
..  *.  22 0.061

0.114 174.48 0.000
..  ..  23

0.032

0.021 174.89 0.000
*.  *.  24

0.102

0.091 179.00 0.000
.*  ..  25 0.101

0.026 183.06 0.000
..  ..  26

0.025 0.012 183.30 0.000
*.  *.  27

0.072

0.097 185.39 0.000
.*  ..  28 0.152 0.055 194.60 0.000
*.  ..  29

0.105 0.014 199.06 0.000
98
..  ..  30 0.025

0.006 199.32 0.000
..  ..  31

0.011 0.005 199.37 0.000
..  ..  32 0.009 0.048 199.40 0.000
..  ..  33 0.009 0.030 199.43 0.000
*.  ..  34

0.071

0.040 201.47 0.000
.*  ..  35 0.109

0.011 206.32 0.000
..  ..  36

0.030 0.022 206.68 0.000
12
8
4
0
4
8
80 60 40 20 0 20 40 60
DCDF
N
o
r
m
a
l
Q
u
a
n
t
i
l
e
Theoretical QuantileQuantile
99
Figure 15: QuantileQuantile plot of the logreturns
1.2
0.8
0.4
0.0
0.4
0.8
1.2
25 50 75 100 125 150 175 200 225 250
LHELSINKI
Figure 16: A log transformation of Helsinki prices
.5
.4
.3
.2
.1
.0
.1
.2
.3
.4
25 50 75 100 125 150 175 200 225 250
LSYSTEM
Figure 17: Log transformation of system prices
100
1040
1080
1120
1160
1200
1240
25 50 75 100 125 150 175 200 225 250
CLOSE
Figure 18: S&P500 index.
LOGRETURNS
0.30
0.20
0.10
0.00
0.10
0.20
0.30
0.40
0 50 100 150 200 250 300 350 400
time
l
o
g
s
Figure 19: Logarithms returns of the System price
101
Jumps
0.30
0.20
0.10
0.00
0.10
0.20
0.30
0.40
0 50 100 150 200 250 300 350 400
Time
R
e
t
r
u
n
s
Jumps
Figure 20: A plot of number of jumps against returns
Volatity & Returns
0.30
0.20
0.10
0.00
0.10
0.20
0.30
0.40
0 100 200 300 400
Time
R
e
t
u
r
n
s
Log Returns
30day rolling Volatility
Figure 21: A combinations of 30day volatility and logarithms returns of the
System price
APPENDIX 3
102
Maximum Drawdown
3500%
3000%
2500%
2000%
1500%
1000%
500%
0%
Time
D
r
a
w
d
o
w
n
Maximum Drawdown
Figure 22: Maximum Drawdown of S&P500 without forecasting
.020
.015
.010
.005
.000
.005
.010
.015
10 20 30 40 50 60 70
RETURNS
9Day EMA
20Day MA
Figure 23: Returns and 9Day EMA and 20Day MA series
103
.08
.07
.06
.05
.04
.03
.02
.01
.00
10 20 30 40 50 60 70
Maxi mum Drawdown
Figure 24: Maximum drawdown for S&P500 with ARMA forecast
.03
.02
.01
.00
.01
.02
10 20 30 40 50 60 70
Daily Trading Profit
Figure 25: Daily profit for S&P500 with ARMA forecast
104
.05
.00
.05
.10
.15
.20
.25
10 20 30 40 50 60 70
Cummulative Profit
Figure 26: Daily cumulative profit for S&P500 with ARMA forecast
1040
1080
1120
1160
1200
1240
2004M04 2004M07 2004M10
MA EMA Adj Close
Figure 27: Comparing price, moving average, exponential moving average
105
Equity Curve(%)
5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
50.0%
1 25 49 73 97 121 145 169 193 217
Tme
%
A
c
c
o
u
n
t
B
a
l
a
n
c
e
Figure 28: Equity curve of S&P500 without forecasting
Forecasting with Ordinary Least Square as applied to power data
(CDF)
20
15
10
5
0
5
10
15
290 300 310 320 330 340 350 360 370
LSYSTEMF_OLSQ
Forecast: LSYSTEMF_OLSQ
Actual: LSYSTEM
Forecast sample: 290 400
Adjusted sample: 290 371
Included observations: 82
Root Mean Squared Error 2.204098
Mean Absolute Error 1.602345
Mean Abs. Percent Error 270.1602
Theil Inequality Coefficient 0.355895
Bias Proportion 0.000113
Variance Proportion 0.030467
Covariance Proportion 0.969420
106
20
16
12
8
4
0
10 20 30 40 50 60 70 80
Maximum Drawdown
Figure 29: Graph of Maximum Drawdown of OLSQ applied to CDF
30
20
10
0
10
20
30
40
10 20 30 40 50 60 70 80
Cumulative Profi t(%)
Figure 30: Graph of Equity curve
107
30day volatily & returns
0.4
0.2
0
0.2
0.4
0 100 200 300 400
time
R
e
t
u
r
n
s
log returns
30day
volatility
Figure 31: 30day volatility
.006
.005
.004
.003
.002
.001
.000
2004M09 2004M10 2004M11 2004M12
Maximum Drawdown
Figure 32: Graph of maximum drawdown
108
Equity Curve
0.000%
0.002%
0.004%
0.006%
0.008%
0.010%
0.012%
0.014%
0.016%
0.018%
1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65
Time
%
P
r
o
f
i
t
Profit
Figure 33: Graph of cumulative profit
Append Public Function MV(X, a, u, t, sigma, nsim)
Dim rnmut, sigt, Sum, S1, S2
Dim i As Integer
Randomize
rnmut = X + a * (u  X) * t
sigt = sigma * Sqr (t)
For i = 0 To nsim
rands = Rnd + Rnd + Rnd + Rnd + Rnd + Rnd + Rnd + Rnd + Rnd + Rnd + Rnd +
Rnd  6
S1 = rnmut + rands * sigt
109
S2 = rnmut  rands * sigt
Next i
MV = 0.5 * (S1 + S2)
End Function
APPENDIX 4
0
50
100
150
200
250
300
350
250 275 300 325 350 375 400
ERROR_SQUARE
Figure 34: Error Square
Table 13: Forecasting with OLSQ
Dependent Variable: LSYSTEM
Method: Least Squares
110
Date: 03/06/08 Time: 11:17
Sample (adjusted): 2 250
Included observations: 249 after adjustments
Variable
Coefficie
nt Std. Error tStatistic Prob.
LHELSINKI
0.42508
7 0.023186 18.33387 0.0000
C
5.79763
1 0.427433 13.56383 0.0000
Rsquared
0.57642
4 Mean dependent var 0.059474
Adjusted R
squared
0.57471
0 S.D. dependent var 6.871133
S.E. of regression
4.48096
1 Akaike info criterion 5.845552
Sum squared resid
4959.51
6 Schwarz criterion 5.873804
Log likelihood

