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1.1
Let rit = ln(Pit /Pt1 ) denote the continuously compounded return on asset
i at time t. We make the following assumptions regarding the probability
distribution of rit for i = 1, . . . , N assets over the time horizon t = 1, . . . , T.
Assumption 1
1
1.1.1
= i + it ,
GWN(0, 2i ),
t=s
ij
cov(it , js ) =
.
0 t 6= s
(1.1)
The notation it GWN(0, 2i ) stipulates that the stochastic process {it }Tt=1
is a Gaussian white noise process with E[it ] = 0 and var(it ) = 2i . In
E[rit ]
var(rit )
cov(rit , rjt )
cov(rit , rjs )
=
=
=
=
E[i + it ] = i + E[it ] = i ,
var(i + it ) = var(it ) = 2i ,
cov(i + it , j + jt ) = cov(it , jt ) = ij ,
cov(i + it , j + js ) = cov(it , js ) = 0, t 6= s.
Given that covariances and variances of returns are constant over time implies that the correlations between returns over time are also constant:
ij
cov(rit , rjt )
=
= ij ,
cor(rit , rjt ) = p
i j
var(rit )var(rjt )
0
cov(rit , rjs )
=
= 0, i 6= j, t 6= s.
cor(rit , rjs ) = p
ij
var(rit )var(rjs )
Finally, since {it }Tt=1 GWN(0, 2i ) it follows that {rit }Tt=1 iid N(i , 2i ).
Hence, the CER regression model (1.1) for rit is equivalent to the model
implied by Assumption 1.
1.1.2
The CER model has a very simple form and is identical to the measurement
error model in the statistics literature1 . In words, the model states that each
asset return is equal to a constant i (the expected return) plus a normally
distributed random variable it with mean zero and constant variance. The
random variable it can be interpreted as representing the unexpected news
concerning the value of the asset that arrives between time t 1 and time t.
To see this, (1.1) implies that
it = rit i = rit E[rit ],
1
In the measurement error model, rit represents the tth measurement of some physical quantity i and it represents the random measurement error associated with the
measurement device. The value i represents the typical size of a measurement error.
= i + it = i + i zit
GWN(0, 1),
(1.2)
In this form, the random news shock is the iid standard normal random variable zit scaled by the news volatility i . This form is particularly convenient
for value-at-risk calculations.
1.1.3
The CER model for continuously compounded returns has the following nice
aggregation property with respect to the interpretation of it as news. Suppose that t represents months so that rit is the continuously compounded
monthly return on asset i. Now, instead of the monthly return, suppose we
are interested in the annual continuously compounded return rit = rit (12).
Since multi-period continuously compounded returns are additive, rit (12) is
the sum of 12 monthly continuously compounded returns:
rit = rit (12) =
11
X
k=0
Using the CER regression model (1.1) for the monthly return rit , we may
express the annual return rit (12) as
11
11
X
X
rit (12) =
(i + it ) = 12 i +
it = A
i + it (12),
t=0
t=0
where A
i = 12 i is the annual expected return on asset i, and it (12) =
P
11
k=0 itk is the annual random news component. The annual expected
return, A
i , is simply 12 times the monthly expected return, i . The annual
random news component, it (12) , is the accumulation of news over the year.
2
As a result, the variance of the annual news component, A
, is 12 time
i
the variance of the monthly news component:
11
X
itk
k=0
=
=
11
X
k=0
11
X
k=0
2
.
= 12 2i = A
i
It follows that the standard deviation of the annual news is equal to
times the standard deviation of monthly news:
SD(it (12)) =
12
12SD(it ) = 12 i .
This result is know as the square root of time rule. Similarly, due to the
additivity of covariances, the covariance between it (12) and jt (12) is 12
=
=
11
X
k=0
11
X
k=0
k=0
= 12 ij = A
ij .
