14.3.23 Computational Finance

Computational Finance
AY 2022-2023
VI Trimester
Dr. Narend. S
Professor & Chairperson – Accounting &
Finance,
Thiagarajar School of Management
Dr. Narend Subramanian, Prof & Chairperson Accounting & Finance,

1 TSM
Computational Finance – Course modules
 Module 1 : Univariate Time series analysis and forecasting
 Time series analysis - Preparing data for analysis, Univariate time series analysis, Autocorrelation function (ACF) ,
Partial autocorrelation function (PACF), Moving Average processes (MA), Auto Regressive processes (AR), ARMA
process, Building ARMA models, Forecasting ARMA models using EVIEWS, Exponential smoothing models,
ARIMA models, applications in financial decision making
 Module 2: Multivariate models
 Multiequation modelling- Simultaneous equation modelling. Vector Auto Regression (VAR), VAR with exogenous
variables, VAR estimation in E Views, Impulse Response and variance decomposition
 Module 3: Modelling long-run relationships
 Stationarity and unit root testing, cointegration, equilibrium or error correction models, testing for cointegration
using Johansen technique
 Module 4: Modelling volatility in time series
 Modelling time series volatility: Volatility - Historical volatility, Implied volatility models, ARCH processes,
GARCH Processes, Estimation of ARCH, GARCH models in EVIEWS, Extensions of GARCH models,
Multivariate GARCH models
 Recommended Books
 1. Ruey S. Tsay “Analysis of Financial Time Series”, (Wiley Series in Probability and Statistics) 2nd Edition,
Wiley India, Pvt. Ltd, New Delhi.
 2. Montgomery, D. C., Jennings, C. L., & Kulahci, M. (2015). Introduction to time series analysis and
forecasting. John Wiley & Sons.
 EVIEWS – Student version to download
2
Dr. Narend Subramanian, Prof & Chairperson Accounting & Finance, TSM
CF – Course modules
 Module 4: Modelling volatility in time series
Modelling time series volatility: Volatility - Historical
volatility, Implied volatility models, ARCH processes,
GARCH Processes, Estimation of ARCH, GARCH
models in EVIEWS, Extensions of GARCH models,
Multivariate GARCH models
3
Computational Finance – Course evaluation
S.NO Topics Weightage Deadlines
1 Assignments 10% TBC
2 First quiz 10% TBC
3 Case studies, class participation 10% TBC
4 Mid term 30% TBC
5 End Term 40% TBC
Assignment – Individual (Word doc. 10 to 15

pages – A4, Times New Roman 11, Plagiarism will be checked)
 Stationarity - Unit root testing
 Granger causality testing
 AR, MA, ARMA, ARIMA models in EVIEWS
 VAR or VECM modelling using EVIEWS
 ARCH, GARCH modelling in EVIEWS
4 Dr. Narend Subramanian, Prof & Chairperson Accounting & Finance, TSM
Types of Data
Data Properties
Time series data Data on one or more variables over a period of time
Daily frequency Stock prices, weather reports, etc
Monthly CPI , unemployment rate

frequency
Quarterly GDP (Gross Domestic Product)

frequency
Annual frequency Annual budgets
Decennial Population census
5
Types of Data
 Shows an upward trend

 Data is not stationary –
 Does not have a constant mean and constant variance
6
Types of Data
Data Properties
Cross sectional Data on one or more variables collected at the same
data point of time. Eg: Number of eggs produced in 1990
7
Types of Data
Data Properties
Cross sectional Data on one or more variables collected at the same
data point of time. Eg: Number of eggs produced in 1990
8
Types of Data
Data Properties
Pooled data Combination of both time series and cross sectional
data
Panel data Special type of pooled data – same cross sectional
data
9
Types of Data
Data Properties
Pooled data Combination of both time series and cross sectional
data
Panel data Special type of pooled data – same cross sectional
data
10
Time series models
 Structural models – Multivariate in nature
 Eg: Linear regression analysis
 Stock returns = F ( GDP, Inflation, Unemployment…)
 Sometimes structural models are not viable
 All variables are not observable or measurable- Unemployment rate in
India
 Lower frequency –Eg: Stock prices are daily, macro economic variables
are quarterly (GDP)
 How to model ??? Can we model variables with different time frequencies
– Stocks (daily prices), GDP (quarterly), IIP (monthly)??
 Structural models are not suitable for out of sample forecasting
 Univariate models
 Based only on their past values and also based on their error term
• Time Series models -
 Also known as “ a-theoretical” models and not based on underlying theory
 ARMA and ARIMA (p,d,q) – important class of time series models
 AR- AutoRegressive & MA Moving Average
11
Time series models
 Regression analysis assumptions
 The regression model
 Weekly consumption is dependent on weekly family

income

12
Time series models
 Significance of error term
 1) Vagueness of theory
 Unsure of other variables in the above e.g. U I captures all other terms missing
2) Unavailability of data
 Some data may be unavailable .
Eg: Family wealth. Difficult to get the wealth details.