725.771
2 Fstatistic 336.1309
DurbinWatson stat
1.24412
6 Prob(Fstatistic) 0.000000
111
Figure A summary of output of ordinary least square estimation of the model
20
10
0
10
20
30
275 300 325 350
LSYSTEMF
Forecast: LSYSTEMF
Actual: LSYSTEM
Forecast sample: 251 400
Adjusted sample: 251 371
Included observati ons: 121
Root Mean Squared Error 2.578828
Mean Absolute Error 1.789171
Mean Abs. Percent Error 235.8585
Theil Inequality Coefficient 0.324692
Bias Proportion 0.004656
Variance Proportion 0.257563
Covariance Proportion 0.737781
Figure 35: Result of forecast using OLSQ
Forecasting with ARIMA model
10
0
10
20
30
0
10
20
30
40
250 275 300 325 350
Resi dual Actual Fitted
112
Figure 36:
Table 14: Unit root test
Null Hypothesis: RESID06 has a unit root
Exogenous: Constant
Lag Length: 1 (Automatic based on SIC, MAXLAG=15)
tStatistic Prob.*
Augmented DickeyFuller test statistic 7.287126 0.0000
Test critical values: 1% level 3.456730
5% level 2.873045
10%
level 2.572976
*MacKinnon (1996) onesided pvalues.
Augmented DickeyFuller Test Equation
Dependent Variable: D(RESID06)
Method: Least Squares
Date: 03/06/08 Time: 11:29
Sample (adjusted): 4 250
Included observations: 247 after adjustments
Variable Coefficie Std. Error tStatistic Prob.
113
nt
RESID06(1)