The above results imply that the correlation between the annual errors it (12)
and jt (12) is the same as the correlation between the monthly errors it and
jt :
cov(it (12), jt (12))
cor(it (12), jt (12)) = p
var(it (12)) var(jt (12))
12 ij
= q
12 2i 12 2j
ij
=
= ij = cor(it , jt ).
i j
1.1.4
The CER model of asset returns (1.1) gives rise to the so-called random
walk (RW) model for the logarithm of asset prices. To see this, recall that
the continuously
(1.3)
The model (1.3) is technically a random walk with drift i . A pure random walk has
zero drift.
In the RW model (1.3), i represents the expected change in the logprice (continuously compounded return) between months t 1 and t, and it
represents the unexpected change in the log-price. That is,
E[pit ] = E[rit ] = i ,
it = pit E[pit ].
where pit = pit pit1 . Further, in the RW model, the unexpected changes
in log-price, it , are uncorrelated over time (cov(it , is ) = 0 for t 6= s) so
that future changes in log-price cannot be predicted from past changes in
the log-price3 .
The RW model gives the following interpretation for the evolution of log
prices. Let pi0 denote the initial log price of asset i. The RW model says
that the log-price at time t = 1 is
pi1 = pi0 + i + i1 ,
where i1 is the value of random news that arrives between times 0 and 1.
At time t = 0 the expected log-price at time t = 1 is
E[pi1 ] = pi0 + i + E[i1 ] = pi0 + i ,
which is the initial price plus the expected return between times 0 and 1.
Similarly, by recursive substitution the log-price at time t = 2 is
pi2 = pi1 + i + i2
= pi0 + i + i + i1 + i2
2
X
= pi0 + 2 i +
it ,
t=1
which is equal to the initial log-price, pi0 , plus the two period expected
P2 return,
2 i , plus the accumulated random news over the two periods, t=1 it . By
repeated recursive substitution, the log price at time t = T is
piT = pi0 + T i +
3
T
X
it .
t=1
The notion that future changes in asset prices cannot be predicted from past changes
in asset prices is often referred to as the weak form of the ecient markets hypothesis.
var(piT ) = var
it
t=1
= T 2i
Hence, the RW model implies that the stochastic process of log-prices {pit } is
non-stationary because the variance of pit increases with t. Finally, because
it iid N(0, 2i ) it follows that (conditional on pi0 ) piT N(pi0 +T i , T 2i ).
The term random walk was originally used to describe the unpredictable
movements of a drunken sailor staggering down the street. The sailor starts
at an initial position, p0 , outside the bar. The sailor generally moves in
the direction described by but randomly deviates from this direction after
each step t by an amount
PTequal to t . After T steps the sailor ends up at
position pT = p0 +T + t=1 t . The sailor is expected to be at location T,
but where he actually
Pends up depends on the accumulation of the random
changes in direction Tt=1 t . Because var(pT ) = 2 T, the uncertainty about
where the sailor will be increases with each step.
The RW model for log-price implies the following model for price:
St
s=1 is
St
= Pi0 ei t e
s=1 is
P
where pit = pi0 + i t+ ts=1 s . The term ei t represents the expected exponential
growth rate in prices between times 0 and time t, and the term
St
is
s=1
e
represents the unexpected exponential growth in prices. Here, conditional on Pi0 , Pit is log-normally distributed because pit = ln Pit is normally
distributed.
1.1.5
2
12 1N
1
2
12 2 2N
=
..
.. . .
.. .
.
.
.
.
2
1N 2N N
Then the CER model matrix notation is
rt = + t ,
t GW N(0, ),
(1.4)
1.2
Monte Carlo referrs to the famous city in Monaco where gambling is legal.
20
Frequency
-0.1
-0.4
-0.3
10
-0.2
returns
0.0
0.1
30
0.2
40
0.3
1993
1996
Ind e x
1999
-0 .4
-0 .2
0 .0
0 .2
re turns
11
(1.5)
mu = 0.03
sd.e = 0.10
nobs = 100
set.seed(111)
sim.e = rnorm(nobs, mean=0, sd=sd.e)
sim.ret = mu + sim.e
par(mfrow=c(1,2))
ts.plot(sim.ret, main="",
xlab="months",ylab="return", lwd=2, col="blue")
abline(h=mu)
hist(sim.ret, main="", xlab="returns", col="slateblue1")
par(mfrow=c(1,1))
20
Frequency
0.0
-0.3
-0.2
10
-0.1
return
0.1
30
0.2
0.3
40
20
40
60
80
100
-0 .3
-0 .1
m o nths
0 .1
0 .3
re turns
t
X
j=1
j , t GWN(0, (0.10)2 ).