3) Core variables vs peripheral variables
Other variables like family size, age, sex, education, etc could also play a role.
Also interaction of these variables could play a role
For sake of brevity and cost purpose – they may be ignored and U I captures those
terms
4) Intrinsic randomness
Even after capturing all variables some intrinsic randomness may be missing Ui
captures that
5) Poor proxy variables
 Milton Firedman Permanent consumption is dependent on permanent income
 Proxy variables used - current consumption vs current income
 These proxies may not capture them accurately
13
Time series models
 Significance of error term
 6) Principle of parsimony
 Regression is explained by 2 or 3 variables and other variables – unsure whether they
can have an effect – better to use lesser no. of variables
7) Wrong functional form
 Linear form and non-linear form – not chosen properly
 Ui will capture those errors
14
Time series models
 1) The regression model is linear in the parameters
 2) X values are fixed in repeated sampling


15
Time series models
 3) Zero mean value of disturbance

 E(ui )=0
16
Time series models
 4) Homoscedasticity or equal variance of (ui )
17
Time series models
 5) No autocorrelation between the disturbances
 6) zero or no covariance between
 7) No. of observations n must be greater than explanatory variables

 Cannot estimate the parameters from lesser no. of observations
 8) Variability in X values
 Cannot estimate the parameters
 9) Correctly specify the functional form to avoid specification error or bias
 10) There is no perfect multicollinearity among the explanatory variables
18
Time series models
• Exponential Smoothing
 Not based on ARIMA approach
 Uses a linear combination of previous values for modelling
and forecasting
 Gives more weight on recent observations than the past
values
19
Stationarity of series
 Many financial and economic time series exhibit non
stationarity:
• Stock market indices, exchange rates, interest rates,
commodity prices
 Leads to spurious regressions
 What are the consequences of spurious regressions?
 Properties of Stationary Time Series
 Constant mean over time (i. e., no trend)
 Constant variance over time
 Correlation over time depends on relationship between Yt and

Y at some lag k, (Yt-k) doesn’t depend on any other variable.
20
 Stationarity, is defined as a quality of a process in
which the statistical parameters (mean and
standard deviation) of the process do not change
with time. (Challis and Kitney,1991)
 A weakly stationary process has a constant mean,

constant variance and constant autovariance
structure
 A truly stationary (or strongly(strictly) stationary)
process has all higher-order moments constant
including the variance and mean. i.e the
distribution of values remain the same as time
progresses
21
Nifty closing price vs Nifty closing returns
22
Nifty closing price vs Nifty closing returns -
EVIEWS
Close
9,200
8,800
8,400
8,000
7,600
7,200
6,800
M10 M11 M12 M1 M2 M3 M4 M5 M6 M7 M8 M9
2015 2016
closret
.04
.03
.02
.01
.00
-.01
-.02
-.03
-.04
M10 M11 M12 M1 M2 M3 M4 M5 M6 M7 M8 M9
2015 2016
23
EVIEWS – Variable transformation
 Variable transformations
 Variables are transformed to make it stationary
 Generally
1) Natural log transformation
2) First differences
 Lagged variables
 Lag1 .. Lag1close = close(-1)
 Lag 2.. Lag2close = close(-2)
 Differenced Variables
 First difference – fdi = d(close)
 Second difference sdi = d(close,2)
 Returns Series
 Closeret = d(log(close)or ret1 = log(close/close(-1))
24
 How to detect stationarity of series?
Visual inspection of time series
 Can evaluate the Autocorrelation Function (ACF)
 Can also conduct a formal test:

 Augmented Dickey-Fuller test (ADF test)
 Phillip Perron’s test (PP test)
25
Stationarity
 A non stationary series is said to have a unit root.
 e.g. Yt= ρYt-1+ut
 If ρ=1 then series Yt has a unit root
 Null Hypothesis:
 Ho: Series has unit root and is non stationary
 HA: Series is stationary
 Here, if you reject the null, you have stationarity and thus, don’t need to
difference.
26
27
28
Autocorrelation Function (ACF)
 The autocorrelation measures the correlation between
some value of a series (e.g., Y) and the value of that
series at some lag.
e.g., autocorrelation at a lag of 1 is the pairwise correlation
between Yt and Yt-1 for all n-1 pairs.
For all n-k pairs of observations

