The Econometrics of Financial Markets

John Y. CamPgeU
AndrewW.Lo
I

A. Craig MacKinJay

Princeton University Press

Princeton, New Jersey
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 Contents

List of Figures xiii

List of Tables xv

Preface xvii

Introduction 3
1.1 Organization of the Book 4
1.2 Useful Background. . . . {)
1.2.1 Mathematics Background {)
1.2.2 Probability and Statistics Background (j
1.2.3 Finance Theory Background 7
1.3 Notation................ H
1.1 Prices, Returns, and Compollnding . 9
1.1.1 Defmitions and Conventions. 9
1.4.2 The Marginal, Conditional, anclJoint Distribution
of Returns. . . . . . . . . . . . . . . . . . . . . . .. 13
I.:) Market Efliciency . . . . . . . . . . . . . . . . . . . . . .. 20
1.5.1 Efficient MarkrL~ and the l.aw of Iterated
Expectations .. . . . . . . . . . . . . . 22
Is Market EffIciency Testable? 24

TIle Predictability of Asset Returns 27

2.1 The Random Walk Ilypotheses . . . . . . . . . . . . . 2R
2.1.1 The Random Walk I: lID Incremenl~ . . . . . . 31
2.1.2 The Random Walk 2: Independent Increment!! 32
2.1.3 The Random Walk 3: Uncorrclated Increments 33
Tests of Random Walk I: lID Increlllents .
2.2.1 Traditional Statistical Tests . . . . .
2.2.2 SCf)uences and Reversals, and Runs
 viii
COII/m!.1

2.~ Test s of Ran doll l Wal k 2: Inde pcn

den t Incr eme nts 41
2.3.1 Filte r Rule s . . . . . . . . .
........ .
2.3.2 Tech nica l Analysi~ . . . . .
.... ..... .
2,4 Test s of Ran doll l Wal k :\: Ul\c ond
.\led Incr emc nts
2.4.1 Aut ocor rela tion Coe flici ents
2.4.2 Port man teau Stat istic s
2.'1.3 Vari ance Rali m . . . .
. . .
2.!:i Lon g-Il oriz on Rell lrBs . . . . ·IH
. . .
2::>.1 Prob lem s with LOllg-1 [oriz :):)
on Infc renn :s :>7
2.G Test s For Lon g-Ra nge Dep end
encc . . . . . . .
2.ti.l Exal llple s of I.on g-Ra ngc lkpc !/l
/lclc ncc . !",!l
2.6.2 The Hur sl-M ancl clbr ot Resc
aled ·Ran gc Stat istic li2
2.7 Uni l ROOl Test s . . . . . . .
2.H Rec cnt EmpiriC<l\ Evid ellce . li4
2.S.1 AUl Oco rrcla tion s .. Ii:>
2.8.2 Vari ance Rati os . . . titi
2.8. 3 Cro5 s-Au toco rrch lliol lS '\Il(\ ti8
Lead -Lag Rc::IatiollS 74
2.8,4 Test s Usin g Lon g-H oriz on
RCll IflIS
2.n Co nc lu sio n.. ... ... 7H
... ... ...
KO
3 Mar ket Mic rost ruct ure
3.1 { Non sync hron olls Trad ing . . 83
....... . \H
~ 3.1.1 A Mod el of NOl lSyn c!tro
llous Trad ing K:>
I 3.1.2 Exte nsio ns and Gen eral izat
ions ~)H
3.2 I The Bid-Ask Spr e'ld . . . . . .
. . . . . . . !)~)
I 3.2.1 Rid-Ask Bou ncr . . . .
...... .
I 3.2.2 CompOnel\L~ of the \)id-A~k W\
3.3 !
I
Mod elin g Tran sact ions Data .
... .
Spre ad lin
107
'j 3.3.1 Mot ivati on . . . . . . . . .
. . 10K
I 3.3.2 Rou ndin g <inc ll\ar rier Mod
els 114
3.3.3 The Onl trcd Prob it Mod el
3.4 I Rec ent Emp irica l FilH lings . .
... .
. 122
3.4.1 Non sync itrol lolls Trad ing 12H
.. 12K
3.4.2 Esti mati ng the Effe ctive Bid-
Ask Sprc ad . I:H
3.4.3 Tran sact ions Data
'} r,
••.• 1 I
\ ( ',onc I '
IISIO I1 • • . . . . •
1:I!i
144
4 Eve JStu dy Analysis
4.\ ; Out line of an Evel lt Stud y
......... .
'I.~ All Exa mpl e of an Evcn t Stud y .
...... .
4.:-1 Mo<iels for Mea s\lri llg Nor mal I'crfOnll'<lIlCC
4.3.1 Con stan t-M can- Retu rn Moc kl
4.3.2 Mar kct Mod el . . . . . . . . .
... .
CCJllifll 1.1 ix

'1.:~.3 Other Statistical Mlldds I:)~

,1.::1.'1 Ecollomic Modds . . . . 15ti

4..1 Me;\sul'illg and AnalYl.illg Abl\ormal Retlll"lls . [57
4.4.1 Estimation of the Market Model . . . . 15H
'1.4.2 Statistical Properties of Ahllonnal Rellll'lls 159
4.4.:~ Aggregation of AIlllormal Returns . . . . . IGO
4.4.4 Sensitivity to Nor11lal Rl'llll'l\ Modd . . . . IG~
4.4.5 CARs for the Eamiligs-Allllolllll'l'ment Example 1U3
4A.G Inferences with Cilisterillg ltiG
4.:> Moclifying the NullllYl'othesis 107
Hi Allalysis of Power . . . IGH
4.7 Nonparametric Tests . 172
4.K Cross-Sectional Models 173
4 .~l Further Issues . . . . . 175
4.9.1 Role of the Sampling lntel'val 175
4.9.2 Inferences with Evelll-Date Uncertainty 176
4.9.3 Possible Biases. 177
4.10 Conclusion 178 I

5 The Capital Asset Pricing Model 181

:1. I Review or the CAI'M .. . IHI
S.~ Results from Efficient-Set Mathematics . . . . . . 184
:>.:~ Statistical Framework for Estimatioll and Testing. IH8
5.3.1 Sharpe-Lintner Version IH9
:l.:t2 nlack Versioll 1%
:>.4 Size of Tests . . . . . . . . . . 203
5.:> Power of Tests . . . . . . . . . 204
S.li Nonnormal and Non-lID Returns 208
:>.7 Implementation of Tests . . . . .
:>.7.1 Summary of Empirical Evidence
211
211
•
5.7.2 Illustrative Implementation 21~
:l.7.~ Unobservability of the Market Portfolio 213
?i.H Cross-Sectional Regressions 215
:).~l Conclusion . . . . . 217

6 Multifactor Pricing Models 219

G.I Theoretical Background . . . . . . . . . . . . . 219
(;.2 Estimation and Testing . . . . . . . . . . . . . . 222
1;.2.1 Portfolios as Factors with a Riskfrcc A.sset 223
li.2.2 Portfolios as FaClors without a Riskf'ree Asset 224
ti.~.:~ Macroeconomic Variables as Factors . . . . . 226
(i.!!A Factor i'ortfillios Spallllilll-\" the l\kall-V;triance
Frolllicr .. ' . . . . . . .22H
 IU Estimation of Risk PrellIia and Expcelcd Returns
li,4 Sdcelion of FaclOrs . . . . . .
li.'1.1 Statistical Approaches ..
li..l.~ NlImher of FaCiors . . .
{i.'l.:\ TllI'oretical Approach('s
1i5 Empirical R('sults . . . . . . . .
li.li Interpreting Deviations from Exact Factor Pricing
{i.{i.1 Exael Factor Pricing Models, Mean-Variance Anal-
ysis, and the Optimal Orthogonal Portfillio
li.li.2 Squared Sharpc' Ratios . . . . . . . . . . . . . .
(i.fi.:~ Implications fi)J' Sc'parating Altcrnativc Th('mil's
1i.7 Conclusion .................... .

7 Present-Value Relations 253

7.1 The Relation I)('twec'n Prices, Dividends, and Returns ~:I·1
7.1.1 'I'lli'I .inear Pn'sc'nt-Value- Relation with Constant
Expected Relllnls . . . . . . . . . . . . . . . . . . . ~:);)
7.1.~ Rational Blibbles . . . . . . . . . . . . . . . . .. :!:.~
7.1.:1 All Approxilllalc'l'n'sc'nl-Vahlc Relation wilh Tillle-
Varying Exp('cled R('lurns . . . . . . . . . . . . . . . <'(ill
7.1.4 Prices and Retul'lls in a Simple Example ~(i·1
7.'2 Present-ValliI' Relations and US Stock Pricc Ikhavior ~(i7
7.~.1 I.ollg-iioriwil Regressions . . . ~(;7
7.~.'2 Volatility 'Ii'sts . . . . . . . . . . n:;
7,'23 Vector AlilOregn'ssive Mc,tllOds
Conclilsion

8 Intertemporal Equilibrium Models 291

H.I The- Stochastic Discounl FaCIOI' . . . . . . . . . . . . 2~l:\
H.I.I Volatility BOllncls . . . . . . . . . . . . . . . . 2%
H.'2 Consumptioll-Basl'd Asset Pricing with Pown Utility. :10,\
H.:!. I Powc'r Utility ill a I.ogllol'lnal Model. . . . :1(Hi
H.'2.'2 Power lItility and (;('ll\'rali'.cll Method of
MOlllents . . . . . . . . . . . . . . . . . . . . . . . . :q 4
Market Friel ions
H.:I.l Market FriClion~ and Il;ulsclI:)agalinathan
Boullds . . . . . . . . . . . . . . . . . . . . . :11:.
H3.'2 Markc,t Frictions and Aggre-gatc Consllmption
Data . . . . . . . . . . . . . . . . . . . . . . . :1 I Ii
HA More (;('nnall 1tility FunC'lions . . . . . . .
H..t.1 Iiallit Forillation . . . . . . . . . . .
H.·I.'2 Psychological Mockls or Pr('fucnc('s
( :ondllsion
9 Derivative Pricing Models 339
9.1 Brownian Motion . 341
9.1.1 Constructinr; Brownian Motion . 341 I
9.1.2 Stochastic Differential Equations 346 [
9.2 A Brief Review of Derivative Pricinr; Methods. 349 .
9.2.1 The Black-Scholes and Merton Approach . 350
9.2.2 The Martingale Approach . . . . . . . . . 354
!1.3 Implementing Parametric Option Pricing Models 355
9.3.1 Parameter Estimation of Asset Price Dynamics 356
9.3.2 Estimating (j in the Black-Scholes Model . . . 361
9.3.3 Quantifying the Precision of Option Price
Estimators . . . . . . . . . . . . . . . . . . . . . . . . 367
9.3.4 The Effects of Asset Return Predictability. 369
9.3.5 Implied Volatility Estimators . . . . . . . . . . .. 377
9.3.G Stochastic Volatility Models. . . . . . . . . . . .. 379
9.4 Pricing Path-Dependent Derivatives Via Monte Carlo Sim-
ulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
9.1.1 Discrete Versus Continuous Time . . . . . 383
9.1.2 How Many Simulations to Perform . . . . 384
9.4.3 Comparisons with a Closed-Form Solution 384
9.4.4 Computational Efficiency . 386
9.1.5 Extensions and Limitations. 390
Conclusion '" 391

10 Fixed-Income Securities 395

10.1 Basic Concepts . 396
10.1.1 Discount Bonds 397
10.1.2 Coupon Bonds 401
10.1.3 Estimating the Zero-Coupon Term Structure 409
10.2 Interpreting the Term Structure of Interest Rates 413
10.2.1 The Expectations Hypothesis . . . . . . 413
10.2.2 Yield Spreads and Interest Rate Forecasts 418
10.3 Conclusion . . . . . . . . . . . . . . . . . . . . 423

11 Term-Structure Models 427

11.1 Affine-Yield Models . 428
11.1.1 A Homoskedastic Single-Factor Model 429
11.1.2 A Square-Root Single-Factor Model 435
11.1.3 A Two-Factor Model . . . . . . . . . 438
11.1.4 Beyond Affine-Yield Models . . . . 441
11.2 Fitting Term-Structure Models to the Data 442
11.2.1 Real Bonds, Nominal Bonds, and Innation 442
11.2.2 Empirical Evidence on Affine-Yield Models 445
xii (.'U/I 11'11 1.1

11.3 Pricing Fixed-Incomc Dcrivativc Sccuritics ..

11.3.1 Filling the Currcnt Terlll Structure Exactly
11.3.2 Forwards and Futures . . . . . . . . . . . .
11.3.3 Optioll Pricing in a Tcrlll-Structure Modc1
11.4 Conclusion . . . . . . . . . . . . . . . . . . . . .

12 Nonlinearities in Financial Data 467

12.1 Nonlinear Structure in Univari<lte Timc Scric~ . 11iK
12.1.1 Some Paramctric Models . . . . . . . . . 470
12.1.2 Univariatc Tcsts for Nonlincar Structure 47:)
12.2 Modc\s of Challgill~ Volatility 479
12.2.1 Univariatc Models . . . . . . . . . . . . . 4HI
12.2.2 Multivariatc Models. . . . . . . . . . . . 490
12.2.3 Links between First and Second Moments 494
Nonparametric Estilllation . . . . . . 49K
12.3.1 Kernel Regression. . . . . . . !",oo
12.3.2 Optimal Bandwidth Selcction :)02
12.3.3 Average Derivative Estimators 504
12.3.4 Application: Estimating State-Price Densities !i07
12.4 Artificial Neural Nctworks . . :)12
I 12.4.1 Multilayer PerccptfOns . . . . 512
12.4.2 Radial Basis Functions . . . . :) I Ii
12.4.3 Projcction Pursuit Regression 51H
\ 12.4.4 Limitations of Learning Networks !ilK
I 12.4.5 Application: l.earning thc Bbck-Scholes FOflllllla 51\1
1~.5 Overfllting and Data-Snooping :)~:{

12 G Conclusion . . . . . . . . . . . :,24
1
Appendix
A I Linear Instrumelllal Variablcs . . . . . . . . . .
A.2 Generalized Mcthod of MOlllcnts . . . . . . . .
A.3 Serially Correlated and f Icteroskeoastic Errors.
A.4 GMM and MaximulII Likelihood . . . . . . . .

References 541

Author Index 587

Subject Index 597

 List of Figures

1.1 Dividend Payment Timing Convention . . . . . . . . 12

I.~ Comparison 0(' Stable and Normal Density Functions II:!

<~.l Nontrading-Induced AutocolTelations . . . . . . . . 96

:t2 Histogram of Daily Price Fractions and Price Changes for
Five NYSE Stocks from January 2, I~)~)O to December 31.
1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. III
:).:) 2-Histories of Daily Stock Returns luI' Five NYSE Stocks from
.Ianuary2, 1990 to Deccmber:ll, 1992 .. . . . . . . . . . . 113
~.-1 TIll: Ordered Probit Model . 125

'1.1 Tinlt.' l.ine for an Event Study 157

4.2 (a) Plot of Cumulative Market-Model Abnormal Return for
Earning Announcements; (Il) Plot of Cumulative Con-
slant-Mean-Return-Modcl Abnormal Return for Earning
Announcements . . . . . . . . . . . . . . . . . . . . . . .. 165
-1.3 Power of Event-Study Test Statistic Jl to Reject the Null Hy-
pothesis that the Abnormal Retllrn Is Zero. When the Square
Root of the Average Variance of the Abnormal Return Across
Firms is (a) 2% and (b) 4% . . . . . . . . . . . . . . . . . , 171
4.4 Power of Evelll-Study Test Statistic Jl to Reject the Null Hy-
pothesis that thc Abnormal Return is Zero. for Differelll
Sampling Intervals, When the Square Root of the Average
Variance of the Abnormal Return Across Finns Is 1% for the
Daily Interval . . . . . . . . . . . . . . . . . . . . . . 176

:),1 MinimulIl-Variance POrll'olios Without RisHree Asset 187

:i.~ Minimulll-Variance Portfolios With Riskfree Asset . . 189

(i.l Di~trihlllions for the CAPM Zero-I II tercept Tesl Statistic fur
FOIII' Ilv\lollH'~(,s 'lUI
7.1 I.og Real Slock 1'1 ice and Dividend Series, An""al US Data,
lH72 to I ~)~ltl . . . . . . . . . . . . . . . . . . . . . . . . . . ~H~
7.'2 Log Real Stock Pric(' and Estimated Dividend Compo"e"t,
Annual US Dala, I H7/i 10 I !'!H . . . . . . . . . . . . . . . .. '21':\
7.:1 I.og Dividend-Pric(, Ratio and ESlimaled Dividend COlllPO-
1I('nl, Annual US d;lIa, IH7G 10 Iq!H . . . . . . . . . . . . . '2~·1

H.I (a) Mean-Standard Deviation Diagram for Asset Returns;

(h) Implied Sla"c\arc\ Deviatio,,-Mean Diagram for Stochas-
lic Discount Factors . . . . . . . . . . . . . . . . . . . . . . 2~'9
H.2 (a) Mean-Standard Dcviatio" Diagram for a Single Excess A~­
set Return; (h) Implied Standard Deviation-Mean Diagram
for Stochastic Discount Factors . . . . . . . . . . . . . . .. :\02
H.~ Feasible Region for Slochastic Discounl Faclors Implied hy
AnllllallJS Dala, I H~J\ to I ~'~J1 . . . . . . . . . . . . . . ~O.'l

!I. I Salllple Path of a Discret('-Tillle Random Walk. . . . . ~·12

!I.'2 Salllple Path and Conditional Expectation of a l\rownian
Motion with Drilt . . . . . . . . . . . . . . . . . . . . . . .. :\4:.

10.1 Zero-Collpon Yidd a"d Forwanl-Rate Cllrves in Jallllal),

I !IH7 . . . . . . . . . . . . . . . . . . . . . . . . :\~)H
10.2 Cash Flows in a Forward Trallsactioll . . . . '100
10.:1 Calculatioll of llmation (1I' a Coupon Hond . . . 402
lOA The Prire-Yil'ld Relationship. . . . . . . . . . . . 40/
I lUI Short- alld I.ong-Terrn I n(erest Rates 1952 to 19!11 41 Ii

11.1 Change ill Short Rate I )ivided hy Short Rate to the Power y 4;,()
11.2 Sample and Theoretical Average Forward-Rate Curves 4!'H

12.1 The Tent Map. . . . . . . . . . . . . . . . . . . . . . 47·1

1'2.2 Monthly Ex('('ss I.og liS Siock Returns, 1926 to 1!J!J4 41'2
12.:\ Shifled ,\lHI Tilll'd Ahsoillte-Valll(, FIIllctioll 'IH()
12.4 Simulation of}', = Sin(X,) + O,:'f, . . . . . . . . . . . r.ol
12.;. K('(IIeI Estimalor . . . . . . . . . . . . . . . . . . . . :.(n
12./i Bullish Venicil Spl'l';ld 1':lyolf Fllnclioll and Silloothed
Vnsion .. . . . . . . . . . . . . . . . . . . . . . . . . o. \ ()
12.7 Biliary Thr('shold t-.I"dcl . . . . . . . . . . . . . . . . . :d:1
I :!.H COlliparisoll of I kavisidc and I.ogistic Activation FIIIICliolls :; 1:1
12.!) MIIJtila)'('I' I'CI'Cl'I"l'On wilh a Single IIidden l.ayer . :d 1
12.10 MI.!'( \.:.) Model of l', = Sin( X,) -+ O':'E, ....... !llfi
12.11 Typir:1l Silllillated Trainill)!; !'ath . . . . . . . . . . . . :.~tl
12.12 Typicallkha\'ior or FOIII'-Nonlill<'ar-Tl'I'lIl RBF Model :.21
 List of Tables

l.l Stock market returns, 1962 to 1994 . . . . . . . . . . . . . .

2.1 Classification of random walk and martingale hypotheses. 29

~
2.2 Expected runs for a random walk with drift J.I.. • • • • • • •
2.3 Autocorrelation function for fractionally dilTerenced process.
2.4 Autocorrelation in daily, weekly, and monthly stock index
returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . " 67
25 Variance ratios for weekly stock index returns . . . . . . '. 69
2.fi Variance ratios for weekly size-sorted portfolio returns. . . .. 71
2.7 Variance ratios for weekly individual security returns. . . . . , 73
2.H Cross-autocorrelation matrices for size-sorted portfolio returns. 75
2.9 Asymmetry of cross-autocorrelation matrices. 77

3.1 Summary statistics for daily returns of five NYSE stocks. 109
3.2 Relative frequencies of price changes for tick dara of five
stocks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 112
:t::la Expected upper bounds for discreteness bias: daily returns. 118
::I.::Ih Expect.ed upper hounds for discreteness bias: monthly returns. 119
'\.::1(' Expected upper bounds for discreteness bias: annual returns. 120
:t4 Autocorrelation matrices for size-sorted portfolio returns. 131
:t:J Estimates of daily nontrading probabilities. 1::12
:tli NOlltrading-implied weekly index autocorrelations. . 13:~
::1.7 SUJllmary statistics for transactions data of six stocks. 13H
:~.Ha Estimates of ordered probit partition boundaries. 141
:tHh Estimates of ordered probit "slope" coefficients. . . . 142

4.1 Abnormal returns for an event study of the information con-

telll of earnings <lnIlOllllcemeIllS . . . . . . . . . . . . . . " 164
4.~ POW('f of evellt-study test statistic JI to reject the null hypoth-
esis that the abnormal return is zero. . . . . . . . . . . . " 170

xv
 xvi
I.isl oj '['abil's

5.1 Fini te-sa mpl e size of tests of tile Sha

rpe- l.int ner C'AI'M !Ising
large-salllple test statistics . . . .
............... .
5.2 Pow er of f'-test of Sha rpe- Lint ner
CAPM usin g statistic Jl ..
5.3 Emp irica l results for tcsts of thc
Sha rpe- I.ill tncr versio/l of
theC APM . . . . . . . . . . . . .
.............. .
6.1 1SUJIlmary of results lilr tests of exaCl blCIO !' pric ing lIsing
'zcro -illl erce pt F-tes!. . . . . .
I . . . . . . . . . . 2·11
7.1 : Lon g-ho rizo n regr essio lls of' log
stoc\:. retu rns on the log
,div iden d-pr ice ratio . . . . . . .
. . .•. . . . . . . .
7.2 II.on g-ho rizo n regr cssi ons oflo g
stoc k relll rns on the stoc has-
\tically detr end ed shor t-ter lll inte
rest rate. . . . . . . .
I no
8.1 \Molllents of cons ulIll lliol l grow th
and asset retu rns'. . . . .
H.:.! \1~lstrumental variables rq~rcssiollS for retll 30l:\
ms and COIlSlllllP-
,tlOlI grow th . . . . . . . . . . . .
............... .
9.1 ~lIltiplic~tion rulcs for slOchast~c diffe rent
9.2a ials.
{\symptol1c stan dard erro rs for a
. ...... .
9.2h Asymptotic stan dard erro rs for 0 2
• •••••
9.3 ~uto{rva!lIes for colllparativc statics of VI' • •
...
9.4 .;\sYlllptotic variances of' Black-Sc
holes call pric c sensitivity
estim ator s. . . . . . . . . . . .
............ .
9.5 Opt ion prices on asseL~ with nega :no
tively aillo corr elat eu
retu rns. . . . . . . . . . . . . .
. . . . . . . . . . .
9.li Mon tc Carl o estim atio ll of look back
opti on pric e. . . .
10.1 Macaulay's and mod ificd dura tion
for sele cted hon ds.
10.2 Mea ns and stan dard devi atio ns of
terll l-str uctu re vari able s.
10.3 R.egression coef licie nls fill and YII'
... ... ... ... . .
 Pr efa ce

Thc secd s of lhis hoo k wcr e plan

led 01'('1 ' fifteell year s ag-o. al lhc
of 0111' prok ssio ll;t1 care ers. Whi very slar l
le sllidyillg- fillallcial ('con ollli cs,
wc 1)('g-;1I1 to lcac h iI, we disc over and as
cd seve ral exce llcn l ICXlbooks
c;:tl Iheo ry-D uffi e (1 U92 ), I'lua for (ina n-
llg alld l.ilzcnbcrg-l'I' (19HH), and
( 1~)K7), for cxa lllp lc-b ul no equi Ing-ersoll
vale llt ICXlbook for elllp irira lmc
Dur ing lhe sam e pcri od, we parl lhod s.
icip aled in resc arch con fcrc nces
Fill;lllcial M:lrkels and MOllelary 011
Eco noll lics. held und er lhe allsp
Nati ollal BlIr eau orEc onu lIlic Resc ices of lhe
arch ill Call1ilridge, Massaciluscl
or Ihe pape rs lhal cap lure d our lS. Man y
allel liiol l al lhcs c Illceling-s invo
ccol lolll eiric IIwlhoc!s or new elllp lved new
irica llind illgs ill filla ncia l econ ollli
felli hat this was SOIl l(' of the Illos cs. We
l exci lillg rese arch hein g don e
•lIlC! lhal sllld cIIls shou in !ina nce •
ld be exp osed 10 lhis Illal crial al
III 1!)H!) we bega n to disc uss lhe idea an earl y slag e.
OrWriling- a hoo k lhal wou ld cove
ecol lolll elric IlIClhoc!s as app lied r
10 filla llce. alol lg wilh som e of
prOlllill('Il1 elllp irica l resu lts ill lhe mor e
lhis arca . We hcga ll wl'iling- in
I ~)91, com plel ing lhis ardu ous earn esl in
pr<~jccI five ycar s and almO
page s latcr. This boo k is consi<ler SI six hUl ldre d
.lbly long cr lhal l we had orig illal
bill wc havc finally over ly plal lned ,
com e lhe lcm ptal ioll 10 incl ude
lopi c .• lIld hal'c pUI our pcn s to jusl one lIlor e ncw
res!. or cour se. lhc acad emi c liter
evolved rapi dly whil e wc have bcen alur e has
wril ing, and il con linu cs to do
;1,\ litis boo k goes
to pres s. We have alleJ
so cven
llplC d 10 prov idc hroa d cove rage
IlIlI ('1'(,11 ,\0. Iher e are JlIan
y su!~j('C1S lhal IVt' do 1101 louc h ,
o111ns lit;ll wc can ollly JlIclllion Ilpo n, and mallY
ill p;lssing.
y\'e OI,'t' 1I1;lllY Illor c dcb ls-p crso
llal alld illle llec lual -tlia n IV(, (,'In
,\ihll' ;ICkllowlcdgc. Thr oug hou l pos-
our pl'oks~j()lIal cal'ccl's our coll
1II('Illors h;II'c o/ln ed us advic(', cagu es awl
d('h ale. imp irali oll, alld fricl ldsh
to lh;lllk ill parl inrl ar And y Al>c ip; IYC wish
l, lkll lknt allk e. Sln' (' CC('ChClli
AlIgll~ Dea loll. (;cll e Faill ../oh ll Cox .
a. Ihllc e (;rlll lcl),. Jerr y llauSIlI<l
~1,'n')'11 Killg. Noh ll Kiyo Il, Chi-I'u IllIallg-.
laki. \'el( ' Kyit-. C.cg Mallki\\', Bob
\/,,\, '('\',1 \,," Sllill ('I'. lilll 'Ii," Mnl oll. WhillH'Y
i" ",,,1 \, ",,1,1 '/,·11 .....
 Man)' individuals ha\'(' also I'rovid('d us with invaluahle COIIIIIH'nts alld
discussions n·ganling the COIIIl'nis and I'XPOSilioll of this hook. WI' thauk
David Backus. Nil-k Barhnis. D,wid Barr. David Hates. KI'I\ Ikdllllallil. Dilll-
itris I\l'rtsilllas. Tilll IlolIl'lsll'\'. Peter ChriSloffl'rsl'lI. Susall KelT Christo/~
krsl'n. (;I'orgl' Conslantinidl's . .John Cox. Xavier Gahaix. Lorenzo (:ior-
gianlli •.Il'rl'lny (;0111. I.ars I Iotusl'n. Camphdlllarvl'Y•.Iohn JIeaton. I.udgl'r
Ilenlsdll'l, Rogl'r 111I_lIlg. R_\\'i.lagannathan. Shmllel Kandel. (:aulam K.III!.
.Iung-Wook Killl. 'I')dcl f\lillon. Dan Ndson. Amlan Roy. Boh Shiller. Marc
Shivers. Rohert SI;lIllhaugh. Tom Stoker• .Iean-Lllc Vila • .Iiallg Wang. and
Ihl' ph.n. SllIdl'nls at IIaITard. MI'I: I'rincetoll. alld Wharton Oil wholll Ihis
lIIaterial was "test-marketed" alld rdinl'd.
\"'1' have rdied heavily on Ihe ahle research assislance o/'Pl'lr Adalllek.
Sangjoon Kim. f\brtill 1.(·l\all. Terenn' Lim. Conslanlin Pelrov. Chllllshellg
Zhou. and parlicllbrly Mall Van Vlack and Luis Vin·ira. who undertook the
diffinllt lasks 01' prool'n'ading Ihe llI;l\lllsnipt and prq>aring the ilHlex.
WI' an' grall'ful 10 Sll'phani(' Ilogu\' fill' h<'l' greal skill and carl' ill
prl'parillg Ihl' l'Il'Clmllic version of this llIalluscripl. alldlhe Iypcselll'rs ,It
Archl'l)'pe fill' producing Ihl' final \,I'rsion oflhc hook.
WI' Ihank 1'('ln \)oughl'rly. 0\11' ('(Iilo)' al Princelon UniversilY Press. fur
his pati('IHT, ('II .. "urag(·IlH'nl, alld support throughout this project.
Se\,l'ral orgalli/atiolls provid('d IlS wilh generous suppon during \',11-
ious S\;lges of Ihis hook's geslalion; in paniclllar, we thank Ballcryman h
Financial Managellll'nl, the National I\lIreall of E.conomic Rl'search. till'
Nalional Science Foundalion, Ihe John M. Olin Foundation, Ihe Alfred 1',
Sloan FOllndalion, alld research cl'nlers at I larvaI'd, MIT, Prin('('toll. and
Whanoll.
i\lltllillal\y, we OWl' 11101'1' thall WI' ('all say 10 the SlIpport alld lo\'l' 1lJ' "Ill'
/;lIl1ilics .

.lye
AWl.
,\(:M
The Econometrics of Financial Markets

•
 1
Introduction

FINANCIAL ECONOMICS is a highly empirical discipline, perhaps the most

cmpirical among the branches of economics and even alllong the social
sciences in general. This should come as no surprise, for financial markets
arc not mere figments of theoretical abstraction; they thrive in practice
:llId playa crucial role in the stability and growth of the global economy.
Therefore, although some aspects of the academic finance literature may
seenl abstract at first, there is a practical relevance delllanded of financial
lllodeis that is often waived for the ll10dels of other comparable disciplines. l
Despite the empirical nature of financial economics, like the other so-
ci:.il sciences it is almost entirely noncxperilllentai. Therefore, the primary
method of inference for the financial economist is model-based statistical
inference-financial cconolJleu·ics. While ecollometrics is also essential in
other branches of economics, what distinguishes financial economics is the
central role that uncertainty plays in both linanrial theory amI its empirical
implementation. The starting point for every financialmodcl is the uncer-
tainty facing investors, and the substance of every financial model involves
the impact of uncertainty on the behavior of investors and, ultimately, on
market prices. Indeed, in the absence of ullcertainty, the problems of fi-
nancial ecollomics reduce to exert"ises in basic microeconomics. The very
cxistence of financial economics as a discipline is predicated on uncertainty.
This has important cOllsequences fi)!" finaJlcial ecollometrics. The ran-
dOIH fluctuatiolls that require the use of statistical theory to estimate and test
tiluncial models are intimately related to the ullcertainty on which those
Ill()(lcls <Ire based. For example, the maningale Illodel for asset prices has
V('I)' specific implications for the behavior of test statistics such as the au-

toc()rrelatioll coellicient of price innelllcnts (see Chapter 2). This close

cOllllection between theory and empirical analysis is unparalleled ill the

i B<", ml .. in (I ~J~:l) provides a highly, c.ulab,," '''"("'H'''I "I Ih .. inl<·rpl •• y h.·lween theory and
pr;l("tiu~ ill tilt" dt·."c!OpJIIClll of Illodt'nl fiualu"iai econolllics.
social sciences, although it has been the hallmark of the natural sciences
I()r finite some tillie, Il is ont' of the mosl rewarding aspens of Iin<lnci,lI
('(ollolll('trics, so IIlllch so thaI we fell impellcd to writc this graduate-len'l
textbook as a n)('ans or introducing otht'rs to this cxciting lide\.
Section 1,1 explains which topics we (over in this hook, and how we have
organized the material. WI' also sugg('st sOllie ways in which the hook might
he used in a OI)('-S('II)('st('r cours(' on financial econolllctrics or ('mpirical
finance,
III Senioll 1.2, W(' desnihc the kinds of hackground material that ;Il e
1I\0st IIScful for financial (TOnOlll('trks and suggcst refcrcnces for thos('
read('rs who wish to review or karn slI('h matcrial along the way, In 0\11'
eXperil'lKe, students an' oftI'll more highly Illotivatcd to pick up the Ill'(-
essary background Ilf/rr th('y se(' how it is to be applied, so we encourage
reaclers with a serious interest in financial econometrics btll with somewhat
less preparation to tak(' a crack at this material anyway.
In a hook of this magnitud(" notation becomcs a nontrivial challenge
of coordination; h('n('(' Section 1,:\ descrihes what method there is in our
notation;11 1I\;l(lness, v"'e urgl' rca(krs to review this carefully to lIIillimi/('
the ("(mfllsioll that 1';\11 arise whell ~ is mistakell for fl al)(\ X is illnnrt'cllv
assulllcd to he the sallle as X.
Senion I A extends onl" discussion oi" notation by presenting notational
conventions for and definitions of so III I' of the fundamental obje('fs of ollr
stud),: pricl's, ('('turns, lIH'thods of compounding, and probability distribu-
tions. Although IIIl1ch of this material is well-known to finance students and
invcstment prof(.'ssionals. we thillk a hrief review will help many reaelns,
III Scctioll U"), we tmll om attention to fluitc a different sul~jc(\: 'hl'
Eflkicnt Markels Hypothesis. Because so milch attcntion has been lavished
Oil this hypothesis, oftell al the ('XI}('IIS(' of othcr more Sllbst<llllive isslles,
we wish 10 dispcns(' with this isslle first. Milch of thc debate involves theo-
logical tellets that are elllpirically un(kcidablc <Incl, therefore, beyond th\'
purview of this t(,xt. But for completen('ss-no self-respectillg fillallce text
could olllit llIarket efficiellcy altogethn-Senion 1,5 bridly discusses tIl!'
topic

1,1 Or~ani7.ation of the Book

In orgallizillg this hook. we 11;1\,(' ",lIowed two gelleral prillciples, First, tIl<'
('ady chaptns nlll('('lItrat(' ('xdllsivdy Oil stock markets, Although many 01
the IIl('thO(\s discllsse" c<llIl)(' "}lplie" equally well to other ass('t markets, til"
t'lnpiricallil('l"alllrt' 11I1 slllck JIlark(,ts is particnlarly large and hy f()('usillg Ol\
thesl' lIIark\,tsw(' an' able til k('C), the discussioll connell', III bIn chapin"
we cover dni\'atin' _,,'('wities «:ltapt('ls ~l alld 12) alld fixe<\-incolIH' S(Tllri-
 ;5

I
ties (Chaptcrs 10 and II). Thc last chaptcr of thc book prescnts nonlin~ar
methods, with applications to both stocks and derivatives. \
Second, we start by presenting statistical models of assct returns, and
then discuss more highly structured ecollomic models. In Chapter 2, for
example, we discuss mcthods for predicting stock returns from their 0"11
past history, without much atlention to institlllional detail; in Chaptcr 3 we
show how the microstructure of stock markets affecL~ thc short-run behavior
of returns. Similarly, in Chapter 4 we discuss simplc statistical models of the
cross-section of individual stock returns, and thc application of these models
to evcnt studies; ill Chaptcrs 5 and G we show how the Capital Asset Pricing
Model and multifactor models such as the Arbitrage Pricing Theory restrict
the parameters of the statistical models. In Chapter 7 we discuss longer-run
evidence on thc predictability of stock returns from variables oth~r than
past stock returns; in Chaptcr 8 wc explore dynamic equilibrium models
which can gcncratc persistent timc-variation in expcctcd returns. We use
the samc principle to divide a basic treatmcnt of fixed-income securitics
in Chapter 10 from a discussion of equilibrium term-structure models in
Chapter II.
We havc tricd to makc each chaptcr as scll~o[\tained as possiblc. While
SOIllI' chapters naturally go together (c.g., Chapters 5 and G, and Chapters
10 .mll II), there is certainly no need to read this book straight through
frolll heginning to cnd. For classroom usc, most teachcrs will find that there
is too much matcrial hcrc to he covcrcd in onc semcstcr. Therc are scvcral
ways to usc thc hook in a onc-semcster coursc. For cxamplc onc teachcr
might start by discllssing short-run time-serics bchavior of stock priccs using
Chaptcrs 2 and 3, then covcr cross-scctional models in Chaptcrs 4, 5, and 6,
then discuss intcrtcmporal cquilibrium models using Chaptcr 8, and finally
(over dcrivative securitics and nonlinear methods as advanced topics using
Chapters 9 and 12. Anothcr tcachcr might first prcscnt the cvidence on
short· and long-run prcdictability of stock returns using Chapters 2 and 7,
then discuss static and intcrtcrnporal equilibrium thcory using Chaptcrs 5,
{i, and R, and finally covcr flxcd-incomc securities using Chapters 10 and II.
Therc arc somc important topics that wc havc not been able to include
in this texl. Most obviously, our foclls is almost cxclusively on US domestic
asset markcts. Wc say vcry littlc about asset markets in othcr countries, and
we do not try to covcr intcrnational topics such as exchange-ratc bchav-
ior or the homc-bias punic (the tcndency for each country's investors tei
hold a disproportionatc sharc of their OWJl country's assets in their portfo-
lios). We also omitslIch important economctric subjects as Bayesian analysis!
and frequency-domain methods of time-serics analysis. In many cases our
choice of topics has becn influcnccd by the dual objectives of the book:l
10 ('xplain the methods of financial cconoIllctrics, and to review the ("IIl-'
piric .. 1 literature in finance. We havc tended to conccntrate on topics that
I I
 I
i I ' ,.' • , .,:: "" • ~ t; •

1
inv~lve cconometric issucs, somctilllcs at (hc expensc ofo(her equally ill('/'-
cstill~ l1Iatcrial-indudill~ IHuch rcccHt work ill hchavioral !inan('t'-that
is ccbllollletrically more straightforwanl.