mu = 0.03
sd.e = 0.10
nobs = 100
set.seed(111)
sim.e = rnorm(nobs, mean=0, sd=sd.e)
sim.p = 1 + mu*seq(nobs) + cumsum(sim.e)
sim.P = exp(sim.p)
Figure 1.3 shows the simulated values. The top panel shows the simulated
log price, pt , the expected price E[pt ] = 1 + 0.03 t and the accumulated
0 1 2 3 4
13
p(t)
E[p(t)]
p(t)-E[p(t)]
-2
log price
20
40
60
80
100
60
80
100
20
0
price
40
Time
20
40
Time
Pt
j=1 j ,
P
random news pt E[pt ] = ts=1 s . The bottom panel shows the simulated
price levels Pt = ept . Figure 1.4 shows the actual log prices and price levels for
Microsoft stock. Notice the similarity between the simulated random walk
data and the actual data.
1.2.1
Creating a Monte Carlo simulation of more than one return from the CER
model requires simulating observations from a multivariate normal distribution. This follows from the matrix representation of the CER model given
in (1.4). The steps required to create a multivariate Monte Carlo simulation
are:
1. Fix values for N 1 mean vector and the N N covariance matrix
.
10
20
40
80
1993
1994
1995
1996
1997
1998
1999
2000
2001
1998
1999
2000
2001
20
40
60
80 100
1993
1994
1995
1996
1997
Figure 1.4:
2. Determine the number of simulated values, T, to create.
3. Use a computer random number generator to simulate T iid values of
the N 1 random vector t from the multivariate normal distribution
N(0, ). Denote these simulated vectors as
1 , . . . ,
T .
t for t = 1, . . . , T.
4. Create the N 1 simulated return vector rt = +
To motivate the parameters for a multivariate simulation of the CER
model, consider the monthly continuously compounded returns for Microsoft,
Starbucks and the S & P 500 index over the ten-year period July, 1992
through October, 2000 illustrated in Figures 1.5 and 1.6. All returns seem
to fluctuate around a mean value near zero. The volatilities of Microsoft
and Starbucks are similar with typical magnitudes around 0.10, or 10%. The
volatility of the S&P 500 index is considerably smaller at about 0.05, or
5%. The pairwise scatterplots show that all returns appear to be positively
related. The pairs (MSFT, SP500) and (SBUX, SP500) appear to be the most
correlated, and the shape of the scatter indicates correlation values around
0.5. The pair (MSFT, SBUX) shows a weak positive correlation around 0.2.
Let rt = (rmsf t , rsbux , rsp500 )0 . Then, a plausible value for is = (0, 0, 0)0 ,
15
sbux
sp500
0.0
-0.15
-0.2
msft
0.2
-0.4
-0.2
0.0
0.2
1993
1994
1995
1996
1997
1998
1999
2000
Index
Figure 1.5: Monthly continuously compounded returns on Microsoft, Starbucks and the S&P 500 index. Source: finance.yahoo.com.