0.51206
5 0.070270 7.287126 0.0000
D(RESID06(1))

0.17651
3 0.062993 2.802108 0.0055
C

0.00416
6 0.261331 0.015940 0.9873
Rsquared
0.33247
9 Mean dependent var

0.00743
2
Adjusted R
squared
0.32700
8 S.D. dependent var
5.00649
0
S.E. of regression
4.10712
9 Akaike info criterion
5.67539
7
Sum squared resid
4115.91
6 Schwarz criterion
5.71802
1
Log likelihood

697.911
5 Fstatistic
60.7658
7
DurbinWatson stat
1.98302
9 Prob(Fstatistic)
0.00000
0
114
Table 15: Summary of estimation of ARMA (10, 10)
Dependent Variable: DCDF
Method: Least Squares
Date: 03/06/08 Time: 12:00
Sample (adjusted): 13 250
Included observations: 238 after adjustments
Convergence achieved after 13 iterations
Backcast: 3 12
Variable
Coefficie
nt Std. Error tStatistic Prob.
C
0.03073
4 0.438951 0.070016 0.9442
AR(10)
0.41715
1 0.375670 1.110417 0.2680
MA(10)

0.52888
1 0.353149 1.497612 0.1356
Rsquared
0.01336
0 Mean dependent var
0.01710
8
Adjusted R
squared
0.00496
3 S.D. dependent var
7.93309
6
S.E. of regression 7.91338 Akaike info criterion 6.98751
115
5 3
Sum squared resid
14716.0
9 Schwarz criterion
7.03128
1
Log likelihood

828.514
1 Fstatistic
1.59106
9
DurbinWatson stat
2.55500
0 Prob(Fstatistic)
0.20589
4
Inverted AR Roots .92 .74+.54i .74.54i .28.87i
.28+.87i .28.87i .28+.87i .74.54i
.74+.54i .92
Inverted MA Roots .94 .76.55i .76+.55i .29+.89i
.29.89i .29+.89i .29.89i .76.55i
.76+.55i .94
116
10
0
10
20
30
40
275 300 325 350 375
CDFF
Forecast: CDFF
Actual: CDF
Forecast sample: 251 400
Adjusted sample: 251 381
Included observati ons: 121
Root Mean Squared Error 7.971633
Mean Absolute Error 7.166969
Mean Abs. Percent Error 66.33961
Theil Inequality Coefficient 0.244146
Bias Proportion 0.579859
Variance Proportion 0.090201
Covariance Proportion 0.329940
Figure 37: A summary of forecasting result of BoxJenkins method
Table 16: GARCHM model
Dependent Variable: CDF
Method: ML – ARCH (Marquardt)  Normal distribution
Date: 03/06/08 Time: 12:17
Sample (adjusted): 2 250
Included observations: 249 after adjustments
Convergence achieved after 18 iterations
Variance backcast: ON
GARCH = C(3) + C(4)*RESID(1)^2 + C(5)*GARCH(1)
Coefficie
nt Std. Error zStatistic Prob.
@SQRT(GARCH)

0.27927 0.103521 2.697787 0.0070
117
9
C
14.1238
2 0.584897 24.14756 0.0000
Variance Equation
C
21.5422
2 2.626939 8.200500 0.0000
RESID(1)^2
0.70764
8 0.068842 10.27931 0.0000
GARCH(1)

0.08378
0 0.047718 1.755740 0.0791
Rsquared

0.16536
9
Mean dependent var
13.7191
2
Adjusted R
squared

0.18447
4 S.D. dependent var
8.35327
2
S.E. of regression
9.09116
0 Akaike info criterion
6.60525
6
Sum squared resid
20166.4
0 Schwarz criterion
6.67588
8
Log likelihood