1.2 Useful Background

The lIIany rewards of financial cconometrics come at a price. A solicll>ack-

ground in m.athematics. prohahility and statistics, and finance theory is nc('-
essary for the practicing financial economctrician. for precisely the reasolls
that make financial cconometrics such an en~a~ing endeavor. To assist
readers in obtaining this background (since only the most focused and di-
rected of st\l(ients will have it already), we outline in this scction the IOpics
in mathematics, probability, statistics, and finance theory that havc becollle
indispensahle to financial ecollomctrics. We hope that this outline call scrve
as a self-study guidc for the lIIore enterprising rcaders and that it will bc a
partial substitute for includin~ backgruund material ill this houk.

1.2.1 Atllt/wlllltirs B(!ckg'HlUUd

The mathcmatics background most useful for !inaneial ecollonletri('s is not
unlike the background necessary for econollletrics in general: lIlultiv'\I·iate
calculus, linear algebra, and matrix analysis. References for each or these
topics arc Lang (1973), Strang (197!i), and Magnus and Neudecker (I ~IHH),
respectively. Key concepts include

• multiple intcgration
• multivariate constrained optimization
• matrix algeura
• basic rules of matrix difti.'rentiation.

In addition, optiun- and other dcrivativ{:-pricin~ models, and contillllollS-

time asset pricing models, require somc passing familiarity with the Illi or
.I/or/untie ((l/eu/us. A lucid and thorough treatment is provided hy Merion
(1!190), who pioneered the application of stochastic calculus to lin.uH"ial
economics. More mathematically inclillcd readers fIIay also '''ish to {"O!lSuit
Chllll'fand Williams (1990).

1.2.2 "lOllIlhilitv 111111 SllItisliLl i!tlfi<gwwlIi

Basic ill"ohahility theory is a prerequisite f(,r any disci pi inc in which u!l{"{'r-
t<limy is inl'olved. Althou~h prohahility theory has varying de~rees oflllathe-
matic'il sophistication, frolll coill-Ilippin~ l:alcuhltions to measure-theoretic
foun<l1ltions, perhaps the most IIseful approach is one that cmphasi/.('s tlte
\
illluilion alld suhllclies or deillclltar), I'rohahilistic rcasollin~. An amaz-
illgly dmable t'lassic that ta"es just this appn><\ch is Fe\ler (I ~I(;H). nrielllan
(I ~)~)~) provides similar intuitioll hut al ;1 IIlGlslllc-theoretic level. Key COII-
c('pts incillde

• ddillilioll of a ralldom variable

• illdepelldellce
• di,trii>ulioll and density fUllctiolls
• c()nditional prob~lbility
• modes of cOllvcrgenct:
• laws of large numbers
• centrallilllit theorems.

Sialistics is, of course, the prilllal)' engine which drives the illferences
that fillallcial ecollolllt:tricians draw from the data. As with probability the-
ory, statistics can be taught at various levels of mathematical sophistication.
Moreovcr,unli"e the narrower (and sOllie would say "purer") focusofproba-
hilit)' theory, statistics has increased its breadth as it has matured, giving birth
1(> nWlly well-delined subdisciplines such as lIIultivariate analysis, nonpara-
lIlelrics, tillie-series allalysis, order statistics, allalysis of variance, decisioll
Ihcor)" Ha)'esian statistics, etc. Each of these subdisciplines has been drawn
upon by financial econometricians at on(' tilllc or another, ma"ing it rather
difficult to provide a single rderellct: for all or these topics. Amazingly,
sllch ;1 rdercllce does exist: Stuart alld Ord's (I ~)H7) three-volullle lour de
jil/ce. A lIIorc cOlllpacl reference that contains most of the relevant material
lor 0\,1' purposes is the elegant IIlollog,-aph by Silwy (197:'). For topics ill
ti,"e-series analysis. Hamilton (\ !l94) is an excellenl comprehensive text.
Key concepts include

• Neyman-Pearson hypothesis testin~

• lint'ar n:gression
• IIl<lximlllll likelihood
• hasic lillie-series analysis (stationarit)" alltoregn.'ssi\·e and ARMA pro-
,"('sses. vc("(or alltoregrcssiollS, unil rools, etc.)
• ('I"III('lIlar), Bayesian illferellcl'.

F()r ("(JlIi ill1lOm-lilIlc financiallllodds, an additional dose of stochastic pro-

n'ss('s is <I l\Iust, at least at the level of eo x and MilicI' (1!)(i5) ,lIld Hoel, Port,
~\lld SIOIll' (1~ln).

J.2.3 Filllll/u' 'filml)' HllrkgmHlld

Since lhe mi.l()11 drlrf of financial c("onOllll'trics is the t'mpirical ill1plelllen-

1~lIioll and cvaluation of financial Illl)dds, a solid \);ld.grolllld ill finance
III('()'), i, Ill(' most in,portant of all. Scvcral texis pro\'id(' exccllent coveragc
 or this material: Duffie (I!l!l~), /-luang and Litzenberger (19HH), Ingersoll
.14·'- L"~~I.~ t,1·· .... ; ,"
1 J_I" !~"'" .'~I:~·:)L" iIJCJudt"

• ,hI. ,.I<·ISIIIJI .tlllI ''''IWI 11'11-,<111111' IIJ('ory

• s!<llic lIIean-varian((' portfolio II1('0ry

• the Capilal Ass!'1 Pricillg Model (CAI'M) and the Arhitrav;e Pricing The-
ory (AI'T)
• dynalllic ass('t pricing models
• optioJl pricing th('on'.

1.3 Notation

We have fimnd that it is 1;lr rmm silllple to devise a consistcnt notational

schellle lilr a hook or Ihis scope. Thc dirricllity cOllies rmlll thc fan thai
linancial econometrics spans s('\'('I'al \'ery different strands of the financ('
literature, ('ach replc-h' with its own lirlllly estahlished sct of potational
('OIl\'('lltiollS. I\llt till' COllVl'lltiollS in Ollt' litcrallll'C orten conflict wilh Ihe
convcntions ill another. Ilna\'oidahly, tll('ll, WI' IIIl1sl sanifice either ill\('I-
llal notational (,(lIlsistl'ncy across dilli'n'llt chapters of Ihis tcxt or cxtcrIlal
cOllsisll'lH'Y with the 1I0tatioll used ill th(' professional lit('ralun~. Wc hav!,
chos('n Ihl' «mll('r as Ih(' kS'lT ('\'il, hUI we do mainlain Ih(' «)\Iowing COII-
1'('lliions throughout lilt' hook:

• We IISC holell;\("(' for \'cctors alld matriccs, and rq.(ular race for scalars.
Where possihle, W(' US(' hold IIppercase for lIIatrices and hold lowcrcase
filr vcctors. Thlls x is a \'('ctor while X is a matrix.
• Where possihle., we lise IIppercase letters ror thc levds or variahles aJ:<1
lowercase ktters for thc lIatllrallogarithllls (logs) ofthc sallie variabks.
Thlls ir I' is an assct price,/! is th(' log asset price.
• Our stalldard notation filr all innovation is thc Creek Ic-lI('1' L When'
we nced to defille se\'eral dilfl'l'I'lIt illnovations, we IIS(' the alternalivc
(;rl'l'k 1I'1I1'rs 'I, l;, alld (.
• Wher(' possihle, WI' IIS(' (;n'l'k 1e1l('rS to dellote paranll'ters or parallll'tl'l'
\'('('\ors.
• WI' uS(' 1iJ(' (;n'l'k II'th'r" to <I('I\OIl' a v(,ctor of OJIl'S.
• '''''(' US(' hals 10 d('llOh' sa III 1'\(' ('slimal('s, so if fJ is a parallH'l('r, fo is ;111
('slimall' of fJ.
• \\'h(,11 WI' lise sllhsnipls, W(' al\\',,,'s liS(' IIPI)('I'I'a,,' kllers for Ihl' IIppl'r
lilllits of the suhsnipts. WII('I"I' possihle', we lise thc same kllers «"
IIppt'l' lilllits as for titc suhsnipts thl'lIIselvcs. Thlls sllhsnipt I nms
from I to T, sllhscript Ii IIIIIS frOll1 I to K, alld so Oil. All exception is
tItat WI' willll't snhscript i (lIsllally d('lIoting all as"'t) nlll fronl I to ,\'
hCCIIISC this notation is so COlli 111011. We lise I alld r for tillle sllhscript,;
 j for asset subscripts; k, m, and n for lead and lag subscripls; and j as a
{!c.-Dc.-riC subscripl
.. M--~' J.tr.. JlDllt;!' GIIIW!':llllU'1 u.:u.':...;, ;ur.mitt": *' cia!rri.1 lifru'-I~
the end of period t. DllIs RI dcnotes a rcturn on an asset held from the
end of pcriod /-1 to the end of pcriod t.
• In writing variance-covariance matrices, we use n for the variance-
covariance matrix of asset returns, L for the variance-covariance matrix
of residuals from a time-serics or cross-sectional model, and V for the
variance-covariance matrix of parameter estimators.
• We usc scriptlellers sparingly. N denotes the normal distribution, and
L denotes a log likelihood function.
• We usc Pr(·) to denote the probability (lfan event.

The professional literature uses Illany specialized terms. Inevitably we

also use these frequently, and we italicize them when they first appear in the
book.

1.4 Prices, Returns, and Compounding

Virtually every aspect of financial economics involves returns, and there are at
leasltwo rcasops for focusing our attcntion all returns rather than on pri~es.
Firsl, for the average investor. financial markeL~ may be considered c1os<lto
pnft"l:tly competitive, so thatthc sizc of the investment does not alTect prke
changcs. Therefore, since the investment "tcchnology" is constant-retu~ns­
to-scale, the return is a complctc and scale-free summary of the investment
i
opportunity.
Second, for theoretical and empirical reasons that will become apparent
below, returns have more attractive statistical properties than prices. such
as stationarity and ergodicity. In particular. dynamic general-equilibrium
models often yield nonstationary priccs, but stationary returns (see, for
example, Chapter 8 and Lucas [1978]). •

1.4.1 Definitions and Conventions

Denote by 1', the price of an assct at date I and assume for now that this asset
pays no dividends. The Jim/lie nfl rl'lum, n,
on the asset between dates I - 1
and I is defined as
1',
H, --I. (1.4.1 )
P'-I

Tht" silll/Ill' {!!OH rp/um on the asset is just one pillS the net return, 1 + R,.
Frolll this definition it is apparent that the asset's gross return over the
most recent k periods from date / - k to date t, written I + ~(k), is simply
p<~'~":': ;~Jt .
,: 10 ..
I. Ill/mt/ue/illll

cC]ualto thc product of the k single-period returns frolll 1- k + I to I, i.('.,

1+ R,(k) - (I + I?d . (I + /{,-I)'" (l + I?,-k+d

I', 1',-1 I',_.~ I',-H I I',
== --.--.--."--- -- ( I.·U!)
1',-1 I',_~ P'-:I I',-k J',-k

and its net rcturn over the 1I1osl recent k periods, written /{,(k), is simply
cCjualto iLS k-pcriod gross return minus olle. These llluitiperiod returns are
callcd com/Jound rcturns.
Although returns arc scale-free, it shollid he emphasized that they are
1I0t IIl1illess,'uut are always defined with respect to some tilllc intcrval, e.g.,

onc "pcriod." In fact, R, is lIIore properly called a rale of retlll'll, which is

mon "jcullluersomc tcrminology butlllore accurate in refcrring to HI as a rate
or, in! cconomic jargon, a flow variable. Thereforc, a return of 20% is not
a coniplete dcscription of the invcstmcnt opportunity without specification
of the retllrn horizon. In the academic literature, the relllrn horizon is
generally given explicitly, oftell as part of the data description, e.g., "The
CRSP monthly returns file was used."
14owever, among pr~ctitioners and in the limlIlcial press, a return-
horiz{lII of one ycar is usually assumed implicitly; hencc, unless stated oth-
crwis<t. a rcturn of20% is generally takcn to mcan an annual return of20%.
MorC\lVer. multiyear returns arc oftcn anllualized to make invcstmcnts with
differbll horizons comparable, thus:

\
\ Annualized[RI(k)) ==
[Hn(l + R'_j)
Jl/k - I. (1.'1.3)
\ j:O

Sincc l~ingle-periodrcturns are gencrally slllall in magnitudc, the follow-

ing a~proxilllation bascd on a first-ordcr Taylor expansion is often used to
annu~lize multiyear returns:
I A-I
Anllualizl'd[U,(k)] ~ k L Ilt-r (1.'1.'1)
j=1l

Whether such an approximation is ade<)l1ale depends on the particlliar

application at hand; it may suffice for a <)ui<"k and coarse comparisoll or
invcstmcnt pcrformance across many assets, bllt for finer calculations in
which thc volatility of returns plays all important role, i.e., whell the higher-
.. order terllls in thc Taylor expansion arc not negligiblc, the approxill1ation
t (1.4.4) lIlay hreak down. The only advantage orslich an approximation is
•. (OIlVcnience-it is easicr to calculate all arithmetic rather than a geolllet-
• ric avcrage-howevcr, this advantage has diminished considerably with the
.. advclll of cheap and convenienl computing power.

,.~
j:.
1.-1. }'ril'f.\', 1II'lUnt.l, !luti C0mfruUIlfLillg 11

(:oll/ill Will.\' (:olll/mulldilll{

'! '", diflicully or manipulating g\~ol\wtrir ,Iverages surh as (1.4.:~) motivates
,t .. · .. <'1' approach to compound returns, (In(' which is not approximate and
,dso has important implications for modeling asset returns; this is the notion
or con tin uous COlli pounding. The (Oll/jlluowly COIII/lOlllllil'd rflum or {ogrelum
r, ofan asset is dclined to be the naturallogaritlilll o('its gross return (I + H,):

( 1.4.5)

\"here h == log 1',. When we wish 10 ('lllphasiJ.e the dbtinl'lion between R,

and rl, we shall refer to R, as a sim/)ifo return. Our notation here deviates
slighLly from our convention that lowercase letters denote Ihe logs of up-
percase lettel>, since here we have rl == log(l + lll) rather than log(/l,); we
do this to maintain consistency with standard conventions.
The advantages of continuously compounded returns become clear
"hen we consider multi period I'eturns, since

1',(11) logO + R,(h)) == log«l + HI)' (1 + RI _ I )··· (1 + U'-H1)

logO + H,) + logO + H,_I) + ... + logO + RH+I)
== r, + T,_I + ... + r,-ktt, ( 1.4.ti)

and hence the continuously compounded llIultiperiod retum is simply the

sum of continuously compounded single-period returns. Compounding,
a multiplicative operation, is converted to an additive operation by taking
logarithms. However, the simplification is not merely in reducing multi-
plicatioll to additioll (since we argued above that with modern calculators
and computers, this is trivial), but 1II0re in the modeling of the statistical
behavior of asset returns over time-it is far easier to derive the lime-series
properties of additive processes thall of multiplicative processes, as we shall
~('e in Chapter 2.
Continuously compounded returns do have one disadvantage. The siJn-
pie relU!'ll Oil a portfolio ofassels is a weighted average of the simple rellIrns
011 the assets thelllselves, where the weight 011 each assel is the share of the
portrolio'~ value invested in that asset. ]j' portfolio /) places weight W,p in as-
Sel i, thell lhe return 011 the portfolio at litlle /, HI'" is related to the returns
Oil individual assets, Rjlo i == I ... N, hy R/" = L:':'d W,/,Hil . UnforlUnatrly
conlinllously compounded returlls do lIot share this conveniellt property.
Since Ihe log or a SUIII i~ 1I0t the sallie as the stun or logs, 'i" docs not equal
\~.v
L...,=1 1l'I/ lrli'
In empirical applicalions this problem is IIsllally minor. When returns
,Ire lIwasured over short intervals of lime, alld are therefore dose to zero,
Ill(' cOJltinllously (,OIllPOIIlHlcd /'(>Iurll Oil ,I port!,.!io is close to Ihl' weightl'd
 Ii, Ii",
J',

1+ I

Fi}.,"In' 1,1, I Jil'idl'lld I'mll/PIII "'ill/il/~ CIIIIl'rIIlill/!

average of the continllollsl\' COlJlpoIIIHled returns Oil lhe individual a~scts:

'i,' "" L:t lfIll"i"~ We lise this approxiliialioll in Chapter :1, Nonl,thelc,s
it is conllnon to USI' ~illlpk returlls when a (Toss-section of assets is heillg
stlldied, as in ChaplCls ·I-(i, ;IIId cOlllilluously cOIlIpounded relUnls whl'1I
Ihe lelllporal behavior of relllnlS is the lilcus of interesl, as in Chapll'!s '2
and 7,

I )ir/it/nlll I'ayllll'll/.\
For ;\.sSI'ls which IIIake periociic ciivicielld paYl11l'nlS, we I11I1SI IlIociil)' our
ddinilions or 1'('1 II rns anci compounciillg, lknole hy /), the assel's divicielld
pa)'IIIelll al dale 1 alld aSS"IlIe, »lIlrly as a malleI' or COnV('IIlioll, Ihat Ihis
di\'idcnd is paidjllst herore Ihe ciale-I price 1', is recorded; hence 1', is lakell
10 be Ihl' (',\'·dir,it/I'IIII price ;11 dall' I, AlIel'llalivcly, one Illight dl'snihl' I', ;"
all elld-ol~period assct price, as showII ill Figure 1,1, Then Ill!' IIet silllpk
l'('UII'Il at dall' 1 1ll;1)' 1)(' dc/illl'd as

1'1 + /),
f{, ---I. (J.oI,7l
1',-1

Multipl'riod and cOlllillllollsly COIIIIHHllldcti relllrns 1\Iay hc oi>uilll'ci

ill Ihe sallie way as in Ihe lIo-dividellds case. Nute that the cOlltillllOllSI~'
compollllckd rellll'll Oil a di\'idl'lld-payillg assel, r, = log(/'I + /),) -log(l',_1 ),
is a nonlincar rllll('(ioll or log priccs alld log divicknds. Whell thc ratio
or prices to tlidclcnds is nol ICHI \'ariahle, however, tbis rlllll'liOll elll hc
approxilllaled hy a lilH'ar rllllClioll or log prices alld di\'idelld~. as discllssed
in detail in Chaptci 7,

I':,\H',\.\ U,'/un/.\
II is oftcn COII\'I'lIit'lIl 10 work willI ;111 assel's exccss return, c1dincd as III<'
dini.'n'lIl,(, hl'IW(,I'!I Ihl' ;lss('I\ rl'llIr!l and the retllrll Oil S01\le refl'I"'IlC('
aSSl'!. Thl' n'f(on'!I((' ;ISSl'1 is ofl('!1 ;Issulllcci to Ill' riskless alld ill pranicc i,
~I IIsllallya shorl-l<T!ll Tn';lSlIrl' hill n'lmll, Workillg with silllplc retllntS, thl'
I
:.',,, \1", hmt1 \d"'"'1i''H'l''' IIHtlllIHHI",ItO\ {.(·BH\\~,.(H"'4."u"i.,,(.'<l ,1\ S('( titlll ~I. t .'1(11 (:h.l\ltt"1 I,.
I ,lIIlw 1I"i.t'd 10 Id,lIf' ,ilJll'k ,11111 '''lIliIIlIOIl,h (PlIIl'0lltult·clIC·IUI n~"
silllple excess return on asset i is

0.4.8)

where I~Jt is the reference return. Alternatively one can define a log excess
return as
( 1.4.9)
The excess return can also be thought of as the payoff on an amitmgt
/Jllrtjo/io that goes long in asset i and short in the reference asset, with no
net investment at the initial date. Since the initial net investment is zero,
the return on the arbitrage portfolio is undefined bllt its dollar payoff is
proportional to the excess return as dc!inecl above.

1.4.2 The Marginal, Conditional, and joint Distribution of Rrtums

I"laving defined asset returns carefully, we can now begin to study their
behavior across assets and over time. Perhaps the most important charac-
teristic of asset returns is their randomness. The return of IBM stock over
the next month is unknown today, and it is largely the explicit modeling
of the sourres and nature of this uncertainty that distinguishes financial
economics from other social sciences. Although other branches of eco-
nomies and sociology do have models of stochastic phenomena, in none
of them does uncertainty play so central a role as in the pricing of finan-
rial assets-without uncertainty, much of the financial economics literature,
both theoretical and empirical, would be superfluous. Therefore, we must
articulatl' at the very start the types of uncertainty that asset returns mi~ht
exhibit. "
!
Thr joiJl ( lJistn"blltion \
COllsider a collection of N assets at date t, each with return R,/ at dat9 t,
where I = 1•... , T. Perhaps the most general model of the collection lor
returns I a,ll is iL~ joint distribution function: I
!
( 1.4.10)
,
where x is a vector of slale variables, variables that summarize the economic
{,llvirol1ment in which asset returns arc determined, and (J is a vector of
fixed parameters that uniquely determines C. For notational convenience,
we shall suppress the dependence of G Oil the parameters (J unless it is
Ill'l'ded. ,
The probability law G governs the stochastic bebavior of asset returns
alld x. and represents the SUIll total of all knowable information about tbem.
WI' lIIay then view financial econolJletrics as the statistical inference of e,
giv{,Jl (; and realizations of IR"l. Of course, (1.4.10) is far too general to
 I. Illlroliuriio/l

he of any lise for statistical inference, and we shall have to place further
restrictions on G in the cOllling sections and chapters. Ilowev(~r, (1.'1.10)
docs serve as a cOllvenient way to organize the many models of asset re-
turns to be developed here and ill latcr chapters. For exalllple. Chapters ~
t11}ough 6 deal exclusively with the joint distribution of (ll'll, leaving addi-
ti9nal state variahles x 10 be considered in Chapters 7 and H. We write this
joim distribution as Gil.
I Many asset pricing models, sllch as the Capital Asset Pricing Model
(cArM) of Sharpe (1964), Lintner (1965a,b), and Mossin (l%li) consid-
cred in Chapter 5, dcscribe the joint distrihution of thc cross section of r('-
tIIfns lUll' ... , ){Ntl at a single date I. To n~duce (1.4.10) to this essentially
stalic structure, we shall have to assert that returns arc statistically indepcn-
<leut through timc and that the joint distrihution of the cross-section of
rct\lnlS is idcntical across timc. Although such assumptions seem cxtrcme,
th1 yield a rich sct of illlplications for pricing fmancial assets. The CAPM,
forrxample, dclivers an explicit formula for the trade-off between risk and
ex~ec(cd return, the celebrated security market line.
\
?'he; Conditional Dislribulion
In ~hapter 2. we place anothcr set of rcstrictions on Gn which will allow us
to f~cus on the dynamics of individual assct returns whilc abstracting li'OlU
croSs-sectional relations bctween the as,5ets. In particular. cOllSider the joint
distribution F of I R", ... , R'TI for a given asset i. and observe tli,1I we may
always rewritc F as thc following product:
FUlil' ... ,Rrr) = /';1 (R.d . /';~Ul,t I n,d· /'i:l(fl,:1 R,2. R,d

... /';'r\R,'f I lilT-I •. ·· .fl,d. (1.'1.11)

Frolll (1.4.1 I). the tcmporal depeudencies implicit in {R'II are apparent.
Issues of predictability in asset rcturns involve aspects of their fOlUliliOIl(l{
distributions and. in particular, how the conditional distributions evolve
Ihrough time.
By plac-ing further restrictiollS on the conditional distributions 1';,(·), we
shall be able to estimate thc paramcters 0 implicit in (1.4.11) and exam-
inc (he predictability of asset retuflls explicitly. For example, one versioll
of the random-walk hypothesis is obtained by the restriction that thc con-
ditional distribution of rcturtl /lit is equal to iL~ marginal distributioll, Le .•
l'il(1l/l I .) = Jo;I(1~iI)' If this is the case, thcn returns are temporally indqll'n-
dent and thcrcfore unpredictahle using past r('(urns. Weaker versions oftlH'
randolll walk are obtained by illlposing weaker restrictions Oil I';,(ll/l I . ).

The UllfOllliilioll(l{ Distributioll

In cases where an assct f(~tllfll'S conditional distribution differs from its
llIarginal or IIlIconditional distriillttioll. it is dearly'the {"(mdilional distrihlt-
1.". Prias, Returns, and Compoundillfi 15

tion that is relevant for issues involving predictahility. However, the proper-
ties of III(' unconditional distribution of returns may still be of sOllie interest,
l:~pc('i;dll' ill cases where we expect pn'dictability to be minimal.
One or Ihc most cOlllmon models for asset returns is the temporally
inde[Jelldel1tly and identically distrii>uteo (liD) normal 1Il0del, in which
returns arc assumed to be indepellden I (lvel' tillle (although perhaps cross-
sectionally correlated), identically distributed over time, and normally dis-
Iributed. The original formulation of tlw CAPM employed this assumption
of' normality, although returns were only implicitly assulllcd to be tempo-
rall), liD (since it was a static "two-period" model). More recently, models
of asymllletric information such as Grossman (19H9) and Grossman and
Stiglilz (1980) also use normality.
While the temporally lID normal modclmay be tractable, it suffers from
al leasltwo important drawbacks. First, most financial assets exhibit limited
liability, so that the largest loss an investor can realize is his total investment
and no more. This implies that the smallest net return achievable is -1
(,r -100%. But since the normal distributioll's support is the entire real
lill':, this lower bound of -1 is clearly violated by normality. Of course, it
Illay be argued that by choosing the mean and variance appropriately, the
probability of realizations below -I can be made arbitrarily small; however
il will never be lero, as limited liability requires.
Second, if single-period returns arc assumed to he normal, then multi-
period returns cannot also be normal since they arc the produrtsoflhe single-
perind returns. Now the sums of norlllal single-period returns arc indeed
normal, hut the slim of single-period silllple rellll'IIS does not have any eco-
nomically meaningful interpretation. However, as we saw in Section 1.4.1,
the slim of single-period continuously COlllpOlllHlcd rclllrns docs have a
meaningful interpretation as a llIultiperiod continuously compounded re-
turn.

'Jile 1.og71oTlIlal Distribution

A sensible alternative is to assume that cOlllinllollsly compounded single-
period returns Til are lID norlllal, which implies that single-period
gl'Oss silllpll~ returns arc distributed as liD lO!-,'1wnllal variates, since Til ==
log( I + RII ). We lIIay express the lognormal model then as

(1.4.12)

l: ndt:r the lognormal model, if' tltt· 11I(,~\l1 and V~II'i;\llCC or r,l arc 111 alld a/,
respectively, tilen the mean and variance of simple returns are given by

(1.4.13)

(1.4.14 )
AIII'matin-h', if \\'1' ;1.~~II/lJ(' that Ihl' /lIl'an and variance orsimpk retllJ'll' a'l
arc III, and I;, rl'sp('ctin'II-, thl'lI IIlHkr the IO):(lIorlllallllodt'llill' Ill!'all ,llld
\'"ri;l/l('c of 1;1 arl' gin'II bl'

111,+ I
log --;:=====
" )~
I -I- ( ~

\\111',11 log [I + (_S'

111,+
)~].
I
(J..l.1 til

'1'111' 10):(nonll;1I Illodl'l has till' added adl'antage of IIot violatillg lilllil!'d
liability, sincl' limilt'd liability ddds ;1 low('\' hound of /.no on (I + I?'II.
which is satisficc! h)' (I + No) = 1,1" whell I;, is assllnwc\ to 1)(' normal.
The IO):(lIormalllllldd has a long alld illustrions history. hegillnill):( with
the dissl'rtation ort hI' Frl'nch III;\thl'llIatician l.otlis nachdin (I ~lO(), wili(h
contained the lIIathematics or Brownian lI\otion and hcat conduction, Ii\"('
years prior to Eillstl'i" 's (I !l()!"l) ElIllOIIS paper. For other reasolls that will 1)('-
1'0111(' appalTnt in later chapters (SI'(', I'specially, Chapter !l), the lognonllal
model has bl'('ollw tIll' workhorse or the fillancial asset pricing litnaturc.
nllt as attractivl' as thl' IO):(lIortllallllodcl is, it is not consistent with al\ the
properties or histol"ical stock returns. At short horizons, historical retllrns
show weak evidence of skewness "nd strong evidence or exn'ss kurtosis. The
Jkntlnr.f.\, or norlllali/l'c1 third IllOIll('nt, or a randolll variahl(' ( with IlIl'al1 /1
alld \'arialKI' (J ~ is ddilwt\ by

( 1.4. Ii)

The lil/r/llli.I, or lIortn;tii/.l'd ',l\lItll I\lOllll'lll, of £ is defined hy

Thl' \lonl\al disirilllitillll 1,,1' S\....'WIII·S' "'111011 10 l.l'J"(I, as do all othn ': Ill-
IIll'tric distribllli""s. Th .. "Orlll,1i dislriblltioll has kurtosis l'ljl\al 10 :1. IlIll
.!',I-Iaifl'/{ dist rihlltiolls wit h <,xll;\ Iliohahility IIlass ill t 11(' tail art'as lIaw highn
or 1'\'('11 illli"it!' kurlosis.
Skcwllt'ss alld kurlosis I ;111 hI' t'SI illlatni ill ;\ salllpk of (bt;l hI' COllstl1 /( t-
ill!!: till' ,,11\·ioll' sallll'l,' ;I\ ... ra~,·': IIll' ,a III ph- 1\1 ('a II

/1 ( 1.1. I (I)
I .. /. l'nuI, I!I'LrII7l.I, 1I1It! COII//IIJlllldillJ; 1.7

Ill(' sample variance

T
a~ - TI '\'(( ,.)2
L-'-'" ,
1:1

Ihe salllple skewnf'Ss

r
. I", -3
.Ii -- 'fo-:I L-(f, - Ii) , (1.4.21)
1=1
\
alld the sample kurtosis

l\." == -I-4 L T
-
(E, - Ii) 1 . (1.4.22)
Ta 1=1

III lar~e samples of normally distrihuted data, the estimators ,~and k are
lIormally distributed with means 0 and 3 and variances 6/ T and 24/ T'
respectively (sec Stuart and Ord [ 1987, Vol. I]). Since 3 is the kurtosis ofth~
normal distribution, sample ex(f'SS kurtosis is defined to be sample kurtosis
less 3. Sample estimates of skewness for daily US stock returns tend to be
IIq!;ative for stock indexes hut close to zero or positive for individual stocks.
Sample estimates of excess kurtosis for daily US stock returns are large and
positive for hoth indexes and individual stocks, indicating lhat returns have
more lIIass in the tail areas than would be predicted by a normal distribution.