and a plausible value for is
(0.10)2
(0.10)(0.10)(0.2) (0.10)(0.05)(0.5)
2
= (0.10)(0.05)(0.5)
(0.10)
(0.10)(0.05)(0.5)
2
(0.10)(0.05)(0.5) (0.10)(0.05)(0.5)
(0.05)
-0.2
0.0
0.2
0.0
0.2
-0.4
0.0
0.2
-0.4
-0.2
sbux
-0.15
sp500
-0.4
-0.2
msft
-0.4
-0.2
0.0
0.2
-0.15
mu = rep(0,3)
sig.msft = 0.10
sig.sbux = 0.10
sig.sp500 = 0.05
rho.msft.sbux = 0.2
rho.msft.sp500 = 0.5
rho.sbux.sp500 = 0.5
sig.msft.sbux = rho.msft.sbux*sig.msft*sig.sbux
sig.msft.sp500 = rho.msft.sp500*sig.msft*sig.sp500
sig.sbux.sp500 = rho.sbux.sp500*sig.sbux*sig.sp500
Sigma = matrix(c(sig.msft^2, sig.msft.sbux, sig.msft.sp500,
sig.msft.sbux, sig.sbux^2, sig.sbux.sp500,
sig.msft.sp500, sig.sbux.sp500, sig.sp500^2),
nrow=3, ncol=3, byrow=TRUE)
0.1
0.0
0.05
0.00
msft
-0.05
sp500
0.10
-0.2 -0.1
sbux
0.2
0.3 -0.2
-0.1
0.0
0.1
0.2
20
40
60
80
100
Index
1.3
The CER model of asset returns gives us a simple framework for interpreting
the time series behavior of asset returns and prices. At the beginning of every
month t, rit is a random variable representing the continuously compounded
return to be realized at the end of the month. The CER model states that
rit iid N(i , 2i ). Our best guess for the return at the end of the month
0.0
0.1
0.2
0.3
0.1
0.2
-0.2 -0.1
0.1
0.2
0.3
-0.2
-0.1
0.0
msft
0.05
0.10
-0.2 -0.1
0.0
sbux
-0.05
0.00
sp500
-0.2
-0.1
0.0
0.1
0.2
-0.05
0.00
0.05
0.10
Figure 1.8: Scatterplot matrix of the simulated returns on Microsoft, Starbucks and the S&P 500 index.
is E[rit ] = i , our measure of uncertainty about our best guess is captured
by SD(rit ) = i , and our measures of the direction and strength of linear
association between rit and rjt are ij = cov(rit , rjt ) and ij = cor(rit , rjt ),
respectively. The CER model assumes that the economic environment is
constant over time so that the normal distribution characterizing monthly
returns is the same every month.
Our life would be very easy if we knew the exact values of i , 2i , ij and
ij , the parameters of the CER model. In actuality, however, we do not know
these values with certainty. Therefore, a key task in financial econometrics
is estimating these values from a history of observed return data.
Suppose we observe monthly continuously compounded returns on N different assets over the horizon t = 1, . . . , T. It is assumed that the observed
returns are realizations of the stochastic process {ri1 }Tt=1 , where rit is described by the CER model (1.1). Under these assumptions, we can use the
observed returns to estimate the unknown parameters of the CER model.
1.3.1
Let denote some characteristic of the CER model (1.1) we are interested
in estimating. For example, if we are interested in the expected return, then
= i ; if we are interested in the variance of returns, then = 2i ; if we are
interested in the correlation between two returns then = ij . The goal is to
estimate based on a sample of size T of the observed data.
Definition 4 Let {r1 , . . . , rT } denote a collection of T random returns from
the CER model (1.1), and let denote some characteristic of the model. An
estimator of , denoted , is a rule or algorithm for estimating as a function
of the random returns {r1 , . . . , rT }. Here, is a random variable.
Definition 5 Let {r1 , . . . , rT } denote an observed sample of size T from the
CER model (1.1), and let denote some characteristic of the model. An
estimate of , denoted , is simply the value of the estimator for based on
the observed sample. Here, is a number.
Example 6 The sample average as an estimator and an estimate
Let {r1 , . . . , rT } be described by the CER model (1.1), and supposeP
we are
interested in estimating = = E[rt ]. The sample average
= T1 Tt=1 rt
is an algorithm for computing an estimate of the expected return . Before
the sample is observed,
is a simple linear function of the random variables
{r1 , . . . , rT } and so is itself a random variable. After the sample is observed,
the sample average can be evaluated using the observed data which produces
the estimate. For example, suppose T = 5 and the realized values of the
returns are r1 = 0.1, r2 = 0.05, r3 = 0.025, r4 = 0.1, r5 = 0.05. Then the
estimate of using the sample average is
1
1.3.2
Properties of Estimators
0.0
0.5
1.0
1.5
theta.hat 1
theta.hat 2
-3
-2
-1
estimate value
2
2
se() =
1.3.3
q
var().