 The autocorrelation function (ACF) (Correlogram)
maps the ACF’s for various lags.
29
Partial Autocorrelation Function (PACF)
 The Partial Auto Correlation measures the direct
correlation (for example say) between Y(t) and Y (t-2)
after removing the intermediary effect of Y(t-1)
30
Graphical tests for autocorrelation in residuals
Positive autocorrelation in residuals
Scatter plot of residuals Residuals moving over time
31
Negative autocorrelation in residuals
32
No autocorrelation in residuals
33
Detection of autocorrelation – Durbin Watson Test
DW test used to detect autocorrelation
Null and alternate
DW test

34
Detection of autocorrelation – Durbin Watson Test
DW test used to detect autocorrelation
, DW =2  No autocorrelation
, DW =0  +ve autocorrelation
, DW =4  -ve autocorrelation
35
 Closing prices of Nifty series (prices)
 Replication in excel
36
Closing prices of Nifty series ( Returns)
37
Time Series Components
Components
Trend
Seasonal
Irregular
Cyclical
38
Time Series Components - Trend
Indicates long term behaviour of the time series
39
Time Series Components - Seasonal
Regular pattern – visible. Eg: Due to weather

Can be modelled using X13 – ARIMA SEATS
40
Time Series Components - Irregular
Random fluctuation
41
Time Series Components - Cyclical
Gradual up and down movements – Due to economic

factors
42
Time Series Components -
43
Time Series
Developed by G. P. E Box and G. M Jenkins, “Time
Series Analysis: Forecasting and Control”, 1976.
Popularly known as Box-Jenkins (BJ) methodology, but

technically known as ARIMA methodology.
A time series Yt is explained by past or lagged values of

Y itself and error terms.
ARIMA models are not derived from any economic

theory.
44
Time Series
 Notations and concepts
 Confidence interval =
 T is the sample size
 Box & Pierce developed the Q statistic

Q =
 T= sample size
 M= max lag length
Modified Q statistic by Ljung & Box (1976)
45
Time Series
 One can think of a time series as having structure related
to:
• long run trend
• Its’ past values
 AutoRegressive (AR) structure
• Its’ past error terms
 Moving Average (MA) structure
46
Time Series
AR (p): Auto Regressive Process
y t    1 y t 1   2 y t 2     p y t  p  ut
MA (q) Moving Average Process
ARMA (q)
p q
yt    
i 1
i yt i  j 0
j ut  j
47
Time Series
Original Stationary AR MA White
Series Series Structure Structure Noise
Yt Y*t Y*t = ƒ(Y*t-1,Y*t-2 ,..) Y*t=ƒ(et-1,et-2,.) ut
Modelling steps
1) Identification
2) Estimation
3) Diagnostic Checking
4) Forecasting
48
Time Series
 1) Identification (Model Building)
 Plotting time series data

 Pattern of the ACF and PACF - Within +/- 1.96/sqrt.n
– significant (i.e. +/- 2 Standard error)
 2) Estimation
 By Least squares or
 Maximum Likelihood
49
Time Series
3) Diagnostic Checking
How is model fit estimated for linear regressions???
For time series Information criteria (widely used)
AIC (Akaike Information Criteria)
SBC (Schwarz Bayesian Information Criteria)
50
Time Series
Model validity tests
 Residuals plot – Correlogram
 Breusch Godfrey LM test F sig. > .05 – no serial
correlation in residuals
 Durbin Watson statistic for residuals = 2, no serial
correlation , d=0 – positive correlation, d=4 negative
correlation
 Test normality of residuals – Jarque Bera test, Shapiro
Wilks test, etc.
51
Characteristics of AR, MA process
AR(Autoregressive order) MA(Moving Average order)

Geometrically declining ACF ACF – No. of non-zero determines MA
order
PACF- no. of non zero determines AR Geometrically declining PACF
order
52

order
order
53
order
order
54
order
order
55
AR(Autoregressive order) MA(Moving ARMA process
Average order)
Geometrically declining ACF ACF – No. of non- Decaying ACF
zero determines MA
order
PACF- no. of non zero determines AR Geometrically Decaying PACF
order declining PACF
56
Above details in the fig – Rarely seen