Stable Distributions
Early studies of stock market returns attempted to capture this excess kur-
tosis by modeling the distribution of continuously compounded returns as
a memher of the stable class (also called the stable Parf'icrLivy or stable Pare-
film), of which the normal is a special case. 3 The stable distributions arc a
natural generalization of the norlllal in that, as their name suggests, they are
slahlc under addition, i.e., a sum of stable random variables is also a stable
random variable. However, nOllllorl11al stable distributions have more prob-
ability mass in the tail areas than the normal. In fact, the nonnormal stable
distributions arc so fat-tailed thaI their variance and all higher moments are
infinile. Sample estimates of variance or kurtosis for random V<\riablcs with

"The Frenrh probabilist raul Levy (1924) was porhap' the Ii ... t to initiate a genel4l inve,ti·
gation "("table di.tributions and proVided a complete characterization of them Ihrough their
log~ haranrristic functions (,e~ Iwlow). l.evy (192:» .Iso ,howed Ihal the tail probabilities
01 st"hlt· db{r,hut~on~ approximat{" those of the Part'to distribution, hence the t~nn "stable
}';II"('lo-l.(·\,y" or "s[ahl(, rarrli<lll" fiil\trihlltion. For appli(~lioru to financial autt T~tum~. ~e
IIbttl>l't ~ ,tnd (;onedes (1974); Failla (196:'); Fam. and Roll (1971); Fieliu (1976); Fielitz and
HOII'll (1~1H:1); (;ran~rr atld Mor~e"'l.rn (1970); IbRennan (197H); Ihn, Miller, and Wichern
(I <17·\); ~bt"klhrot (I%~,); Mandell>rol3l,,1 Taylor (1%7); OfTicer (1972); Samuelson (1967,
I '17Ii); Silflklll,'ill and Ik.,II,'., (I')HO); and Tttrker (11)92).
J~ 1. Introductioll

,
\ ,,"

n.lo
\ " Cauchy
\ "
I '.
I
II
-3 -2 -I 0 3

Figure 1.2. CompariiOll o/Slab'" (wd Nomlfll Dl'Ilsily FIUlcliolU

these distributions will not converge as the sample size increases. but will
tend to increase indefinitely.
Closed-form expressions for the densilY functions of stable randolll vari-
ables are available for only three special cases: the normal, the Cauchy, ami
the Bernoulli cases. 4 Figure 1.2 illustrates the Cauchy distrihution, wilh
density function
j(x) = y
T( y2 + (x - <5)~

In Figure 1.2, (1.4.23) is graphed with parameters <5 == 0 and y \, and il

is apparent from the comparison with the normal density fUllction (dashed
lines) .that the Cauchy has faller tails than the normal.
Although sc.able distributions were popular in the 1960's and early 1970's,
they are less commonly used today, They have fallen out of favor partly be-
cause they make theorelicallllodelling so difficult; standard finance theory

4I!uwever;I..e"'! (1925) deriveilihe \ol\owillK ~xplicil exp ....,sioll for Ih" 10Ka";III", of Ihl'
ch'lra<ll"rislic fUllelion \0(1) of allY slahlt' laudolll v;triahle X; 10K \0(/) == lOll EI ,"'\) = i.l-
rlll"11 - i,8'gll(l)lan(aJl'l2»). where (a.fI,., y) are Ihe lour paramelers lhal chara('('rilt'
each .!able clisuibution, 6 e (-00,00) is said 10 he Ih" loraliUlI "arameter, fI e (-00,00) is Ihe
,len."", inrinr, r e (0,00) is the '(flU "a""la'tl'l. and" e (O,:l\ is the fxpVllml. Whellll = :l.
Ih .. ~table di~lribulion reduce~ tn ,I nOl'lIIal. A" a. dCO't,IM'~ hlllll 'l 10 0, Ihc lail area. or lIlt'
51allle dislribution become incrl"asinf;ly "(aner" Ih,,,, Ihe nor",al. When a e (I. 2), the .Iahl,'
distribution has a finite mean Kivell hy &. hut when a € (0, I\, "vcn Ihe mean is illlillite. TIlt'
parameler fJ meamres the symmelry of Ih,' slahle dislribution; when {j = () the distrihution b
'ynlmelric, and when fJ > 0 (or fI < 0) Ihe distribution is skewed to the riKht (or lefl). Wh"11
= =
fI = () ")'d a = I we have the Cauchy di,lIihulion. ,lIId when" 1/:l, fl I, & ll, allli r I= =
we han! Ihe Bernoulli diMriblltion,
1.4. Pl'ires, Uellmls, IHld CornpoullliillK 19

almost always rcquires finite second IIlOnJents of returns, and often fmitc
highcr moments as well. Stablc distriblllions also have sOllie counterfac-
Illal implications. First, thcy illlply thaI sample estimates of the variance
,md higher lIlomcnts of returns will tend to incrcasc as the sample sizc in-
creascs, whereas in practice thcsc cstimalcs sccm to convergc . .sccond, they
imply th,\t long-horizon returns will he just as non-normal as short-horizon
returns (s'nce long-horizon returns are SUIllS of shon-horizon returns, and
these distributions arc stable undcr addition). III practice the evidence
for non-normality is much weaker for long-horizon returns than for short-
horizon returns.
Recent rcsearch tends instead to llIodel returns as drawn from a fat-
tailcd distribution with finite higher moments, such as the I distribution,
or as drawn from a mixture of distributions. For cxample the return might
bc conditionally normal, conditional on a variance parameter which is itself
random; thcn the unconditional distribution of rcturns is a mixture of nor-
mal distributions, somc with small conditional variances that concentrate
mass around the mean and others with large conditional variances that put
mass in thc tails of the distribution. The result is a fat-tailed unconditional
distribution with a flllite variance and finite higher moments. Since all
momcnls are (initc, the Central Limit Theorem applies and long-horizon
rcturns will tend to bc closer to the norlllal distributioll than short-horizon
rcturns. It is natural to model the conditional variance as a time-series
process, and we discuss this in detail in Chapter 12.

All J~'IIlIJl'riCllllllllslmliuTl
Table 1.1 contains some samplc statistics for individual and ap;gregate stock
rcturns from thc Ccnter for Research in Sec\IJ'ities Priccs (CR.SP) for 1962
to 1994 which illustrate some of the issues discussed in the previous sec-
tions. Sam pic moments, calculated in the straightforward way described
ill (1.4.19)-( 1.4.22}, arc reported for value- and equal-weighted indexes
of stocks listed on the New York Stock Exchange (NYSE) and American
Stock hchange (AMEX), and for ten individual stocks. The individual
stocks wcre selccted from market-capitalization deciles using 1979 end-of-
year markct capitalizations for all stocks in the CRSP NYSE/ AMEX universe,
whcre in[em'llional Business Machines is the largest decile's representative
and Contincntal Materials Corp. is the smallcst dccilc's rcpresentative.
Panel A reports statistics for daily rcturns. The daily index returns have
('xlrelllcl)' high sample exccss kurtosis, :11.!) and 2(i.O respcctively, a clear
sign of fat tails. Although the exccss kurtosis estimates for daily individual
stock returns arc p;cncrally less than those for thc indcxes, they are still large,
r'-lngillg 1'1'01\1 3.35 to 59.4. Sincc thcrc are H179 obscrvations, the standard
error for thc kurtosis estimatc undcr thc lIull hypothesis of normality is
J24/H 179 = 0.0;)4, so these estimalcs of excess kurtosis arc overwhelmingly
·
 1o JltjlfJtl/l11l1J1I

statistically si!!;nificant. TIl(' skcwncss ('stilllates are ne!!;,lliV(' lill' lhe daily
index retllrns, -I.:B ;lnd -O.!I:~ respectively, but gCII!'rally positive 1'01 Ihe
individual stock retUrIlS, rangillg from -O.IH to 2.25. Many of Ihe ske\\'n('~s
estimates art' also statistically sign ifirall t as the standard error ullder lhe null
hypothcsis of nonllalit)' is /ti/H 17!) = 0.027.
Panel B reports salllplt' statistics f(lI' lIlonthly returns. These arc COIl-
siderably less leptoklll'tic than daily rcturns-the vallle- and eqllal-weighled
CRSP monthly indt'X returns haw' excess kurtosis of only 2.12 and 4.11, IT-
speclively, all orcin of magnilude smaller than the excess kurtosis of daily
n~tllrns. As Ihert' are ollly :~90 ohs('l'valions the slandard error for Ihe kurto-
sis estimate is also Illllch larger, O.21H. This is olle piece of evidence Ihat h,ls
led researchers to usc hll-Iailcd distrihlllillns with linile higher moments, f()r
which Ihe Centrall.illlil Theorelll applics and drivcs longn-horil.oll rt'lmIlS
lowards normality.

1.5 Market Efficiency

Tht' origins or Ih(' EHici('nt Markt'ts II),polhesis (EMH) can he tra('(~d hack
at least as far as tht' pion('('I'in!!; thcort'tical cOlltrihlltioll ofBachelit'r (I!JO())
and the empirical research of Cowles (I!J:\:\). The modern literature in eco-
nomics hegins with Samuelsoll (I!Hi!',), whose contrihution is neatly Slllll-
I lll<lril,e(\ hy tht' titlt' of his articlt': "Proof that Properly Anticipaleo Prices
Fluctllate Ralldolllly":' III an illrol'lll<ltiollally t'fficient llIarket-lIot to b('
\ confused with all alloraliollally or I'areto-eflicielll markel-pricc chan~es
IIlllst he IInfoJ'('c;lstahk if tll('Y arc proP(~rly anticipated, i.e., if they l\dly
I incorporate the ('xp('n<ltions and inforlllation of all market partiripants.
Failla (1!170) stlnllllarizcs this idea ill his classic survey hy wriling: ",\
markel in which pritTs always 'ftllly rdlcCl' availahk' information is called

I I
·emcient'." Failla's IIS(' of Cjuotation marks around the words "fully rcflcct"
indicales thalthes(' words art' a rOrlll orshorlhand anclneed to he explained
lIlon~ flllly. More re('ently. Malkiel (I !)!12) has offered lhe fi.lllowing llIOIT
I
\ ('xplicit cklinition:
II
\
! A capital mark('t is said to ht' ('fficienl if it fully anc! correClly rd1cns
all relevant inhmnatioll in cielennining sccurity priccs. Formally. Ihe
lIlark(,t is said to h(' cffici('nt wilh respcct to SOlllC inforlllalioll sct ... if'
s('ctlrit)' prin's \\'ould II(' unafkn('d hy r('v('alin~ thaI inflll'lnation 10 all
participants. Mor('o\'('\". ('f'lici(,Il(Y with !'C'spect 10 an informalion s('\

-11\("IH"'.\t'tl1 ( I ~t~I'.!\ di,( U"t"' Ill(" (01111 ihu1iuH' (ll Itl("hc:li<"I. (:o\\"1t:Ir\. S,\llltu:l~on •• uul",.",,·
o,I\\"1" ... ;.nt\" a\l1hol'_ I"IH" .ntH k, H'P'\Hl\od \1\ loU (lq~H,) indHd(' somt' of ,itt" mos.\ impolt.ulI
p.'I)t'rs ill 1his httOLHUI to.
I.). M(lTkt'1 Jll'rinley 21

1abk 1.1. S/ork marl,,/ "/lIm.<, 196210 J 994.

Standard Exce",
St'rurit)' M~an Deviation SkCWIIt'\S Kllrtosis Minimum Maximum

Pond A: Daily Rrlurru

Valllt'-Wt'i!(htt'd Index 0.044 O.R2 -1.11 14.92 -111.\0 1I.1I7

Eqllal-W~i!(hted Index (um 0.76 -0.'1:\ 26.03 -14.19 9.83
Intefnati(Hlal Bw;inc5..o;
Machines Om!) 1.42 -0.11l 12.48 -22.96 11.72
Crr1l"r,,1 Si!(n,,1 Corp; 0.054 I.f,f, (Ull 3.3:' -13.46 9.43
Wri!(lt'yCo. 0.072 1.45 -f).OO 11.03 -18.67 11.89
Interiak .. Corp. 0.041 2.16 0.72 12.35 -17.24 23.08
R"ylrrh Corp. 0.050 B9 2.2:' 59.40 -57.90 7:'.00
AlIlpco-l'ill,bllrgh Corp. 0.053 2.41 0.66 5.02 -19.05 19.18
Encrgt"n Corp. 0.054 1.41 0.27 5.91 -12.82 11.11
Ceneral 11"'1 Corp. 0.070 2.79 0.74 6.18 -23.53 22.92
Caran Inc. 0.079 2.35 0.72 7.13 -16.67 19.07
COlitint"nt,,1 Materials Corp. 0.143 5.24 0.93 6.49 -26.92 50.00

Pan.' B: Monthly Returm

Valll"-W"i~hled Index 0.96 4.33 -0.29 2.42 -21.81 1651

Eqllal-Weighted Index 1.25 :'.77 0.07 4.14 -26.80 33.17
Intt"rnational Business
Machillt"s 0.81 6.IR -0.14 0.83 -26.19 18.95
,
(;"n"lal Si~n;\1 Corp. 1.17 R.I'1 -0.02 1.87 -36.77 29.73
i
Wrigley Co. 6.68 0.30 1.31 -20.26 29.72

•
I." I
Intc-ridke Corp. 0.H6 9.311 0.67 4.09 -30.28 54.84
R;lylech Corp. O.R:! 14.IIR 2.7:l 22.70 -45.65 142.11
Al1\p("n-rilt.c:..hllr~h Corp. 1.06 IO.M 0.77 2.04 -36.08 46.94
ETlt"Jgell Corp. 1.10 ~'.7:' 1.47 12.47 -24.61 48.~fi

Cent'ral Ilost Corp. I.:n II.fi7 OY, 1.11 -38.05 42.8fi

Gar-all Inc. 1.64 11.30 0.76 2.30 -35.48 51.f>O
CmHinelllal Maleriah Corp. 1.64 17.76 1.13 3.33 -58.09 84.78

SllInllJary statistics for daily ami monthly returns (in percent) of CRSP equal- and value-
weighted SlOck indexes and ten individual securities continuously lisled over the entire sample
p<,riod frolll.!"ly~, 19fi2 to Derember 30,1994. Individual securities are selected to represent
'torks in each SilO decile. Statistics are defined in (1.4.1~)-(L4.22) .

. . . implies that it is impossible to make economic profits by trading on

the basis of [tbat information setl.

Malkil'l's first sentence repeats Failla's definition. His second and third sen-
tellCl'S expand the deflJlition in two alternative ways. The second sentence
SltJ!:J.!;('.~ts that Illilrket efficiency can he tested hy revealing information to
22l I. Ill/mi/w/iol/

rna kel pilrticipanlS and mcasuring thc rcaction of sccurity prin's. If prices
do \101 rnove when information is revealed. thell the market is dlicil'llt with
reS~)CctlO thaI information. Although this is clear conceptually. it is hard to
carty out such a tcst in practice (except perhaps ill a lahoratory).
i Malkicl's third sentence suggesL~ an alternative way to judge the dli-
ciellcy of a market, by measuring the profits that can bc made by tradillg Oil
information. This idca is thc foundation of almost all thc cmpirical work
011 market efficieucy. It has heen lIsed ill two main ways. First, lIIallY 1'1'-
searchers have tried to measure the proliL~ carncd by markct proiCssionals
such as mutual fund managers. II' thcse managers achicve supcri(Jr rcturns
(after a<ljlistmcllt for risk) then the market is lIot dficient with respcClIO the
information possessed by the managers. This approach has thc advantage
that it concentrates on rcaltrading by reallllarkct panicipanL~, hut it has the
disadvantage lhal olle cannot dircctly ohservc the inform<ltioll used hy the
llIanagers in their trading str;llegies (sec Failla [1970, I ~l~lll for a thorough
review of this literature).
As an alternative, one CIII ask whether hypothetical trading hased <Ill
an explicitly specified infcHlllation set would carn superior returns. To
implement this approach, onc must first choose an information set. Thc
classic taxonomy of information sets, due to Roberts (1967), distinguishes
among

Weak-Corm Efficiency: The information set includcs only the history of

prices or returns themselves.
Semistrong-Form Efficiency: The information set includcs all informatioJl
known to all market participaJlts (publicly available information).
Strong-Form Efficiency: The information set includes all inforlllatioll
known to any market participant (private information).

The next step is to specify a 1II0dei of "no rill a I" returns. Here the dassil'
assllmption is that the normal returns on a security arc constant over time,
hut in recenl ycars there has hecn increased intt'l'est in equilibriulIl models
Wilh time-varying normal security returns.
Finally, abnormal security returns are computed as the dill'erclllT be-
twecllrthe return on a security and iL~ normal return, and forecasts of the
ahllor/,Ial returns are constructed lIsing the chosen infilfluution set. If till'
abnormal security return is unforec<1stahlc, and in this sense "randolll," th('n
the h)~pothesis of market effici('ncy is not rc.:iected.

1.5.1 Ffficif'll/ MtlTkrl.1 (/Ilil/hr i.alll o/lIrlil/l'd EX/ll'r/a/ioll.\

\
The idea that efficient security returns should be random has oftcn caused
confll~ion. Many people scem to think that ;lnefficicllt security price shollid
I
J.5. Mil/lid J~jli(il'l/ly'

he SlllOOlh ralhn thall randOln. Black (I !)71) h;ls ;Illa('k(~d this idea rather
t'ffl-nil't'ly:
:\ perren lIlarket for a stor\;. is olll' ill whidl then' arc Ill) proliL~ to
he made by people who haw no special inforlllation about thc com-
pany, and in which it is dilIicult eVl'1I for people who do havc spccial
inlill'mation to make profits, beGIllS(~ the pritT a(ljusts so rapidly as the
information becomes available .... TilliS we would like to see randomness
ill the prices of successive transactions, rather than great continuity ....
Randomness means that a series of slllall upward lIIovelllellts (or slllall
downward movcments) is very unlikely. Ir the price is going to move up,
il should move lip all at OIlCC, rathcr than in a scries or small steps ....
I .;lrge price movcments arc desirable, so long as they arc not cOllsistently
i(lllowed by price movemcnts in the opposite direction.
Underlying this confusion lIIay be a bclief that retunts cannot be randolll
if security prices are dctermincd by discounting future cash 1I0ws. Smith
(1968), for examplc, writes: "I suspect that even if the random walkers an-
nounced a pcrfcct11lathematic proor ofrandolllncss, I would go on believing
tha, in the long run future earnings influencc prcsent value."
III fan, the discounted present-valuc model of a sccurity price is entirely
consistent with randomness ill security returns. The key to understanding
lhis is the so-called Law oj Iterated Hxpe(/aliufIJ. To state this result we define
information scts I, and j" where I, C J, so all the information in I, is also in
J, bUl JI is superior bccausc it contains some extra information. We consider
cxpcn,\lions of a random variable X conditional 011 Ilws(' illrormatioll S{·ts,
wrillcn E[ X I I,] or E[ X I J,j. The l.aw of Iteratcd Expectations says that
E(X I ILl = E(E[X I jLl I I,]. In words, if one has limited information
II> the best forecast one can make or a random variable X is the forecast
of the forccast one would make of X if one had superior information J"
This can be rewriuen as ~:[X - E[X I J,] I I,J = 0, which has an illtuitive
interprctation: Onc cannot lise limited information lito predict thc forecast
crror one would make if one had superior information J,.
Samuelsou (1965) was the first to show the relevance of the Law of
Iterated Expectations ror sccurity market analysis; I.e Roy (l9H9) givcs a
lucid review of thc argulIlent. We discuss the point ill detail in Chaptcr 7,
hill a brief sllllllllary may be helpful here. Suppose that a security price at
lime I, /'" can be wrillen as the rational expectation of some "fundamental
value" 1", conditional on information I, available at tillle t. Then we have

P, := 1':[ V' I I,] = I':, V'. (\.5.1)

The s;lIne equation holds one period ahead, so

1',+ I = E( V' I I" I I = E'l I \,'. ( 1.5.2)

filiI Ihen Ihe ex(>eclalioll of III(' chan).!;e in the price over the next period is

1-:,1/'1+1-1',1 = E,IE,tIIV'j-F./[V')) = 0,

Iwcallse I, C l,t I. so E,I 1-:/ + II \"11 = E,I V' J hy Ihe I.aw of Iter;\!ec\ Expecta-
liollS. Thlls rl';lli/ell ch;lIIgl's in plin's arc IInlilrcr;lslable ).!;iven information
ill the sci 1/.

1.5.2 !., lI/(///U'I/':llifil'llry '/r.\lab!r?

Althollgh the l'mpirirallllt,thodoloh'Y slIllImari7.ed here is wdl-('SI;lhlishcd,

Ihere arc sOllie seriolls C\if'firultics ill inllTpreting ils resllJrs, Firsl, allY lest of
efficiency nnlst asslln\(' an eqllilibrilllll model thai c\ermes nOflllal secoritv
relurns. If dIicicncy is rejeclec\, Ihis could be because the markel is Iruh·
incl'lkienl or bccallse all illcorrcci cqllilibrium model has hcen asslIl\lcd,
This joillllr:v/ltlllrl'.li,1 pl'OlIl('\1I \\leans 11\;11 lIIarkel crrlciency as slIch em newr
he n:je('\I'c\,
Second. perli'('\ I'fficiency is an lin realistic benl'hlllark th;1I is uillikely
10 hold in pranicl'. Evell in thcory. as Grossman alld Sliglitz (I !lHO) h;l\c
shown. allllonnal \'('tllI'llS will exist iftherl' are costs of ).(.lIherillg and pm-
cessill)!; ill(III'lIIalioll. Thcse rellirns are necessary 10 compensate illv('siors
fill' their infonnalion-gathnill).!; alld informatioll-processing eX)lenses, and
are 110 lon).!;er ahllol'mal whell Ihese expellSes arc properly accollnlcd (i,l'.
III a large and liqllid mark('I. inlilrlllalion cosls are likely tojllstify (111)' snd}
allllOrmall'l'llInlS, hili il is dimcllit 10 say hnw small. evell if sllch costs could
he measllred precisc\}',
The nolioll or rrialil'f efficicncy-Ihe efficiency of one marketmc;lSlll('d
agaillst allothcr. e,g,. tlie N('w York Stock Exchange vs, Ihe Paris BOllrsc. 1',,-
lures markets vs, SpOl markets, or all('\ion vs, dealer markels-llIay he a mort'
IIscrlll rOllccpl Ihall Ihc all-Ol'-llothill).( view lakcn by milch or Ihe tradilional
lIIarkel-eflicit'IKY lilnatllre, The adv;llIla).!;es of rclaliw elliciellcy over ab-
solule efliciellcy arc easy 10 SC(' hy way of all ;lIIal0!n'. Physical syslelIIs arc
ofIe II ).!;iv(,11 all ('nici('III"}, rat ill).!; has('d Oil the rclalivc propol'.tioll of cllergy
or flld ('ollwr!ed to IIsd'lIl work. Therdc)J'(\ a pis Ion ellgille lIIay he rated
al n()'){, eflici('lIcy, 1I\('allillg Ihal Oil avcra).!;c 1;0% of tilt" ellnh,)' cOlllailled ill
the ell).!;illc'S fllel is IIseli 10 tllm lhe nallkshafr, wilh the remaillill).!; 40'7" lost
\0 olhel' forms of work slich as hcal.lighl. or noise.
Few ell).!;illeers wOllld e\'eI' t'ollsilln pCfrOrtllill).!; a stalislicaltesllo (11:1('1'-
lIIille whclhn or 1101 a givclI ('lIgillC i.~ perfcnly d'lirienl-sllch all cllgill!'
exists ollly ill 11\l' idt',11 i/.ed frid iOllll'ss world of Ihe imaginatioll, I\lIlnwasll r-
ill).!; I'elalivc eflkiclI('\'-rclalivc 10 Ihe friniolliess idcal-is conHllonplan',
hHh-I'I\. wc ha\'\' fllllH' \1) ,"xpcn SlIl'h IIH'aSlln'lI\ellts (i)\' lIIallY hOllsl'!lold
prodll('I~: ail' fOlldilioll('JS, hoi wal('J healers. rcfri).(('raIOl's, ('tf. Similarly,
 25

market efficiency is an ideali7.ation that is economically unrealizable, but

that serves as a useful benchmark for measuring relative efficiency.
For these reasons, in this book we do not take a stand on market effi-
ciency iL~e)f, but focus instead on the statistical methods that can be used
to test the joint hypothesis of market efllciency and market equilibrium.
Although many of the techniques covered ill these pages are central to the
market-dflciency debate-tests of variance bounds, Euler equations, th¢
('APM and the APT-we feel that they can be more profitably applied to
measuring efficiency rather than to testing it. And if some markets tuI"it
oUI to he particularly inefficient, the diligent reader of this text will be wel~­
prepared to take advantage of the opportunity. !
I
1

f
I

I
"
 2
The Predictability of Asset Returns

ON!:: OF TIlE EARLIEST and most enduring questiollS of financial economet-

rics is whether linancial asset prices are forecastable. Perhaps because of
the obviolls analogy between financial investments and games of chance,
Ill<lthelllaticalmodels of asset prices have an unusually rich history that pre-
dates virtually every other aspect of economic analysis. The fact that many
prominent mathematicians and scientists have applied their considerable
skills to forecasting financial securities prices is a testament to the fascination
and the challenges of this problem. Indeed, modern financial economics is
firmly rooted in early attempts to "beat the market," an endeavor that is still
0(' current interest, discussed and debalecl in journal articles, conferences,
and at cocktail parties!
In this chapter, we consider the problem of forecasting future price
changes, lIsing only past price changes to construct our forecasts. Although
restricting ollr forecasts to be functions of past price changes may seem too
restrictive to be of any interest-after all, investors are constantly bombarded
with vast quantities of diverse information-nevertheless, even as simple a
problem as this can yield surprisingly rich illSights into the behavior of asset
prices. We shall see that the martingale and the random walk, two ofthe most
important ideas in probability theory and flnancial economics, grew out of
this relatively elementary exercise. Moreover, despite the fact that we shall
present more sophisticated models of asset prices in Chapters 4-9, where
additiollal economic variables are lIsed to construct forecasts, whether fu-
tllre price changes can be predicted by past price changes alone is still a
~\lhjl'([ or cOlltroversy and empirical itlvestigatiotl.
III Section 2.1 we review the variolls versiolls of the random walk hy-
pothesis and develop tests for each of these versions in Sections 2.2-2.4.
l.ong-horil.OtI returns playa special role in detecting certain violations of
the randolll walk and we explore some of their advantages and disadvan-
tages in Sectioll 2.5. Focusing Oil \ong-ilori/oll retllrns leads naturally to
the notion of IOIlv;-rallgl' dCpCII(/CI\(T, and a test ()r this phenolllenon is
prest'lIt('(1 ill SCrlion ~.(i. For complewlll'ss, we provil\e a hricr discussion or
tests for IInit roots, which an' son\('lin\('s confused wilh lesls of 11((' randolll
walk, III S('CliOIl ~.H WI' prescnt s('\'l'I'al cmpirical illustratiolls that docull1ellt
illlportantdepartur('s from thc random walk hypothesis for r(,Cl'nl US stork
markel dala.

2.1 TIle Random Walk Hypotheses

A uscfnl way 10 organizl" Ihl' various versions or Ihe ralldolll walk alld mar·
lillv;ale IIwdds Ihal 11'(' shall ]In'st'llt 1)('1011' is 10 consider the varions killd,
or depl'llIl('ncl' Ihal can exisl helwl'I'1I an asset's returns T, and T'H all\\'11
dales t alld (+ k. To do Ihis. dl'lIlIl' Ihe random variahles !(r,) alld ~(7i+d
where I(') and g-(.) are Iwo arhilrary functions, and consider thl' situatioll'
in which

(:01'1 I( r, l. g( r, \ ~)I o CU.!)

ror all I and 1'01' ko;fO. For appropriately chosen !(.) and K(·). virtually all
versions or the random walk and lI1artingale hypotheses an.' captured bv
(2. I ,I), which lIlay he interpreted as an orthogo7lality condition.
For ('Xalllple, if I(') alld g(.) an' ('('striucd to he arhitrary /illPllI' fULl"
lions,then (2.1.1) implies th.ll returns arc serially uncorrc1atec1. correspond-
ing to the Ufl/II/om Walk J lIlodel described in Section 2.1.3 h .. low. Alterna-
tively, ir !(-) is unrestricted but g(-) is restricted to be linear, then (2.1.1) i,
equivalent to the marling'lle hypothesis Ilescribed in Sectioll ~.I. FilJ;llly. if
(2.1.1) holds I()!' all functions!(.) and ~(.), this implies that returns art' 11111-
wally independellt, COIT('SI)(l\\(iillg to the /lam/om Walk I ;lIld /law/om Hfdh 2
l1lodels discllssl'I\ in St't·tiolls 2.1.1 and ~.1.~. respectively. This dassilicatioll
is sUIIIIll;lrized ill Tahle 2.1,
AhhouV;h there an' several other ways to characteri7.e the various rall-
dOI1l walk alld marlingal(' lIlodels. COllditioll (2.1.1) and "nIhil' 2.1 are pank-
IIlarly rdevallt 1(11' ('('ononli!' hypotheses sinct' almost all eqllilibriulll assel-
pricing lIIodels can he reduced to a sct or orthogonality cOllditiolls. This
interpretation is explored ('xtl'lIsively in Chaptl'l's Hand 12.

Thl' MtlTlillKillt' M(I(it-l

}'erhaps the ear/il'st III1Hkl oflillallrial asset prices was the mrlTlil1Ka/r 1ll00kl.
whose oriv;in lies in tIll' hi~tory or gallles or chance and till' hirlh of proh-
ahility theor\,. The pr<llnilH'nt It.dian lIlathelllatician (;irolalllo Cardall"
proposed all cI('l\Icntar\, tll('or\' "I' galllhiing in his I :)II:ll1lanllSlTipt l.ilwr tfr
 Table 2.1. Cuusificalion of random 'l'f1{p. and martingalR hypo/hPsrs.

g(T,+.). g(r, •• ),
Co\'[j(r,), g(T,+.») =0
Yg(.) Linear 'V g(.)

Uncorrelated Increments.
Random Walk 3:
f( r,). VfO Linear
Proj[r,+.lr,) = J.L

Martingale/Fair Game: Independent Increments, Random

Walks I and 2:
fer,). Vf(·) E[r'HIT,] = J.L
pdf(r'Hir,) = pdf(r, •• )

"Proj[.y I xl" denote, the linear projection of J onto x, and "pdfC)" denotes the probabit:t)' densit), function of its
argument.
 30
2. 77le Predictubili/.v oj A.U
ft Uptuml
Lud o Ak ae (Th e Boo
k oJ GmllfS 0JC hal lrf)
, in wh ich he wro te: 1
Th c JIlost fun dam ent al
pri nci ple of all in gal llb
dit ion s, e.g., ofo pp on lin g is silllply eql lal ('111
cn ts, ofh yst and ers , of 1
dic c box , an d of the die mo ney , ofs itll atio ll.· >1
itself. To the ext ell l to Ihe
tha t cqu alit y, if it is in wh ich YOI l dep;1I1 1111111
yo ur op po ne nt' s favollr
yo ur ow n, you arc IIn , YOI I arc a fool, all d if ill
jllst.
Th is pas sag e clc arl y con
tai ns the no tio n ofa Jai
in yo ur favor no r you rgt lllle , a gam e wh ich
r op po nen t's, and thi is ne ith er
sto cha stic pro ces s {I',} s is the ess enc c of a lIla
wh ich satisfies the fol rtil/ jial l', a
low ing con dit ion :
E[ /"I I I I'/, ["- I, ... J
=:= 1'/,
(2. 1.2 )
or, equivalently,
E[ I', tl- I'/ 11 ',,1 '/-1 ,
... 1 = o.
If P, rep rcs cnt s on e's
rtll llli lati ve win nin gs
sOllie galliC of cha nce or we alth at dat e I fro
eac h pcr iod , the ll a fai lll playiflg
exr }'c ted wc alth nex t r gal lic is oll e (l>l' wh
per iod is sim ply eql lal irh the
(2.1\.2)), con dit ion ed to thi s pcr iod 's
011 the his tor y of we alth (se e
if tli,c exp ect cd inc rcm the gam e. Alt ern ativ ely
ent al win nin gs at any , a gal lic is (~Iir
on the his tor y of the gam sta ge is zer o wh en con
e (sc c ('2 .1. 3». dit ion ed
If 1', is tak cn to be an ass
et's pri ce at dat e I, the
esis sta tes tha t tom orr n the ma rtin gal e hyp oth
ow 's pri ce is exp ect ed -
givch thc ass et's ent ire to be equ al to tod ay'
pri ce history. Alternativ s pri tT,
cha lig c is zer o wh en con ely, the ass et's exp ect
dit ion ed on the ass et's ed pri ce
is ju~t as likely to rise pri ce his tor y; hen ce iL~
pl'i re
as it is to fall. Fro m
mar~ingale hyp oth a illr cca stin g per spe cti
esi s im pli cs tha t the "be ve, the
sim~y tod ay' s pri st" for eca st of tom orr
cc, wh ere "bc st" me ans ow 's pri ce is
Ch al> ter 7). mi nim all llc an- sql lar ed
err or (se e
An oth er asp cct of the
ma rtin gal e hyp oth esi
pri ed cha ng cs arc un cor s is tha t no no ver iap
rcl ate d at all lea ds and pin g
efTccliveness of all line lags, wh ich im pli es the
ar for eca stin g rul es in-
on hIstorical pri ces alo for fut ure pri ce cha ng
ne. Th e hlct tha t so sw es bas cd
cOlin! fro m as sim ple a eep ing an im pli cat ion
mo del as (2.1.2) for esh cou ld
the nla rtin gal e hyp oth ado ws the im po rta nt
esi s will play in the lIIo rol e Iha l
(se c thc dis cus sio n bel del ing of ass et pri ce dyn
ow and Ch apt er 7). alll ics
In fact, the ma rtin gal e
was lon g con sid ere d to
for an 1firienl assct ma be a nec ess ary con dit
rke t, on e in wh ich the ion
pri ces is instantly, fully, in( llfI lla tio n con tai ned
an d per pet ual ly ref l(,c in pas l
If the ma rke t is eff icie ted ill the ass et's cll rre
nt, th( 'n il slio lll< lno t be nt pric(':~
pos sib le to pro llt by tra
dil lg Oil
'Se e \laI d (1990, Cha pte
r 4) III' \",., ll<'r ,\('t;,i\"
1Se~ Sam llet ."" (I
!Iii,>, I !In , \'IT \) , R"h
form market effIciency. t·rt, (1\)1,7) ,;oil, Iht· martjll~;ol .. hyp
}1(" .,lso ,\d' lu's an ~'s~('1
"IIo,·,j, Il'I'fl h'
malKet to he .\,mi.um
ll):-fontl .HH t "IOU!["{mm
 2. I. The R(l//(~{)1Il Walk Hypolhe.lf
.l

the illfo rma tioll cont aille d ill the

asse t's pric (' histo ry; hCl ln'lh e cond
expc n;lIi oll offl ltllr e pric e chan ition al
ges, cond itiol lal olltl ae pric e histo
ill' eith er p"'l ii,,' or nega live ry, cann ot
(ifsh or\s alcs arc I.... asih le) and ther
he 1.('1"0. Thi~ lIoti on of enic iellc efor e nllls t
y has a won derf ully cOll lller intll
secm ingl y cOll trad icto ry flavo r to itive and
it: The llIor e dlk icnt the mar ket,
r;tlHlolll is thc sC'l uell ce of pric e the lIIor e
chan ges gell erat ed hy Ih(' mar ket,
IllOSt eflic ielll mar ket of all is olle alld the
ill whic h pric e chan ges arc com
r.lndOIll anel ullp redi ctah le. plet ely
How cver , one of the cell irall enei
s ofln odc m fina llcia l econ omi cs
ncce ssity of sOlnc trad c-of fbet wee is Ihe
ll risk and exp ecte d retll rn, and
the lIlar ting ale hypo thes is plac es alth oug h
a restr ictio n on exp ecte d retu rns,
Ilot ,\CCOUllt for risk in any way. it doc s
In part icul ar, if an asse t's exp ecte
chal lge is posi tive, it may be the d pric e
rewa rd nece ssar y 10 attra ct inve
hold the assel and bear its asso ciate stor s to
d risks. The refo re, d('sp ite the
iq)j> calth at the fair-galliC inte rpre intu itive
tatio ll lIIight have , it has been show
th" Illar ting ale prop erty is neit her n that
a ncce ssal )' nor a suff icien t cOll
riltionally dete rilli ned assc l pric ditio n fOI·
es (sec , for exal ilple . I.em y [197
[ : ~)7H]. and Cha pter 8). 3]. Luc as
Nev crth eles s, the mar ting ale has
beco me a pow erfu l 1001 in prob
anel .,tatistics and also has illlp orta abil ity
nt appl icat ions ill mod em theo
sct pric es. For cxal llplc . onc e ries of as-
<lsset ITtUI"IlS arc prop erly ;J(!i"~lcd
tl1e mar ting ale prop erty does hold fill· risk,
(see Luc as [197 8], Cox and Ross
I brri son <lnd Krep s [197 9)). In [197 6],
part icul ar. wc shal l sec ill Cha pter
Illarg-inal-utility-weighted pric es 8 that
do follow JIlar ting ales und er ljuit
COllditiom. This risk- a(lju sted mal e gen eral
lillg aie prop erty has led to a vCI·
III lion ill thc- pric ing of com plex itable rev()-
fina ncia l instr ullle nts such as opti
alld othe r deri vativ e secu ritie s (see ons. swaps,
Cha pter s 9. 12. and Mer ton [199
exam pie) . Mor eove r. the mar ting 0], for
ale Icd to the dev elop men l of a
lated JIlo dclt hat has now beco me clos ely re-
an illle gral part of virtu ally ever y
di~ci plin c con cern ed with scie ntifi c
dyna mics : the rand olll walk hypo
thes is.