Estimator bias and precision are finite sample properties. That is, they
are properties that hold for a fixed sample size T. Very often we are also
interested in properties of estimators when the sample size T gets very large.
For example, analytic calculations may show that the bias and mse of an
estimator depend on T in a decreasing way. That is, as T gets very large
the bias and mse approach zero. So for a very large sample, is eectively
unbiased with high precision. In this case we say that is a consistent
estimator of . In addition, for large samples the CLT says that f () can
often be well approximated by a normal distribution. In this case, we say
that is asymptotically normally distributed. The word asymptotic means
in an infinitely large sample or as the sample size T goes to infinity. Of
course, in the real world we dont have an infinitely large sample and so the
asymptic results are only approximations. How good these approximation are
for a given sample size T depends on the context. Monte Carlo simulations
can often be used to evaluate asymptotic approximations in a given context.
Consistency
Let be an estimator of based on the random returns {ri1 , . . . , riT }.
Intuitively, consistency says that as we get enough data then will eventually
equal . In other words, if we have enough data then we know the truth.
Statistical theorems known as Laws of Large Numbers are used to determine if an estimator is consistent or not. In general, we have the following
result: an estimator is consistent for if
bias(, ) = 0 as T
se = 0 as T
(1.6)
There are actually many versions of the CLT with dierent assumptions. In its simplist form, the CLT says that the sample average of a collection of iid random variables
X1 , . . . , XT with E[Xi ] = and var(Xi ) = 2 is asymptotically normal with mean and
variance 2 /T.
1.3.4
i =
rit = ri ,
T t=1
1 X
(rit
i )2 ,
T 1 t=1
q
i =
2i ,
(1.7)
2i =
1 X
=
(rit
i )(rjt
j ),
T 1 t=1
(1.8)
(1.9)
ij
ij =
ij
.
i
j
(1.10)
(1.11)
Example 13 Estimating the CER model parameters for Microsoft, Starbucks and the S&P 500 index.
To illustrate typical estimates of the CER model parameters, we use data on
T = 100 monthly continuously compounded returns for Microsoft, Starbucks
and the S & P 500 index over the period July 1992 through October 2000.
These data are illustrated in Figures 1.5 and 1.6. The estimates of i using
(1.7) can be computed using the R functions apply() and mean()
> muhat.vals = apply(returns.mat,2,mean)
> muhat.vals
sbux
msft
sp500
0.02777 0.02756 0.01253
msf t = 0.02756 and
sp500 = 0.01253. The expected
giving
sbux = 0.02777,
return estimates for Microsoft and Starbucks are very similar at about 2.8%
per month, whereas the S&P 500 expected return estimate is smaller at only
2sbux = 0.0185,
msf t = 0.1068,
2msf t = 0.0114,
2sp500 = 0.0014,
sp500 = 0.0379.
Starbucks has the most variable monthly returns, and the S&P 500 index
has the smallest. The scatterplots of the returns are illustrated in Figure 1.6.
All returns appear to be positively related. The pairs (MSFT, SP500) and
(SBUX, SP500) appear to be the most correlated. The estimates of ij and
ij using (1.10) and (1.11) can be computed using the functions var() and
cor()
> cov.mat
sbux
msft
sp500
sbux 0.018459 0.004031 0.002158
msft 0.004031 0.011411 0.002244
sp500 0.002158 0.002244 0.001432
> cor.mat = cor(returns.z)
> cor.mat
sbux
msft sp500
sbux 1.0000 0.2777 0.4198
msft 0.2777 1.0000 0.5551
sp500 0.4198 0.5551 1.0000
Notice when var() and cor() are given a matrix of returns they return the
estimated variance matrix and the estimated correlation matrix, respectively.
To extract the unique pairwise values use
1.4
1.4.1
Statistical Properties of
i
#
T
1X
E[
i ] = E
rit
T t=1
"
#
T
X
1
= E
( + it ) (since rit = i + it )
T t=1 i
"
T
T
1X
1X
=
+
E[it ] (by the linearity of E[])
T t=1 i T t=1
T
1X
=
(since E[it ] = 0, t = 1, . . . , T )
T t=1 i
1
T i = i .
