Research
with Jasmina Hasanhodzic and Emanuele Viola, Hasanhodzic, Jasmina, Andrew W. Lo, and Emanuele Viola (2019), What Do Humans Perceive in Asset Returns?, Journal of Portfolio Management 45 (4), 49–60.
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In this article, the authors run experiments to test if and how human subjects can differentiate time series of actual asset returns from time series that are generated synthetically via various processes, including AR1. In contrast with previous anecdotal evidence, they find that subjects can distinguish between the two. These results show that temporal charts of asset prices convey to investors information that cannot be reproduced by summary statistics. They also provide a first refutation based on human perception of a strong form of the efficient-market hypothesis. Their experiments are implemented via an online video game (http://arora.ccs.neu.edu). The authors also link the subjects’ performance to statistical properties of the data and investigate whether subjects improve performance while playing.
Abbe, Emmanuel A., Amir E. Khandani, and Andrew W. Lo (2012), Privacy-Preserving Methods for Sharing Financial Risk Exposures, American Economic Review 102 (3), 65–70.
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Unlike other industries in which intellectual property is patentable, the financial industry relies on trade secrecy to protect its business processes and methods, which can obscure critical financial risk exposures from regulators and the public. We develop methods for sharing and aggregating such risk exposures that protect the privacy of all parties involved and without the need for a trusted third party. Our approach employs secure multi-party computation techniques from cryptography in which multiple parties are able to compute joint functions without revealing their individual inputs. In our framework, individual financial institutions evaluate a protocol on their proprietary data which cannot be inverted, leading to secure computations of real-valued statistics such as concentration indexes, pairwise correlations, and other single- and multi-point statistics. The proposed protocols are computationally tractable on realistic sample sizes. Potential financial applications include: the construction of privacy-preserving real-time indexes of bank capital and leverage ratios; the monitoring of delegated portfolio investments; financial audits, and the publication of new indexes of proprietary trading strategies.
Econometric Measures of Connectedness and Systemic Risk in the Finance and Insurance Sectors
Billio, Monica, Mila Getmansky, Andrew W. Lo, and Loriana Pelizzon (2012), Econometric Measures of Connectedness and Systemic Risk in the Finance and Insurance Sectors, Journal of Financial Economics 104 (3), 535–559.
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A significant contributing factor to the Financial Crisis of 2007–2009 was the apparent interconnectedness among hedge funds, banks, brokers, and insurance companies, which amplified shocks into systemic events. In this paper, we propose five measures of systemic risk based on statistical relations among the market returns of these four types of financial institutions. Using correlations, cross-autocorrelations, principal components analysis, regime-switching models, and Granger causality tests, we find that all four sectors have become highly interrelated and less liquid over the past decade, increasing the level of systemic risk in the finance and insurance industries. These measures can also identify and quantify financial crisis periods. Our results suggest that while hedge funds can provide early indications of market dislocation, their contributions to systemic risk may not be as significant as those of banks, insurance companies, and brokers who take on risks more appropriate for hedge funds.
Lo, Andrew W. (2012), Reading about the Financial Crisis: A Twenty-One-Book Review, Journal of Economic Literature 50 (1), 151–178.
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The recent financial crisis has generated many distinct perspectives from various quarters. In this article, I review a diverse set of 21 books on the crisis, 11 written by academics, and 10 written by journalists and one former Treasury Secretary. No single narrative emerges from this broad and often contradictory collection of interpretations, but the sheer variety of conclusions is informative, and underscores the desperate need for the economics profession to establish a single set of facts from which more accurate inferences and narratives can be constructed.
Bertsimas, Dimitris, and Andrew W. Lo (1998), Optimal Control of Execution Costs, Journal of Financial Markets 1 (1), 1–50.
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We derive dynamic optimal trading strategies that minimize the expected cost of trading a large block of equity over a fixed time horizon. Specifically, given a fixed block S of shares to be executed within a fixed finite number of periods T, and given a price-impact function that yields the execution price of an individual trade as a function of the shares traded and market conditions, we obtain the optimal sequence of trades as a function of market conditions—closed-form expressions in some cases—that minimizes the expected cost of executing S within T periods. Our analysis is extended to the portfolio case in which price impact across stocks can have an important effect on the total cost of trading a portfolio.
Nonparametric Estimation of State-Price Densities Implicit In Financial Asset Prices
Aït-Sahalia, Yacine, and Andrew W. Lo (1998), Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices, Journal of Finance 53 (2), 499–547.
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Implicit in the prices of traded financial assets are Arrow-Debreu state prices or, in the continuous-state case, the state-price density [SPD]. We construct an estimator for the SPD implicit in option prices and derive an asymptotic sampling theory for this estimator to gauge its accuracy. The SPD estimator provides an arbitrage-free method of pricing new, more complex, or less liquid securities while capturing those features of the data that are most relevant from an asset-pricing perspective, e.g., negative skewness and excess kurtosis for asset returns, volatility "smiles" for option prices. We perform Monte Carlo simulation experiments to show that the SPD estimator can be successfully extracted from option prices and we present an empirical application using S&P 500 index options.
Lo, Andrew W., and A. Craig MacKinlay (1997), Maximizing Predictability in the Stock and Bond Markets, Macroeconomic Dynamics 1 (1), 102–134.
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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.
Lo, Andrew W., and Jiang Wang (1995), Implementing Option Pricing Models When Asset Returns Are Predictable, Journal of Finance 50 (1), 87–129.
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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.
A Nonparametric Approach to Pricing and Hedging Derivative Securities via Learning Networks
Hutchinson, James M., Andrew W. Lo, and Tomaso Poggio (1994), A Nonparametric Approach to Pricing and Hedging Derivative Securities Via Learning Networks, Journal of Finance 49 (3), 851–889.
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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 1991.
Hausman, Jerry A., Andrew W. Lo, and A. Craig MacKinlay (1992), An Ordered Probit Analysis of Transaction Stock Prices, Journal of Financial Economics 31 (3), 319–379.
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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.