2.1.1 The RandulIl Wal/( I: /lj) !1l0f

llle/l1 5
Perh aps the simp lesl vers ion of
the rand olll walk hyp othe sis is
pend entl y and iden tical ly dist ribu the inde -
ted (liD ) incr ellle nis case in whic
d!'na lllic s of {I'd arc give n by the h the
follo wing equa tion :

(2.1.4)
wile re J1 i~ t he exp ecte d pric e chan
ge or drill, and 11»( 0, 17~) dcn otes
illde pend elltl y and iden tical ly dislr thai f, is
iilut ed Wilh IIICi lll () an<i .vari ance
a 2. The
effici eilt if the cond ition al l'xpec
t~llioll of flllufC.' prin· flJ~'l1
~,\'.,il;thk gt'~ is It'rO, cOJld itione d
puhlic infor malio n, and all (iv,lil 011 all
ahlc pllhli c .tlld pri\';tlt· illltH
!-itT Chap lt'r I lor fUflli er lIlClli oll. respl'ctin·ly.
di,'\nl~.. ioll of".."It'.\c ("(HI< cpb.
indt'pcnd(,IHT orlht' in('Jt'III('nls {f,} implics Ihatthc randolll walk is also a
/;Iirgamt', hUI in a IIl1l<"h sll"OlIgt'rst'lIsc thalllhc martingale: Indq)('ncll'll("('
illlplit's Ilot ollly Ih;11 illn('IIH'nls an' IlIlcolTclaled, hilt Ihal allY Ilolllilll'ar
fUllclions of Ihl' ill<TI'IIH'IIIS ;11(' abo IUlcolTl'ialcd. WI' shall call Ihis Ihl'
NII/llillm I\(tih I model or RW I.
'Iil dl'l'ciop SIIIlII' inluilioll 1m RWI, consider ils coudiliollallllcall ;11111
\'ariallcc al dall' I, cOIHlilioll;ti Oil SOIll(' inilial valu(' n
al dall' 0:

1-:1/', /'01
(:1.1.1; )

which /illlows frolll r('cursin' suhSlilulion oflagged 1', in (2.1"1) ;lIlIllh(' IIll
ilHT('m('nls assumplion. From (2.1.:1) and (2.1.0) il is apparenl Ihal Ihe
ralldom walk is lIollslalionary alld Ihal ils conditional IIIcall and variance
art' hOlh lint'ar inlimt'. Tht'st' implicalions also hold for Ihc IWo olher lill'lllS
or lilt' random walk 1I~'P0IIH'sis (RW2 and RW~) dcsnihcd helow.
I'l'rilaps 111(' moSI CIIIIIIIIOII dislribulional assumplion for III(' inllo\';I-
tions or in('J'(,llIl'nls f, is normality. If t hc f /s arc liD N (0, a ~), Ihcn (2.1.'1)
is l'lJllivaknl III all flrilh/llt'/i,. Hmwl/;'lII /II 01 i'lI/, sampled at rq~ularly SP;ll'l'd
unil inlervals (Sl'l' Sl'('liou ~1.1 in ChapIn 9). This dislrihuliollal assump-
tion silllplifies lIIany of Ihe calculations slIIToulHling the randolll walk, but
suffers frolll Ihl' same problclII Ihal afIlicts norlllally distrihuted returns:
\'iolalioll or\imiled liahilily. Irlhe condilional distrihution of 1', is normal,
Ihcn therc will always he a posilil'l' prohabililY thai 1', <0.
To avoid viola ling limiled liabilily, we may use Ihe salllc device a, in
Section 1.4.2, namely. 10 assert Ihal Ihe nalural logarithm of prices /It ==
loj.{ 1', follows a random walk wilh llorlllallY distrihuled inCl'cmcllls; hence

I', == /1 + /It_I +f" (2.1.7)

This itllplies Illal conlilluously COIllPOIlIH\c(IITlllrtlS arc liD normal \,~lrialc,

wilh 1I11'<l1I /1 <111(1 "<lri<lIHT (l ~, which yields 11ll' \ogllo\'IIl<l\I'llo(ld of l\achl'-
lin (I ~l()O) alld Einstl'in (I ~lO:)). \1\'(' sh.lIl rcillfll 10 this ill Serlioll ~1.I 0('
(:hapltT ~).

2.1.2 nil' NIII/I/OIII II'II/Ii 2: ftlth'l"'lIt/pl/lln(/'PIIII'I//I'

Ill'spile 1IIl' degalHT alld silllplilil)' of RWI, Ihe assumplion of'id('nlil'all\'
dislrihlllni illlTl'lIll'lIls is 1101 plallsihle iiII' financial assel priCl'S OWl' IOllg
Ii IIIl' spa liS. For l'xalll pie, ovcr Illc Iwo-IIIII HII'l~d-ycar h iSlory of Ih c New York
SllIck Exdl;lIIgc, Ilwre 11;1\'(' b('('11 counlless changes ill Ihe (,CIlIlOlllic, so-
ci;d. Ic.-iliiological. ill'lillllillll;d. alld rcglllaloryellvironllH'll1 ill wllicll siock
prin's arc dClnlllilll'd, 'I'll(' assl'l'lioll 111;\1 IlIl' proh;,hililv!oJ", of' daily ""Hk
relllrns has rem-ained the same over this two-hundred-year period is simpl~
implausible. Therefore, we relax the assumptions of RWI to include pro-
cesses with independent but not identically distributed (INID) increments.,
and we shall call this the Random Walk 2 model or RW2. RW2 clearly contains
RWI as a special case, but also contains considerably more general price pr;
('('sses. For example, RW2 allows for unconditional heteroskedasticity in the
(/'s, a particularly useful feature given the time-variation in volatility of man)'
financial asset return series (see Section 12.2 in Chapter 12). •
Although RW2 is weaker than RWI (sec Table 2.1), it still retains the
most interesting economic property of the lID random walk: Ally arbitrary
transformation of future price increments is unforecastable using any arbi-
trary transformation of past price incremenL~.

2.1.3 The Random Walk 3: Uncomiall'd incremmts

• An even more general version of the random walk hypothesis-the one most
often tested in the recent empirical literature-may be obtained by relaxing
the independence assumption of RW2 to include processes with dependent
but un correlated increments. This is the weakest form of the random walk
hypothesis, which we shall refer to as the Random Walk J model or RW3,
and contains RWI and RW2 as special cases. A simple example of a process
that satisfies the assumptions of RW3 but not of RWI or RW2 is any process
for which Cov[( to Et-kl = 0 for all k '" 0, but where COV[E;. E;_kl -I 0 for
some k j O. Such a process has uncorrelated increments, but is clearly not
independent since its squared incremenl~ are correlated (see Section 12.2
in Chapter 12 for specific examples).

2.2 Tests of Random Walk 1: lID Increments

Despite the fact that RWI is implausible from a priori theoretical considera-
tions, nevertheless tests of RWI provide a great deal of intuition about the
behavior of the random walk. For example, we shall see in Section 2.2.2 that
tbe drift of a random walk can sometimes be misinterpreted as predictabil-
ity if not properly accounted for. Before turning to tbose issues, we begin
with a brief review of traditional statistical tests for tbe llD assumptions in
Section 2.2.1.

2.2.1 Traditional Statistical Tests

Since the assumptions ofIID are so central to classical statistical inference, it'
should come as no surprise that tests for these two assumptions have a long ':
and illustrious history in statistics, with considerably broader applications i
than to the random walk. Because of their breadth and ubiquity, it is virtually \
34 2. 'f'lte Predictability oJ A55el Uelu71/.1

impossible to catalog all tests of 110 in any systematic fashion. and we shall
mention only a few of the most well-known tcsts.
Since liD are propcrties of random variables that arc not specific I', .1
particular parametric family of distributions. many of thcse tests fall uillin
the rubric of nonparamelrir tcsts. Some examples arc the Spearmall rallk
correlation tcst, Spearman's footrule tcst, the Kendall r correlation test,
and other tests based on linear combinatiolls of ranks or R-statistics (5('('
Randles and Wolfe [1979] and Serflin~ [1980]). ny using information con-
tailled solely in the ranks of the observations. it is possible to develop tests
or ~ID that are robust across parametric familics and invariant to changes ill
Un\L~ of measurcment. Exact sampling theories for such statistics arc gener-
ally available but cllmbersome. involving transformations of the (discrete)
uniform distrihution over the set of permutations of the ranks. llowever, fill
mo~t of these statistics, normal asymptotic approximations to the samplillg
distributiolls have been developed (sc(~ Serfling ( 1980]).
; More recent techniqul's based on the empirical distributioll fllllnioll
of the data havc also been used to construct tests of lID. These tests of~
ten :require slightly stronger assumptions on the joint and lIlar~inal distri-
but\on functions of the data-gcncrating' proccss; hellcc they fall illto the
clas~ of umiparametric tesL~. Typically, such tcsts form a direct rDlllpari-
SOli (between the joint and marginal empirical distribution functions or an
indirect comparison using the (juantiles of the two. For these test statis-
tics,!(~xact sampling thcories are generally unavailable, amt we must rely on
i
asymptotic approximations to perfilflll the test.~ (see Shorack and Wellner
[ 19H6]).
~nder paramctric assumptions, tests of lID arc gencrally easier to COII-
struCt. for example, to test fiJr indepcndcncc among k vectors which Me
jointly normally distributed. several st;lIistics may be used: the likelihood
ratio statistic, the canonical correlation, eigellvalues of the covariance ma-
trices, etc. (see Muirhead 11 !)83]). Of course, the tractability of sitch [csts
/IIust be traded ofT against their dependence 011 specific paramc[ric assump-
tions. Although these tests an~ oftcn more pownful than their nonparamet-
ric counterparts, evell small departures frOI\1 the hypothcsized parametric
family can read to large difTcrl'lIces hetwecn the actual alld nominal sizes of
the t('st.~ in finite samples.

2.2.2 SI'f{III'1/(fJ IInti Unwr.\(/Is, (/1/(1 Hu7ts

Thc early tests of the randolll walk hypothesis were largely tesL~ of I{W I and
RW2. Although they arc now primarily of historical interest, nevcrtheless
we can learn a great deal about the propcrtics of thc random walk from slIch
tests. Moreover, several recelllly developcd econometric tools rely heavily
on RWI (sec. for example, Sections 2.5 and 2.(i), hence a discIISsion oftl\('se
2.2. Tflls of R(/lldom Walk ): 11) )IlC1I'IIlflll.1 35

lests also provides us with an opportunity to develop SOIllC lIIachillery that

we shall 1't'<I'lire later.

.'iN/llell(f.\' flIul Unwna!.s

V','e begill with the logarithmic vClsion or RW I or geol1letric Brownian 1110-
lion ill which the log pricc proccss PI is asslllllcd to li)lIow an lID random
walk wil/LUul drift:

(2.2.1 )

and denote by I, the following r;III<!O!ll variahle:

I, == g if
if
1',

1'1 -
/1, -
/'t -
/'t-I > 0
P,--I < O.
(2.2.2)

~'!Il('h like the classical Bernoulli coin-lOss, I, indicates whether the <iate-I
cOlllinliously compounded return 1', is positive OJ' negative. In fact, the coin-
l'lssing analoh'Y is quite appropriate as lIIany of the origin;titests ofRWI were
based Oil silllple coin-tossing probabilities.
Olle or the first tests of RW 1 was proposcd by Cowles and Jones (I937}
;ln1l consists of a comparison of the frequency of .lfqumcl'.l· and lfVerJ{lLI in his-
wried stock rcturns, where thc formcr arc pairs of consecutive returIls with
lhe salllc sign, and thc laller arc pairs of consecutive returns with oppositc
signs. Specifically, given a sample of n+ I returns 1'1, ••. , 1',,+1, the number
of sequcnces N, and reversals N, may be expressed as silllplc functions of
the I, 's:

N, - 2:" Y I, 1'1 - II I(j-j + (I - / / )(1 - IIt-d (2.2.3)

'~I

N, == 11- N,. (2.2.4)

If log prices follow a driftlcss lID random walk (2.2.1), and if we add the
further restriction that the distributioll of the increlllclll.S ( I is symmetric,
then whether rl is positive or negative sho\lld be equally likely, a fair coin-toss
with probability one-half of cither outcome. This implies that for any pair of
consecutive returns, a sequence and a reversal arc equally probable; hence
the C:ow\cs:Joncs ratio q ;::
N,I N, should be ;lpproxilllatdy equal to one.
More formally, this ratio m<ly be interpreted as ~l cOllsistent estimator of the
ratio q of the probability Jr, of a seqUl'llCe to the probability of a reversal
I - IT> siuce:
j
(J _ N, N,fn Jr,
..
-I"
Jr,
q 2
== I.
N, N,/n I, - n, I - Jr, 1
q
 /"
where "--" d('lIo\('s cOllvngclKl' ill prohahility. The fart that this ratio
(·xn·(·(h·i\ Olll' Ii)r mall)' hislOriral stock returns scries kd Cowlcs andJolH'S
(1!1:l7) to cOllrl\J('" Ihallhis "reprCsl'lIls conclusivc evidellcc orstrllCiIllC ill
stock pritTs ... :1
II0wcVl'r. Ihe assumption of a I,ero drift is critical in dctermining the
vallll' of q. In particular. q will l'xITcd Olle for an liD randolll walk with
drift. sincc a drift-cil her positive or negative-c1carly makes sefll I l'Jl( cs
lJ\ore likely than n·\'l'Isals. To sce this. suppose that log pritTS f()lIo\\' a
normal random walk with dril't:

/', = /1 + 11,_1 + ~,.

Theil the illdicator variahle I, is uo IOllger a fair coin-toss hut is hiased ill
Ihe direclion orlhe dril't. i.c ..

I, = {Io with prohahility

wilh prohahility I -
7T

7T.
(2.2,:i)

where
rr =: I'r(r, > 0) = ¢l (;;'). (2.2.1i)

If the drift JA is posilive Ihen Jr > ~. and ifil is ncgative Ihcn Jr < ~. Under
Ihis 11101'1' gt'n('ral spccification. Ih .. I'alio of Jr, to I - Jr. is given hy
Jr~+(I-Jr)2
q = 2Jr (I _ Jr) ::: 1.

A~ long as the drifr is 1I0nl.ero. it will nlwllYS be the case that sequcllc('s are
more likely thall reversals. simply because a nonzero drift induces a trend
in the process. It is ollly for Ihe "fair-game" case of 7'( == ~ that CJ achi<. ves
ils lower hound of OIlC.
To sec how large all cflen a 1I0llzero drift might have Oil q. suppose
thai /1 == O.OH alld f1 == 0.21. values which correspolld ronghly to anllual US
stock ITltll'llS indexes OWl' Ih(' 1;lsl hal f-l'Cn tllry. This yieJ!ls the folJowill~
estimate of'rr:

IT ¢l
O,OH) == O.fi1R4
--
( (1.~1

Jr, ir~+(I-IT)~ 0.5440

q J.I!J.

:\111 a late· .. siudy. (:owl('s (I!Uifl) (OIIC'C" tor hi;\."i('s ill linH'~aV('r;lg('<1 price.' ".ata ;111<1 . . [I!)
fillfJ.. (;J lali,,, ill c'Xc C'" of 01iC'. I h"'."'\'c'I, hi, (1I1l( hl,jnn i.Ii sOlJlt'what mOl"(, H".II(\(''': .... ,. whIle
ollr \';11 iuu, ;1II.1Jy~C·.' h;l\"(' (li~( )u,,,d ~I Ictldc'll( y loward." p(·rsi."i.I('lIct' ill stork 1)1 in' mO\'(,IIH'lIh.,

ill Ilei (a"iC' i~ Ihi.Ii ~lIlIici('1l1 10 pJurick 11100e' Ih.tII II('gligihlt" I)lolif~ aher p.IY"U'1I1 orhrnJ..c'I.lgc·
C"lJ.\h.
which is close to the value or 1.17 that Cowles and Jones (1937, Table II)
report ror the annual returns or an index or railroad stock prices rrom 1~35
to 1935. Is the difference statistically significant? . i
To perform a formal comparison of the two values 1.19 and 1.17, ~e
reqllire a sampling theory ror the estimator CJ.
Such a theory may be ~h.
tained by noting rrom (2.23) that the estimator N, is a binomial random
variable, i.c., the sum or n Ikrnoulli randolll variables YI where

y = {I with probability IT, = rr2 + (I - rr)2;

I 0 with probability 1 - Jf,

hcnce we may approximate the distribution or N, ror large n by a normal

distribution wi~h mean E[N,] == nJf, and variance VarIN,). I\ecause each
pair ofa<Uacent Y/'s will he dependent,1 the variance of N, is not nJf,d -rr,)-
the usual expression ror the variance or a binomial random variable-but is
instead

Var[N,) mr,(1 - rr,) + 2nCov[Yf, YHd

nrr,(1 - rr,) + 2 (rr 3 + (1 - rr)~ - Jf;). (2.2.7)

Applying a first-order Taylor approximation or the delta method (see Sec-

tion AA of the Appendix) to q
== N,/( n - N,l using the normal asymptotic
approximation for the distribution or N, then yields

(2.2.8)

where ,,~" indicates that the distributional relation is asymptotic. Since the
Cowles andJones (1937) estimate or 1.17 yields JT, == 0.5392 and JT == 0.6399,
with a sample size n or 99 returns, (2.2.8) implies that the approximate
standard error of the 1.17 estimate is 0.2537. Thererore, the estimate 1.17 is
not statistically significantly different from L 19. Moreover, under the null
hypothesis rr = 4, q
has a mean of one and a standard deviation or 0.20 10;
hence neither L 17 or L 19 is statistically distinguishable rrom one. This
provides little evidence against the random walk hypothesis.
On the other hand, suppose the random walk hypothesis were ralse-
wOllld this he detectable by the CJ statistic? To see how departures from the
randoJll walk might affect the ratio CJ. let the indicator II be the following

'III bn. 1', is a tw(~stat~ Markov chain with prohahilities Pr( Y, =1I Y'-1 = I) = <p" +
<I - /,1"1/1', ,md Pr( Y, == 0 I Y,_I = 0) = 1/2.
 2. TIll' I'mli(/abilil)' 1I/A.I.II'IIMum.\

Iwo-slate Markov chain:

\ I (I .- (j
()

I,
o Ii
\\"11('1:(' (j denutes thc fU1II/ili(J1I1I1 prolJ'lhililY Ih,lI 1",+ I is negalivl', condilioll.1I
Oil a \msilivc Ii. and fl elCIlOIt'S Ih(' mJldili(JllIli proh"hility 11I.1I1111 is POSiliv<',
n"l(~itiol\al on a IIcgative I;. If a = 1- fJ.this rcd\lces 10 thc rasc exanlinl'd
aho\'(' (setl! = I - a): lhc Ill) r,llldol\l walk wilh drift. As IOllg as a t- I - fl.
I, (hl'nce ,.,) will he serially corrdatl'd. \'iolating RWI. In this cas('. th('
thl'ol\etiral \'aille of lhe ratio (:J is givl'1l hy
\ , (I - O'}fl + (I - fJ)a
\ (.). == 'J II '
(:!,~.l 0)
I _0'/,

whidi ran take Oil ,lilY nOlIlIl'g.llin' I ('al \',JlII(" as illlistratcd hy Ill!' ")lIowiJlg
tahk.\
I
Ii
n.1O o.:m n.:lO 0.·10 0.:)0 0.1i0 0.70 O.HO 11.~IO 1.llI)
Il.I 0 !l.OO fi.:'O !Ui7 :),:!~) :).00 ·IXI ·1.71 ·!.I,:I ·151; ·150
n.:!\) li':'O ·1.00 :1.17 '!..7:) '!..:)O '!..:n '2.21 2.1 :~ '!..(lIi '!..oo
0.:10 :),(;7 :1.17 2.:1:1 1.~1'2 l.ti7 1':'0 1.:IH 1.2~) I.'!.'!. 1.17
0.'10 r).~:) '2.7:) J.!1'2 1':'0 1.~:}' I.OH 0.% O.H7 O.HI 0.7:)
O.!)O 5.00 '!.511 1.1;7 1.~:} 1.00 OXI 0.71 O.li:1 0.:)1; 0':'0
u
lI.tiO -I XI '2.:n 1.:)0 I.OH OXI 0.1i7 O.!):) OAIi O.:I!I O.TI
0.70 4,71 '2.'21 1.:iH o.'IIi 0.71 0.:,:) 0.·1:1 0.:"1 0.'27 O.'!.I
II.HO 4.1;~ '2.1 :1 1.'29 0.H7 0.1;:1 0.·\1; 0.:1·\ 0.'2:) O.IH O.I'!.
O.!lO 'U)(i '2'()(; 1.'2'2 O.HI IU)li II.:I~I 1I.'!.7 O.IH n.11 lUll;
1.00 4.:,0 '2.00 1.17 0.7:, 0.:)0 O':\:I 0.'21 Il.I '2 D.I)(' 0.00

A~ 0: and fJ hoth approach Oill'. tile lik('lihood of revn~als increases alld

hencc q approaches O. A~ either Ci or fJ approadlt's I.no. th(' likelihood
of sequl'nces increases and q ill('l'l'as('s wilhout bOllnd. In such CISl'S. ( ]
i~ d('arly a rcasonablc illclicator of deparlurt's from RW I. [Iowt'\'('r. lIot('
that there exisl combillatious of (a. {I) for which at-l-{i alld q= I. ('.g.,
(o:.fi)=(~. ~); hence the (;1 statistic canllot distinguish illt'sl' ca.~(·.~ froJlI
RWI (s('t' I'robl('1I1 2.:~ for hlrtlH'r discussioJJ).

/{un\
Allot her cOllllllon test for RW I is th(' fllII.1 11'.1/, ill II'hidl tht' llullliln 01
Sl'qlll'tH,(,S ofcol\s('clltin' posili\'(' ,tilt! n('g,lIi\'(' n·tlllll~, or runs, i~ tahulated
and t'O\l\IMITd against its sa\llplill~ distrilllJliOIl ulldn tht' ralldom II'dlk
hypothesis. For cxalllpk, \lsillg tht' inclicalor \'ariahlt' I, ddill('d ill (~.~.~).
a partir\llar s('qucnce or 10 l('tunlS Illa\' he rqll('~('llt('tI b\' 10011 \0\00.
Clllltaillill!-,: thrl'(' rllIIS or 1~ «(JrI(,Il~1 It I. :\. alld I. \'("IH'r\ ill'II') ;IIHllhn'(' 1I11l'
2.2. '1'1'.1[.1 o/fill/lli(J/Il'Walk I: /If) /111'11'1111'111.1 39

of Os (oflcnl-\th~, I, and 2, respectively), thus six runs intota!' III contrast,

the seqll('Jl(T 0000011111 l'OlllaillS thl' S<tllll' 1Illillber Os alld Is, hut olily or
~ I'Iln,. I\y COlli paring the lIulllher of nUlS ill lhe dala wilh Ihe expected
11Ilill ber of rum under RW I, a lest of the 11 () randolll wal k hypothcsis \IIay
be cOllstruct('(!. To pel'fonH thc test, we reqllire Ihe samplillg- distribution
of the totalllllllli>er ofnllls N,,,m in a saillplc of Ii. Mood (1940) was the (irst
to provide a cOlllpn:hellsivc allalysis of rllllS, .111<\ we shall provide a brkf
slllllillary of his \IIost general resulL~ here.
Suppose that each of 11 liD observations takes 011 olle of q possiblc
v;t1ues with probability Jr" i = I, ... , I{ (hence Li Jri = I). In Ihe case or
the indicator variable I, defined in (2.2.2), q is equal to ~; wc shall return
to this special case below. Dellote by Nrun,(i) the total Ilumber or runs
of type i (of allY lellgth), i =
I, ... , q; hence the tOlal IIl1mber of nllls
Li
N,,,.,, ;;:: N,,",,(i). Using combinatorial argulIlenls and Ihe properlies of
the Illullinolllial distribution, Mood (1940) derives the discrete distribution
or N,,,,,,(i) frolll which he calculates the f()lIowing 1Il01lle11lS:
E[N,,",,(i)] 1IJr,( I - Jr,) + If/ (2.2.11 )

Val' [N""" (i) ] IIlf,(l - ·Ilf, + (;If,~ - :~lf;l)

+ If,~ C~ -- Hlf,l- !)Jf /) (2.2.12)

Cov(N,,,m(i), Nru",(j)] -Illfi If,( 1 - ~lf, - 2lf, + 37(i Jrj)

- lfi If,(2Jri + 2lf, - 5Jri Jr,).

Mor('( 'vcr, Mood (I D40) shows thal the distribution oj' the lIumber of nlIIs
converges to a normal distributioll aSYlliptotkally whell properly lIormal-
iLccI. III particular, we have

x,
N,,,,,,(i) - Illfi( I - If,) - If /
fit
N(O, lfi(l - If,) - :'If/( I '- If,)l) (2.~.14)

(2.2.15)

N,,,,,, - 11(1- L,lf,~)

x ==
fit

(2.2.16)

where .. ~ .. indicates that the eCJllalil), holds aWlllplolicallr. Tests of RWI

b(' pl'I'j'ol'llll'd using- IIze aSYlllptOlic appl'O~ill1~tli()lls C!.~.14) or
1lI;1)' (itcll
 Tahle 2.2. 1:\lJnIPfIIllIH!"r" /(/Ildom walk with fiJl!/11.

1/ /1 rr ErN",,,,]
1,000 0 0':'00 SOO.:>
1,000 '2O.:,?tH 497.ti
1,000 0.:>7Ii
·1 'IH~).I
I,OOIl Ii
IUil:? 47:>.'2
1,000 H0.li4H 4:>C>':'
I ,DOll 10 O.liH:\ 4:n.ti
1,000 I:?0.7lfi 407.2
1,000 J.I O.7·1H :nH.I
1,000 IIi 0.777 :\47.:'>
1,000 IH O.HO·\ :~ I :>.:,
1.000 20 O.H:\O 2H:t:>

EXPt'{"I('d lotallillmht'f of III"" il1.I ... ;tlHP!c· oln ind(·I)t·,)(It."nl8~rnoulii (rials rt'I)J('s('lIting po,,·
iti\'('/lIc'gati\'(' fOlllinlloll.lril\' fOIU}lOlllHlt'd r('lurn" fCu' a GillI.~"iian gromerri(' I\rowllial1 mOlioJl
wilh II .. in/1 = Of:k .... ~O'.)'r, allli !'Il.lIUi;lId d('viation n == ~1 %.

(2.2. Hi), an<llhl' prohahilil ics rr, lIIay he ('slim'lled directly frolll lhl' d;tl.t as
11ll' ralios if, == /li/ II, whl'I'(' II, is of Ihl' nll1111>rr of rullS in lhl' sample of 1/
lhal an' Iht' ilh l)'p('; Ihlls 1/ = L,
II,.
To dn'dop SOI1l(' S(,IlS(, of Ih(' h('havior or Ih(' tolal nlllllb('r or rullS,
consider Ih(' B('rnolilli caS(' /( = 2 corr('sponding 10 lhe indicalor variable
I, dcfined in (2.2.2) or S('nioll 2.2.2 wh('rc rr dCIIOICS lh(' prohahilit:· tllal
I, = 1. In Ihis caSt', Ill(' ('XIW(·\('(IIOI.tllllllnher of nllls is

ErN,I/,,,] == 211JT(1 _rr)+n 2 +(I_n)2. (2.2.1'7)

()hserV<' Ihal for an)' II :::: I, (2.2.17) is a glob'llly concave quadralic rUllllioll
illlT Oil 10, I J whirh ,lIlaills a maximlllll value of (11 + 1)/2 allT :::: ~. Th('1'('-
/1m', a driftkss ralldolll walk maximil(,s Ih(' exp('cled lotalnlllllbcr or rllm
for all)' (ix('d s~u\lpk sill' /I or, ait('ntaliVl'ly, Ihl' pres(,llce or a drift o( (,ither
sigl1 will (kcH'as(' Ih(' ('''I"'rll'd 10lal \lumber of runs.
To S('(' Ih(' Sl'lIsilivill' or El NIII/,'] wilh r('sp('('( 10 Ih(' clrift, ill Tahle 2.~
we r('port 11)(' ('"1'('('((''' IOI,t\ 11111111)('1' or runs for a sarnpl!' or II == I.(JO(J
ohs('rvaliolls fil!' a J.:l'oll)('lric ralldolll walk wilh lIormally dislrihul('d ill<T('-
1ll('nlS, drift II = 0'1." ... , ~O'Yc" ;\lId siandan( d('vialioll r1 == 21 'Yc, (which is
calihral('d 10 mall'll .lIlIlual liS SIOI'k ind('x r('lurns); hl'lI('(' rr = <1>(11/0).
Frolll Tahk ~.~ WI' S(T Ihal ;tS Ihl' drift in('l'('ases, Ihl' ('X 1)('('\ ('{I lolal ntlllllH'r
or I tillS dnlil\('s (ollsidnahly, (rolll :)()().:) 1'01' l('ro-ilrirl 10 21-\:1.:) ror ;t 21l(.~.
drirt. Ilo\l'('n'I, all or Ih('s(' \'ah\('~ an' slill COJlsistt'nl wilh 11)(' ralldOiIl \\;dk
hvp()1 h('sis.
 41

To perform a test for the random walk in the Bernoulli case, we may
calculate the following statistic:

Nun, - 2n7r(1 - rr) ~ N(O, 1) .

z ==
2Jmr(l - rr)[ 1- 3rr(l - rr»)
and perform the usual test of significance. I\. slight adjustment to this statis-
tic is often made to account for the fact that while the normal approximation
yields different probabilities for realizations in the interval [Nun.. Nrum + I),
the exact probabilities are constant over this interval since Nruns is integer.
valued. Therefore, a continuity (orrection is made in which the z-statistic is eval·
uated <It the midpoint of the interval (sec Wallis and Roberts [1956j); thus

NJlln1 +~ - 2nrr(l - rr) •

z == ~ N(O, I).
2.Jnrr(l-rr)[I-3rr(l-rr»)
Other aspects of nms have also been used to test the lID random walk,
such as the distribution of runs by length and by sign. Indeed, Mood's
(I !140) seminal paper provides an exhaustive catalog of the properties of
runs, including exact marginal and joint distributions, factorial moments,
centered moments, and asymptotic approximations. An excellent summary
of these resulL~, along with a collection of related combinatorial problems
in probability and statistics is contained in David and Barton (1962). Fama
( I !I(5) presen ts an extensive empirical analysis of runs for US daily, four-<iay,
ninc;:lay. and sixteen;:lay stock returns from 1956 to 1962. and concludes
Ihat, "... there is no evidencc of important dependence from either an
investment or ~ statistical point of view."
More recent advances in the analysis of Markov chains have generalized
the theory of runs to non-lID sequences, and by recasting patterns such
as <I run as elemenL~ of a permutation group, probabilities of very comple~
patterns may now be evaluated explicitly using the jir;t-passagr or hitting time
of a random process defined on the permutation group. For these morr
recent rcsulL~, see Aldous (1989). Aldous anc! Diaconis (1986). and Diaconi~
(I !)HH). .

2.3 Tests of Random Walk 2: Independent Increments

The restriction of identical distributions is clearly implausible. especially

when applied to financial data that span several decades. However. testing
for independence without assuming identical distributions is quite difficult; .
particularly for time series data. If we place no restrictions on how the.
marginal distributiolls of the data can vary through time. it becom~s virtually
illlpossible to conduct statistical inference since the sampling distribution,
of l"VCll the most elementary statistics cannot be derived.
 2. Tht' Prt'diclabilil.y of Awl /{dllnl.1

I
: SOllie oflhe lIonparamclric lIIethods melltioned in Section ~.~.I such ;IS
ran~ correia lions do lesl for independencc wilhoUI also rC!Juiring identical
dislhhlliio/ls. bUI the number of distinrl marginal distriblitions is typically
a lillite and slIIall lIullIber. For t·x~!lllpk. ~I tcst of independt'\lIT ('l'tWl'l'lI
IQ tcores and academic performance involves two distinct margin;ll dis-
trii>lllions: one for IQ scores and the other f()(" academic perf()J"JIl'IIHT.
Mul~iple observations are drawn frOIll ealh lIIarginal dislributioll alld vari-
OilS \Ilonparametric tesls can he designed to check whether the prodllrt of
Ihe ~Ilarginal distribulions equals Ihe joint distribution of the paired oh-
serv\ltions, Such an approach ubviously GlIIllot slJcceed if we hypothesi!.('
a l1Jiifllle marginal dislri1>ltIion f<II' each observation of IQ and academic
performance,
Nevertheless. Ihere are IWo lines of elllpirical research Ihat CIII 1)('
viewed as a kind of "e("(lII0 III ic" lest or RW2: jil/a ntln. and leelwintl wlltly.I;I.
Although neither of these approaches makes much usc of forlllal statistical
inferenle. hoth have captured the interesl of Ihe linalllial COllllllllllily 1(11"
pranicOII reasolls. This is lIot 10 say that statistical inference (/III/lOt bl' "1>-
plied to thcse modes of analysis, hut rather that the standards of ('vidence ill
this literature have evolved along very different paths. Therefore, we shall
present only a cursory review of thl'se techniques.

2.3.1 Fillt'r Rules

To test RW2, Alexander (1961, 19(1) applied a filter rule ill which all asset
is purchased when its price increases by x%, and (short)sold when its price
drops by x%. Such a rule is said to be an x% filter. and was proposed by
Alexander (1961) for lhe following reasons:

Suppose we tentatively assume the existence of trends in stock market

pdccs but believe them to he masked by the jiggling of the market. We
might filter out allmovelllellls smaller than a specified sile and examine
the remaining movements.

The total return of this dynafllil portfolio strateb'Y is then taken to be a

mcasllre of the predktability in assel returns. A comparison of the tOlal
retllrn to the retllrn from a huy-and-hold stratq..'Y for thc Dow Jones and
Standard ,lIld Poor's industrial averages led Alexander to conclude that
" ... Ihere liTe trends in siock lIl<lrkl"t prites. , . ,"
Failla (191l;J) and Fama and Blume (I!JGli) present a morc detailed em-
piric; I analysis of filter mil'S, fOIT('((ing for dividends ,\l1d trading ("Osts,
and tbnrlude that such rules du not perform as well as the buy-and-hold
stratt·~'Y' 11\ the absence of transanions costs, very slllall filters (1 % ill
Alexander [ 1~Hi41 and belWet'n OSlo and 15% in Fama and Blume { 191i!i 1)
do "itl)cl superior returns, hili hec!lIs(' slIlall filters generate considerably
2. J. TI'Jls (if /{1/111101ll Walk 2: hllll'{'I'III/1'II1 /lIrrl'llll'IIi.1 43

more frequellt trading, Fallla and IIlullle (I !)(j(j) show that evcn a 0.1 %
roulldtrip transaction cost is enough 10 eliminale the prolils from such 1iI-
I(T rules.

2. J. 2 -Ife/wiml Ibwly.,i.l
:\s ;\ measure of predictability, til(' (iller rule has lhl" ;I<IV;II\I<ll-\e of prafliGl1
n:lev;lllce-it is a specific aud n:adily illlplelllentablc trading strateh'Y, and
the metric of its sllccess is total retllrIl. The filtn nde is jllst one example of
a much larger class of trading rules arising from /I'r/Illim/ Ilnalysis or charling.
li:chnical analysis is an approach to investlllenl manal-\elllclll based 011 the
bdid lhat historical price series, trading volulIle, all<l other market statis-
til'S exhibit reguiarities-often (but 1I0t always) in the form of geometric
p;lllerns such as double bolloms, head-lIlu[-:,lwuldeIJ, alld Jul'porl and resistance
levels-that can be profitahly exploited to extrapolate future price move-
IlIl"JlIS (sec, for example, Edwards and Magee [ I DGG 1 and Murphy [19H6).
'lithe words of Edwards and Magee (1966):
Technical analysis is the science of recording, usually in graphic form,
Ihe actual history of trading (price changes, volume of transactions,
elc) in a certain stock or ill "the averages" alld then deducing from
lhat pictured history the probable future trelld.
Hislorically, technical analysis has been tlw "bbck sheep" of lhe academic
finance community. Regarded by many academics as a (pursuit that lies some-
where between astrology and voodoo, technical analysis has never enjoyed
the 5ame degree of acceptance thaI, for example, fundamental analysis has
received. This state of affairs persists today, even though the distinction be-
tween technical and fundamental analysis is becoming progressively fuzzier. 5
Perhaps some of the prejudice against technical analysis can be at-
tributed to semantics. Because fundamental analysis is based on quantities
familiar to most financial economists-for example, earnings, dividends,
and other balance-sheet and income-stalement items-it possesses a natu-
ral bridge to the academic literature. In contrast, the vocabulary of the
tcchnical analyst is complelely foreign to tile academic and often mystifying
to Ihe general public. Consider. for example, lhe following, which mighl
be found ill any recent academic finance journal:
The magnitudes alld decay pattern of the first twelve alllocorreiations
;lnd the statistical signilkance of the gox-Pierce Q-slatistic slIgl-\cst the
prescnce of a high-frequcncy pr('dina!Jle COIllPOIiClll ill stock returns.