T
Hence, the mean of f (
i ) is equal to i . We have just proved that
i an
unbiased estimator for i in the CER model.
=
Precision
i ) =
Because P
bias(
, ) = 0, the precision of
i is determined by var(
T
1
var(T
t=1 rit ). Using the results about the variance of a linear combination of uncorrelated random variables, we have
!
T
1X
var(
i ) = var
rit
T t=1
!
T
1X
= var
( + it )
(since rit = i + it )
T t=1 i
!
T
1X
(since i is a constant)
= var
it
T t=1
T
1 X
= 2
var(it ) (since it is independent over time)
T t=1
=
=
T
1 X 2
T 2 t=1 i
(since var(it ) = 2i , t = 1, . . . , T )
2i
1
2
T
=
.
T2 i
T
bi
var(
c i ) =
T
(1.15)
which is just (1.14) with the unknown value of i replaced by the estimate
bi given by (1.9) .
Example 14 se(
b i ) values for Microsoft, Starbucks and the S&P 500 index
0.8
0.4
0.0
0.2
0.6
pdf 1
pdf 2
-3
-2
-1
estimate value
msf t
0.02756
=
= 2.580,
se(
b msf t )
0.01068
0.02777
sbux
=
= 2.044,
se(
b sbux )
0.01359
sp500
0.01253
=
= 3.312.
se(
b sp500 )
0.00378
2i
i N i ,
.
(1.16)
T
The distribution for
i is centered at the true value i , and the spread about
the average depends on the magnitude of 2i , the variability of rit , and the
sample size, T . For a fixed sample size, T , the uncertainty in
i is larger
2
for larger values of i . Notice that the variance of
i is inversely related to
i ) is smaller for larger sample sizes than
the sample size T. Given 2i , var(
for smaller sample sizes. This makes sense since we expect to have a more
precise estimator when we have more data. If the sample size is very large (as
T ) then var(
i ) will be approximately zero and the normal distribution
of
i given by (1.16) will be essentially a spike at i . In other words, if the
sample size is very large then we essentially know the true value of i . Hence,
we have established that
i is a consistent estimator of i as the sample size
goes to infinity.
The distribution of
i , with i = 0 and 2i = 1 for various sample sizes is
illustrated in figure ??. Notice how fast the distribution collapses at i = 0
as T increases.
1.4.2
The precision of
i is best communicated by computing a confidence interval
for the unknown value of i . A confidence interval is an interval estimate of i
such that we can put an explicit probability statement about the likelihood
that the interval covers i .
The construction of an exact confidence interval for i is based on the
following statistical result (see the appendix for details).
Result: Let {rit }Tt=1 denote a stochastic process generated from the CER
model (1.1). Define the t-ratio as
ti =
i i
,
se(
b i )
(1.17)
1.5
0.0
0.5
1.0
pdf1
2.0
2.5
pdf: T=1
pdf: T=10
pdf: T=50
-3
-2
-1
x.vals
i i
Pr tT 1 (1 /2)
tT 1 (1 /2) = 1 ,
se(
b i )
which can be rearranged as
Pr (
i tT 1 (1 /2) se(
b i ) i
i + tT 1 (1 /2) se(
b i )) = 1 .
(1.18)
i 2 se(
b i ).
(1.19)
The above formula for a 95% confidence interval is often used as a rule of
thumb for computing an approximate 95% confidence interval for moderate
sample sizes. It is easy to remember and does not require the computation
of the quantile tT 1 (1 /2) from the Students-t distribution. It is also
an approximate 95% confidence interval that is based the asymptotic normality of
i . Recall, for a normal distribution with mean and variance 2
approximately 95% of the probability lies between 2.
The coverage probability associated with the confidence interval for i is
based on the fact that the estimator
i is a random variable. Since confidence
interval is constructed as
i tT 1 (1/2) se(
b i ) it is also a random variable.