Hence, go for information criteria
AIC
SBIC
HQN
57
Forecasting in Econometrics
 Forecasting – Determine the values that a series is likely to take.
 Why forecasting?
 Useful to make financial decisions
 More accurate the forecast more the utility
 Examples in finance where forecasting is useful
 Forecasting stock returns
 Forecasting the price of a house
 Forecasting the riskiness of portfolio
 Forecasting the volatility of bond returns
 Forecasting number of likely defaults on home loans
 Time series forecasting – Done using its previous values and/or previous
error terms
 Point forecast – predicts single value
 Interval forecasts – gives a range of values
58
Time Series Forecasting
 In sample
 Out sample
In sample period Out of sample forecast
Jan 1990 Dec 1998 Jan 1999 Dec 1999
 One step forecast – Forecasting done only for the next step
 Multistep forecast – done for the next ‘s’ steps i.e 1,2,3,… s
steps
59
Forecasting in Econometrics
 Some more concepts used in forecasting
 Rolling windows – The length of the period remains same
 Recursive windows – Length of the period changes due to addition
60
Forecasting accuracy
 Forecasts produced for out of sample
Compared with actual values & diff. is aggregated in various
ways
Main types
 MSE (Mean Square Error)
 MAE (Mean Absolute Error)
 MAPE (Mean Absolute Percentage Error)
61
Forecasting accuracy
 Forecasts error aggregation
 Example
62
Forecasting errors measured by
 MEAN Square error
 Mean absolute error
 Adjusted MAPE =
T represents the total sample

T -1 represents the out of sample
63
ARMA and ARIMA Forecasting in EVIEWS

examples
64
Time Series
Nifty prices
3000
2500
2000
Series1
1500
1000
500
0
1 20 39 58 77 96 115 134 153 172 191 210 229 248
65
Time Series
 Nifty returns
0.02
0.015
0.01
0.005
0 Series1
1 21 41 61 81 101 121 141 161 181 201 221 241
-0.005
-0.01
-0.015
-0.02
66

14.3.23 Computational Finance

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14.3.23 Computational Finance

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Computational Finance

Dr. Narend Subramanian, Prof & Chairperson Accounting & Finance,

 EVIEWS – Student version to download

Assignment – Individual (Word doc. 10 to 15

Daily frequency Stock prices, weather reports, etc

Monthly CPI , unemployment rate

Quarterly GDP (Gross Domestic Product)

Annual frequency Annual budgets

Decennial Population census

 Shows an upward trend

 Weekly consumption is dependent on weekly family

Eg: Family wealth. Difficult to get the wealth details.

 2) X values are fixed in repeated sampling

 3) Zero mean value of disturbance

 6) zero or no covariance between

 7) No. of observations n must be greater than explanatory variables

 10) There is no perfect multicollinearity among the explanatory variables

 Properties of Stationary Time Series

 Constant mean over time (i. e., no trend)

 Constant variance over time

 Correlation over time depends on relationship between Yt and

 A weakly stationary process has a constant mean,

 Can also conduct a formal test:

 e.g. Yt= ρYt-1+ut

 If ρ=1 then series Yt has a unit root

 Ho: Series has unit root and is non stationary

 HA: Series is stationary

For all n-k pairs of observations

Scatter plot of residuals Residuals moving over time

Scatter plot of residuals Residuals moving over time

Scatter plot of residuals Residuals moving over time

Null and alternate

Indicates long term behaviour of the time series

Regular pattern – visible. Eg: Due to weather

Gradual up and down movements – Due to economic

Popularly known as Box-Jenkins (BJ) methodology, but

A time series Yt is explained by past or lagged values of

ARIMA models are not derived from any economic

 Box & Pierce developed the Q statistic

• long run trend

• Its’ past values

 AutoRegressive (AR) structure

• Its’ past error terms

 Moving Average (MA) structure

MA (q) Moving Average Process

Yt Y*t Y*t = ƒ(Y*t-1,Y*t-2 ,..) Y*t=ƒ(et-1,et-2,.) ut

 Plotting time series data

SBC (Schwarz Bayesian Information Criteria)

AR(Autoregressive order) MA(Moving Average order)

AR(Autoregressive order) MA(Moving Average order)

Above details in the fig – Rarely seen

In sample period Out of sample forecast

Jan 1990 Dec 1998 Jan 1999 Dec 1999

 MAE (Mean Absolute Error)

 MAPE (Mean Absolute Percentage Error)

 Mean absolute error

T represents the total sample

ARMA and ARIMA Forecasting in EVIEWS

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Yt Yt Yt = ƒ(Yt-1,Yt-2 ,..) Y*t=ƒ(et-1,et-2,.) ut