Lecture 2 Lecture 2

Market Data Analysis

Dr HK Pradhan
Professor of Finance & Economics
XLRI Jamshedpur p
We are dealing with financial risk
Financial risk originate from the changes in asset Financial risk originate from the changes in asset
prices
(exchange rates, interest rates, commodity (exchange rates, interest rates, commodity
prices, stock prices, etc)
Change in the market prices affect asset values
Prices are called risk factors
Risk is measured in the volatility of returns
Volatility can be conditional or unconditional
Historical data analysis is the key to risk
t measurement
Market Risk
In todays world all asset prices are volatile In today s world, all asset prices are volatile,
and all asset classes are exposed to market risk
Market risk arises due to also the regulatory Market risk arises due to also the regulatory
requirements of the MTM valuation
M k i k l d i h h f f Market risks are correlated with other forms of
risk (credit, liquidity)
Whole lot of financial derivatives were
designed to hedge market risks(options,
forwards, swaps, futures)
Volatility, Clustering & Asymmetry y, g y y
Ch i f k t d t Choice of market data
Exchange rates, yields, commodity prices, stock g , y , y p ,
prices
Type of data, data period, frequency are important
d i l ili ( i k) determinants of volatility (risk) measures
Long historical data vs recent observations(regimes)
D d th t f / i k t Depends on the type of exposure/ risk measurement
under consideration
Trading position assets with longer holding Trading position, assets with longer holding
periods, illiquid assets
Rs-USD 2008-2011
trends donot reveal any discernible pattern
of distribution that we can infer for risk of distribution that we can infer for risk
considerations
Type of Data
Data do display different volatility depending on
what data used
hl kl d il i d Monthly, weekly, daily, intra-day
We need to know the underlying distribution
of the data
Euro/Per USD rate: Sept 2007-April 2008
Euro/Per USD rate: June 2008 August 2008 Euro/Per USD rate: June 2008-August 2008
Euro/Per USD rate: 23
rd
August 2008
Intra-Day Data Intra Day Data
Time Varying Volatility
0 02
0.04
0.06
0.08
-0.04
-0.02
0
0.02
1 25 49 73 97 121 145 169 193 217 241 265 289 313 337 361 385 409 433 457 481 505
-0.08
-0.06
Conditional variance of returns is not constant, and that asset
returns may show alternative periods on higher or lower
volatility (volatility clustering), with time varying parameters y ( y g), y g p
such as mean and sigma
Understand Market prices Understand Market prices
Something we can discern Something we can discern
from the past behavior of
the market prices: its
return
Past behavior would
reflect future (or expected
return), given all other
f t factors
Efficient market hypothesis..
Measuring Return Measuring Return
Risk is measured from return and not from the asset price Risk is measured from return and not from the asset price
levels
Let us define daily geometric or log return on an asset y g g
as the change in the logarithm of the daily closing price
of the asset
| |
S
|
|
.
|

\
|
= =

1
1
) ( ) (
t
t
t t t
S
S
Ln S Ln S Ln r
The arithmetic return is instead defined as
( ) 1
1 1 1
= =
+ + + t t t t t t
S S S S S r
Log Return
An advantage of the log return concept is that we
can easily calculate the compounded return over K-
days as the sum of daily return days as the sum of daily return

= = =
K K
R S S S S R ) ln( ) ln( ) ln( ) ln(
L t d t id ti i

= =
+ + + + + +
= = =
k k
k t k t k t t K t K t t
R S S S S R
1 1
1 : 1
) ln( ) ln( ) ln( ) ln(
Log return does not consider negative prices
Log return & percentage return are close on g p g
a daily basis
Measuring Risk & Return
Daily return
|
|
.
|

\
|
1 t
t
S
S
Ln
Weekly or monthly
return
|
|
.
|

\
|
i t
t
S
S
Ln
Intra-day Changes
. \ i t
|
|
.
|

\
|
H
S
S
Ln y g
between H/L
|
.

\ L
S
Risk & Returns Across Horizons Risk & Returns Across Horizons
M 0 01%
1-day Return
The means and standard
deviations increase as
Mean -0.01%
St. Deviation 0.11%
Skewness -0.809
Kurtosis 10.446
number of days increase.
Excess kurtosis, on the
Mean -0.06%
St. Deviation 0.23%
Skewness 0.300
5-day Return
,
other hand, decreases.
Kurtosis 1.807
Mean -0.12%
St. Deviation 0.33%
10-day Return
Skewness 0.078
Kurtosis 2.997
Mean -0 18%
15-day Return
Mean 0.18%
St. Deviation 0.45%
Skewness 0.846
Kurtosis 2.509
Distribution Assumptions
Fundamental assumptions considered in assets price models
Log Returns follow a normal distribution (i.e. the
d l i i f ll l l di ib i ) underlying asset prices follow a lognormal distribution)
A random variable X is said to have a lognormal distribution
if its natural logarithm, Y = ln(X), has a normal distribution if its natural logarithm, Y ln(X), has a normal distribution
) , * ( ln t t N
S
t
o ~
|
|
.
|

\
|
i.e.
sd mean = = o &
0
S
|
.