An intuitive way to think about the coverage probability associated with the
confidence is to think about the game of horse shoes. The horse shoe is the
confidence interval and the parameter i is the post at which the horse shoe
is tossed. Think of playing game 100 times (i.e, simulate 100 samples of the
CER model). If the thrower is 95% accurate (if the coverage probability is
0.95) then 95 of the 100 tosses should ring the post (95 of the constructed
confidence intervals contain the true value i ).
Example 15 95% confidence intervals for i for Microsoft, Starbucks and
the S & P 500 index.
Consider computing 95% confidence intervals for i using (1.18) based on
the estimated results for the Microsoft, Starbucks and S&P 500 data. The
degrees of freedom for the Students t distribution is T 1 = 99. The 97.5%
quantile, t99 (0.975), can be computed using the R function qt()
1.4.3
Interpreting E[
i ], se(
i ) and Confidence Intervals
Using Monte Carlo Simulation
0.3
Series 7
Series 8
Series 10
-0.1
0.1
0.3 -0.1
0.1
Series 9
-0.1
0.1
-0.1
0.1
Series 6
0.2
0.0
0.1
-0.1
0.1
0.2
0.0
0.2 -0.2
0.0
-0.2
Series 5
Series 4
-0.1
Series 3
0.3
-0.3
Series 2
0.3 -0.2
Series 1
20
40
60
80
100
Index
20
40
60
80
100
Index
Figure 1.12: Ten simulated samples of size T = 50 from the CER model
rt = 0.05 + t , t GW N(0, (0.10)2 ).
To illustrate, consider the CER model
rt = 0.05 + t , t = 1, . . . , 100
t GW N(0, (0.10)2 )
(1.20)
= 0.04969,
1000 j=1
which is very close to the true value 0.05. If the number of simulated samples
is allowed to go to infinity then the sample average
will be exactly equal
to = 0.05 :
N
1 X j
= E[
] = = 0.05.
lim
N N
j=1
The typical size of the spread about the center of the histogram represents
se(
i ) and gives an indication of the precision of
i .The value of se(
i ) may
be approximated by computing the sample standard deviation of the 1000
j values:
v
u
1000
u 1 X
t
(
j 0.04969)2 = 0.01041.
=
999 j=1
= 0.01. If the number of
Notice that this value is very close to se(
i ) = 0.10
100
simulated sample goes to infinity then
v
u
N
u 1 X
lim t
(
j
)2 = se(
i ) = 0.10.
N
N 1 j=1
Example 16 Monte Carlo simulation using R
The R code to perform the Monte Carlo simulation presented in this section
is
>
>
>
>
mu = 0.05
sd = 0.10
n.obs = 100
n.sim = 1000
20
0
10
Density
30
40
0.02
0.03
0.04
0.05
0.06
0.07
0.08
muhat
> set.seed(111)
> sim.means = rep(0,n.sim)
> for (sim in 1:n.sim) {
+
sim.ret = rnorm(n.obs,mean=mu,sd=sd)
+
sim.means[sim] = mean(sim.ret)
+ }
> mean(sim.means)
[1] 0.04969
> sd(sim.means)
[1] 0.01041
1.4.4
Bias
Assuming that returns are generated by the CER model (1.1), the sample
variances and covariances are unbiased estimators,
E[
2i ] = 2i ,
E[
ij ] = ij ,
but the sample standard deviations and correlations are biased estimators,
E[
i] =
6 i,
6 ij .
E[ij ] =
The biases in
i and ij , are very small and decreasing in T such that
bias(
i , i ) = bias(ij , ij ) = 0 as T . The proofs of these results
are beyond the scope of this book and may be found, for example, in Goldberger (19xx). However, the results may be easily verified using Monte Carlo
methods.
Precision
The derivations of the variances of
2i ,
i,
ij and ij are complicated, and
the exact results are extremely messy and hard to work with. However, there
are simple approximate formulas for the variances of
2i ,
i and ij based on
the Central Limit Theorem that are valid if the sample size, T, is reasonably
se(ij )
,
T
(1.21)
(1.22)
(1.23)
2
se(
b 2i ) p i ,
T /2
i
se(
b i ) ,
2T
(1 2ij )
.
se(
b ij )
T
(1.24)
(1.25)
(1.26)
b i ), and se(
b i ) for Microsoft, Starbucks
Example 17 Computing se(
b 2i ), se(
and the S & P 500.
