Maximizing Predictability in the Stock and Bond Markets1997
We construct portfolios of stocks and of bonds that are maximally predictable with respect to a set of ex ante observable economic variables, and show that these levels of predictability are statistically significant, even after controlling for data-snooping biases. We disaggregate the sources for predictability by using several asset groups—sector portfolios, market-capitalization portfolios, and stock/bond/utility portfolios—and find that the sources of maximal predictability shift considerably across asset classes and sectors as the return-horizon changes. Using three out-of-sample measures of predictability—forecast errors, Merton's market-timing measure, and the profitability of asset allocation strategies based on maximizing predictability—we show that the predictability of the maximally predictable portfolio is genuine and economically significant.
Securities Transaction Taxes: What Would Be Their Effects on Financial Markets and Institutions?1995
A securities transactions tax is likely to have far-reaching and profound implications for the financial systems and institutions. We evaluate the effect that a transactions tax will have on the financial system's role in transferring resources over time and in allocating risk efficiently across individuals and sectors. In particular, we examine the impact of a transactions tax on individual investors due to the reduction in the rate of return on savings, the reduction in trading, and the likely reduction in the value of stocks. We also consider the possible effects of a transactions tax on market liquidity. By reducing the informational role of prices and reducing market liquidity, a transactions tax may result in higher market volatility. We provide a simple numerical example that illustrates the enormous impact such a tax will have on the derivatives markets, where participants rely heavily on dramatic trading strategies to control risk. This sector is the financial system, along with its jobs, revenues, and risk-management capabilities are likely to move offshore in response to the tax.
Implementing Option Pricing Models When Asset Returns Are Predictable1995
The predictability of an asset's returns will affect option prices on that asset, even though predictability is typically induced by the drift which does not enter the option pricing formula. For discretely-sampled data, predictability is linked to the parameters that do enter the option pricing formula. We construct an adjustment for predictability to the Black-Scholes formula and show that this adjustment can be important even for small levels of predictability, especially for longer-maturity options. We propose several continuous-time linear diffusion processes that can capture broader forms of predictability, and provide numerical examples that illustrate their importance for pricing options.
Data-Snooping Biases in Financial Analysis1994
Data-snooping--finding seemingly significant but in fact spurious patterns in the data--is a serious problem in financial analysis. Although it afflicts all non-experimental sciences, data-snooping is particularly problematic for financial analysis because of the large number of empirical studies performed on the same datasets. Given enough time, enough attempts, and enough imagination, almost any pattern can be teased out of any dataset. In some cases, these spurious patterns are statistically small, almost unnoticeable in isolation. But because small effects in financial calculations can often lead to very large differences in investment performance, data-snooping biases can be surprisingly substantial. In this review article, I provide several examples of data-snooping biases, explain why it is impossible to eliminate them completely, and propose several ways to guard against the most extreme forms of data-snooping in financial analysis.
Neural Networks and Other Nonparametric Techniques in Economics and Finance1994
Although they are only one of the many types of statistical tools for modeling nonlinear relationships, neural networks seem to be surrounded by a great deal of mystique and, sometimes, misunderstanding. Because they have their roots in neurophysiology and the cognitive sciences, neural networks are often assumed to have brain-like qualities: learning capacity, problem-solving abilities, and ultimately, cognition and self-awareness. Alternatively, neural networks are often viewed as "black boxes" that can yield accurate predictions with little modeling effort. In this review paper, I hope to remove some of the mystique and misunderstandings about neural networks by providing some simple examples of what they are, what they can and cannot do, and where neural nets might be profitably applied in financial contexts.
A Nonparametric Approach to Pricing and Hedging Derivative Securities via Learning Networks1994
We propose a nonparametric method for estimating the pricing formula of a derivative asset using learning networks. Although not a substitute for the more traditional arbitrage-based pricing formulas, network pricing formulas may be more accurate and computationally more efficient alternatives when the underlying asset's price dynamics are unknown, or when the pricing equation associated with no-arbitrage condition cannot be solved analytically. To assess the potential value of network pricing formulas, we simulate Black-Scholes option prices and show that learning networks can recover the Black-Scholes formula from a six-month training set of daily options prices, and that the resulting network formula can be used successfully to both price and delta-hedge options out-of-sample. For purposes of comparison, we perform similar simulation experiments for four other methods of estimation: OLS, kernel regression, projection pursuit, and multilayer perceptron networks. To illustrate the practical relevance of our network pricing approach, we apply it to the pricing and delta-hedging of S&P 500 futures options from 1987 to 1992.
An explanation of the nontrading effect. The New Palgrave Dictionary of Money and Finance is a 3-volume set which provides an unparalleled guide to modern money, banking and finance with over 1,000 substantial essays. It provides the most comprehensive analysis available of contemporary theory and the fast-evolving global monetary and financial framework.
Empirical Issues in the Pricing of Options and Other Derivative Securities1992
The pricing of options, certificates, and other derivatives or assets—financial assets whose payments depend on the prices of other assets—is one of the great successes of modern financial economics. Although the pricing of derivatives is computationally intensive, there is little done in terms of the traditional empirical analysis since by the very nature of the determination of prices and arbitrage there is no error term to minimize. There are, however, many issues of statistical inference that affect the pricing of options and other derivatives. This paper analyzes two of the most common issues neglected in the literature: reduced form empirical instruments for the determination of prices and how to use Monte Carlo simulations to calculate option prices depend on a path.
An Ordered Probit Analysis of Transaction Stock Prices1992
We estimate the conditional distribution of trade-to-trade price changes using ordered probit, a statistical model for discrete random variables. This approach recognizes that transaction price changes occur in discrete increments, typically eighths of a dollar, and occur at irregularly-spaced time intervals. Unlike existing models of discrete transaction prices, ordered probit can quantify the effects of other economic variables like volume, past price changes, and the time between trades on price changes. Using 1988 transactions data for over 100 randomly chosen U.S. stocks, we estimate the ordered probit model via maximum likelihood and use the parameter estimates to measure several transaction-related quantities, such as the price impact of the trades of a given size, the tendency towards price reversals from one transaction to the next, and the empirical significance of price discreteness.
Long-Term Memory in Stock Market Prices1991
A test for long-run memory that is robust to short-range dependence is developed. It is an extension of the "range over standard deviation" or R/S statistic, for which the relevant asymptotic sampling theory is derived via functional central limit theory. This test is applied to daily and monthly stock returns indexed over several time periods and, contrary to previous findings, there is no evidence of long-range dependence in any of the indexes over any sample period or sub-period once short-range dependence is taken into account. Illustrative Monte Carlo experiments indicate that the modified R/S test has power against at least two specific models of long-run memory, suggesting that stochastic models of short-range dependence may adequately capture the time series behavior of stock returns.