\
Normal Distribution Normal Distribution
The probability density function for
l di ib i i a normal distribution is:
For a mean of 0 and a standard
deviation of 1, this formula
simplifies to
which is known as the standard normal distribution
Approximately bell shaped, would have a skewness of around
0 together with a kurtosis of close to 3
Stylized distribution properties of the Stylized distribution properties of the
asset prices by its four moments
Di ib i i h i ifi Distribution properties have significant
implications on risk
We can consider higher moments of the return We can consider higher moments of the return
data
First moment: mean, ()
Second moment: standard deviation, (o).
Third moment: Symmetrical: Skewness, (sk)
Fo rth moment: Kurtosis (kurt) Fourth moment: Kurtosis (kurt)
We use daily returns on the Rupee-USD rates for
the period January 2002-January 2004 the period January 2002 January 2004
Unconditional Mean & Sd Unconditional Mean & Sd
Define P
i
as the price of an asset at end of day i
Define Return = ln(P /P ) or continuously Define Return as r
i
= ln(P
i
/P
i-1
) or continuously
compounded return over multiple-day
The standard estimates of mean & Sd from n observations
is: is:

=
n
i
r
n
r
1
is unconditional Mean of
the return

=
=
n
i
r r
n
2 2
1
) (
1
o
the return
is unconditional Sd of the

=
i
i n
r r
n
1
) (
1
o
return
Sd is a measure of unconditional volatility, used as a y,
proxy for risk
Skewness
Skewness: Skewness is a
measure of the asymmetry
Skewness
measure of the asymmetry
of the distribution
1
n
3
1
3
) (
1

=

=
i
i
r r
n
sk
3
o

=
=
n
i
i n
r r
n
1
2 2
) (
1
o
and the sample variance defined as
Skewness is a measure of symmetry, a ve skew implies y y, p
return data in tail, or tail risk
Kutosis
Kurtosis relates to the
balance between the tails of
Kutosis
balance between the tails of
the distribution versus its
center center
1
4
) (
1

=

n
i
i
r r
n
kurt
4
1
o
=
i
kurt
Leptokurtic distributions have heavy concentrations around the
mean, which when combined with ve skewness can have
significant risk implication
Stylized Facts of Asset Return
Descriptive Statistics
Mean -0.0001243
Standard Error 0 0000468
Stylized Facts of Asset Return
Mean return is ve (very close
i hi )
Standard Error 0.0000468
Median -0.0001027
Mode 0.0000000
Standard Deviation 0.0010539
Sample Variance 0.0000011
K t i 10 4456157
to zero in this case)
The standard deviation of
returns completely dominates
th f t d il
Kurtosis 10.4456157
Skewness -0.8091802
Range 0.0140579
Minimum -0.0079121
Maximum 0.0061458
the mean of returns on a daily
data.
The unconditional distribution
f d il t h f tt t il Sum -0.0631685
Count 508.0000000
of daily returns have fatter tail
than the normal distribution.
Fatter tails mean a higher
probability of large losses
50
60
probability of large losses
than the normal distribution
would suggest.
It is more peaked around zero
20
30
40
50
It is more peaked around zero
than the normal distribution.
0
10
1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96
Using Eviews
140
160
Series: SER01
Sample 1 508
Observations 508
80
100
120
Obse at o s 508
Mean -0.000124
Median -0.000103
Maximum 0.006146
Minimum -0.007912
Std Dev 0 001054
20
40
60
Std. Dev. 0.001054
Skewness -0.806789
Kurtosis 13.33130
Jarque-Bera 2314.350
Probability 0.000000
0
-0.0075 -0.0050 -0.0025 0.0000 0.0025 0.0050
Stylized Facts..
Return distribution if asymmetric or negatively Return distribution if asymmetric or negatively
skewed, has greater implications on risk
management
Other markets such as that for stock markets
tend to show evidence of greater skewness.
The stock market exhibits occasional, very
large drops but not equally large up-moves
(assymetric behaviour: Narasimhan & Pradhan,
2004, NSE Discussion Paper)
Non-Normality in asset return Non Normality in asset return
normal distribution
actual distribution
normal distribution
Normal based risk measurement may understates the losses under non-
normality assumptions y p
Non-normality requires simulation approaches, extreme value theory,
different measure of volatility, etc
Comfort Zone for the Normal Distribution
Tail probability
0
p y
0
Sd*z-values Observations Lower
(confidence level) Tail Probability
1 84% 16% 1 84% 16%
1.65 95% 5%
2.33 99% 1%
Locate the risk by measuring the distance by how many sd from the mean
Kernel Density
600
700
SER01
400
500
600
200
300
400
D
e
n
s
i
t
y
0
100
200
0
-.012 -.008 -.004 .000 .004 .008
Q-Q Plots
.003
.004
.001
.002
N
o
r
m
a
l
002
-.001
.000
Q
u
a
n
t
i
l
e
s