"'hll' l"X~lIlIple, 1Il.'IlY It'Chllir.tl analysL' 110 IOllge!" bas(' ,heir tOf(,CdM.\ ~oldy un past prict"s
alld \'olulII(, bUI abo use earnings and divideJld illtOriliatioll ~lI1d othel" "'hllulamental" d.tta,
i.HIII a~ lIIallY fUlld.lIl1t'lJliJl iJl1aly!'ils now look at past prin.' ;uHI \"011l1l1t' piJUt'rwi ill addiliull In
11101(' tI.lditioll.d variables.
 _. ~ ' . . . IfHII HIIIIIII)' f~1 J"',Uf'/ J{t'/lIrll.\

COlltrast this with the statclII('lIt:

The pn'S('IHT or dearl}' id(,11 tifled,~lIpp()rt and resistallcc levels, couplc:d
\vith a olH,-thinl retra("('IIH'lIt parametcr whclI prices li(, betwcen thelll,
slIggests the pn'selH"(, of strong buying alld scllillg opportullities in the
ncaHenll.

l\oth statclllellts ha\'e !Ill' sallie IIIcaning: Using historical priccs, one Gill
predict rlltllre prices to sOllie extent in the short ntn. Hilt becausc the tW<l
statemcnts arc so laden withjargon, the type or response they elicit depends
vcr)' milch 011 the individllal reading them.
Despitc the differences in jargon, recent empirical evidence sugg('sts
that lechnical analysis al\(I more traditionalllnancial analysis ilia), have IIlllch
in common (see, in particnlar, Section2.H), Recentstlldies by mllllle, Easley,
and O'Hara (19!14), Brock, I.akonishok, and LeBaron (1992), Brown and
Jennings (19H9), l.eBaron (HI96), Neftci (1991), Pall (1991), Tilylor and
Allen (1992), alld Trcynor and Fcrguson (19R5) signal a growing interesl in
technical analysis ,\ilIOn)!; financial academics, and so it may becorne a lIlore
artiv{' rcsearch area ill the Ileal' flltllre.

2,4 Tcsts of Random Walk 3: Uncorrclated Increments

()nl' or the 1II0st direct alld illlllilivl' tests or the ralldolll walk ,lIl(illlanill-
gale hypotheses iill' all individual lilll(, series is to check ror .Inial (on"rlnlioll,
correlatioll hctw('cn two ohservations of the S,III1C series at difkrelll dates.
Under the weakest version of the /'<lndOIll walk, RW3, Ihe inCrelll(nL~ or
flrst-difrerences of th{' kvel of the randolll walk are ullcorrclatetl at allleacls
and lags, Therefore, we may test RW3 hy testing the nult hypothesis that ,he
autocorrelation coemcients of the lirst-dilTerenccs at variolls lags arc <III zcro.
This sct~lIIingly silllplc approach is the hasis for <I surprisillgly l<lrge va-
riety or t('SI.~ of the ralldolll walk, and we shall deVelop these tests in thi.~
chapter. For l'X,Ul1plt-. tests of the ralHlom walk may he based 011 the autocor-
rdation ('()cf[kiellts thcmselves (Scnioll 2.4,1), More powerru\ tesls may be
cons.lructcd I'rontthe slim ofsl(uarl'd alltocorrclatiolls (Section 2.4,2), Lin-
(,ar comhinations of II", ;lIltocolTdations lIIay also havc rcrtain advantages
1
1
ill d('I('cting parlicu\ar departures fromtlw random walk (Sections 2.'1.3 <111(1
~':;), Tlwre/ill'C, 11'(' shall dcvole ('ollsid('l'ahlc allelltioll \0 the propenies of
I
autocorrdalioll coefficicnts ill the cOllling sections,

2. .J. / II lI/oml7l'/((lio/l {;ol'/jiril'n/J

The alltocorrdatioll cod'lici('1I1 is a lIatllraltime-scri('s eXlellsion oftl\(' w('l1-
klloll'n correlat ion cod licienl h('IW('I'1I IWO randolll varia hies x and .1':
(:ov[x, ),J
COIT/x •.1'1 == (2.4.1 )
JVar!xl.jVar[y!·
2.4. Tfjls oj ilandom Walk 3: UI/(orre!ated Increments , 45

Given a covariance-stationary time series {T,}, the hth order autocovariance

and autocorrelation coefficients, y(k) and p(k), respectively, are definedtts6

y(k) COV[T,. T'H1 (2.4.2)

Cov[r,. T,Hl Cov[ r,. r'Hl y(h)
p(k) ==
Var[ rtl
= yeO) •
(2.4.3)

where the second equality in (2.4.3) follows from the covariance-stationarity

of {T,I. For a given sample {T,I;"'I' aULOcovariance and autocorrelation coeffi-
cients may be estimated in the natural way by replacing population moments
with sample counterparts:

1 T-A
y(k) == T 2:)r, - fr)(Tt+A - TT). 0 ::; k < T (2.4.4)
,=1
y(k)
p(k) == (2.4.5 )
yeO)
1 T
TT - TLT,. (2.4.6)
,=1
The sampling theory for y(k) and p(k) depends. of course. on the data-
generating process for I rtl. For example. if r, is a finite-<>rder moving aver-
age,
M
T, == LakE,-b
.=0
where {E,) is an independent sequence with mean 0, variance 0'2, fourth
moment 1')(14, and finite sixth moment, then Fuller (1976, Theorem 6.3.5)
shows that the vector of aULOcovariance coefficient estimators is asymptoti-
cally multivariate normal:

JT[ y(O)-y(O) y(l)-y(l) ... y(m)-y(m)]' :.- N(O, V). (2.4.7)

where

v == [Vi] 1
00

v,) - (1] - ?»y(i) y(j) + L [y(i) y(f-i+j)

(:;:-00

+ y (l+ j) y (l- i) ] . (2.4.8

IIThr- rrC]uirement of (~uvarian(e-stationariry i:o. pr)Jn;nHy for notational conv~nien[e

(llht'",i, .. y(k) and p(k) may be functions of I a, well as k. and may nOI even ~ well-defined i
s(,fond moments are not finite.
 2. The Predictability oj A.\sft Hfturn.!

Under the same assumptions, Fuller (1976, Corollary 6.3.5.1) shows Ihal
the asymptotic distribution of the vector of autocorrelation coerlicient esti-
mators is also multivariate normal:

v'T[ p(O)-p(O) p(l)-p(l) p(m)-p(m)], ~ N(O, G). (VUI)

where

00

g'j
'I
- L [p(e) p(l'-i+ j) + p(l'+ j) p(l'-i) - 2p(j) p(f) p(f-i)
(=-00

rI - 2p(i) p(l') p(/'- j) + 2p(i) p(j) p2(e) ]. (2.4.10)

!
For purposes of testing the random walk hypotheses in which all thc pop-
ulation autocovariances are l.ero, these asymptotic approximations reduce
to simpler forms and more can be said of their finite-sample means and
varia~ces. In particular, if hI satisfies RWI and has variance o~ and sixth
mo~ent proporlionalto 0 6 , then
I
T-k .
E[p(k) 1 ---+
=
T(T-l)
O('r- 2 ) (2.4.1 I)
\
I;;J. + O( r2) if k I' i: 0
Cov[p(k), p(m = ,.
{ O(T-2)
(2.4.12)
otherwise.
\
From\ (2.4.11) we see that undcr RWl, where p(k)==O for all k>O, the sample
autocprrelation coefficients i>(k) are negatively biased. This negative bias
comer from the fact that the autocorrelation coefficient is a scaled sum of
cross-p,roducts of deviations of T/ from i\.~ mean, and if the mean is unknown
it must be estimated, most commonly by the sample mean (2.4.6). But
deviations from the sample mean sum to zero by construction; therefore
positive deviations must eventually be followed by negative deviations on
average and vice versa, and hence the expected value of cross-produc\.~ of
deviations is negative.
for smaller samples this eITecl can be significant: The expected value
or p(l) ror a sample size of 10 observations is -)0%. Under RWI, fuller
(1976) proposes the following bias-corrected estimator p(k):7

-
p(k) ==
_
p(k) + --,'{-It
--" ( I -2)
- p (I,) . (2.4.1:1)
( f-I)<

7 NIlI Ihal pIA) i~ nllt IInbia",,": 11ll' I<'nll "hias<olT.. ctcu" rcfers lU Ihe fan Ih.1I
Etp(h)I=Orr-~).
2. ·1. ·I;'.I/s 0/ Url/II/O/ll IVlIlI, J: Ullmnl'/a/I'I/IIIOI'1Il1'll1.1 47

Wilh IIllililr!lIf)' houtlded sixth 1II01lletltS, he shows Ihat the s.\llIl'le auto-
rorrelatioll coefficicnts arc asymploticall), independcnt and normally dis-
tribilled wilh distribution:

Nw. I) (2..1.14)

N(O, I). (2.4.15)

These r('stllls yidel a variel), or atllocorrdalioll-lJasnl lesls or the ralldolll

""Ilk hypothesis RWI.
1.0 and M.ICKillhty (1~18H), Richarclsoll and SllIith (1!1~14), all(l Romano
and Thombs (f9!l(i) derive asymptotic approxilllatioll~ for salllple aUlOcor-
relatioll codliciellis under evell weaker cOliditioIiS-lIl1corrdatcc\ weakly
dq>ellc\ellt observatiollS-and Ihesl' results lllay he used 10 COllstruct tests
or RW~ and RW:~ (sec Sectioll 2.4.3 helow).

2.4.2 Portmall/Pal! .'i/a/istirs

Sillce RW I implies that all aUlOcorrclatiolis arc zero, a simple test statistic
of RWI that has power against mallY alternative hypothescs is Ihe Q-statislic
due to ~ox and Pierce (1970):

'"
~II - TLp~(lC). (2.4.16)
h=1

Ullder the RWI nlill hypothesis, and using (2.4.14), it is ea~y to sec that
c1.. = 'I"'£;~I P(lc) is asymptotically distrihuled as X~,. qUllg and Box
(197H) provicle the (ollowing finite-sample correctiotl whirh yidds a helll'r
(it lO the X~, for slIlall sample sizes:

'" 2(k)
== '1'('1'+2) "" -p-
fl'
"'-'II b T-k
. (2.4.17)

By summing the squared autocorrclations, the Box-Pierce Q-statistic is de-

signed to detect departures from zero alllOl'orrclatiom in either direction
anel al all lags. Therefore, it has power' against a broad r'angt> or alternative
hypotheses to the random walk. However, selecting the \l\lInber of autu-
correlations III re'l"irc~ SOlllC care-if too /CW arc used, the prcsencc of
highcr-orcler autocorrelation lIlay hc IIIbsccl; if too lllallY arc IIsed, the test
Illa), lIol have lllllCh power due to insignificant higher-order aUlOcorrela-
lions. Therefore, while sllth a portlllanteall st,l\islir does have sOllle appeal,
IWlLcr tesL~ of thc random walk hypothcscs lIlay he availahle when spedne
allcl'Il;lIiVl' h)'I)otheses can be identified. We shall lui'll to slIcll examples ill
III<' /ll'xi sCl'lions.
 L., 1111' 1'll'Il/dli/II/I/,\' "/ 11.1.11'/ UI'/IIII1,\

2, -I, } \{II1I1//(/' IIn/io,1

An important pl'Opnl\' of allthn'(' randolll walk hypotheses is th,1\ thl' \'ali-

anft' of ral1dom walk iIHT('I111'nIS ""ISI Ill' a Iin('ar rUllclioll or Ihc lilllC
il1tt'rvaJ. H For ('"ample. Ulldl'l' RW I 1<11' lo~ prices wher(' conlillll()IISI~' COIII-
»otllllied r('tlll'\lS I,"" lo)!; I',-Io)!; I', I alT liD, the varialllT of 1",+1"" I mllst
he twin' the \'ariaIHT or 1'" Thneiorc, thc I'Jausihilit)' or til(' ralldolll \1';r1k
modcllllay I)l' r\1('('k('d In' l'IlIIlparill)!; III(' variallcc of 1,+Ii_1 10 tll'ice (he
varianc(, or r,,!' Ofcoltrsc, ill practicl' thl'Sl' will not he 1l1l111l'ril"ally idclltical
('\'I'n if RW I were trill', hut their rat io shonld be statistically indistinguishahll'
from OIH', Tl1l'rl'fon', (0 rOllslnlcl a slalislical I('SI or IIH' ralldoll1 walk 11\'-
pOlhcsis usin~ I'arianrc ratios, liT n'quirc Ihcir samplillg distrihulioll under
tIll' ralldolllwalk nlill h\'jlotill'sis,

l'o/l11/a/ioll I'm/lI'l/il'l 0/ \ II/iiII/O' NII/illl

Ikillfl' (Icriving slich s;lIliplilig dislrihlltiolls, we develop sOllie intuitioll for
the pOjlllhllioll valll('s of t!rl' varianrl' ratio statistic Ilnlln variolls scenar-
ios, COl1Sic\l'I' again IIIl' ralio or Ihl' variancc or a two-period (onlilluol"ly
compoundcd ITlurn I,I:!) == 'I + '1,,1 (0 Iwirl' the variance or a olle-period
H'tllnl 1',. and 1111' the 11101111'111 kt liS aSSIIIII(, lIothing "hollt the time scri('S
of n'turlls othn th;\1l st;lIionarity, Thcn this varianre r;ltio, whirh WI' Wrill'
as \'R(~), I'('cluccs 10:

VOId I, + Ii· I I
~ V;ld 1',1

~ \'011'1 It 1+ 2 Cov! Tt • Ii-II

2Var[r,J
VR(2) +p(l). C~.4,IH)

Wlll'IT p( I) is thc Iit-st-onln alltocorn'lation ('od'llcil'l1t of \'('turns {I,\, For

any slationary lillie series, Ihl' populatioll value or thc variallcc ralio stali~lic
VR(2) is simply OUI' plus Ihl' first-md('!' aUlocorrelation co('fficiellt. III par-
ticular, IIlIdl'r RW I a!lthl' ,lIlIOCOlTl'btiollS an' 7.1'1'0, helll'(' VR(2)= I in tltis
rase, as ('''periI'd,
IlIth(' pn'sl'IH,(, ofposilil'l' lirsl-orcln autocorrelatioll, VRe!) will ('xl'l'l'd
Ollt', If rl'tllrllS arl' positi\'d\' ;lll\o('olTclal('d, Ihl' variallce of 11t(' SIIIII of 111'0

"Thi\ Iilu-arilr propPllV j, iliOn' difli, lilt 10 ,';IIt' ill Iht" rase.' of R\\'~ and R\\,:\ hl'r;IIIS(' du'
\';uiann's 01 iIlIT('IIU'III."; ilia\" ";11\' 1IIIIIIIgla lilllt'. 11ow("\'(" 1", (,\'("11 in Iht-,(, ('''''I'S .li(' \'ar-jallfT
oltlu' .";11111 11111,1 f·fjll.tllhe· '11111 (If lh(' \';lIi;lIl(('S, and Ihis b Ihc.' lilU'aril), IJlopc'ny \dlirh lilt'
\;11 i'lllt t' lalio ,,"~I (·xploih. \\'f' .. h.tli ('Oll"nll I h· ... b of;,lIllIn'c' hypfllh(,~f''; helo\\,.
')~I;III\ .. llIdic', 1t,1\"t' ("1'10111'" liIi .. I" CIlu', IV 01 lilt' lalUlo11l walk hypolh,"" ill dc" j .. illg ,'III-
I,i, ic.II 1(""«,' 1)1 ('flu fahilil\,: I ('f CIII ",.11111 ,Ie' ill( Illcle (~HHplU'11 ;lIIcI ~Ltlll..i,\' ( I ~IH7), ( :( If 1lr.1l1t'
(I!IHH), F.III,1 (lqlJ'.!l. 1.41 ,IIICI i\1.h Killl;1\ (PIXX). I'ott'rha ;\1111 SUIIHIIC'I' (1~'HN), Ric h,llcI"'fllI
(I!I!I:\). .11111 Ri( h.tld",1t ;11111 SIOf I.. 'J:I~~II.
2.4. "I'r.I!'1 of Ralldolll H'tilk J: Ullron'f'llIlrrllllnrlllflllJ 49

one-period returns will he larger dian the sum of the one-period return's
variances; bel.ICe variances \ViII grow faster than linearly. Alternatively, in
lhl" presence of negative first-order autocorrelation, the variance of the slim
01 two one-period returns will he smaller than the sum of the one-period
r('IIII'Il's variances; hence variances will grow slower lhan linearly.
For comparisons beyond one- and lw(}-period returns, higher-order au-
tocorrclatio!lS come into play. In p,lrticuiar, a similar calculation shows that
the gener;'!1 q-period variance ratio statistic VR(q) satisfies the relation:

VR(q) ==
Var[r,(q)]
== 1 + 2 L.
'II ( k)
I - - p(k). (2.4.1\)
q. Varlr,l LI q

+... + r'-H I ,md p(k) is the kth order autocorreiatiQ,n

",lIn(' r,(k) '"' r,+ r'_1
coefficient of (rrl. This shows that VR(q) is a particular lineaT combination
of the first k-\ autocorrelation coefficients of I Ttl, with linearly declinil1g
weights. :
Under RWI, (2.4.19) shows that for all q, VR(q)=I since in this Ca.'le
p(k)==() for all k~ 1. Moreover, even lInder RW2 and RW3, VR(q) must still
eqllal one <IS long as the variances of r, arc finite and the "average variance"
L/~I Var[ r, 1/ T converges to a finite positive number. But (2.4.19) is eve~1
lIIore inforlllative for alternatives to the random walk because it relates the
t)('h,lVior of VR(q) to the autocorrelation cocflkients of I Til under such
allcrnatives. For example, \Inder an AR(I) alternative, TI = tPT,-1 + f"
(2.4.1 !) implies that

VR(q)

Relations sllch as this arc critical for constructing alternative hypotheses for
which the variance ratio tesl has high and low power, and we shall return lO
I II is isslle below.

Srull/dinK lJislribulioll of VD(q) (Il1d W(q) lmdrr HWI

To cOllStrllct a statistical test for RWI we follow the exposition of 1,0 and
MacK.illla), (19HH) and begin by stating the null hypothesis Ho tinder which
Ih(' samplillg distribution (lfthe test statistics will be derived.'" Let p, denote
lile log pric(' pr()Ct:~s and r, == /Ir- /J,_I ,ol1till\lOIlSly [ompounded returns.

'''For ,"'1'111,11;,,(' c·,po,itiolls ,,·c· Call1pll<'l1 allci ~1;,lIkiw (I<lK7), Codlrdne (ICJKK). FA,,"
( I CI~I:'>). l'otC'. Ita .111(1 StllIlI"''''', (I !IHK). Rirhanholl (I!I(I:I) .•\I,d RirhA«j"on A",I Stuck (19K!I).
 50
2. The PTedirtability of A.I.II'I /(1'1/1 m.1

The n the ilUli hypo thes is we cons

ider ill this sect ion is II

Ho :
Let our data cons ist of 211+ I obse
rvat ions of log pric es {f~). 1'1 . ....
cons ider the follo wing estim ator I'l" \. 'IIU\
s for p and a~:
'2'1
[J. -
~II
L (I'. - 1'.-1 ) I
"i""II (/'2" - 1~1l (2.<I.~O)
"'-I

'l.u
cr; -
211
L (I'. - I'H - II) ,~
(2.4.21 )
.= I

'2
°b -
211
L" ({'!. - .
{'l.- ~ - 2/~) 2 . (2.4.~~)
.~t

Eqll ation s (2.4 .20) alf(l (2.'1.~ I)

Me the IIslIal sam ple mea
estil llato rs. The y are also the maxi n and vari ancc
mum-likeWwod estim ator s of f.1 and
Sect ion 9.3.2 in Cha pter 9). Thc a ~ (sct"
rand om walk natu re of PI: Und er
seco nd estim ator a/,
of a ~ mak es usc of tIlt·
RWI the mea n and vari ance of incr
arc line ar in the incr eme nt inter cme nts
val. henc e the a ~ can be estim ated
half the sam ple vari ance of the incr hy onc-
cmc ills of even -num bere d obse rv;lI
I/~)./). 1'4 •...• pln)' ions
Lind er stan dard asym ptot ic thco ry.
all thre e estim ator s are stro ngly
sisten~: Hol ding all othe r para met COIl-
ers cons tallt . as the tota lnul llbe
vatioris 2n incr ease s with out hou r of ohse r-
nd the estim ator s conv erge almo
thei r j>opulation values. In addi tion st slIrely to
. it is well know n that cr'/.' and a,7
the following norm al limi ting distr possess
ibut ions (see , for exam ple. Stua
Ord [~987»: rt and
\
I'
i
I
I

,j'j;;(a/,-a~J :.:.- N«J ,4a 1 ). (2.'1.24)

lIow erer . we seek the limi tillg
dislI 'ihut ioll of the ratio of the
Alth ol/g h itllIa y read ily be show n vari ancc s.
that the ratio is also asym ptot icall
with IIlrit mea n und er RW I. the y Ilorm al
vari ance of the limi ting dist ribu
appar~nt siricc the two v;lriallce tion is not
cstil llato rs arc dear ly /lot asym
IInc orfe lated . ptot icall y
Bilt sinc e the estim ator
hypo tlles is RW I. we may \lse llall
cr,;
is asym ptot icall y crtic ient und er
the nllll
sma n's (1~7H) insig ht that the asym
ptot ic
II \\'t' a\.lIjume nonn ality only tor
t·xpo . . itioll.lI ("onn 'lIicn rt'-th l' resl1l
1I111ch 1II0re gelle rally to log price t~ in this s('nio ll "pply
I'lOces,,"s with liD illrn"II1<"lIt'
Iltnm eilis. th;\l posse ss fillite I(lIIllh
2, ·1, 'li',I/.1 4UflllI/OII/ Walk J: l/lIomdfllnllllrll'll/l'/Il.l

",Iriallce of tite differenct" of a consistent estilllator and an asymptotically

dlicil'llt estilllator is simply the C\iI"i"el"clln' of II\{' aSYIll(>lOtic varian(es,l~
II IV(' ddill(' tlw vari'lllce di(fc.'ITIIlT estimator as VI)('2) == tl\{'n n;; - n,;.
C!"I.~:-\), (~.'I.~.j). and I'!ausman's result implies:

TIll' Illll1 hypothesis" can then he t('stnlusillg (~ .. I.~:» alld allY cOllsistcnt
('stilll;llOr :!a'i of 20'1 (for example. :2(a~)~): COllstrud the standardized
sl;ltistic \'1)(:2)1 ~ which has a lilllitill~' standard lIoml;d distrihutioll 1111-
dn RW I. and reject the null hypothcsis at th(' :if;;, hoyd if it lies outside the
illt(,ly;dl-I.%,I,%j,
The as),lllptotic distrihutioll of the t,,'o-lwriod v;lriaIK(' ratio statistic
\"71\(2) == a,~ In,;
now follows directl), fmlll (:2A,2!i) usillg a (irst-onierlil),lor
applOxilllatioJl or the delta Illethod (se(' SeClion/\..J of the Appendix):I:1

'I'll< 111111 !!y(>othesis 110 can he t('stnl Il)' ("ollllllilillg the standardized statis-
tic ~(VR(2)-I)/~ which is asynl()tolic;dly st,lIHttrd Jlormal-if it lies
()llIside the illtnval 1-1.~l(i. I.~HiJ. RWI Ilia), 1)(' rl'jnwd at thl' :)'}{, kvd of
si~Jlili(allce,
AlillOugh litl' vari,III('C ratio is ,,1"1 ell pn'krrl'd to Ihe \',lIi,III("(' dint'n'll(T
1)('("'\\ls(' Ill(' ralio is scalc-fret", ohserv(' Iltat ir~(a,;)~ is IIsed 10 eSlilllale 2a I.
lhell lite sl,llllbrd sigllilicalHT ll:Sl ofVD=() lor tilL' dilkrelllT will yidd lhl:
saille inferellces as the correspollding test ofVR-I=O (l!' lhe ratio SiIlCl':

~VT)(2) ff,i(a,; - a,;)

JET,} ~a,;

Tltnt'i"ure, ill Illis silllple cOlltexl th(' IWo tesl statistics arl: ('ljuivaklli. Ilow-
('\"l'r, 111('1'(' ;11"(' othl:l" reasolls that Illake tll(' I'ariallcc ratio Illore appealing

\'.! HI il'll}, 11.111'1111.111 (I ~)7H) c.'xploib III(' LH t 11,,11 ,IllY .I:'I~ IIIIHllllf.dly dlidc.'11i I..':.lilll.lIor 01
.1 p.II'IlIl('Ic.'1 (I, ~.I\"
Ii,., 1II11:-.t I't):-.~c.·s., the.' p"oP('II~' Ih.11 it i~ 'I'~ IIIpIOlit';dly unfOI n'lo"t:d with
Iill' 11111"1 ('lit"(' (i" -- (i,. where: (itt i~ au)' olher (·~lilll.ltor 0111. II lIot, dlt:1I tllC.'''''' t"xi!oots a liue.n
("Ollibill.tlillll (II (i,. ,lIltl (ill -fir IhOit is iliOn.' c.'Hi("it'lll IIi.lllli, (CJlllr.uli< lillg Illl' ''-,.'IIIH«,'d l'Ilirielu"y
I

0111, "111(' I ("'1111 1t)lIo\\'~ dirt'nly. thcll. sinn';

,'\',III,i,,1 '" ,,\';11 Iii, + Ii" -,i,1 ,'\',11 I Ii, I ,'\',III,i" - ,i, I
=> ,I\'a'IO" - Ii, I ,'\';111';" I - ,1\';11 \Ii, I,
",hefe ;I\',III·J d('IIIJI('~ thl' a~>'llIptolic \',uian("(' "pCI ;11111'.
\'~111 p.lIlirlll.tr, apply Ihl" ddt.llIlethod to I({il.,i'.!l:::;(i,/fi',! \\liel"(' fjl=n/~-n,;. fi,;!:=(j,;. aud
oh,cl \"(" [h.1I r1f~ -r.-:;
,11111 n-,; ,II (' a.,YIIIIHCJ!i( all~· 1111( 011 (,l.lIc·d IIt'( .111'(' n,! j,;111 dfifi('1I1 {".,lim:.tlol".
and tll<'s(' arc disnlss{'d ill (;ochr,lIIe (l~lHH). Falls\ (19~1~), ',1I1d 1.0 and
MacKillla), (I!IHH, I!lH!I).
The I'aliall(,(' elilklt'llIT anel lalio sialislics elll })(' easil)' gcnl'r;di/l'd
Itl IIllihipnioC\ ITllirIlS. I.t'! 0111' salllpll' cOllsist of IIq+ I ohsl'I"l'aliollS 1/~1o

/1\, ... ,/1",,1. wh('l'(' '/ is "III' illtl').(('J' J.(lc"tcr than one "lid define Ihl' eslim,,-
lors:
1/11
}
II .-
/1'1
L (Ilk - 11. - I ) -
1/({
(II,,,, -/~I) (2.4.:2H)
'=1

L
III/

-"
(1,; ,~ (:~. ·1.:2!I)
- (I'k - /1.·-1 - II)
11,/ k,-I

°/~(q)
//11
L" (/'"k - /1"*_,, - '
qll) ~ C~.·I.:W)
k~1

Cr/;(q)
\'1)(1/) - 0/; (1/) - G,;, VR(q) - 0'1.
(2.4.:\1 )
"
llsillJ.( silllilar arglllll('lIlS, Ihc aSYlIlplolic distributiolls of VOl'll alld \/R(,/)
IItHlcr till' RW I 111111 h)'JJotlwsis are

JiIii (1)( 'I) N(O,'2(q-I)IT' I )

JIif/(Vlt(q) - I) N(O,'l(q-I)). (2.4:1:\)

Two illlportalli ll'iin('nH'nts of these statistics can improve their finite-

sample propntics slIhstantially. Th(' first is to lISC OlIIT/aNlinK q-peric,d rc-
IlIrns ill estimaling Ih(' variances h)' dellning Ihe following alternative l'sli-
malor for IT ~:
I'~
.. "
IT,-Utl = -'7
/Ill
L (I'k -
k~"
Ilk-" - 'Ill)-.
.... J

This eslimalor conlaills /1,/- q+ I t('J'IIlS, whereas the l'SlimalOro;; ('I) (ontains
only 1/ tl'l'Ins. Using overlappillg 'I-(l('l'iod rCllll'lls yields a lIlore effici('nt
cSlimalor and hell('e a Illore pownflll Il'SI.
The s('('olld rdill<'m('1I1 im'Olves (·(lIT(·(·ting lh(' bias ill Ihe valiant'{· es-
limators 0,; alld h,~ herOIC dividing OIl(' hy Ihe olher. Denole the IInbiased
estimators as i1~ and n;
(II), whnl'

,"/
1
- - L (II. -/1.-1
'''/ - 1 k~ I
"" - ' ~
Jl)

",
 •. , J • ..... UV ... 53

m (2.4.36)

and define the statistics:

(2.4.37)

This yields an unbiased vari;lIlce difference estimator, however, the variance

ratio estimator is still biased (due to jensen's Ine<]uality). Nevertheless,
simulation experiments reported in Lo and MacKinlay (1989) show that
the fi~te-samplc properties of VR(q) arc closer to their asymptotic limits
thall VR(q).
Ullcler the null hypothesis II, the asymptotic distributions of the vari-
alice difference and variance ratio arc given by .

VD(q)
a
~
( 2(2q-l)(q-l)
N 0, a
1) (2.4.38)
3q

J1lii (VR(q) - I)
a
~
N (0, 2(2 q-l)(q-l)). (2.4.39)
3q
These statistics can then be standardized ill the usual way to yield asymptOl-
ically standard normal test statistics. A5 before, if 0 4 is estimated by ~in
standardizing the variance difference statistic, the result is the same as the
stanclarclized variance ratio statistic:

Vr (q) J1lii(VR(q) - 1) (2(2 Q-,I)(q-I))-1/2 (2.4.4P)

$q I

J'ilfjVf5(q) (2(2 Q-1)('1- I

r;;4
»)-1/2 ~
N(O. 1).
ya! 3q

Sam/}/ing Distribution of VR(q) under RW3

Since there is a growing consensus among financial economists that volatil-
ities change over time (sec Section 12.2 in Chapter 12), a rejection of the
random walk hypothesis because of heteroskedasticity would not be of much
interest. Therdore. we seek a test for RW3. A5 long as returns are lIncorre-
lated, even in the presence of heteroskedasticity the variance ratio must sti.1I
approach unity as the lIumber of observations increases without bound, ft'
the variance of the SUIll of un correlated increments must still equal the sum
of the variances. Howeyer, the asymptotic variance of the variance ratios will
clearly depend on the type and degree of heteroskedasticity present.
One approach is to model the heteroskedasticity explicitly as in Section
12.2 of Chapter 12, and thell calculate the asymptotic variance ofVR(q) un-
cler this specific Ilull hypothesis. However, to allow for more general forms
 54
2. The Predictability oj A.I.Ip ( HI'll/m.1

of hete rosk edas ticil y, we follo w

Ihe app roac h take n by 1.0 and
(198 8) \'{hidJ relie s on the hete Mac Kin lay
rosk edas ticit y-{: onsi sten l met hod
(198 0) and Whi te and ))om owit s of Whi te
l. (1 ~184). This app roac h appl
broa der class of log pric e proc ies 10 a IIlttc h
esse s !tIll than the liD 1I0r mai
proc ess of the prev ious seCl ioll, incr ellll 'nls
.\ part icul arly rele vant cOll cern
retu rns as Tab le 1.1 illus trate s. I 1 for US stoc k
the follo wing com pou nd nlill
• Spec ifica lly, let r
l Jl + ii, alld defi ne =
hypo thes is H~:
(Ill) For ailt, E[ir l == O,ll luIE [i l il_ r ) = OJura71yr '" O.
(112) Ii rl is CP-lIiixillg wilh curfJicieu
ts cP (lit) vJ siu r/ (2r- l) vr is a-mixillg
(oifficimts a(m ) oj size r/(r -I), wher witli
e r > I, such that Jor all t (lwl Jur
r ~ 0, iI!l're exists s07l/eli > 0Jor (lilY
whi rhE lklil _rl'l (,H) ) < D.
< 00.
I nq
lim -
"'1_ 00 nq
L, .,
E[i; J = a- < 00.
1:::01

j'llr rlllt, E{il il_; fl (,-.1 = 0 jor

/Wl/Z. I'I'O j and k will'l l'
1
(lil)'
j l' k.
Con ditio n (Il I) is the unco rrcla
ted incr eme nts prop erly of the
walk Jhat we wish to test. Con ditio rand om
ns (112) and (H3 ) are restr iClio
max illlu m degr ee of dep end ence ns on the
and hete roge ncit y allow able
perll~illing sO/lle form of the Law of Larg whil e still
e Num bers and thc Cen trall .illli
TheO rellJ to obta in (sec Whi te t
[I mH) for the defi nitio ns of cp- and
rand+1IJ sequ ence s). Con ditio a-m ixin g
n (1!4 ) imp lies that the sam ple
tion spf' l are asym ptot icall y IIJlc aUlO corr ela-
orrel ate< i; this cond ition may be
cons iller ably at the expe nse of w('a kene c\
cOll lput ation al silllp licit y (see
'I~Jis com pou nd null hypo thes !lole I:».
is assu mes that jJ, poss esse s lInc
incr etne nlS but allow s for 'Illit one lalc d
e gene ral form s of hetc rosk edas
illg dtte rmin istic chan ges in ticit y, incll ld-
the vari allce (due . for exam ple,
factor~) and Eng le's (1~)H to seas onal
2) ARC II proc esse s (ill whic
h the cond ition al vari-
ance (~epe~~ on past info nnat
ioll) .
Sihc e VR( q) still appr oach es one
IInd er lit" we need only com pute
asym p'tot ic vari ance [call it U(Ij) it~.
J to perf orm the stan dard
and Mac Kin lay (198 8) do this infe renc es. 1.0
ill two step s. First , reca ll that
equa lity hold s asym ptot icall y und the follo wing
er 'Illit e gene ral rond ition s:

-
VR(I"
j) == I +28
L (I - ;k) p(h). (VI Al)
'~I I
l.Jor rOIlI~(". second 11I0ll lt'ub an'
",1111 .t....!'IIIIBe d 10 hc' fillite
; other\\,ls(', Iht" \'ari~lIln'
j, 110 lougt"r \\'e11 defin ed. This rull'., r.1l1t1
out (1i:"'l Iibulio lls with IIIlilll tc
Ihe st.thlt' P,lrt" lo.. Le\y f.uuil), (with \·"lri~lIlre. such as thoM '
flt.n,1 ( It'n:"l. lif eXpO llt'Ill.
ill
~1.11l(1t·lhr(}t (19tj3 ) al1d \ th.1l are Ic~s tll.tn 2) prop
Failla (I~)I;:)). J1{)WC H'r, 1l1;IIIY o\('d In
olll('r fC)lIII!'o ofl('p tokur
"I< h 'I' Illal ~enerdled
hy ElIgl e', (1 \IH~) ""tol q~ .. ""in t()\is ~,rt· .111(Jwc'd.
11IOf~" \'ee ScClill1l 12.2
· (olldi lioll,l lIv 1t~lel ",~,'d'''li( (AI{(
ill CIt"PI"\' 1'2) :111
2, 5, 1,{JI/~-lllJriwll 1&llLm.l

Secolld, II' ,It' Ihal undl'J' 1I~ (conditioll (114» the autocorrelation coelE-
el,':11 estilll(k) are asym(ltotkally uncorreiatedY' II' the aSYllJptotic

\\lri.1J1Ce O. ( " of the p(k)'s call he obtai lied Ul\dn II;,. the asymptotic
\'~Iriallre (}(q) oj \'R('1) lIlay he calnilated as the weil-(hted SUIII 01' the Ilk's,
whne Ihe weigh Is arc simply the weighL~ ill relalion (~.4.41) squared. De-
note by Il. and U(q) the asymptotic variances of Ii(k) and VR(q), respectively.
Then ullder Ihe lIull hypothesis II~ Lo and MacKinlay ( I UHH) show that
I, The slatistics VD(q), and VR(q)-1 converge almost surely to zero for all
q as 11 increases without bound.
') The following is a heleroskedastirity-n)Jlsistenl eSlimator of Il.:

(2.4.42)

:t The followillg is a heleroskedastit:ily-rollsisll'nl estimator of O(q):

1- 1 ,.