817.354 DurbinWatson stat
0.68483
9
118
4
Output from the parameter estimation of the model proved significant, and in
addition the coefficients of the sum of the Arch and Garch were closer to one, thus
proving that the model is stable.
120
80
40
0
40
80
120
275 300 325 350
CDFF
Forecast: CDFF
Actual: CDF
Forecast sample: 251 400
Adjusted sample: 251 372
Included observat ions: 121
Root Mean Squared Error 4.854295
Mean Absolute Error 3.447139
Mean Abs. Percent Error 25.84455
Theil Inequality Coefficient 0.185171
Bias Proportion 0.002594
Variance Proportion 0.695304
Covariance Proportion 0.302101
0
100
200
300
400
500
275 300 325 350
Forecast of Variance
119
Figure 38: A summary of result of a dynamic GARCHM forecast
120
80
40
0
40
80
120
275 300 325 350
CDFF
Forecast: CDFF
Actual: CDF
Forecast sample: 251 400
Adjusted sample: 251 372
Included observati ons: 121
Root Mean Squared Error 4.854295
Mean Absolute Error 3.447139
Mean Abs. Percent Error 25.84455
Theil Inequality Coefficient 0.185171
Bias Proportion 0.002594
Variance Proportion 0.695304
Covariance Proportion 0.302101
0
100
200
300
400
500
275 300 325 350
Forecast of Variance
Figure 39: Asummary of result of a static GARCHM forecast
120
Vector Error Correction Model (VECM)
Table 17 Result from Cointegration test using Johansen Cointegration
test
Date: 03/06/08 Time: 12:33
Sample (adjusted): 7 371
Included observations: 365 after adjustments
Trend assumption: Linear deterministic trend (restricted)
Series: LSYSTEM LHELSINKI
Lags interval (in first differences): 1 to 4
Unrestricted Cointegration Rank Test (Trace)
Hypothesize
d Trace 0.05
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.416156 214.7072 25.87211 0.0000
At most 1 * 0.048882 18.29287 12.51798 0.0049
Trace test indicates 2 cointegrating eqn(s) at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
**MacKinnonHaugMichelis (1999) pvalues
Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
121
Hypothesize
d MaxEigen 0.05
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.416156 196.4143 19.38704 0.0001
At most 1 * 0.048882 18.29287 12.51798 0.0049
Maxeigenvalue test indicates 2 cointegrating eqn(s) at the 0.05
level
* denotes rejection of the hypothesis at the 0.05 level
**MacKinnonHaugMichelis (1999) pvalues
Unrestricted Cointegrating Coefficients (normalized by
b’*S11*b=I):
LSYSTEM LHELSINKI @TREND(2)
0.538467 0.010573 0.000447
0.231916 0.185189 0.000963
Unrestricted Adjustment Coefficients (alpha):
D(LSYSTEM
) 4.445258 0.321946
D(LHELSIN
KI) 6.526396 0.654185
122
1 Cointegrating
Equation(s):
Log
likelihood 2236.576
Normalized cointegrating coefficients (standard error in
parentheses)
LSYSTEM LHELSINKI @TREND(2)
1.000000 0.019635 0.000830
(0.02035) (0.00111)
Adjustment coefficients (standard error in parentheses)
D(LSYSTE) 2.393623
(0.15612)
D(LHELSIKI) 3.514246
(0.23655)
Estimation of Error Correction Model (ECT)
ECT=LYSTEM+0.019635*LHELSINKI0.000830*@TREND (2)
123
50
40
30
20
10
0
10
20
30
40
50 100 150 200 250 300 350 400
ECT
Figure 40: Error correction term series
Table 18: Results from the Unit root test
Null Hypothesis: D(ECT) has a unit root
Exogenous: Constant
Lag Length: 12 (Automatic based on SIC, MAXLAG=16)
tStatistic Prob.*
Augmented DickeyFuller test statistic 11.53205 0.0000
Test critical values: 1% level 3.448518
5% level 2.869442
10%
level 2.571047
*MacKinnon (1996) onesided pvalues.
124
Augmented DickeyFuller Test Equation
Dependent Variable: D(ECT,2)
Method: Least Squares
Date: 03/06/08 Time: 12:55
Sample (adjusted): 16 371
Included observations: 356 after adjustments
Variable
Coefficie
nt Std. Error tStatistic Prob.
D(ECT(1))