For the Microsoft, Starbucks and S&P 500 return data, the values of se(
b 2i ),
7
se(
b 2msf t )
se(
b 2sbux )
(0.1068)2
0.1068
= p
= 0.00161, se(
b msf t ) =
= 0.00755
2 100
100/2
(0.1359)2
0.1359
= p
= 0.00261, se(
b sbux ) =
= 0.00961
2 100
100/2
(0.0379)2
0.0379
= 0.00268
se(
b 2sp500 ) = p
= 0.00020, se(
b sp500 ) =
2 100
100/2
1 (0.2777)2
se(
b msf t,sbux ) =
= 0.09229
100
1 (0.5551)2
se(
b msf t,sp500 ) =
= 0.06919
100
1 (0.4198)2
se(
b sbux,sp500 ) =
= 0.08238
100
Sampling distributions
i and ij are dicult to derive8 . However,
The exact distributions of
2i ,
approximate normal distributions of the form (1.6) based on the Central
Limit Theorem are readily available:
4
2 4 i
N i ,
,
T
2i
,
i N i,
2T
!
(1 2ij )2
ij N ij ,
T
2i
2
b 2i ) =
2i 2 p i ,
2i 2 se(
T /2
i 2 se(
b i) =
i 2
2T
(1 2ij )
ij 2 se(
b ij ) = ij 2
T
Example 18 95% confidence intervals for 2i , i and ij for Microsoft, Starbucks and the S&P 500.
For the Microsoft, Starbucks and S&P 500 return data the approximate 95%
confidence intervals for 2i ,are
MSF T : 0.01141 2 (0.00161) = [0.00818, 0.01464]
SBUX : 0.01846 2 (0.00261) = [0.01324, 0.02368]
SP 500 : 0.00143 2 (0.00020) = [0.00103, 0.00184]
The approximate 95% confidence intervals for i are
MSF T : 0.1068 2 (0.007554) = [0.09172, 0.1219]
SBUX : 0.1359 2 (0.009607) = [0.11665, 0.1551]
SP 500 : 0.03785 2 (0.002676) = [0.03249, 0.0432]
The approximate 95% confidence intervals for ij are
MSF T, SBU X : 0.2777 2 (0.09229) = [0.09314, 0.4623]
MSF T, SP 500 : 0.5551 2 (0.06919) = [0.41674, 0.6935]
SBU X, P 500 : 0.4198 2 (0.08238) = [0.25499, 0.5845]
i by Monte Carlo
Evaluating the Statistical Properties of
2i and
simulation
We can evaluate the statistical properties of
2i and
i by Monte Carlo simulation in the same way that we evaluated the statistical properties of
i.
50
50
100
100
150
150
200
200
0.004
0.006
0.008
0.010
0.012
0.014
0.016
Estimate of variance
0.08
0.10
0.12
} and {
1, . . . ,
1000 }. The histograms of these
estimates {
,...,
values are displayed in figure 1.14.The histogram for the
2 values is bellshaped and slightly right skewed but is centered very close to 0.010 = 2 . The
histogram for the
values is more symmetric and is centered near 0.10 = .
The average values of 2 and from the 1000 simulations are
1 X 2
= 0.009952
1000 j=1
1000
1 X
= 0.09928
1000 j=1
1000
43
1.5
Further Reading
To be completed
1.6
Appendix
1.6.1
2
Result: mse(, ) = E[( E[])2 ] + E[] = var() + bias(, )2
) = E[( )2 ]. Write
Proof. Recall, mse(,
= E[] + E[] .
Then
2
( )2 = E[] + 2 E[] E[] + E[] .
2
h
i2
+ E E[]
mse(, ) = E E[]
= var() + bias(, )2 .
1.6.2
Z12
Z22
ZT2
T
X
i=1
Zi2 .
1.6.3
1.7 PROBLEMS
45
1.7
Problems
To be completed
Bibliography
[1] Campbell, Lo and MacKinley (1998). The Econometrics of Financial
Markets, Princeton University Press, Princeton, NJ.
47