8(q) - 4L (I - ~). 8•. (2.4.43)

~~t q
Despite the presence of general heteroskl'dasticity, the standardized test
st:11 i,)tic if' (if)

J1zij(VR('/) - I)
if;' (q) N(O,i) (2.4.44)
fii
CIII 1)(' used 10 lesl il,~ ill lile usual way.

2.5 Long-Horizon Returns

St'\'nal recent sludies have focused on the properties of long-horizon re-

turns to test the random walk hypotheses, in some cases using 5- to 10-
yt'ar ITtUJ'IlS OWl' a 65-ycar salllple. There are fewer nonovcrlapping long-
hori/ol1 rcturns for a given tillle span, so samplillg errors are generally

l\lthollgb Ihl., 1("~lriClion 011 the fOllrth ('r()!\!\'lIlOlIIl'l1l~ 01 f;, III .. }' ~t'l"Jll sOIllt'whdt lIlIiJlIIl~
l'l
ill\(', it i", :-.ati:-.f"ll'd tor .~ny process with itHkpelHlent illcrelllelits (legaJ(lIess of heterogeneity)
.IIHI ~Ibt) luI' Ijllt'~lr (;all:-.~iaJl ARCII processes. This a . . sumptioll !Hay he relaxt'd entirely, req\lir~
IlIg tilt' l"lilll~llioll of the asymptotic rov.uiuHTS of tht' ~IHI()n)IT(·l.ttioll (,!'ttiIllClIOr:'i in order In
\",illl"'" lilt' lilllitillg ';tri"Jl(e f) of VR(q) vi" (~,~,'II), Allhollgh thl' r,'slIilillg estimator of II
\\(lIdd he 1110)"(' c.:olllplicatcd than equdliou ('2AA.:-\). ill~ coun'pln.lIly Mlaigilllorw.... d dud lIIay
I(,adily IH' forlll('d .d()l1~ the lines of N,·w('y .uHI \t\'(.'~t (I ~JH7). All ('\"('11 III()((~ Kt'llC'lal (and pos~
:-.ihly won.' t'xart) sampling thew), ftH"lht' v,lriillln' r~llio~ m;IY he olHailJ('d IIsing- the result'" uf
nll"",r (I ~IH I) alld 1)1I1<,"r ""d Roy (IYW,), Again, lhis wo"ld ",nili",' IlIlIrh of till' ,implicily
of (lur ;1.'Ylllptotir u'.'HIL,.
larger fllr statistil'S hased Oil long-horizon returns. Hut for some a\lertlati\'es
to the randolll walk. long-horil.on returns can he 1II0re informative than
their shorter-horizon ('Ollllterparts (sec Scction 7.2.1 in Chapter 7 and 1.0
ami MacKinlay I 1~IH9j),
One motivation flu' using long-horizoll returns is thc permancnt/tran-
sitory componcnts alternativc hypothesis. lirst proposed hy Muth (1!)(iO) in
a macroC(,(l11omic context. In this model. log prices arc c0111posed of 1\\'0
componcnls: a rando111 walk and a stationary process.

W, )i + 11',_.1 + f,.
)', any l.{'ro-l11ean stationary proccss.

and (w,1 and \),,1 ;\1'1' 1111\111ally indcpendcllt. Thc common interpretalion
h)r (2.:1.1) as a nlOdc! of stock prices is that II', is the "fundamental" COIll-
ponent that r('lIe('\s the efficient markets pricc. anc! _v, is a ZCfO-l11ean ~ta­
tiouary COI11POllCIH Ihal rdkrls a short-Ierm or transitory (\eviatioll from
the e('fi('ienl-lnark('ls price II'" il11pl)'ing the prescnce or "fads" or othef mar-
ket inefficiencies. Sin('c )', is slationary. it is mcan-rcvcrting by delinilioll
and revcrts to its 111ean of zcro in the 10llg rUII. Although there are sevcral
difficulties with such an illtnprctatioll of (2.5.1 )-lIot the least of which
is the 1;I('t that market efficiellcy is talltological without additional rt'IlII(ill1i(
strlll:tllrt·-ncvcrthdess. sllch an altcrnative provides a good bhorat()ry for
studying the variance ratio's perilll'mance.
While VR(q) can behavc in l11any ways under (25.1) for small If (<1<:-
pending on the cOlTdatiol1 structure of)',). as q geL~ larger the hehavio, of
VR( ,,) becol11es less arhitrary, ) II partirular. observe that

1', Ji,-Ji, = II+f,+.v,-,~'-1 (~,c),~)

1

,/-1 q-I
1',( II)
L'
,...=:/I
t -, If)L + L f,-k +
k=()
,y, - .V'-'I (::!,:,,:I)

Val'l 1',(1/) I 'P~ 1- ::!)'I(O) - '2y\(q), (:!,:l'I )

wh('1'C y,(q)= COVi.v, . .v1l ,/1 is IIH' aulol'ovariance runctioll of .y,. Thncrol('.
ill this case the poplllatiol1 valll(, of the variance ratio he('()n](',~

l/a 1 + 2y\.(O) - '2y\(q)

VR(If)
If (a~ + '2y,(O) - '2y\( I»)
 .,
0-
as q -+ 00 (2.5.6)
a~ + 2y\(O) - 2y\(I)

2y\(O) - ~y,(I)
1--------
o~ + 2y,(O) - 2y,(I)

Var[ l'.y]
I - ----'-----
Var[l'.y] + Var[l'.w]
Var[l'.y]
VR(q) -+ 1- . (2.5.7)
Var[l'./J]

whl'l'e (2.:l.6) requires the additional assumption that y,(q)-+O as q-+oo,

,11\ asymptotic independence condition that is a plausible assumption for
most economic time series. II; This shows that for a sufficiently long hori-
zon q. the permanent/transitory components model must yield a variance
ratio less than one. Moreover, the magnitude of the difference between the
long-horizon variance ratio and one is the ratio of the variance of l'.YI to
the variance of l'.PIo a kind of "signal/ (signal+noise)" ratio, where the "sig-
nal" is the transitory component and the "noise" is the permanent markets
cOlllponent. In fact, one might consider extracting the "signal/noise" ratio
frolll VR(q) in the obvious way:

1 Varl.6.yJ
---I -+
VR(I/) Var[l'.tuJ

2.5. J Problems with Long-/lorizon Inferences

There are, however, several difficulties with long-horizon returns that stem
frolll the f;\ct that when the horizon q is large relative to the total time span
'J'= "'1. the asymptotic approx:mations that are typically lIsed to perform
infercnces break down.
For exalllple, consic\er the test statistic VR(q)-l which is asymptotically
nOrlnal with mean 0 and variance:

2('2q- 1)( q-I)

(2.5.8)
?>l1q~

IIn<\('I" the RW I nnll hypothesis. Observe lhal for all q>2, the bracketed term
in (25.R) is hounded hetween ~ and I and is monotonically increasing in
q. Therefore, for fixed n, this implies upper and lower bounds for V are
,i,; and t"respectively. Now since variances cannot be negative, the lower

HI'I his j... ilnpliecl hy ergociirit}'. {lJld ('\'('11 Iht' 1()lIg~r..tTl~e . .depencit"lIt time ~rie~ di~{lI~\('d!in
St·rtinn '2.t; sati . . ty this nmditioll.
58 2. The Predictability oj A.w'l J{d/lrm

hound for VR(q)-1 is -I. Buttilcn the smallest algebraic vallie thaI the test
statistic (VR(q)-l)/.fV can tak(' on is:

. VR(I/) - I -I r.;- _ ~)'I'I

Mill "'V = == -,,'211 = '11"'11 11,
"V Min.fV

suprlOSC that If is set at two-thirds oj" the salllple sill' 'f' so that TI '1= This ~.
implies that the lIormalized lest statistic VR(q)/,fV can never he less thall
-1.73; hence the test will nnWT n~ectthc lIull hypothesis at the 9:>% level or
significance, regardless or the data! or course, the test statistic can still rt~jen
the lIull hypothesis by drawing from the right tail, but against alternative
hypdtheses that imply variance ratios less than one for large II-such as the
pernbanent/transitory compOnenL'i model (2.5.1 )-the variance ratio test
will II ave very lillIe power whclI If / T is not close to zero.
~ \\lore explkil illustration oj' the prohlems that arise when III T is largc
may ~)e obtai lied by perrorllling an alternal(~ asymptotic analysis, olle in
which q grows with 'j'so that q( T)I Tapproachessome limitS strictly between
zero ~nd one. In this case, Hilder RWI Richardson and Stock (1989) show
that ~he un normalized variance ratio VR(q) converges in distributioll to the
following:
I
\
! -.
" 111
-
o J
'J
X;(r) tir (25.10)

Xs(r) !J(r) - H(r-o) - SU(!). (2.:>.11 )

where no is standard Brownian motion ddillcd on the unit interval (see

Section 9.1 in Chapter 9). Unlike the standard ufixed-q" asymptotics, ill this
case VR(q) does not converge in probability to one. Instead, it converges in
distribution to a random variable that is a runctional or Brownian llIotioll.
The ex'pecled value of this limiting distribution ill (2.5.10) is

In our ('arlier example where Ifl T = ~,the alternative asymptotic approxi-

Illation (2.5.10) implies that EIVR(q) I ~'onvtTges to ~. considerably less than
Ollt' despite the ract that RW I holds. .
These biases arc not unexpected in light of the daunting demands we
are pbcing on long-horizon returns-withont more specific economic strllc-
\\Ire, it is extremely difficult to infer llIuch abollt phenomena that SP;lI\S a
signiflrallt portioll of the entire dataset. This problem is closely related to
olle ill spectr;ll analysis: estilll~lling thl' ~pcnral density function n('ar frc-
qUl'llCY 1 ('-ro. Fr('qu(,IH'il'~ Ileal' len) COlTcspmHI !O ('xtrnl1cly IOllg pnio(h..
2,0, 'If.!t,\ N,r /,ollg-U(Wgl' DI'/JI'lu/l'Il(f 59

.11)(\ it i~ llotoriou~ly difticult to draw illkrCflce~ ahout periodicities that ex-

cCl'd :), ": ',111 uCthe data. 17 We ~ha!l M'e explicit l'vil\eflce orsudl difficultics
ill lhl' l'11'i,11 ir.tI resulL~ orSectioll ~,H, llowcvcr. ill ~OJll{' ca~es lon~-horizon
1t'llll'IlS call yield importallt in~ighls. <,specially Wlll'll other ecollomic vari-
'lhks slid I as the dividend-price ratio COIlIC illto play-sc(' Scctioll 7.2.1 III
CllaptlT 7 for further discussiofl,

2.6 Tests For Long-Range Dependence

There is olle departurc f.-om thc r.Illt!OI11 walk hypothesis that is ullL~ide the
slalistical framework we have developed so I;tr, and that is the phenomenon
of long-rangf de/Jelllimce. LO\lg-rall~{'-dcpelHlcllt limc series exhibit an un-
u~Llally high (lcgree ofpersistellce-ill a seme to be made precise beluw-su
that observatiom in thc rcmute past arc llulltrivially correlated with uhser-
vatioIlS in the distant future, even as the time span between the two ob-
servatiuns increases. Nature's predilection towards lon~-range dependcnce
hJS becn well-documented in the natural sciences such as hydrology, mete-
orolu6,)" and geophysics, and some have argued that cconomic time series
are also long-range dependent. In the frequency domain, such time se-
rics cxhibit power at thc lowest frequencies, and this was thought to he so
cOIlllllonplace a phenumenon that (;rallger (J ~(ili) dubbed it the "typical
spectral shape of an economic variable." MandcIbrot and Wallis (1968) used
the more colorful term "Joseph Effect," a rdl'\'cnce to the passagc in the
Book of' Genesis (Chapter 41) ill which Juseph rOl'elold the sevcn years 0('
plenty followed by the seven ycars of lamine that Egypt was to experience. 1H

2.6.1 examples oj Long-Range De/Wilder/a

A typical example of long-range dependence is given by the fractionally dif-
ferenced time series models ofGran~er (19t:lO), Granger andJoyeux (1980),
and Hosking (!9t:ll), in which PI satislies the following dificrence equation:

<I ~ IID(O, a/), (2.6.1)

I"here I, is the lag operator, i.e., I./'t = /It-l. Cl-angcr and Joycux (1980)
and I1usking (19H I) show that when the quantity ([ - L)d is extended to
nOllil\tt'~cr powers of Ii in the mathematically natural way, the result is a

17 ~t't· tilt' di~r\l~~iull ;,uHl allJlysis ill Se( 11011 L.h lUI further clr.[.lib.
ll'iThi:"l biblir.ll aualoK)' is Hot (Omplt'ldy 'I i\'O!OIl."I, _.,inn' IOl1g-l~lllge depend.ence h.lS been
doculIlenled in variolls hydrological Silldi"., nol th .. It'd" of whirh was lIurst's (1951) seminal
~(Udy OIl lIlt:a~lII ill~ the IOJlg-lcnn sloraKt' cap.H:ity of n.,~t~l"'\'o~rs. hull-eel. much of )furst's
rt:'~earch Wi.l." motivated by his erupiricdl ohs.t'rvations oj the Nile. Ihe \'{'ry saIBt' river Ihat
played:\o prolllill('lIt a rolt' in.Jo~t·ph\ J)J'opiln it,\.
 ·'0' J"

well-defined lillie seri('s that is said to he frartionally dif/fTl'1lm/ of order Ii

(or, r()llival('Jllly, fi'flrliolllll~y illlrgrlltn/ or
ordcr -Ii), Briefly, this involvcs
expanding th(' ('xpn'ssion (I-I,)" via the hinomial thcorelll fi)r nOllilltq~er
powers:

(I - /.)"

d(d-l)(d-2)---(d-k+ I)
(2.1;_2)
Ii!

and Ihell applying Ihe expansioll 10 III:

00

LAk/ll-k == flo (2,(i,3)

k~tJ

wh('J'(' t\le autoregressive C()('flicicnts Ak arc often re-expressed in t('l"IlIS or

the gamma funt'lion:

Ak = (-I) k(d)It \'(11 - d)

/11 may also he viewed as an infinite-order MA process since

nli + d}
/J
k
= J'(d} ['(Ii + I)
It is not ohviou's that such a definitioll orfractional dirrcrcllcing might ):cld
a tlscrul stochastic process, bllt Granger (1980), Granger andJoyeux (I !IHO),
and I-Iosking ( 19H I) show that the characteristics or fractionally clirrerenccd
time series arc interesting indeed_ For example, they show thaI/II is statioll-
ary and invertihle fill' dE (- ~, ~) (scc Ilosking (19H I) and exhihits a unique
kind of c1qwnd('Il('(' that is positive or negative depending on whether d is
positive or ncgat iv(', i,c" t he autocorrelation coefficients of /Jr arc oft\tc sallle
sign as d, So slowly c\o the alltocoJ'lclatiollS decay that when dis posili\'e
thdr slim <iiv('rges to inlinit)', anc\ collapses to zero when dis negative, I"
To el('v('lop a Sl'nsl' li)r long-r,lllg(' depen<ienn" (Olllpart' the allt()(or-
relations of a f,'action,lily diITl'I'('lIcec\ II, with those of a stationary AR( I) ill
'J;,h\c 2,:t Although hoth the AR( I) and the rractionally diITen:llcec! (d= \)

P'MandcliH o( awl Cllhl'l~ havt' (allt'd tht' d<O Cil."'l' anli/JrniMfna, 1 ('serving du' 1(',111 {otlK-
m"J.:' "",,,,,,d"IIO' fOI III" If.,.O (";1"', IlowC'\"c'I, ."inl"(' hoth ca.'''''s iuvolvt' ;111101 orrt'latioTl' 1Ii,It
tl,·t:ay In\u·h mon' :\lu\\'I\' th.u} tho"",' of IlUB,' t·o1\"l'll1i'Hl~,l \imt' st'lit,S, ,,'t' raU hoth long-rallge
d,'I'("""'"1,
 \11

Table 2.3. A utororrriatioll Jlmrtioll Jor Jrartionally diJJtrrnud pmass.

l.at: pp(k) PI,(k) Pp(lt)

k [d==~ ] [<1== - ;] [ARO)'.p == .5]

0.500 -(l.::~:)() 0.500

~ 0.4()0 -0.071 0.250
3 0.350 -(l.03e) 0.125
1 O.3IH -tum 0.0[,3
:) O.29!i -0.015 0.031
10 0.235 -0.00:; 0.001
2:) 0.173 -0.001 2.98 x 10-"
:)0 0.137 -3.21 x 10- 4 R.RR X 10- 1•
100 0.109 -1.0~ x 10- 4 7.89 x 10;-31

Comparison ofautocorrelatioll functions of fractionally differenced time series (1- L)d p, = (,

fo, d ~. -~, with that of an AR(l) p,
= "'1>,-1= + f" '" = .5. The variance of (, wa. chosen
to yield" unit V'anance for p, in all Ihree ca..... ,. '

series have first-{)rder autocorrelations of 0.500, at lag 25 the AR( 1) lcor-

relation is 0.000 whereas the fractionally differenced series has correl~tion
0.173, declining only to 0.109 at lag 100. In fact, the defining characteristic
of long-range dependent processes has been taken by many to be this slow
decay of the autocovariance function.
More generally, long-range dependent processes (1',1 may be definc:d to
be those processes with a~l\ocovariance functions Yp(k) such that .

kV JI (k) for v E (-1.0) or,

(k) ~ as k -4 00, (2:6.6)
Yp • { _kv Ji (k) for v E (-2, -I)

where 11 (k) -is any slowly varying function at infinity.20 Alternatively, I~ng­
range dependence has also been defined as processes with spectral density
functions seA) such that

IX E (-1,1), (2.6.7)

where h(k) is a slowly varying function. For example, the autocovariance

~"t\ function fix) is sait! Il> be slowly varyin); 'II 00 if lim._ oo f(lx)l/(x) = 1 for a\\ I E
I fl. (0). The (unction lo~ x is an rxample ofa slowly varying function at infinity.
 2. The Predictability 11 AI.lrl {(tlllm.1

I
function and spectr,t1 density near frequency zero of the fractionally diller-
enced process (2.6.1) is

Yp(k)
r(d) r(l-d) r(1I + I - ell

(Vi.H)

\I

\ A -+ n.
\
I~here dE (-~, ~). Dqll'llding on whether Ii is nq:;ative or positive, th('
spectral demity of (2.ti.l) at frequt'Jlcy lero will either he I.ero or infinite.

2.6.2 The JIllnl-AlllIHlrlbmllll'.I((Ilrd /{lIllge Slali.llil'

The importance of long-range ,kpl'ndl'llct' ill asset llIart.:ets was tirsl sllld-
ied hy Mandelbrot (1971), who proposl'd \I~ing tltl' range over standard
deviation, or R/S, statistic, also called tlte rr.\CIlled range, to deten long-rangt'
dependence in economic time sl'ries. The R/S statistic was originally dl'\'d-
oped by the English hydrologist Harold Edwin lIurst (l 951) ill his studies
of river discharges. The R/S statistic is the range of partial SlIllIS of de-
viations of a time series rrolll iL~ mean, rescaled by its standard deviation.
Specifically, consider a sample of continuously compounded asset rl'turns
{Tl, T2 • •••• Tn} and let Til denote the sample Jnt'an ~ L, ']. Then tlte classical

rescaled-range statistic, which w(~ shall call ~" is given by

(2.(j.lll)

whc~c s" is the usual (maximullJ likelihood) stanclard deviatioll estilllator,

S" ~
[
I "
-;; '-;-(1) - _r,,) ~]l(t (~.().ll )

The first term in brackets ill (~.(j.1 0) is the maximulIl (over k) of Ihe panial
sums of the first k deviations or ri from the salllple mean. Since the slim
of all n deViations of T, 's frolll their Illean is zero, this maximulIl is always
nonnegative. The second lerlll in (2.li.IO) is the minillllllll (over k) or this
same sequence of partial SIIIllS, ami hence it is always nOllposilive. Tht'
differellce of the two quantities, calkd the rallgr for obviollS reasollS, is
always nonnegative and helHT <1,:::(J.~1

11The- hehavior or Q,. m~\y hl' 1>l'I1("1" tIlUit"f!<o.t(Jod hy (llHsi<ic:ring its urixin~ in hychnl(l~'(.d
~t\\dil'S of It''t'n'oir <It.·siX1\. To .\fr()lIIl11l1d~\t(.· ~,:~\:-,oH~\hti("s ill rln·rtlow.;.\ n·!\t·l\·oll·~ ( ap.t( U\'

)
I
 03

III sncral sCJllillal papers Mandcl lm)(, Taqqll, alld Wallis demons
trate
lite sllJ>criorily of R/S analysis to lIIore nJllvclll iollal JIlelhod s
of detenni ll-
illg IOllg-rallge depend ence, such as allalyzil lg alllOcor relatioll
s, variance
Lllios, and spectral decomp ositiolls . For exampl e, Malldcl hrot
and Wal-
lis (I ~)(j~)I» show by Monte Carlo simlliali oll llial Ihe R/S statistic
call de-
len IOllg-range depelld ence ill highly Iloll-Gaussiall lillie series
with large
s!--ewlless alld/or kllrtosis . III f~ICl, Malldd brot (I!)7:!, 1!175)
reports the
allllOSI-SlIre converg ellce of the R/S statistic fi)!· stochasl ic process
es with
infinite variance s, a distinct advanta ge over <tutocol Telation s and
variallc e
ratios which Ileed not be well-def ined for infinile variance processe
s. Fur-
th,·r aspects of the R/S statistic 's robustn ess arc develop ed in
Mandel hrot
alld T.lqqll (I !17!)). Mandel brot (197:!) also argues thai, ulllike spectral
anal-
ysis which de(ccts periodic cycles, R/S all~tlysis CIlI detect IWlljJeriu
liir cycles,
("y·clt-s with periods equal to or greater thall Ihc sample period.
Altitoug h these claims may all be ("(>Iltested to sOllie degree, it
is a well-
,·slablis hcd fact tliatlon g-range depelld ence ell I indel"d he detecte
d by the
"cLlssical" R/S statistic. Howeve r, perhaps the lIIost illlporta nt shortco
llling
01· tile rescaled range is its sensitivi ty to short-ra
llge depend ence, implyin g
tlLlt allY illcoIllp atibility betweel l the data and the predicte d
behavio r of
tIle R/S statistic under the null hypothe sis need not COIIIC from
long-ra nge
depeIld cIIce, but Illay merely he a symptol ll or short-te rIIl Illeillory
.
III particul ar 1.0 (199 I) shows that under RWI the asympto tic
distri-
bution of (I/.[ii) Q,. is given by the randoIll variable V, the
range of a
firownia ll bridge, but under a stationa ry AR( I) specific ation
with autore-
gressive coeffici ent ¢ the Ilormali Led R/S statistic converg es
to ~ V where
~ == .j( I +¢) /( I-¢). For weekly retums of some portfoli
os of com IlIon stork,
i> is as large as 50%, implyin g that the !Ilcan of C6./.[ii may be biased uI}-

III11S1 he eli",en 10 allow ti)r tlllcillalio ll.' ill Iii .. supply of IVal
.. r abm·.. IIie dalll while .Iill
Ill~lillt;ljllillg a relatively cunstant flow ofwatc.'r
below the dalll. Siufr dam rOJlsrfuctiun costs
al to illllllt.'ll~e. IIH~ ililportdn ce of e~[ill1aliIIK Ihe reservoir rapacity
Ilt"cessary to meet long-term
slOra,;" Ilted., is apparellt. The nUlKe is all eslilllale of ,his quanlity.
If JS i. the riverflow
(per ,,"it lillle) a/Jove Ihe dam and X n i. Ihe d,,,ired rivedlow
below Ihe dalll, Ihe brackeled
'I' .... ltily ill (\!.6.1 0) is Ihe capacilY oflhe reservoir n("~ded 10 tm
....e lhis .Illoolh How Kiven Ihe
p.lllnll of Ilows ill p .... iuds I IhrouKh n. For exalllple, Sllpp"S"
'"lllllal river How. are ""'"ll1ed
to I,,· 100, ;,0, 100. alld :,0 ill years I IhrollKh 4. If a cu,,-,WlIl
allllllal flow of 75 below the dam
i~ d(,~1I"l'd c.'arli yc:ar, a reservoir must have a minimuJI
l total CiJMrity of~:, since it must store 25
111111., ill y.. ars 1 alld:{ 10 provide for Ihe rt"/alivt'ly chy y.. ars:l ,,,"1~.
Now slIl'l'ose inslead Ihal
Ill .. "'llllrall" 'll'·fIl of riverflow is 100,100, :,0, :,0 ill Y",I" I tilr<l"t:"
4 .. ", ,·""m! a flow of 7:,
belu\\' the dam ill thi." Cif.!<.C, the minimulII r.tJMfity 1Il1I . . ' illrr('a~("
10 ;)0!10 as to aCCOIIlIJlu<.ialt'
tlit" l'XU':-':-' ~[()r ..t~(· Jlt"t'(kd ill years I and ~ to Mlpply
\Y~Her during tile "dry spell" ill yean j
,lilt! 4. St'CIl in thi., rOlltt'xt. it is clcar (hat;,tll illtTCJSt' ill pc.&rsi:-.tc.&n
ct· will increase the required
stor,lgc.' capacily a.'i lllt'dSured by the fiHIKc. irult"t·d.
it W~tS Iht' "ppau'ut pcrsi.'Hcnce of "dry
!'olwll.," ill E1-.'Ypt Ihott sparkt"d J IlIrst's lifelong Lis<"ill.llioll
wilh Iht' Nilt', Ic',ulillg t"v("IHllall y to
III . . 11I['·lt· .... 1 III dl(' It'.'i(';ilt'd ra I1gt' ,
 .," • "1'''111"""., " / ,1'111.\111111/.

ward II)' 7:\'X,! Silln' tilt' IIlt'all 01 V is Jrr72~ 1.2:), the "wall or !Ill' classical
n's('ah'd rangl' would Ill' '2. Hi ror slll'h an AR( I) process.
1.0 (I!I!II) dl'\'l'Iops a Illodilicatioll or the R/S statistic to ;1I'1'otllll lilt'
the clfl'l'ls or short-rallgl' dqll'lHletllT, ckrivl's an asymplolic s;lI11pling lhl'-
or\' under sl'\'I'l'al nllil anei altl'rtJatin' hypotheses, and demonslr;ttl's yi;t
!\lonte Carlo silllllbtions alld I'lllpirical examples drawn rlOm rl'Cl'lIt hi""r-
ical stock llIarkl't data that the Inoeiilil'd R/S statistic is I'onsidcrahh' nlOl'('
accurate, often I'idding infi'rl'lIct's that contradicllhose of its classical cotln-
tl'rparl. In particllbr, II'hal Ihc I'arli(,r lilcrature had asslIllIed was 1'\'id('IIIT
of 10llg-rangl' dq)(,lIeil'lICI' ill ltS stock retllrns Illay well he Ihl' 1'1"1111 of
quickly decal'illg sholl-r;lIIge dq)('ndl'nce inste;lIl.

2.7 Unit Root Test..

t\ IIIOl'e I'C(,('lIt alld nHm' spcciali/l'd class or lesls thaI art' orten conruscd
wilh lests or lhl' random walk hypotheses is Ihe colleclion or Iwit rolll lests
in which Ihl' lIuli hl'pollit'sis is

.\', ~, /1 1.\', I + f" ('27.1 )

often with til<' followillg ,tlt('JII,tti\'(' h"l'0thesis:

X, -/il = <p(X, I -. /1(/-·1)) -t f" <p E (-1.1),

where f, is all)' Il'n)-IlH'an st;\lioll;t1T process, stich Ihat

() < "
(J,~ = lim E
I ., '-
[~(tf')~]
I
,=1
< (Xl,

I klll'istil'alil', condition (:2.7.:\) r(,quirl's thaI variance of the partial stlln

2:.:=1 f, inneasl' at approxim;ttl'ly thl' sanlt' rate as T, so Ihal each ne\\' f,
added to thl' palli;Ii sum has a nontrivial contrihulion 10 the partial SIIIlI's
\'ariancl'.~~ This condition enSllrl'S th;\I Ihe usual limit Iheorl'ms are appli-
cahle to the f,'S, alld it is satisfied hy virtllally all of the stational')' pron"sl's
th;\I wc sh;tli han' " .... asion to sttldl' (l'xCCpl for those in Set'lion '2'(i).

'!'!1f lilt, \\'e'I!' In glll\..· ,10\\,('" Ih;1I1

p;lIli,tI ,11111 \ \".11 i.111I t' r.
';'0 that tilt, lilllil ill ('l. 7.:\ I \\('1('
0, IIH' IIIH,{,lt;lilll\' ill the' ,«,cJlU'lIe (. 01 ( I \ \\'lIl1ld he "clIICt'l1il1g 011'" o\'(,r lilll(, ;11,,1 \\'ollid 1101
IH'.I \1'1'\' lI,dllllllCUld 01 1.111(1(1111 I" ic (' d~II.lIlIi('..;,. All ('xall1plt' 01 !'i1tch ;\ pr()('('~' j, all f\1,\( I)
Wilh,llIlIitloell.i.t' .. (/;;-· ,], ··'1, I.WIH·IC'II,i,whil(·noisc.
II tile' p.III1.&I '11111\ \·.III.llle c' \\'('11' 10 glO\\, 1.1'"'' th.1II or,
~o that till' lilllil ill (~.7.:q \\'('1(' "X.."
,hi ... \\'0'11,\ hi' .111 ,·"U\lph· 01 IIIII.I.! HIli,!!" d"',,·IlIt,·Hft'. ill whirh tlu: ~\\lh)( 01 .. \'I,uio" hUH ti(lll (II
IIII' , / \ clcCI\· ... \C., \ ,Ie 1\\ h .. \11 (·".Hllpll' I I' '"1'11 ,I plon's!'i i~ a fr.u·lioll.II" dill"I(,lIn'd I" ell c'"
II - I,", / 'I,. \\ IH'II' 'I, I .... \\ Iliit' lie li . . e·. \cc' SCTIIIJlI ~.ci ;1IIc1I.o (I~,q I) 101 1IIIIh('1 eli" 11"11111
 The unit root test is designed to reveal whether X, is diff"mc~stationary
(the null hypothesis) or trend-stationary (the alternative hypothesis); this
distinction reSL~ on whether rp is unity, hence the term unit root hypothesis.
The test iL~elf is formed by comparing the ordinary least squares estima-
tor ¢ to unity via its (nonstandard) sampling distribution under the null
hypothesis (2.7.1), which was first derived hy Dickey and Fuller (1979).2'
Under the null hypothesis, any shock to X, is said to be permanmt since
E[ XI+k I XI) = /-lk + XI for all k>O, and a shock to X, will appear in the
conditional expectation of all future XII... In this case X, is often called a
slochfl.ltic trend since iL~ conditional expectation depends explicitly on the
stochastic variable X" In contrast, under the alternative (2.7.2). a shock to
XI is said to he tem!lOrary, since E[X'+k I X,J = /l(t+k) + rpl(X,-/lt), and
the influence of X, on the conditional expectation offuture X,+k diminishes
as k increases.
Because the (,'S are allowed to be an arbitrary zero-mean stationary
process under both the unit root null (2.7.1) and alternative hypothesis
(2.7.2), the focus of the unit root test is not Oil the predictability of X" as
it is under the random walk hypotheses. Even under the null hypothesis
(2.7.1), the incremenl~ of XI may be predictable. Despite the fact that the
r,lIldOIll walk hypotheses arc contained in the unit root null hypothesis,
it is the permanent/temporary nature of shocks to X, that concerns such
tesL~. Indeed, since there are also nonrandom walk alternatives in the unit
root llull hypothesis, tests of unit roots are clearly not designed to detect
predictability, but are ;,\ fact insensitive to it by construction.

2.8 Recent Empirical Evidence

pre(~ictability in asset returns is a very broad and active research topic, and jt
is illlpossiple to provide a complete survey of this vast literature;n just a fe~
pages. Therefore, in this section we focus exclusively on the recent empiric,\1
literature. 24 We hope to give readers a sense for the empirical relevance ~f
predictability in recen t equity markets by applying the tests developed in the
earlier sections to stock indexes and individual stock returns using daily and
weekly data from 1962 to 1994 and monthly data from 1926 to 1994. Despite
!
~'Since then, advance, in econometric method, have yielded many extensions and generai-
intio", to thi, 'imple framework: te,ts for multiple unit roots in multivariate ARIMA systems,
tt'st, for rointrgration, consistent estimation of mode" with unit roots cointegration, etc. (~e
Cal~lphell and Perron [19911 for a thorough survey of this literature). i
H Ilowrver, we would be remiss if we did not cite the rich rmpiricaltradition on which th(
reft'nt literature i, built, which includes: Alexander (1961. 1964), Cootner (1964), CowIe,'
(19W), Cowles and Jone' (19~7), Fama (1965), Fama and Blume (1966) Kt,ndall (1953),
C;r"n~('f and Morgenstern (1963), Mandelbrot (1963), Osborne (1959, 1962), Roberts (1959),
;llld Workill~ (191;0).
 2. '/'lIe Predictability of Auet ReinDl,\

the ~pecific.ity
of these examples, the empirical resullS illustrate many of the
issufs that have arisen in the broader search for predictability alllOIlf.: assel
retu\rtls.

, 2.8. I 111l/ocorrela/iulO
I
:
Table 2.4 reporlS the means, standard deviations, alltocorrelations, and Hox·
Pierce Q-statistics for daily, weekly, and llIonthly CRSI' ~lOck retlll'lls indexes
fl'OmJuly 3,1962 to Deccmher 31, 1~\l4.~~ During this period, panel A of
Table 2.4 reporlS that thc daily equal-weighted CRSP index has a first-ordcr
autocorrelation p(l) of 3~.O%. Recall rrolll Section 2.4.1 that under lhe I[l)
random walk nu1\ hypothesi~ RW I, the asymptotic samplinf.: distribution of
.0(1) is normal with mcan 0 and standard deviation I/JT (sce (2.4.14».
This implics that a sample siJ.e or 8,179 observations yields a standard error
of 1.11 % for p( I); hcnce an <llltocorrclatiOlI of 3~.O% is clearly statistkally
significant at al\ conventional levels of significance. Moreover, the Box-
Pierce Q-statistic with fivc aULOcorrelations has a value of 2G:~.:~ whit:h is
significant at all the conventional significance levels (recall that this statistic
is distributed asymptotically as a X;
variate ror which the 99.5-percclltik
is 16.7).
Similar calculations for the value-weighted indexes in panel A show
that both CRSP daily indexes exhibit statistical\y significant positive serial
correlation at the first lag, although the equal-weighted index has hight'r
autocorrelation which decays more slowly than the value-weighted index.
The subsample alltocorreiations demonstrate that the signiiicallce of the
autocorrelations is not an artifact of any particularly influential subset of the
data; both indexes are strongly positively autocorrclatcd in each subs<\mple.
To develop a sense of the pconomir significance of the alltocurrelations
in Table 2.4, observe that the f{2 or a regression of returns on a cOllstant
and itS first lag is the square of the slope coefficient, which is simply the
first-Qrder autocorrelation. Therefore, an autocorrelation of 3:>.0% implies
thaI 12.3% of the variation ill the daily CRSP equal-weighted index return
is predictable using the preceding day's index return.