14.9898
5 1.299843 11.53205 0.0000
D(ECT(1),2)
12.7483
6 1.275552 9.994390 0.0000
D(ECT(2),2)
11.4061
9 1.223897 9.319572 0.0000
D(ECT(3),2)
9.92615
0 1.146680 8.656424 0.0000
D(ECT(4),2)
8.29249
7 1.046997 7.920271 0.0000
D(ECT(5),2)
6.58639
9 0.925844 7.113941 0.0000
D(ECT(6),2) 4.93571 0.782420 6.308269 0.0000
125
9
D(ECT(7),2)
3.68697
9 0.624312 5.905668 0.0000
D(ECT(8),2)
2.70349
7 0.473787 5.706147 0.0000
D(ECT(9),2)
1.81876
0 0.339830 5.351970 0.0000
D(ECT(10),2)
1.10958
4 0.224429 4.944022 0.0000
D(ECT(11),2)
0.61870
9 0.127910 4.837061 0.0000
D(ECT(12),2)
0.25985
4 0.052313 4.967293 0.0000
C

0.01509
0 0.295237 0.051112 0.9593
Rsquared
0.89702
8 Mean dependent var
0.02714
8
Adjusted R
squared
0.89311
3 S.D. dependent var
17.0373
8
S.E. of regression
5.57011
9 Akaike info criterion
6.31124
2
Sum squared resid
10610.9
7 Schwarz criterion
6.46362
6
126
Log likelihood

1109.40
1 Fstatistic
229.175
2
DurbinWatson stat
2.04954
9 Prob(Fstatistic)
0.00000
0
Table 19: Output of the estimation of the shortrun dynamics
Dependent Variable: D(LSYSTEM)
Method: Least Squares
Date: 03/06/08 Time: 13:04
Sample (adjusted): 4 250
Included observations: 247 after adjustments
Variable
Coefficie
nt Std. Error tStatistic Prob.
D(LHELSINKI(1))
0.08743
7 0.033883 2.580541 0.0105
ECT(1)

1.26491 0.078100 16.19598 0.0000
127
2
C

0.54004
1 0.430751 1.253719 0.2111
Rsquared
0.59436
9 Mean dependent var

0.00795
0
Adjusted R
squared
0.59104
4 S.D. dependent var
10.5543
2
S.E. of regression
6.74945
5 Akaike info criterion
6.66887
2
Sum squared resid
11115.4
5 Schwarz criterion
6.71149
6
Log likelihood

820.605
7 Fstatistic
178.765
8
DurbinWatson stat
2.03973
3 Prob(Fstatistic)
0.00000
0
128
200
150
100
50
0
50
100
150
275 300 325 350
LSYSTEMF
Forecast: LSYSTEMF
Actual: LSYSTEM
Forecast sample: 251 400
Adjusted sample: 251 372
Included observations: 121
Root Mean Squared Error 20.41844
Mean Absolute Error 17.15579
Mean Abs. Percent Error 2707.690
Theil Inequality Coefficient 0.818158
Bias Proportion 0.698389
Variance Proportion 0.114911
Covariance Proportion 0.186701
Figure 41: Results of dynamic forecast of VECM model
20
10
0
10
20
275 300 325 350
LSYSTEMFS
Forecast: LSYSTEMFS
Actual: LSYSTEM
Forecast sample: 251 400
Adjusted sample: 251 372
Included observations: 121
Root Mean Squared Error 4.631233
Mean Absolute Error 3.252960
Mean Abs. Percent Error 184.4239
Theil Inequality Coefficient 0.806010
Bias Proportion 0.003729
Variance Proportion 0.561783
Covariance Proportion 0.434488
Figure 42: Results of static forecast of VECM model
129
System& Simulated Price
0.00
100.00
200.00
300.00
400.00
500.00
600.00
700.00
800.00
900.00
1 23 45 67 89 111 133 155 177 199 221 243 265 287 309 331 353
Price
T
i
m
e
System Price
Simulated Price
Figure 43: A comparisons of a System Price and simulated price with a mean
speed of 0.47 and a long run mean of 949.27 with a halflife 1.46
A 30day rolling standard deviation was used instead of a constant standard
deviation
Estimating parameters
y = 0.4743x + 450.24
R
2
= 0.0189
0.00
100.00
200.00
300.00
400.00
500.00
600.00
700.00
800.00
150.00 100.00 50.00 0.00 50.00 100.00 150.00 200.00
Xvalues
Y