o
f

-.004
-.003
-.002
-.012 -.008 -.004 .000 .004 .008
Quantiles of SER01
Test of Conditional Normality
Need to standardize returns
by a time-varying volatility measure, or some y y g y ,
measure of excess returns (although they could
still be fatter than normal tails).
This is referred to this as evidence of conditional
non-normality.
However as the return-horizon increases, the
unconditional return distribution changes and
l k i i l lik th l di t ib ti looks increasingly like the normal distribution
Negative Semi-variance Negative Semi variance
Risk is the downside exposure
How much loss expected by holding an asset?
P
i
as the price of an asset i
Return as r
i
= ln(P
i
/P
i-1
)
Negative semi-variance can be computed as:

=
n
i
n
r r
2
2
) (
1
1
o

=

i
i
n
1
) (
1
Return here is signified as those which are less than the mean return Return here is signified as those which are less than the mean return
Mean return included both positive and negative return
Concept of Squared Return
2
(
2
1
2
) ln(
(

=
t
t
t
S
S
r

~ =
1
0
1
if assuming
n
i
r
n
r

=1 i
n
Unweighted standard deviation with squared return

1
2 2
1
n
Unweighted standard deviation with squared return
becomes

=
1
2 2
) (
1
1
i
i n
r
n
o
iid assumption underlying the
distribution of asset return
Independent: Independent:
correlation coefficients of successive observations
are zero
Identically distributed:
they are assumed to come from the same distribution they are assumed to come from the same distribution
variance of the returns are assumed to be a linear
function of the time period being analyzed u c o o e e pe od be g y ed
Autocorrelations of Daily Returns y
D il h li l
0.1
0.15
Daily returns have very little
autocorrelation, implying that
returns are almost impossible to
predict from their own past
0
0.05
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
predict from their own past.
( ) 0 ,
1 1
~
+ + t t t
r r Corr
0 15
-0.1
-0.05
Squared returns display
positive correlation with its own
0 1,2,3,...5 for = t
-0.15
0.35
0.4
past, at least over short horizons
0.15
0.2
0.25
0.3
( )
t
0 ,
2 2
>
t t
r r Corr
-0.05
0
0.05
0.1
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
( )
t
t
small for
,
t t
A t l ti Autocorrelations
Autocorrelations of variance as measured by
d di l i i l i i h squared returns, displays positive correlation with
its own past, at least in short horizons such as
daily or weekly daily or weekly.
Ref to our autocorrelation in squared returns for
the forex data
small for 0 ) (
2 2
> C
the forex data
Equity and equity indices often display negative
t
t
small for , 0 ) , (
2
1
2
1
>
+ + t t
r r Corr
Equity and equity indices often display negative
correlation between variance and returns.
This often termed the leveraged effect, a drop in stock This often termed the leveraged effect, a drop in stock
price will increase the leverage of the firm as long as
debt stays constant
Autocorrelations of Squared Returns
Squared returns show persistence
0 4
Squared returns show persistence,
implying the persistence in the
scale of fluctuations
0 2
0.25
0.3
0.35
0.4
This can be known as volatility
persistence: large price
movements followed by another 0
0.05
0.1
0.15
0.2
movements followed by another
large price movements, not
necessarily in the same
directions
-0.05
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
( )
Volatility Clustering
directions
Some people use absolute value
of the increments or even runs
( )
t
t
small for
0 ,
2 2
>
t t
r r Corr
test
Market Data Analysis
Is there a trend in the series? Is the series Stationary? Is there a trend in the series? Is the series Stationary?
Are the standard assumptions from theoretical finance
justified? j
Whats the distribution of the data look like:
normal log normal skewness kurtosis normal , log normal, skewness, kurtosis.
How important are the outliers?
Is volatility constant or asymmetric ? Is volatility constant, or asymmetric ?
Independence of asset price changes?
Caution: Caution:
Historical data can be noisy
Historical data can be misleading Historical data can be misleading
if a market is maturing, if there is regime switch, policy
shifts occurring swiftly over the measurement period,
or are affected by specific events that had a large or are affected by specific events that had a large
impact on asset prices (9/11, 26/11, global financial
crisis)
Illiquidity can have problems affect smooth or Illiquidity can have problems affect smooth or
continuous historical data
say for example, prices bonds on certain days not
il bl available
We analysed base don one sample from the
underlying distribution and getting more underlying distribution and getting more
observations may change the shape of the
estimated densities
Assignment
Get at least two asset prices (stock prices, exchange rate,
prices of gold, oil, etc)
Id if h di ib i i f h i i Identify the distribution properties of their series
Interpret mean, sd, Kurtosis & Skewness
Find out volatility clustering in data Find out volatility clustering in data
Compute autocorrelations of return^2
Draw conclusions on risk pattern of asset prices p p
What economic logic, risk implications