,~
'l')UIl?t'~ stated othenYist'. we rakt' returns [0 he rOlllillllollsly compounded. POlltoliu
returns ~re raldtlated first from sirupit' returlls and tht"n are converted to a (outilllluu.;,ly
compo"nded relllm, The weekly H'I"rn of ""ch St'cmilY i, colllpllletl a5 Ilw retllrn III>Ill
Tuesday'I' closing price \0 Ihe followill~ TII""lay's dosill); price. If Ihe t()llowillg TIIl'M!;,Y's
price is Illi"ing. Ihell Wednesday's pri('e (01 MOllddy'S if Wednesday's is also Illissill~) i, \lSl,d,
If hOlh ~Ionday's and Wednesday's prices are missing. Ihe relurn for Ihal week is "'1',,,1,,,1
..., mi",iol!!; llois occurs ollly ,,,,ely. To com pUle weekly relurns Oil sile-SOrled pOrliotios. tor
each week all slOcks wilh nonmissinK relllrn, Ihal week are "-'Signed 10 ponh)lios hased Oil Ihe
lJeKillllirlK of year market value. If Ih< \>C)lilllliIlK "fY"ar lII.lr\c.c1 value is missing.lhell Ihe .<H\
01 "ear \,thlt" is used. If both markel ""lu,', ;Ut' ",i"inK llo,· ,10l1e. is 1101 ""i);ne<l \0 a pOrllotio.

I
 ,,' 2.4. A ullJrurrelatiml ill dllily, wrri<iy, IWrlllwlIlltly '/01 k illtifx "tunt.l.

S.IIUple Sample M SI)

Period Sil.e call (t,

A. [hill' RCllll'llS
CRSI' V'lllIt'-Wci~hl('d Index
ti:!:07:tn-94:12::lO H,I79 0.041 O.H24 17.6 -0.7 0.1 -O.H 21i:D 2695
li~:07:0:~-7H: 10:27 4,090 0.02H O.nH 27.H 1.2 4.ti ~.~ :~2\1.4 ~435
71-1: 1O::{O-~)1: 12:30 1,OH9 O.!)!)4 0.901 IO.H -2.2 -2.\l -:\5 695 72.1
CRSI' Eqllal-Weighted Index
1i:!:07:0:{-94: 12::\() H,179 0.070 0.761 :~;,.() ~J.:\ H5 9.9 1,301.'J 1,36'J5
ii:!:07:0:\-7H: 10:27 4,090 0.Ofi3 0.771 4:1.1 1:\.0 1,>.3 1:>.2 1,062.2 1,110.2
7t'.: 1O::\O-\J4: 12::\0 'I,OK\! 0.07H 0.75ti ~(j.~ 4.\) 2.0 4.\) :HH.'J 379.5

1\. W('(')"I), Retllrns

CRSI' Vahll~-Wt'igh\ed In(h',.
h:!:07: 10-\)·1: I '2:'27 I,W:> 0.1% VI\l3 15 -2.:) :-15 -0.7 H.H 36.7
ii:!:07:IO-7H:IO:(l:\ H4H 0.141 1.9~)4 :>.Ii -:n :>.H I.li 'J.O 215
7H:10:IO-94:1'2:'27 H47 0.248 2.IHH -2.0 -1.5 I.t; -:>.:\ !l.3 2!l.2
CRSP Eqllal-Wci~hled Iudex
ti:!:07: 10-\14: I '2:~n l,fi9.'i 0.339 ~D2I 20.3 ti.1 \l.I ·I.H !14.:{ IO!I.3
h'2:07: 10-78: 10:0:\ H·18 0.324 2.4liO '2I.H 75 11.\) ti.1 tiO.4 tiH.5
7li:J 0: I O-'J4:12:27 H47 0.351 2.171 IHA 4.:~ :).:) 2.2 33.7 !ll.3

C. Monthly RcLUms
CRSP Valllc-W"i~hl .. d ludex
ti:!:07::{1-94: 1:!::lO :-190 0.861 4.336 4.:\ -5.:1 -I.:{ -0.4 ti.H 12.5
li'2:07::{ 1-7H:m):29 19!1 O.64ti 4.21\1 ti.4 -:\.8 7.:{ li.2 3.'J 'J.7
7H: I (I::{ 1-\14: 12::\0 1% 1.076 4.4:,() U -6.3 -H.3 -7.7 7.5 14.0
CRSI' Eqllal-W .. iglllcc\ huh',.
li~:07::\I-\H: I ~::{() :1'J0 1.077 5.749 17.1 -3.-\ --:\.:\ -1.6 12.H 21.3
(i~:1)7 ::\ 1-7H:0\):2\) 195 1.049 fi.I4H 18.4 -2.:) '1.4 204 75 12.t\
7!-l: I ()::\ 1-!I4: I :!::{{) 1'J5 1.105 5.:\3li 1!i.0 -I.ti - 12.4 -7.4 H,9 14.2

l\'II>I'I>'"'\'\\i,," H)('fti. i., lib (ill p('rrelll) ;,,1<) II .. ,-Pi ......· (l-,t.lli,lir, 101 t:/{SI' dJily, weeki)',
alld IlIollllrly val 11('- alld (,<)lIJI-w('ighl('cI 1('1\ II'll indexes I()r tire ,.11111'1,' period frolllJllly :{, IYI;~
10 ))"«'II1IJ<'1' :1O. I!)!H and slIbperiods.
 i. j hI' j'mlidllhility oj AUft /{I"tll/I/.\

The weekly alld lIlollthly retllrn aUlOcorrelations reponed ill pallels B

and C of Table ~.'1, respectively, exhibit pallerns similar to those of the daily
autocorrelatiolls: positiv(, alld statistically si~nificallt at the first lag over the
clltire samplc and Ii)!' all sllhsamplcs, with smaller and sometimes lIegative
higher-orcin an[('("(lIre\ati(IIIS,

2,8.2 \'rllil/llrl' /lotios

The fact that the auto(orreiations of daily, weekly, and mOllthly index re-
tllrns in Tahle ~A an' positive and orten significantly different frolll 7,no has
illlplications for the hehavior or the variance ratios of Senioll 2.'1 alld we ex-
plore these illlplicatiolls ill this sectioll for the returns of ill de xes, portfolios,
and individllal sl'rllritit's.

CIlSP hllll'Xf.1
The alltocorreiations ill Tahle 2.4 sllggest variance ratios greatn thall Olle,
and this is confirllled ill 'nlhk 2.:' which reporL~ variallce ratios VR defilled
in (2.4.:\7) alld, in parenth('ses, hewroskedasticity-nl!1sistellt aSYlllptoticallv
standard normal test statistics 1/I'(If} defined in (2.4.44), for weekly CRSP
eljual-and va It Ie-wei gh ted market retllrn indexes. 2t\ Panel A (olltains results
lilr tl\(' ('qllal-weighted indl'x and panel n contains results !i)r Ihl' \"011111'-
wd~hted index. Withifl each pand, the first row presents the variall(e
ratios afld test statistics fi,r the elltire l,fi!I!i-week sampk and the lIext two
rows presl'nt silllilar results lin' the two suhsampks of H4H and H47 w('eks.
rand A shows that the r;llldolll walk null hypothesis RW3 is rejected at
all the usual si~nifkal1("e levels for th(' entire time period and all ,ubperi-
ods fOl' the equal-weight(,d index. Moreover, the rejections are not !III(" to
changing varianc(,s sinc(' til(' ",'('1)\ arc heteroskedasticity-collsistenf. Th('
estimates ofth(, variance r,ltio arc {((rgrr thau olle for all cases. For example,
the entries ill thl' Iirst cohunll of panel A corresponoto varianc(' ratios with
an aggrl'g;lIioll valu(' 'I of~. Invi('w of (2.4.18), ratios with '1=2 are approx-
imately ('(]lIal to I plus th(' lirst-or!ln autocorrelation coefficient estim,llor
of weekly retunts; hellc(', [he elltry ill the first row, ) .20, implies that th('
first-order autocorrelation fi,r we(,kly returns is approximately 20 'f.! , which
is consistent wilh Ih(' \'alue rqHll\ct\ in l;lh\c 2.1. With a corresponding
1/1' ('I) stat ist ic of '15:1, the randolll walk hypot hesis is resoundingly rejected.
The suhsamplc r('sults show that although RW3 is easily n:inlet! over
Imth halves of 111t' sa III pit' period, Ihe varian('c ratios arc slightly brgcr ,\Ild
the rejections sli~hllv strollger ovn th(' first haIL This pallerll is re)leated
in Tahle 2.li and in other eUlpirical studit's of predictahility in l;S siock

:!liSinc c' ill 0111 ~alllplt' 1/,' (1/)--( CllIlplllt'd under Ilu' 111111 hrpoliu'sis R\\':~-·-.II(·
till" \";1111(,~ III
;II\\'ays sl~tli~li("lIy Ic~~ ,igllific.lIIl ,h;tll rhe' \".tllle' ... of 1/1(//) (';dclllau'<I lIlIde', InVl, (1I101l'('I\('
\pan' W(' I('POII olily rhc' mOl(' ((lIi.\(" \';ui\"c :"ot;lIi"lic~,
2.8. R.ecenl r:mpirical Evidence 69

Table 2.5. Vminnu rat ins Jor wakl) stock intkx Yl'turm.

Number Number q of base observations aggregated

Sample period nq of base -,_._._- 10 form variance ratio II
obserJations 2 4 8 16

A. CRSP Equal-Weighted Index

62:07: I 0-91: 12:27 1.695 1.20 1.42 1.65 i
I. 74
(4.53)* (5.30)· (5.84)· (4.85)*
<i2:07: I ()... 78: I 0:03 848 I.n 1.47 1.74 • 1.90 I
(:'.17)* (4,44)· (4.87)· (4.24)+
78: I 0: I 0-94: 12:27 847 1.19 1.35 1.48 154 "
(2.%)* (2.96)" (3.00)· '(255)~

n. CRSI' Value-Weighted Index

62:07: I 0-94:12:27 1,69:) 1.02 1.02 1.04 1.02
(O.!'>I) (0.30) (0.41 ) (0.14) 'i
62:07: 1()... 78: I 0:03 848 1.06 1.08 1.14 1.19 :
(1.11 ) (0.89) (1.05) (0.95),
78: I 0: I ()"'94: 12:27 847 0.98 0.97 0.93 0.88
(-0.45) (..(J.40) (..(J.50) (-0.64)

VJri:lIlrl··ratio test of the random walk hypothesis for CR5P equal- and value-weighted indexe••
for the sample period from July 10. 19fi~ to December 27.1994 and subperiod •. The variance
ratios VR(q) are reported in the main rows, v..ith heteroskeuasriciry<onsislent le~t statistics
""(q) give" in parentheses immediately below each mJin row. Under the random walk null
hypothesis. the ¥dlue of the variance ratio is one and the test statistics have a stAndard normal
distribution asymptotically. Test stAtistics marked with a.qerisJ<.. indicate that the corresponding
variann: r-atios are Matistically dine-rent from one at the :,% It"vei of .5iRoificance.

returns: the degree of predictability seems to be declining through time.

To the extent that such predictability has been a source of "excess" profits,
iLS decline is consistent with the fact that financial markets have become
increasingly competitive over the sample period.
The variance ratios for the equal-weighted index generally increase with
q: the variance ratio climbs from 1.20 (for q=2) to 1.74 (for q 16), and =
the subsample results show a similar pattern. To interpret this pallern,
observe that an analog of (2.4.18) can be derived for ratios of variance
ratios:
VR(2q)
- - =
VR(q)
1+ fJq(l) (2.8.1 )

where (lq( 1) is the first-order autocorrelation coefficient for q-period retums

rt + rt-i + ... +rt - q+ t. Therefore, the fart that the variance ratios in panel A
ofTahle 2.5 are increasing implies positive serial correlation in multiperiod
 70
2. 'f'/u' I'II'ILir/abilily of 11.\\('1/(1'111111.1

retu rns. For cxam plc, VR( 4)/VR(!1

)== 1.42 / 1.20== I.IH , whic h illlp lies
wcck rctu rns havc a lirst -ord er aUlO thai 2-
corr elati oll coeH icien t of approxiJ
IH%. II;III'I,
Pane l B of Tab le 2.5 show s tllat
the valu e-we ight ed inde x beha v(',
c1iITerclllly. Ove r the ellli re sanl
plc peri od, the vari allce ratio s arc
thal l onc, but not by muc h. rang ,III gl ('.11" 1
ing from 1.02 for q=2 to 1.04
Mor eove r, the test stati stics "" (,,) for q=H.
arc all stati stica lly insig llilic allt,
cann ot he reje cted for any ". The hen ce RW:-I
subs amp le resulL~ show that duri
half ofth c sam ple peri od, the vari ng Ihe firSI
allce ratio s for the valu e-we ight ed
incr ease with q (imp lyin g posi tive illde x do
seria l corr elat ion for lIlul tipe riod
but duri ng thc scco nd half of retllJ 'Jls),
the sam ple, the vari ance ratio s
q (imp lyin g nega tive scria l corr elat ion decl ine with
for Illlli tipcr iod retu rns) . The se
opp osin g patt erns are resp onsi two
ble for Ihe relat ively stab le beha
vari ance ratio s over the ellli re sanl vior of Ihe
ple peri od.
Alth ough the test stati stio ill
Tab le 2.:) arc base d Oil nom illal
retu rns, it is appa rent Ihat vil'lu stoc k
ally Ihe saJlle rcsult.~ wou ld obla
or exce ss retu rns. Sillc e the \'olat ill wilh real
ililY of weekly Ilom inal retu rns
larg er than that of the infla lioll is so Illuc h
alld Trea sury -bill rates , the use
real, or exce ss retu rns in vola tility of nOll linal ,
-bas ed tesls will yield prac tical ly
infc rcnc cs. idcn tical

Size-Sorled Pori/olio.!
Thc fact that RW3 is rcjc ctcd by
Ihe eCJual-weighled inde x but IlOI
valu e-we ight cd illde x SllggesL~ Ihat by Ihe
mar ket capi taliz atio n or size lIlay
role in the bcha vior of the val'i play a
ance ratio s. To obta in a bell er
intu itiol l, Tahl e 2.6 presenL~ vari sellSc or Ihis
ance I'alios fol' Ihe relul 'lls of
porl foVo s. We com pute wcekly sil.e-SO/'l('(l
retu rns for live size-SOrice! pOrl
Ihe Cl~)P NYSE-AMEX daily relU f()lio s from
/'llS file. Stoc ks wilh reili ms f()J'
wcek ;ll'e assig lled to port folio s any give n
base d on whic h <[llilftile thei r
of~year"/Ilarket capi taliz atiol begi nllil fg-
l belo lfgs to. The pOr lfoli m are
and ha.\.e a chan ging com posi tion equa l-we ight ed
Y Pane l A ofT ahle 2.6 repo rts
for the, port folio of Sill all firm s the resu lts
(Iil'sl quin tilc) , pane l B repo rts
for the;p ortfo lio of med ium -size the rcw lts
finm (thir d Cfuinlile), alfd pane
the resu lts for the port folio ofla l C r('po lls
rgc linn s (fift h quin lile) .
EI'(dcllC(' agai nst the rand olll walk
hypo thes is for Ihe port folio of
pani cs ~n the slllall('st <]Uilllile is COIU-
siro llg f()!' the ('nli re sam ple and
sllhs,UI~l'lcs: ill pane l A alltl for b011t
te '1,'('1) Slalistics arc well abov e
I'allll' or 1.!J6, rang ing frolll ·1.li7 the :)% niti ral
10 10.7·1. The l'<lri;IlICC ratio \ are
all grea ter

.... ;\\'c t,ll .. o f't'rlo l"llit'd our

1t'~I~ U\llIg \.dlll" ·weig hted pOlll l}lio\ ,tlHI
Ihe "".1I11t.' I(,!'ouil.'i. The only ohl.li llcd ('~"(·IIII.lih
dillt' n'll( (' ,IPPC;U"!\' III lilt,
portlolio~ lor which tht' r.uuio LlIgr. 'i( qllill liie (If the \';liu(
lH w.tlk laypotile!loi!\ W;I~ gt'IH'
',wciglllt'cI
I.tll)' not l"C.'jc.'ftnl. This.
is not !FIll. pi i!\oil\~. Kivt'll that 01 fOIl!. \t',
I.,,').~(· .. t \.lhH· ·\\Tig hlt·d «jllili
the.'
hTlgh lt·d!lI I.lI kt'l illde·x . lilt' I~ quilt' ~illlil;lr 10 tilC' \'.1 II It'·
'.
I
 71

Table 2.6. Vllrillltf"P mlio.\ jor lII("'dy .liU-.lollnl flllrijo/io Idllm.l.

NliJIlh"r NlIIlIl)('r I{ of has" ohser\';lIions aggrq;att'd

to rOJ III \,~triallc(, ralio
of has"
1111
ohservations H I(i

A. P()rtfolio of linns with markct vallics ill sJIlalkst CRSI' quintile

(i:!:07: 10-~H: I 2:27 l,ti9:1 I.:{:I 1.77 2.24 2Ati
(7.1:1)' (9.42)* ( 10.74)* (9.:-1:\)*
(;:!:07: I 0-7H: 10:0:-1 H4H 1.:14 1.7(; 2.'!.'!. 2.4fi
(:1.47)* (7.:t1)* (H.O::I)* (G.Y7)*
7S: 10: I 0-94: I 2:27 H47 U7 I. 7~J 2.22 2.49
(4.67)* (f).\J 1)* «(Ul!I) * (6.60)*

B. Ponf(,lio of firms with market vallics ill central CRSI' qllintilc

(i~:07: I 0-~J4: I 2:27 1,695 1.20 I.:{!J 1.59 1.65
(4.25)* (4.H5)* (5.16)* (4.17)*
li~:07: I 0-7H: 10:0:'1 H4H 1.21 1.4:1 1.66 1.79
(:1.2:,)* (4.0:{)* (4.27)* (3.67)*
7S: I 0: I 0-\14: I 2:27 H47 1.19 1.:-1:'1 1.41 1.47
(2.7~)* ('2.71)* (2.6:-1)* (2.14)*

C. 1'()J:folio of firms with markct valllt"s in largest CRSI' qllintile

(;:!:07: I 0-\/·1: I '2:27 1#):, I.(H; 1.10 1.14 1.I1
(1.71 ) ( 1.4ti) (UH) (0.76)
li:!:07: I 0-7H: I 0:0:1 H4H 1.11 1.'21 1.:10 l.3'2
('2.0:)* ('2.1 :,) * ('2.1'2)* ( 1.59)
70: 10: 10-\/·': I '2:'27 H47 1.01 1.00 O.'/H O.\J'!.
(0.'2')* «(!.Of, ) (-0.1:1) (-{HI)

VIII.III(l'-r;Hio Il· . . ' of tlie ralldDIlI walk h}'P()lhl'~i:) for :o.i/l·-~ortl'd pOI,rolin,. tor tht" !'lam pIc:
pl"riodlroIll.l"ly 10. lV!i2 10 Decelllher '27,1\1\14. <llld '""periods. TIo," variallce ralios VR('11
~\l·l· H.'ported in tht" Blain rows, with ht"tt"ro~kl"d.l:-.licily-("Ollsislt'nt te:-.( statist irs "'.(q) Kiven ill
p.lrcllIlil'st':o.illlllU.:didtdy ht'luw cach lnalll l"tn\'. Ullder lht' f.llltioill \\r~llk Hull hYPOlh~sis. the
\";1111(' 01 Iht" \',II-j;IIlCt' ratio is one and the.' le.'M st~ltiMin, h~\\-l' ~\ ~\~\1Hl"lI"tl lloJ'lllal ciiMrihutioll
a_'Ylllpl(Jlic;dly_ T(':\1 :\t"ti~ti("s lII.uked with ;.1Mt"rbks indicate tllat tilt, (orrt'spondinH varid.nre
r;ttiu:\ ,1I"e st.lll;\tic;tlly diJkrt"llt from on~ at the :)IYcJ 1t"\'l'I oj :\igllilirall("c.

(h;lIl OIlC, illlplying a firsl-order autocorrelation of :1:J'X, lill· weekly returns

ll\'lT tl;e elltirc s;ullplc pniod.
Fur lite purtfolios of Illcdilllll-sil.l' ("OIIlJ!~lllic~, lltt" of!' (If) statistics in
p~llid 1) shows thal there is also strong t'vic\eIlCl' agaillst RW::I, although
til<" variance ratios arc slllaller 110W, illlplying lower serial correlation. For
tit,· port!i.lio or the largest flrllls, pallel C shows th;l( evidcllcc against RW:~
i, 'par,,·, lilllil .. d !lilly III the first ~lalr or th .. salllpk period.
 TIll' rl'snlls lill' sitl'-hased pOr\lillios art' gem'rally ('ollsislelll ",illl those
fi/!' Ihl' Illarkel indexes: varian('e ralios an' gcnerally grealer than onl' and
increasing in ", implying posilil'e serial corrdalion in IIIl1lriperiod r('llIms,
sial iSI il'ally sign i fici III Ii n' pori Ii II ios or
all 1>111 IhI' largl'sl ('ompa \l it'S, .\IId
1l10re sigllili('anl during Ihe lirsl Iialf of Ihe sampll' period Ihan IiiI' S(,(,OIlc!
half.

Illditlit/llul SI'I'//lili",1
Ilavillg shown that Ihe rallc\olll walk hypothesis is in('onsistellt wilh th(' be-
havior of the equal-weighted index and portlillios of Sill. tll- .l1\d IlIcdiulll-si/,t'
('ompanil's, 1\'1' 1I0W IIIJ'IIIO Iht, cast' orin<iividual sc(urily rl'lurns, Table '2,7
l'I'por\s till' l'I'oss-se('\iollal al't'l'agt' or till' variam'c ratios of individll'll siocks
Ihat have compicll' 1'1' \II I'll Iiislories ill the eRSP datahasl' 1(lr our t'llIirl'
I ,1i9:1-W(,l'k salllph'()('riod, a sample of 111 companies, Panel/\. contains Ihl'
cross-sl'ftional al'l'r;lgc or thl' variance ratios of the 411 siocks, as well ;IS of
Ihl' 100 slIIallcsl, 100 in\('rt\\('t!ia\(', and 100 largl'sl sto('ks,~H ClOss-seClional
slanllaul deviations arc gi"I'n in parl'nlheses helow Ill(' lIIain rows, SinCl' IIil'
variancl' ralios an' ('1t-:11'ly 11IIt lTOss-sc('\ion.llly int\cpl'Ilt\I'llt, these s!;\lHbnl
dl'l'iatillns ('allliol 1)(' IIsed 10 lill'llI Ihl' IIslial tests of signilic;)IIC1'-IIII'\' art'
reported ollly til provide sO\lle illdi('alioll of thc ITOS,-,,'(tiOIl'11 di'IH'1 ,ioll
of the varialll'(' ratios,
The averagl' variall(,(, ralio wilh q='!. is O,~l(i ror Ihl' 411 illC\ividllal '('('11-
rities, implyillg that there is lIegatil't' sl'l'ial COlTcblion on al'nag(', For .111
siocks, Ihe averagc ~nial cOlTdalioll is -4';;" and -:1% lill' tIll' slllalll'si 100
stocks, IloWI'I'I'l', Ihl' sl'Iial correlation is hoth stalislically and I'cOIHlIllirallv
insignificant and prlll'ides lillie ('vidcncc <I){ainst the randoll\ walk 1I:'P0tll-
('sis, For exalll!'\(', till' largcst avnagc I/I'(q) statistic oVC'r all slock~ ocelilS
ror 1]=4 and is -(I.~lO (willi a cross-s('('\ional standard deviation or I, I~l); l!il'
/;lr!!;CSI al't'I'age 1/"(11) lill' rill' 100 smallest stocks is -1.(;7 (fill' ,/='2, \\'iill a
(')'oss-senional standard dl'viation or 1,7:1), Thl'sc rcstllts are ('ollSislCIII "'illl
Frcnch and Roll's (1IJH(i) linding that daily retmlls or individ\lal st'cmili('s
are slightly negativcly alilocOlTelalt'l1.
For ('ollljMrison, panl'! B rl'ports the variance ratio or el]lIal- alld l';lItW-
weighted portlillios of Ihe 411 s('('Ilrilies, The rcslllts are cOnSiSIl'1I1 ",ith
Ihos\' in Tallies :U') allrl '2.1;: sigllili('anl posilivl' allll)('olTcialioll for 111(' 1''1l1al-
\\'I'i!!;hl('d porlf •• lio, alld alll()(,()ITciali()1I d()se 10 I,ITO {ill'lhe v.III1I'-\\'I'ighl('d
pOll" Ilio,
ThOlt IIII' 1'\'1 II I'IIs ()J' illdivid \1.11 sec lIIi t iI'S have stat isti('ally i nsign i lieOlIl I 01\1-
IO(,Of'lT\arioll is nol slIrprising, Illdividllal retllrns conlaill nllich f(lIlIpalll'-
spI'cili(' or idim)'/In/llir noise tll.llmOlkl's il diflictlllio Ilt-tl'('\ Ihl' Pl'l'SI'lllT (If
prcdicraJ.1c ('OIIlP"III'II", Sillcl' IIII' idiosyntTatic lIoise is largely alll'III1;II('1I
 Table 2.7. Variance ratios for weeki) individual security returns.

:--'-umbcr !\'umber q of base observations aggregated

Sample nq of base to form variance ratio
observations 2 4 8 16

A. Averages of variance ratios m'er individual securities

All stocks 1.695 0.96 0.92 0.89 0.85
(411 stocks) (0.04) (0.07) (0.11 ) (0. (4)
Small stocks 1,695 0.95 0.90 0.88 0.85
(100 stocks) (0.06) (0.09) (0.12) (0.15)
Medium stocks 1.695 0.96 0.93 0.90 0.B5
(100 stoc ks) (0.04) (0.07) (0.09) (0.13)
Large stocks l.fi95 0.95 0.91 0.89 0.86
(l00 stocks) (0.03) (0.06) (0.11) (015)
B. Variance ratios of equal- and '"<llue-weighted portfolios of all stocks
Equal-weighted portfolio 1,695 /.11 1.20 1.30 1.29
(411 stocks) (2.75)* (2.83)" (2.88)' (1.99)-
Value-weighted portfolio 1,695 0.99 0.97 0.96 0.93
(411 stocks) (-0.26) (-0.43) (-0.12) (-0.53)

Means of variance ratios over all individual securities with complete reCum histories during the sample period from July 10.
1962 to December 27, 1994 (411 stocks). Means of variance ratios for the smallest 100 stocks. the intermediate 100 MOCks.
and the largest 100 stocks are also reported. For purposes of comparison. panel B reporu the ,,,riance ratios for equal- and
value-weighted portfolios, respectivdy. of the ~ II stocks. Parenthetical entries for average, of indi\idual securities (panel A)
ar~ ~tandard dniauons of the cros.s section of variance ratios. &cau-'t' lhe "-:Jriance ratios are not cro~~ctionall}' indepen-
dent. the sI.1ndard deviation cannot be used to perform the usual si>:nificance tests; they are reported onl)' to pro\ide an
indication of Ihe ,,,riance ratios' cro.'>Hectional di.'persion. Parenth~ticaJ entries for portfolio \"riance ratio, (panel B) are
the heteroskedasticil)'<omistent ""(9) ~~siic,. A..ti:'n.L:..rndlc;iI~\'i'rlii\cE"ra1.ionhal are statistically'different from I at the
5% levd of significance.
 74 2. 'J'III' p,.n!i,t(/bility of AI.lft Uptllnn

by forming portfoli os, we wOlild expect to IIIICOVCl ' the predicta hle .IJltl'/lU/t
i,
compon ellt more readily wh('l1 securitie s arc cOlllbin ed. Neverth
eless. tht'
weak negative autocor rclatioll s ofthe individu al securitie s arc
an intnesti ng
contrast to the stronge r positive ".\lIt()(.:orrd;ltion of the por'th)li
o returns.

2.8.3 Cros5-A lltO(ondl ltiullJ llltt! I.mtf-I.ll g ReilltiuH.1

Despite the fact that ill(\ividu;d security relUrm arc weakly
negative ly au-
tocorrcl ated, portfoli o returns -which ',\re essclHia lly average
s of individ-
ual security returns -are strongly positivel y autocor rclated. This
sOlllewh at
paradoX ical result can lIlean only o/le thing: large positive
crOSS-<lutocor-
relation s across individu al securitie s across lime.
To see this, conside r a c()llenio n of N ~ec\lritit's and denote
by R t tht'
(N x I) veC10r of their period-t simple returns I lilt ... liNt]'.
We switch to
simple returns here becallse the focus of our analysis is on the
interact ion
of returns within portfolio s. and cOlltinu ollsly compou nded returlls
do 1I0t
aggrega te across securitie s (sec Section 1.4.1 in Chapter 1 for further
discus-
sion). For conveni ence, we maintai n the followin g assump tion
through oul
this stlion:'l 9

(AI) R t is a joinlly (Oualiana-statiolwl)' stochastic /)(oa5.1 with expl'(talit

Jll EIR t 1
::: ,.,. 1= [It I /12 .. , /1N]' rmti autocouarirwu lIlatrices E[(R _ - ,.,.)(R -
t k t
,.,.)'] ,; r(k) wherl',withnoloHojgl'llerality. welakek?:.Osinc
. er(k) ::: r'(-k) .
If Lis (Icfincd to bc a vcctor of olles [1 .. , 1]'. we can express
the e<\II;II-
weigh\c d markel index as not ""
L'Rr/ N. The lirst-Qrd er alitocovari<lllCe
of Rmt1may then be dccomp osed illto the sum of the first-Qrd er
OWJl-autoco-
varianre s and cross-au tocovari ,lllces of the compon ent securitie
s:

l
I Cov[ Hmt - I • II mt J = Cov
' rL--;::;- 'tv
L'R t _ 1L'Rt]
=:
LT(I)L
N~ (~.H.2)
I
alld th~rcforc the first-ord er ',lIllo('o rrcblioll of U"., call be express
I ed ,IS
COy ,Umt - I, U,.II LT(I) L LT(!) tr(1'(I))
L - 11'(1'(1»
\, ar! fl,.,] LT(O)
------- + - -- . ('nu)
L LT(O) L LT(O) L
where 11'(') is the trrt(l'opc ralo)' which SIIIIlS the diagoll;t1 entries
ofils s<ju;I)'('-
malrix argulJle nt. The first 11'1111 of Ihe ri~hl side of (2.H.3)
(olliain s only

(A 1) illi IlIJ(h' 101 IIl1l.lIlI)lI.11 ~illll'lH Ily. ~ill( (' jOint ("O\'~II i.1I1n·-~t~ul
:.... , t\1i\lllllpti oll
olI.1I ily .11.
lnw., \I,to t"iimill.Ht' til1le:IIH'ext:~ 110m popul.ltio IlIllOI1ll'Il l\ such ~lS}i. awl r(kL
the qll~\hl.tli\'t·
tt'·dt\lrl'~ of our rt."sU'L\ win not (hange ulHlt'r the
weakt"f a.'i~uJllplion~ of weak.ly dqH.'n<il"JlI
ht·tt·rn~t'nt."\)U~\)' dis\ribut('"c.\ \'ertor~ HI' This would
IHt'rdy reqllire replacing l·xfW(tJtion."
wilh «II r~'p()l\di!lK probabilit y !imiL\ or"lit"bly ,ktilll·,llil
llt'·",·,· .... /l,·s. Sl'~ 1.0 ;\111\ M.l<·Killby
\ \ ')'IOr) lor 1111 Ihf,. <Iflaih.
2.8. Rnm/ 1~'/11I,i1i((jl Hl'itimfr 75

Tablr 2.8. (:w\.\-Ilu/c u ont'iulioll IIlft/rir t'\ for ';1.1'-'>01 it'd /IO,.(/oli(l rf'/unu.

II" U::!I f(.\, [{II 1/,.,

111
H"
H:lI
11." (I."''
O.!l:1H
O.H!)':.!
1).lnH
1.\lOIl
0.~)7ti
O.HI)~

1l.~)7ti
1.(lOO
O.H:\~)
0.9-\4
0.\17\)
on")
H.W,li
H.\) 14
nil O.H:1\) 0.\).\·1 0.97 1 ) I.oo(l H.\lti I
II,., 0.7'2H tl.W)t; 1l.~)H o. \Hi I 1.000
/(" II~, fI. [{" Ilr"
"
11,,- \
N~I_' 0.3:10
O.':.!':.!li
0.':.!:1':.!
0.171
O.IK':.!
0.11:;
O.I':.!\) 00")
o.o:n
Y\ 11:11 -
Il;i-\
I~,,-\
\

C'"
O.3':.!4
0.310
0.':.!ti5
0.':.!44
0.'242
O.':.!2:1
0.1\17
0.201
0.IK7
0.147
0.1:;3
0.147
0.0:,:1
0.059
0.057
/III Nli 11:" Il;, I~"
N,,_~
/(~,-~ 0.141
O.OK\)
0.07K
0.0:,7
O.O!) I
0.tl:1':.!
O.O':.!\) -Iun<l)
-0.010
Y l n,,_~
/{1I .• l
Ilr.,_~
C""
0.1:15
0.121
n.OK4
0.07\)
0.071
0.04:,
0.0:,1
O.lHli
0.02:;
0.0:12
0.02K
0.111 ':.!
'-0.005
-0.006
-0.016
/(" lIu 11.1, [1,4, I~.,
I55 O.IOli 0.o7·l Il.W,O
/(,,_:1
N~,_,\ 0.141 I>.lOO 0.071 1),0:,0 <1'127 )
O.\l:\I
Y" 11."_,,
Il;,_,
//'.,-:1 C n.14:1
0.1:17
O.I':.!O
flit
0.105
0.\04
O.0\)3
flll
0.077
0.07\)
0.074
/(,,,
0.0:,8
O.Olll
0.061

n"
0.03Y
0.044
0.047
Ilr.,
11,,-4 0.063 0.0:16 0.016
-0.006 )
-<10<>7
14
[I,~,-,
U: I/ . ,
1l;'.4
I~.,_,
rIO'
OJl97
U.UY!'!
0.100
0.094
0.062
II.I)(iO
O.Oti7
0.Oli4
O.O:lti
0.033
O.O:l\)
O.03H
0.017
lUll :,
0.023
0.025
-11.011
-11.004
-0.001

II{., J' whe,.e Il" is Ihe wee".