v
a
l
u
e
s
Series1
Linear (Series1)
Figure 44: Estimating parameter of a mean reversion model using Least
Square Estimation.
130
Comparing Returns
0.30
0.20
0.10
0.00
0.10
0.20
0.30
0.40
0 50 100 150 200 250 300 350 400
Time
R
e
t
u
r
n
s
Log Returns of Sytem price
simulated returns
Figure 45: Summary statistics of returns series of GARCH (1, 1) estimation of the
system price
0
10
20
30
40
50
60
70
2.5 0.0 2.5
Series: Standardized Residuals
Sample 3 366
Observations 364
Mean 0.112784
Median 0.206567
Maximum 4.649894
Minimum 3.812500
Std. Dev. 0.995172
Skewness 0.793321
Kurtosis 6.304892
JarqueBera 203.8361
Probability 0.000000
131
Figure 46: Variance of the series returns
Table 20: Summary of Cointegration Test
Date: 03/03/08 Time: 11:16
Sample (adjusted): 7 250
Included observations: 244 after adjustments
Trend assumption: Linear deterministic trend
.00
.01
.02
.03
.04
.05
50 100 150 200 250 300 350
GARCH_VARIANCE
.3
.2
.1
.0
.1
.2
.3
.4
50 100 150 200 250 300 350
RETURNS Residuals
132
Series: LSYSTEM LHELSINKI
Lags interval (in first differences): 1 to 4
Unrestricted Cointegration Rank Test (Trace)
Hypothesize
d Trace 0.05
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.430697 228.9098 15.49471 0.0001
At most 1 * 0.312582 91.45426 3.841466 0.0000
Trace test indicates 2 cointegrating eqn(s) at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
**MacKinnonHaugMichelis (1999) pvalues
Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
Hypothesize
d MaxEigen 0.05
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.430697 137.4556 14.26460 0.0001
At most 1 * 0.312582 91.45426 3.841466 0.0000
Maxeigenvalue test indicates 2 cointegrating eqn(s) at the 0.05
level
* denotes rejection of the hypothesis at the 0.05 level
133
**MacKinnonHaugMichelis (1999) pvalues
Unrestricted Cointegrating Coefficients (normalized by
b’*S11*b=I):
LSYSTEM LHELSINKI
57.72870 5.542096
80.05778 62.11374
Unrestricted Adjustment Coefficients (alpha):
D(LSYSTE) 0.048016 0.009584
D(LHELSIKI) 0.067214 0.052222
1 Cointegrating
Equation(s):
Log
likelihood 665.2841
Normalized cointegrating coefficients (standard error in
parentheses)
LSYSTEM LHELSINKI
1.000000 0.096002
(0.04145)
Adjustment coefficients (standard error in parentheses)
D(LSYSTE) 2.771889
134
(0.21814)
D(LHELSIKI) 3.880190
(0.45750)
1040
1080
1120
1160
1200
1240
2004M04 2004M07 2004M10
Adj Close
Figure 47: Modelling of S&P500 series
135
.020
.015
.010
.005
.000
.005
.010
.015
.020
2004M04 2004M07 2004M10
LSP
Figure 48: The log series of the S&P index
Table 21: Output of the unit root test for stationarity
Null Hypothesis: D(ADJ_CLOSE) has a unit root
Exogenous: Constant
Lag Length: 0 (Automatic based on SIC, MAXLAG=15)
tStatistic Prob.*
Augmented DickeyFuller test statistic 15.41091 0.0000
Test critical values: 1% level 3.457173
5% level 2.873240
10%
level 2.573080
*MacKinnon (1996) onesided pvalues.
136
Augmented DickeyFuller Test Equation
Dependent Variable: D(ADJ_CLOSE,2)
Method: Least Squares
Date: 03/10/08 Time: 21:03
Sample (adjusted): 1/07/2004 12/22/2004
Included observations: 243 after adjustments
Variable
Coefficie
nt Std. Error tStatistic Prob.
D(ADJ_CLOSE(1))

0.99310
6 0.064442 15.41091 0.0000
C
0.35113
7 0.509783 0.688796 0.4916
Rsquared
0.49633
9 Mean dependent var
0.01098
8
Adjusted R
squared
0.49424
9 S.D. dependent var
11.1638
2
S.E. of regression
7.93928
4 Akaike info criterion
6.98972
0
Sum squared resid
15190.7
7 Schwarz criterion
7.01846
9
Log likelihood

847.250 Fstatistic
237.496
0
137
9
DurbinWatson stat
1.99814
1 Prob(Fstatistic)
0.00000
0
Table 22: Output of autocorrelation test
Date: 03/10/08 Time: 21:11
Sample: 1/05/2004 12/22/2004
Included observations: 243
Autocorrelation
Partial
Correlation AC PAC
Q
Stat Prob
****.  ****.  1

0.464

0.464 52.936 0.000
*.  ***.  2

0.073

0.367 54.242 0.000
.*  **.  3 0.081

0.198 55.889 0.000
*.  **.  4

0.102

0.265 58.501 0.000
..  **.  5 0.036

0.234 58.821 0.000
.*  *.  6 0.068

0.128 59.977 0.000
..  *.  7   60.311 0.000
138
0.036 0.094
..  *.  8

0.041

0.143 60.740 0.000
.*  ..  9 0.134 0.058 65.292 0.000
**.  *.  10

0.211

0.161 76.636 0.000
.*  *.  11 0.118

0.088 80.188 0.000
..  *.  12

0.016

0.143 80.255 0.000
Table 23: Output of AR and MA test
Dependent Variable: D(LSP)
Method: Least Squares
Date: 03/10/08 Time: 21:24
Sample (adjusted): 1/15/2004 9/01/2004
Included observations: 159 after adjustments
Convergence achieved after 11 iterations
Backcast: 1/07/2004 1/14/2004
139
Variable
Coefficie
nt Std. Error tStatistic Prob.
C
9.09E
05 0.000545 0.166806 0.8677
AR(6)
0.79603
3 0.048746 16.33022 0.0000
MA(6)

0.93451
3 0.032376 28.86471 0.0000
Rsquared
0.13417
3 Mean dependent var
4.24E
05
Adjusted R
squared
0.12307
3 S.D. dependent var
0.01029
2
S.E. of regression
0.00963
8 Akaike info criterion

6.42751
1
Sum squared resid
0.01449
1 Schwarz criterion

6.36960
7
Log likelihood
513.987
1 Fstatistic
12.0873
1
DurbinWatson stat
2.89384
1 Prob(Fstatistic)
0.00001
3
140
Inverted AR Roots .96 .48+.83i .48.83i .48+.83i
.48.83i .96
Inverted MA Roots .99 .49.86i .49+.86i .49.86i
.49+.86i .99
Table 24: Forecast output (static forecastusing the arma)
.05
.04
.03
.02
.01
.00
.01
.02
.03
.04
2004M09 2004M10 2004M11 2004M12
LSPF_STATIC_ARMA
Forecast: LSPF_STATIC_ARMA
Actual: LSP
Forecast sampl e: 9/01/2004 12/22/2004
Included observations: 79
Root Mean Squared Error 0.008832
Mean Absolute Error 0.007069
Mean Abs. Percent Error 449.4588
Theil Inequality Coefficient 0.663762
Bias Proportion 0.000372
Variance Proportion 0.000263
Covariance Proportion 0.999364
.00006
.00008
.00010
.00012
.00014
.00016
.00018
2004M09 2004M10 2004M11 2004M12
Forecast of Variance
Figure 49: Output forecast (dynamic forecast)
141
.12
.08
.04
.00
.04
.08
.12
2004M09 2004M10 2004M11 2004M12
LSPF_DYNAMIC
Forecast: LSPF_DYNAMIC
Actual: LSP
Forecast sample: 9/01/2004 12/22/2004
Included observations: 79
Root Mean Squared Error 0.010026
Mean Absolute Error 0.008392
Mean Abs. Percent Error 789.5745
Theil Inequality Coefficient 0.645704
Bias Proportion 0.553835
Variance Proportion 0.170345
Covariance Proportion 0.275819
Table 25: List of Ratios
142
143
144
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