'\IIl()[o,.n ·blioll 11I.llri('c. of lhe veclor X, '" I /(" /(~, H" nil
I return Ull dw equal-wci ghted portfoliu of Sl()rk~ ill
the I,iI '1Uilililc.'. i:;:: I ....• 5 (quintile
the ~1I1~IIlt"st ~locks). fur the s~lIl1plt.: of ,P\;YSl-:·AMEX stocks
tUJlIl.Ju1y 10. 1962 tu
I cOllt;lius
U·t/~EI(X'_'-I'J(X'-I')')D-t/~
llC('l·IJlht 'J':n. I!J!H (1.(i!J:.ob, nV'dlioJlS ). Notelh'd ll(k) '"
correlatio ll hetweenll ll_1t dnd
\\'I1t"l"e D == cliag(o: . .... 0::); thus tht· (i. j)th element is tht:"
/(,1. A";YllIptotic stalldanl errurs for the alHo("orre
Jatiolls under all Ill) lluB hypothesi~ are given
h\' I/./'T = O.O:!4.

anccs. If
cross·au toco\,ar iances and the secolld term ollly the OIvll-au tocovari
ocovari ances are generall y ncgative , and index autocov ariance
the own-aut
. Moreov er. the
is positive, thell the cr05s-au tocovari ances must bc positive
so large as to exceed the sum of the
cross'<lutocovariances must be large,
n(~gative oWIl-all tocovari ances .•
 'Clhle ~,H reports autocor relatioll matrices T(k) of the vcctor
of weekly
rctunIs of/i\'(' sil.e-sor ted portfolio s, formed from the sample of
stocks u~inl{
wcekly reluI"IIs fromJ Illy 10, I!Hi2, 10 Dccemb er 27, I ~1~11 (1,(i~I:)
obsl'l"va-
tiollS), 1.('1 XI dello((' Ihe \'('((01' I UtI U~I /l:ll HII U',I J', ",h('l"e
U,I is Ihe
r('(lInt ollihe ('<Jllal-weil{hled porlfoli o of stocks inthc ith qllilllil('
, Thclllh c
klh order alliocor reialioll /lwflixo fX , is I{ivcll by I(k) == D-I/~EI
(X'_k­
Jl)(X I -ltnD-I/~, wh('l"e D == dial{(rr(, '" ,rr,;)
and It == EIX/J, By Ihis
cOllven lion, the i, jlh elclllcnt of I(k) is the correlat ion of
U,I - k wilh Il/"
The cstimato r T(k) is Ihe IIsual sample alltocor relation matrix,
An interesli lll{ pallel'll emerge s from Table 2,H: Thc enlrics helow
thc di-
agollals ofT(k) arc almosl always larl{er th;1II thosc ahove the dial{olla
ls, For
exampl e, the firsl-ord er alliocor relation helwecn Iasl week's rei
II I'll Oil 1;lrl{('
slorks (/l,.,_t ) wil h th is \\'eek 's ret til'll on small stocks (Ill I ) is 2(i5';;"
wher(,'ls
Ihe first-ord er aUlocor relalioll l)('t\\'e(,11 last week's retllrll Oil
small stocks
(Ili/-I) with this week's relurn Oil larl{c stocks (I?r./) is only
2.1%, Similar
pallenls mOl)' he se(,11 illihe hil{her- order autocor relation malrice
s, allhong h
the magllitl ldes a 1'(' sm;1I I1'1' sillce Ihe higher-o rder cross-au loforrcla
liollS dc-
ray, '1'11<' as)'lIl11H'lrV of Ihe TUl) malrice s implies thai Ihe aUlo('ov
ari;III(,('
malrix eSlimato rs h/l) ;11'<' also as)'lnnH 'trir.
This intriguin l{ 11'fIr/,lfI,i!, pallel'll, whcrc largcr capitaliz alion slocks
lead
alld small('l" rapilali/ ,alioll slOcks );Ig, is morc apparcn t ill 'Llble
2,9 which
reports Ihe diff('rell(,(' of the aUlocor relation malrices and II1<'ir
transpos es,
Ever)' lower-d iagonal entr)' is posilive (hencc cver), upper-d iagonal
eiliry is
lIegalive ), implyin g Ihal Ihe correlal ioll between Cllrrcllt reltlrns
of smaller
stocks alld pasl rctllrns of largcr stocks is always largcr than the
cOlTe:atioll
hetw('('11 currl'nl retllrllS of larger slocks and past retllrns of' smaller
stocks,
Of COII/'Sl', the nOlltnH lillg llIodel of Chapter 3 also yields
all as:'Ill-
lIIell'ic alltocor rdalio/l matrix, Iloweve r, we shall sec ill that
chapter that
IInr('alis lically high probabi lities of' nonlrad ing are reqllired
to g('ll('rat<'
Cl'Oss-a lllocorrd aliolls of 111(' magnill lde reported ill 'Elhlc ~,H,
The resulls ill'l;lhle s 2,H and ~,~I point to the cOlllplt' x palll'l'ns
of CI II~S­
effi'cts alllollg sennilie s as significa lll sourfl'S of positive illdex
alllocOITl'-
lalion, luclcl'd, 1.0 alld MacKill lav (1~1!)(lc) show that OVlT half
of Ihe posi-
tivI' iudex ,llllocol Tclaliol l is atlrihut ahk to positive {'f'oss-{'fT('cts,
They also
ohsC'l'vl' Ihal positive noss-dJ' e('(s CUI explaiu the apparen t profitah
ilil\' of
f/ll/lmrif/ 1/ ill\'esllIl<'lIl slral('gic s, slralegi( 's Ihal are coulrary
10 III<' gellnal
lllarkel direnio ll, Thesc siralegic s, predica ted ou the Ilotioll
th,lI ill\'('.'lllrs
lelld 10 O\'('IH'OIn 10 illforlllOllillll, ('ollSisl of sellillg "wilIlH'r
s" alld IHll'ilig
"Ios('rs," Sellillg Ihe willll('rs ;1I1e1 bllyillg til(' losers will ('anI
posilive eX-
pC('ieel prolils ill Ihe pn's('II(,(' "fllegal il'(' scrial cOiTclal ioll h,'('alls('
('111'1'('111
losers an'likel \' 10 IH'(,OIlI<' 1'111111'1' willllcrs alld CIIITellt willllers
are likeh' 10
I)('colll(' hlllln'lo sers,
 Table 2.9. AIYIn1Wtl) of rmIHlIl/or()rrriation matrir,s.

III /I~ II, R.. I~

III -0.104 -0.153 -0.195
R~ 0.104 0.000 -0.061 -0.113 -02<1 )
-0.11l1
Y(I) - Y'(I) II,
HI
fir,
C"""
0.153
0.19:)
0.241
0'{)61
0.113
O.IHI
0.000
0.0:,4
0.134
-0.054
0.000
0.088
-0.134
-0.088
0.000
•
HI /12 H, R.. llo

Y (2) - Y' (2)

III
R2
R, (""00
0.052
0.079
-0.052
0.000
(l.029
-0.079
-0.029
0.000
-0.089
-0.042
-(1.014
-om,)
-(l.O55
-0.029
f4 0.OH9 0.042 0.014 (1.0(10 -O.UIH
f~ (1.094 0.0:)5 0.029 0.018 0.000
HI /I~ H, R.. Il"

YCI) - Y'(3)
HI
U2
R,
(00"0
(l.03S
0.069
-0.035
0.000
O.O:H
·-0.069
-0.024
0.000
-0.OH7
-0.054
-0.022
-O@')
-0.062
-0.035
U4 0.087 0.054 0.022 (),(l00 -0.018
1Ir, (l.093 0.062 0.035 0.018 0.000
HI /12 H, R.. llo
II,
112 COOO
0.033
-0.033
0.000
-0.059
-0.024
-0.084
-0.050 -OJ02)
-0.070
Y(4) - Y'(4) U, 0.059 0.024 0.000 -0.023 -0.049
f4 0.084 0.050 0.023 0.000 -0.030
fir, 0.102 0.070 0.049 0.030 0.000

Diflcrenccs between autocorrelation matrices and their transposes for the v("Clor of !ize-
sorted portfolio returns X, - I III, II~, II" 11." /lo, J' where Fl., is Ihe week·, retUrn on
Ihe e'l"al-weighled portfolio of .rocks in Ihe ilh qllintile, i= I, ... ,5 (quintile 1 contains Ihe
smallcst 'lOeb), for Ihe sample of NYSE·AMEX stocb from July 10, 1962 10 December 27,
1994 (I,W!l' ohservalions). NOle Ihal Y(k) = O-1/ 2 EI(X,_. - jl)(X, - I,)')D- I/', where
D 0= di'I~la~, ... ,a~;J.

But the presence of positive cross-efTecl~ provides another channel

through which contrarian strategies can be profitable. If, for'example, a
high return for security A today implies that security B's return will probably
be high tomorrow, then a contrarian investment strategy will be profitable
even if each security's returns are unforecastable using past returns of th~t
security alone. To see how, suppose the market consists of only the two
stocks, A and B; if A's return is higher than the market today, a contrar-
ian sells it and buys 13, But if A and 13 are positively cross-autocorrelated, a
higher return for A today implies a higher return for n tomorrow on aver-
age, and thus the contrarian will ha\'e profitcd from his long position in I}
Oil average.
 7M
2. Till' Pre dirl abi lily 'if
An l'i lll'i llrl ll

No wh ere is it reCJuired
th~tt the sto rk ma
vid ual ret urn s arc neg rke t ove rre act s, i.e.,
ativ elv aut oco rr( 'lat ed. (ha t ind i-
cO lltr ari all str ate gie s Th ere for e, the fan tha t
h;I\"(' jlositive exp ect son ic
ma rke t ove rre act iol l. ed pro Jits lIe ed not
In f~lIl, for the par tic ilil ply sto ck
and Ma cK in lay (19!Hk ula r con tra ria n strat('h
) eX~lInine, ov er hal f ,)' tha t 1.0
to cro ss- eff ect s and no of the exp ect ed pro
t 10 lIe gal ive aut oco lils is du e
ret urn s. rre lat ion in ind ivi dua
l s'T llri ty
Th ese cro ss- eff ect s In,l
), ;1\sO exp lai n til(' app
oth er tra din g str ate gie are llt pro fita bil ity ofs
s tha t hav e rec ent ly bec l'v('f;11
(om lnu nit )'. Fo r exa oil le po pu lar in the
mp le, IUII!!,/slwrl or fin anc ial
lon'f, pos itio ns arc off IIltL rkl' l-l/l 'lllm l str ate
set dol lar -fo Hlo lla r by gie s in wh ich
reu frn s in exa ctly the sho rt pos itio ns GU I ear
bsh ion des cri bed abo n snp eri or
ve, des pit e the f~tClt
des ign ed to tak e adv ant
age of ow n-c llc us, i.e" hal llley arc
ofi ,)d ivi dua l sec uri tie pos itiv e an d neg ;lli ve
s' ('x p(' dn l ret urn s. fon 'l'a sh
or pai n tra din g str ate Th e per for ma nce of
gie s '~1I1 als o 1)(' alt l'ib /lIIIII'II/'d·/mok
own-cfrecls. llle d 10 cro ss- cll ecb
as well as
i\lt ho ug h sev era l slu di( .
,s ha\'(' all l'lI Ipt ed to
lag qft e(\ s (se e, for exa exp lai n the se slr iki ng
mp le, Ha dri nal h, Ka Ica d-
Rich1anlson, am i Wh le, and No e [1! '!': Ij,
itel aw lI9!141. Jeg ade Bo ud ou ldl ,
Co nl'a d, Kalil, and Nil esh and Swamin~ttll<lll
lla len dra n [19 !1l ], Hr [I !'!':I!.
nal h\m [19 93] . Jeg ade enn an, Jeg adc esh , and
esh and Tit ma n [19 Sw;uni-
stilll~tr fro m hav ing %] , and Me ch [1!1!l:1
a com ple te un der sta lJ, w!' arc
\ nd illg of the ir nat ure
all d SO IIlT "S.
\I
\ 2.8.4 '1i-.llJ (hil l!!, f.U II/i-
IIU liw lI IIrlurn.1
sev el\t l rec cnt slll <ii es
hav e eli lpl oye d lon ger
tUf llsi inl llo st ca ses -in -ho riz on ret urn s-l ilu
exa lili nin g the ran dol lti- yc ar re-
ity, an'd the pro fita bil ity ll walk hyp oth esi s, pre
of con tra ria n str ate gie dic tab il-
Dis tin gui shi ng bet we s, wit h SOIlll' sur pri sin
en sho rt all d IOllg ret ul'l g reSlilts.
cau se· it is now well kno I-h ori /.o ns can he illl
wn Ih~lt we ekl y flu ctu p0r lal ltlw -
in ma ny ways fro m mo ati oll s ill sto ck ret urn
vem ent s ill thr ee- to s dil ll'l '
the eco no me tric tra de- live -ye ar ret urn s. We
off s bet we en sho rt- anc COlIsid!'I'
det ail in Ch apt er 7, llo ng -ho riz on rcl lirn
and pro vid e oil ly a bri s inl llll lT
hor izo n imp lica tio lls ef dis cus sio n her e of
[01 ' the ral ldo lll the lon g-
walk hyp oth ese s.
III con tra st to the pos itiv
e ser ial con -ei ati on in
ind ex ret uri ls do cum daily, weekly, and 1I101I
ent ed by 1.0 an d Ma Ihly
an d Fre nch (HJH8h) cK inl ay (19 88) an d oth
and l'ot eri Ja and Su nll ers , Fai lla
cor rel ati on in mu lti- lle rs (1~)88) fin d llI'i!
yea r ind ex ret urn s. ,alilll' scri~t1
lIIers (1988) rep ort Fo r exa illp le, Po ter lla
a var ian ce r~tlio of O.:1 ancl SUIll-
val uc- we igh ted CR SP 7S t(lr ~){i-lilollth ret urn
NYSE ind ex fro m 19: s of Ih!'
rial cor rel ati on at sOl !!i to 19H5, im ply ing
lie rel lirn llOril.ons (re neg,lIiVl' se-
spe cif ic lin ear com bin cal l tha t the var ian ce
ati on oL lu( oco rrc lal ral io is a
Fre nch (19H8b) and iOIl coe ffic ien ts) . Bo
Po ter ha and Su mm ers th Fam a and
(l!lHH) con clu de tha
I llin !' is
 79

slIiJslalltiaIIlH'all-rev<Tsion in stock Inarkel priccs at long<'f horizon

s, which
llll:)' :llirilllll e lo the presenc e of a "Iramito ry" compol lent such
as the y,
C()lllpOIICnl ill (~.5.1).
There is, however , good reasoll to hc wary of slich illlC:rellces when
they
arc based Oil long-ho rizon returns. Perhaps the most obvious concern
is the
extreme ly small sample size: Frolll I ~J~(i to I ~JH:), there arc ollly
1~ nonover -
lapping five-year rei urns. While overlap ping returns do provide
sOllie illnc-
!llenlal illfoJ'lJlalioll, the results ill I\oudou kh and Richard soll
(1994), 1.0
allri MacKin lay (19H9), Richard soll :u1<1 Smith (19~J I), and Richard
son and
Stock (I9H9) suggest that this increme nt is lIIodest at hest and
mislead ing
:11 worst. In p:lI'licuiar, Richard soll alld Stock (I~JWJ)
propose all aSYlllptotic
approxi lllation which caplure s th(: spiril ofoveri apping long-ho
rizon return
c;J!cula tions-th ey allow the return horizon '/ to in<Tease with
the s<lmplc
size T so that '/1 T converg es to a fillite vahle 8 IlCtween zero
and one-
which shows that variance ratios call be severely biased when
the return
hori/.oll is a sigllific allt fractioll of the total sample period.
For exampl e,
.Ising thei r aSYlllptotic approxi matioll (~.5.IO), discusse d ill Section
2.5.1,
Ih,' expecte d vahle f()r the variallce r:llio with overlap pillg returns
is given
by 12.5.1~) under RW I. This express ion illq>lies that with
a return horil,on
of % 1Il0nths alld a sample period o/" (iO years, o=Hj(iO =O.133
hence the ex-
peeled variance ratio is (I -8 )2=0.7:> I , despite IIIC fact thal RW
I is assulJle d
to nol<l. Under RW2 alld RW3, even more dralllati
c hiases can occur (see,
fo, exam pie, ROlllano and Thom hs [ I ~J9(i 1),
These difficult ies arc reflecte d in the llIagnitu des of the standar
d elTOI'S
associat ed with long-hoI"izon return :lutocor relation s and variance
ratios
(~(T, f(>r exallipl e, Richard soll alld Stock (19WJ,
'Elhk!» ), which are typically
so large dS to yield z-statistics close to l('l"O regardle ss of the point
estimate s.
Richard son (199:1) and Richard son and Stock (19H~J) show that
properly
adjustin g 1'01' the Slllall salllple sizes, alld for otl)('~' statistic al issues
associat ed
Wilh 10ng-horiLol1 returns, reverses many of the inferenc es
of Fama and
French (I9HHb) and I'oterba and SUlIlme rs (I YHH).
Moreov er, the point estimate s of autocor relation coeffici enlS and
other
time series parallle ters tend to exhibit conside rable samplin g
variatio n for
long-ho rizon returns. For exampl e, silllple hi:ls a<\justm enlS
can change
the signs of the autocor relation s, as Killl, Nelson, and Startz
(19HH) and
Richard son and Stock (I9H9) demons trate. This is not surprisi
ng given the
extreme ly slIlall sample sizes that long-ho rilOn returns produce
(sec, for
example , the lIlagnitu de of the bias adjllsln) ('nls in Section 2.4.1).
Finally, Kin), Nelson, and Stanl (PIHH) sholl' Ihallhe IIcg:llive serial
cor~
Icbtion ill long-ho rizon returns is ('xtrelllc ly sensitivc to the saJllple
period
and lIIay hc largely dlle to the first tell years of lhe I ~J~(; to
19H5 salllple.
Althoug h ten years is a very signific ant portion of the data anci
cannot be
exclude d withollt careful considc ration, Ileverth eless il is trollhlin
g thaI the
 sig ll of the ser ial co
nd ali oll coe ffic iell t
prc ssi oll . Th is CO IIII hil lge s Oil clata (i'o m
IHl rlll l1- wh (·th er to the (;r ea tlk -
cat acl ysm ic ('\'1'111. or om it dat a iIlIlIlCI1CC
10 illc ilid c it all d arg t\ Ill' a sill gle
.~cllta Iil'c of II J(' C(O ll(' tha I sllc h all 1'1'(,111
IlOIIl ic sVSI e m- III lt\l is rcp re-
sta tist ica l illf ('lc ll(T . 'rsc ore s tl J(' fra gil il)'
{)l 'n,I II. lit nt' is litt of sllIa II-sa III I'll '
IOl lg- hot i/o ll rct llrn le cvi dcl lcc f(lI' II1Call
s. Iho ug h I his lIIay be rev ers iol l ill
pie sil.es ral lw r Iha ll lIIo re of ,I sym Jllo m
COllclllSivc C"icll-IUT of SIII;III sall l-
cal l1l ot lell . aga ills tlll cal l rel 'er sio
ll-w (' sill lply
Th esc ' cOllsicic-ralioll
s poi lll 10 sito rl-i tor il.o
C\iale .~OIllTC rro lll wh ll reI urn s ,IS the ilio
ich C'\"ic\CI1("(' of prc c\ic n' illl llle -
Ilo t to say IIial a can tab ilit y mi ghl be clil
·fll l ill\ "('s liga liol l of led . TIi is is
bc Ull ill( )fJl lali \"(· . lllc ret url ls ovc r IOllgc'r
\cl' d. ilm ay hc oll ly att tilll(' spa lls will
im pac l or ITO Il() mir hc sc low er freCjllellci
LtctO)S sllc h as thc bus cs IIia llli c
01'(' 1", to the cxt illc ss cyclc- is dClc·CI'liJ
ell l Iha llra lls ani oll k. Mo rc-
cos ts arc grc ate r (1I'
sllOrI-llOrilOlI prl 'cli slr alc gie s exp loi lill g
cl,l bili ty. IOl lg- hor iwl
uill (' for lll ofl lllc xpl oil I pre e!i nah ilil Y lIlay
Cc \ (llOlil opp ort ull ity bc ;1 11101"1' gC'lI-
cha llC 'llg cs POSI'c\ b)' . Nc vcr the les s, Ihe C'C
IOl lg- hor i/o ll rC'llIrns OllOlIlc'lric
for acl (lit ioll al C'conO arc' ('ol lsic lna blc -. all
lllic slr un llr c is par tic d Ihe llC'cd
ula rly gre al ill sllCh
cas cs.

2.9 Co nc lus ion

Rc ('cl lt C'CollOlIll'tric
ac\ val lcc s ane! I'm pir
fin anc ial ass ct rct url ica l evi dcl lcc sec III 10
ls arc prc t\in abl c to sug gc" 1 Ill<It
wOllld hav c I)('cll tall sOllie deg rC' e. Th iny
lalilOllil1 10 ;111 ou trig yca rs ,lgO thi s
Ilo wc ver . lIlo c\c m lill hl n:jc Cli oll of lIla rke
,)ll cia l eco llo mi cs tea l cfli cie llcy .
tio llal , (~Ktors lIlay che s \IS Iha t olh n.
acc oll llt ()r suc h pn· pn fcc lly ra-
sC' cur itie s ma rke ts all dic tab ilit y. Th e fillC
d fric tio lls in the Ira ' ~truClllrc of
dic tah ilil )'. Til lle- var dil lg procC'ss cal l gel
yil lg ('xp c'(" lnl rctufll. ;er ate pre -
tio lls cal l gC lln ate ' prc ~ du e to cha llg illg
clin abi lil) ,. A cer tai ll hus ille ss cOlldi-
IH'("('ssary to rcw ard deg ree of pre dic lab ilil
iIlV(~SIOrS for bea Y ilia), be
hy Ilte sl' cO llsi dcn llio lls. rin g cer tai ll dyn am ic
risks. MO li\'a ted
We' slia ll dCI'!'Iojl ma
adc lre ss tlic sl' and oIl n)' mo del s and tcc hni
ier rel alc d issl lcs in qll cs to
Ihe com illg rha ptc rs.

Pr ob lem s-C ha pte r 2

2.1 If 11',1 is a IIlarliligaic-. sho
w tha t: (I) the llli nim
fill Tca st of I'H I. con ull llll ('an -sc llia rnl nr
dit iol lcd oll thc en or
1',; (2) lIo ll(} \'l'r iap pil ig tin ' his tor y 11',.1',_1
hlh ciif fer cnc cs arc ull ... . 1. is sim pl) '
lor all /; > O. cor rci at( 'c\ at atl lea ds
,lI1 dla gs
2.2 Ilo w all ' till ' RW
I. RW~, R\'\':l, .lIl Clm
clu de' a \'(, lIn di;l gr; art ing ak Iiy pot hes ('s
Jm 10 illl lslr ;llc III<' rda ted (in -
Pro vid c spl 'cif ic c'x am rcl ati ons am on g lill ' fou r
p!c s of I'ac lt. lIIod('ls)~
 lH

2.3 Characterize the set of all two-state Markov chains (2.2.9) that do not
satisfy RWI and for which the CJ statistic is one. What are the general prop-
erties of such Markov chains, e.g .. no they generate sequences, reversals.
etc.?
2.4 Derive (2.4. I 9) for processes with stationary increments. Why do the
weights decline linearly? Using this expression. construct examples;ofnon-
random-walk processes for which the variance ratio test has very low power.
2.5 Using daily ami monthly returns data for ten individual stocks imd the
equal- and value-weighted CR.',!' market indexes (EWRETD and VW1lliTD).
perform the following statistical analysis using any statistical package;ofyour
choice. Note that some of the stocks do not have complete return histories.
so be sure to lise only valid observations. Also. for subsample analys~s, split
the available observations into equal subsamples. ,
a.
2.5.1 Compute the sample mean i<. standard deviation and first-orcier
autocorrelation coefficient p(l) for daily simple returns over the entire
1962 to 1994 sample period for the ten stocks and the two innexes. Split
the sample into four equal subperiods and compute the same statistics in
each subperiod-are they stable over time?

a.
2.5.2 Compute the sample mean il, standard deviation and first·()rder
autocorrelation c"efficient p(l) for continuously compounded daily re-
turns over the entire 1962 to 1991 period, and for each of the four equal
subperiods. Compare these to the results for simple returns-<an con-
tinuous compounding change inferences substantially?

2.5.3 Plot histograms of daily simple returns for VWRETD and EWRETD
• over the entire 1962 to 1994 sample period. Plot another histogram
of the normal distribution with mean and variance equal to the sample
mean and variance of the returns plotted in the first histograms. Do daily
simple returns look approximately normal? Which looks closer to nor-
mal: VWRETD or EWRETD? Perform the same analysis for continuously
compounded daily returns and compare these results to those for simple
returns.

2.5.4 Using daily simple returns for the entire 1962 to 1994 sample pe-
riod. construct 99% confidence intervals for [L for VWREtD. EWRETD.
and the ten individual stock return series. Divide the sample into fOllr
equal subperiods and construct 99% confidence intervals in each of the
four subperiods for the twelve serics-{io they shift a great deal?

2.5.5 Compute the skewness, kurtosis, and studentized range of daily

simple returns of VWRETD , EWRETD, and the ten individual stocks over
the entire 1962 to J ~1(11 sample period, and in each of the four equal
82 2. The Predictability oj AUft Uft /117/J

subperio ds. Which of thc skewncss, kurtosis, and sllldent ized ran~e
esti-
Iljates are statistically differen t from the skcwness, kurtosis, and
s!tll!en-
tifecl range ofa norma! random variable at thc 5% level? For these
twelve
s(/rics, perform thc samc calculat ions using monthly data. What
do YOll
c911c1ude about thc normali ty of these rClllrn serics, alld why?
 3
Market Microstructure

\\'1 III.E IT l~ AI.WAY~

the case that sOllie features of the data will bc lost in the
process of modeling economic phenomena, determining which features
to focus 011 requires some care and judgmcnt. III exploring the dynamic
pmpcrties of financial asset prices ill Chapter 2, we have taken prices and
returns as the principal objects of interest without explicit reference to the
institutional structures in which they arc determined. We have ignored
thc fan that security prices arc generally denominated ill fixed increments,
typically eighths of a dollar or tirks for stock prices. Also, securitics do not
tra(ic at evenly spaced intervals throughout the day, and on sOllle days they
dOllol trade at all. Indeed, the very process of Ira ding can have an important
;llIpact 011 the statistical properties of financial asset priccs: In markets with
designated lIlarketmakers, the cxistence of a J!nmd betwcclI the price at
which the marketmaker is willing to buy (the bid price) and the price at
which the markctmaker is willing to sell (the oJJ/'( or as" price) can have a
llontrivial impact on the serial correlation of price changes.
For some purposcs, such aspects of thc market's micTOstructure can be
safely ignorcd, particularly when longcr investmcnt horizons arc involved.
For example, it is ulllikely that bid-ask bounce (to he de filled in Section
:~.~) is responsiblc for the negative autocorrelation in the five-year returns
of US stock indcxes such as the Standard and Poor's ;)00, t even though
the existellce of a bid-ask spread c10es induce negative autocorrelation in
returns (see Section :{.2.1).
Ilowever, for other purposes-the measurement of execution costs and
Ilurket liquidity, thc comparison of allernative lIIarkelmaking mechanisms,
the impact of competition and thl' potelltial li'r collusioll among market-
makcrs-markct microstructure is central. Indeed, market Illicrostructure
is IlOW olle of the most active research areas in {'COllOlllics and finance, span-

ISt:~ ~c((iOIl ~.!) ill Ch"pl~r:1 "nd Section 7.2.1 ill Ch"PI'" 7 lor ""lher <li,ells.;iun (If
IOlll{-horil.oll rc:tllrll.~.
 Ilillg- lIlall)' 11\;11 \..I'IS al\(I lIIallY lIIod
els,~ To lesl sOllie of Ihes e mod
10 dele rllli llc IIII' illip onal lce of lIIar els, alld
ket lIlic roslr llctl ire effe cts for otlll
sear ch area s, WI' rcqu ire SOI\lI' clllp 'r re-
irica lllle aslir es of lIlar kctl llirr ostr
effec ls, We shal l l'onslJ'llct sllch llctl ire
lIlea sure s ill Ihis chap ler,
In Sl'l'I ion :\,1, Ive pres enl a silll
ple mod el of Ille Iradillg- proc ess
1111'1' IIII' cfkl 'ls of nons ),nc 10 cap-
llrol lous Iraclill~, III Scct ioll :~,~,
eff(ocis of the hid-ask spre ad on WI' cons ider tile
IIII' tillie-series prop ertie s of pric
and in Sect ioll :1.:1 W(' (,xp lore scve e dlan ges,
ral Icch lliqu l's for lIIo ddin g Iran
dala wilich pose sl've ralu niqu (' s<ln ions
chal leng es incl udin g pric c disc
irreg ular salll plin g inl('l'vals, rcle ness and

3,1 NOn.';ynchronous Tra ding

Till' 1I00H )'II(li mllll/ /1 flll/li llK or lIollf

mdil lg effe ci arisc s whe n lillie
ally assel pric es, are lakc n 10 he serie s, IISU-
reco rded at time inler vals of olle
whc n in bl'l Illey an' rc('or<lcd leng th
al time inter vals of otlle r, possihly
Icng lhs, For ex alii pie , Ihc daily irreg ular ,
pric es of secl lritie s qllo ted in the
prcs s an' usua lly dll.liJlK pric es, fina ncia l
pric cs al whic h Iht' last IrallS<lcti
of Illosc sccu rilie s occu lTl'd on on in each
Ilic pn'v ious hllsi ncss day, The
pric es gCllcrally do nOI OITur al st' clos ing
Ilic sam e limt ' each day, bUI by
10 IlIelll as "dai ly" pric refe rrin g
cs, wc have illlplicitly and inco
Ihl'), arc cl(u;llI)' spac cd al !!'I- hour rrec lly assl lmed that
illlc rvals , A~ wc shal l sce helow,
assll lllpl ion can !Tea le a falSI' imp sucl l all
ress ion of prcd ictab ililY ill pric
alld relu ms evell if Inle pric e I'hal e chan ges
l~es or relli rns arc stali slica
dell t. lly inde pell -
III pan klila r, IIII' nOlllrading- effe
ct indllCl's pOle nlial ly serio lls bias
in Ihe 1II00111'nis and CO-IIIOIIH'nls es
of assel retu rns such as Ihei r mea
aIlC( 'S, ('O\'ariallces, hela ns, vari-
s, alld auto corr elal ion and cros s-ali
effic ients , For ex;u llplI ', supp ose loco rrela tion co-
Ihal Ihe retu rns 10 sloc ks A and
lelll pora lly illdq )('nd enl hUI A Il arc
Iracles less freC]u('nlly than B, If
ing Ih(' aggr egal c sioc k mar kel news affect-
arriv es lIea r the clos e of the mar
day, il is lIIore likely 111;11 II's 1'lId ket on one
-()/~day pric e will refle ct
Ihall A's, simp ly heca use A fIIay Ihis info rma tion
nol Irac k afte r Ihe new s arriv es,
A will resp ond 10 Illis ill/iu'III;llioll Of COllrse,
I'vel ltual ly hUI Ihe faci Ihal it resp
wilh a lag indUITS spur ious noss olld s
-alll oco rrda lion helw el'll Ihe daily
of A alld B \\,11('1 1 (';II(,lIlall'lI wilh retu rns
dmil lK pric es, This lagg ed
resp onse will
~Th(' lill'I,l lllIe' j, 1.11 1110 \'~I'1
10 givl'. 1 (01111 '1('((' (iWli oll
Ii"" Jar 1"1', III ~Iclditi()n to tlit"
«il;lIi tHl\ li:-.It'd in ".1( h of die" :-.(·t"licHl~ 1H'low, Ic';,dc 'rs
illlt'l" t'sl('d in all inlrod ll('fio
IlIieT o,,, tI( 1111('.11 C' ('III olll.I
~,·d 10 ('on\1 I1t III(' follow
ll to Illark "t
ing t'xcc llt'ul lIIollograph~ and
\"oltll lit's 111.11, logt· llwl.p IO\'id ccUlh 'n'llft '
c;1 f.lidy nUllp lc,!t· Il"cal lllc'llt
,hi, tile'I,I II1It': I :.. 111'10, ~l.li ... , ,~dl\\, of III(' m;ljo r b.\\I(',o;, alld IIIcl(l
;III1, ,111<1 \\'I,il"'IOIII> (J'IHI
l'b in
(;,IIIi, ,11111 l:i"I', i),Il., vi" allcliiolo (I~I~I:\). !'''"lk
lIlIlil li 11 1
".10;), K.lf!d ,111<1 RII'Io (I ~1~'r)J. I... ''',
( I II~I,I) , (1~1~,r»). (l'II .. r.. (I ~'~I:»), a,,<1 SH:
J.1. HUII'YIIUIIUIWIO I/llUlIlg

also induce spurious own-autocorrelation in the daily returns of A: During

periods of nontrading, A's observed return is zero and when A does trade,
its observed return reverts to the cumulated mean return, apd this mean-
reversion creates negative serial correlation in A's returns. These effects
have obvious implications for tests of predictability and nonlinearity in asset
returns (see Chapters 2 and 12), as well as for quantifying the trade-offs
between risk and expected return (see Chapters 4-6).
Perhaps the first to recognize the importance of non synchronous prices
was Fisher (1966). More recently, explicit models of nontrading have been
developed by Atchison, Butler, and Simonds (1987), Cohen, Maier, Schwartz,
and Whitcomb (1978,1979), Cohen, Hawawini, Maier, Schwartz, and Whit-
comb (1983b), Dimson (1979), Lo and MacKinlay (1988, 1990a, 1990c),
and Scholes and Williams (1977). Whereas earlier studies c~msidered the
effects of nontrading on empirical applications of the Capital Asset Pricing
Model and the Arbitrage Pricing Theory,3 more recent attention has been
focused on spurious autocorrelations induced by nonsynchronous trading.4
Although the various models of nontrading may differ in their specifics, they
all have the common theme of modeling the behavior of asset returns that
are mistakenly assumed lO be measured at evenly spaced time intervals when
in fact they are nolo

3.1.1 A Model of Nonsynchrvnous Trading

Since most e;npirical investigations of stock price behavior focus on ,returns
or price changes, we take as primitive the (unobservable) return-gerlerating
process of a collection of N securities. To capture the effects of nontrad-
ing, we shall follow the nonsynchronous trading model ofLo and MacKinlay
([990a) ~hich associates with each security i in each period tan uno?served
or virtual continuously compounded return ril. These virtual returns rep-
resent changes in the underlying value of the security in the absence of any
trading frictions or other institutional rigidities. They reflect both company-
specific information and economy-wide effects, and in a frictionless market
these returns would be identical to the observed relUrns of the security.
To model the nontrading phenomenon as a purely spurious statistical
artifact-not an economic phenomenon motivated by private information
and strategic considerations-suppose in each period t there is some proba-
bility Jri that security i does not trade and whether the security trades or not
is independent of the virtual returns {rjl J (and all other random variables

~S.... , for .. xample, ('.ohell, Haw'"wini, Maier, Schwaru, and Whitcomb (1983a, b), Dimson
(1~)7~1), Schol .. s and Williams (1977), and Shanken (19R7b).
·S.." Atchison, Butler, and Simonds (1987), Cohen, Maier. Schwartz. and Whitcomb (1979.
19Hfi), and 1.0 and MacKinlay (I 98H, 19H!!b, 1990a, 1990c).
q'~:' .,
B6i 3. Markel Mirroslmrlu/'r

in ~hiS model).5 Therefore~

this nontrading process can be viewed as all
IlQ sequence of coin tosses," with different nontrading probabilities across
sec~rities. By allowing cross-sectional dificrcnces ill thc random IIOIlII
ingi processes, we shall bc able to capture the effects of 1l01ltratiil1).! "
ret~lrns of portfolios of securities.
iThe observed return of security i, fj~' depends 011 whether s('cmil), i trades
in ~eriQ(l/: Ifsecurity i does nottradc in pcriod t, let its obsCl'ved retllrll be
zcnr,-ifno trades occur, then the closing price is set to thc prcvious period's
el0tin g price, and hence ri~ = log(jJI///Jjt_l) = log 1 = 0, II', on the other
han ,security i docs trade in period I, let its observed return be the SIIlIl of
the I irtual returns in period I and in all prior r01l5eculiue periods in which i
did ;not trade,
'For example, consider a sequence of five consecutivc periods in which
security j trades in periods I, 2, and 5, and docs not trade ill periods 3 and
4, The above nontrading mechanism implies that: the observed return in
period 2 issimply the virtual return (T,2 = Tj2); the observed returns ill period
3 and 4 arc both zero (Ti~~ = Tj1 = 0); and the observed return ill period !i
is the sum of the virtual returns from periods 3 to 5 (f,~, = T,~ + f,4 + f ,).7
"
This captures the essential feature of nontrading as a source of spurious
autocorrelation: News affects those stocks that trade more freqnently first
and influences the returns of more thinly traded securities with a lag, III this
framework the impact of news 011 returns is captured by the vi"tllal retllrtJ~
process and the impact of the lag induced by lIontrading is captured hy the
ohserved returns process f,~,
To complete the specification of this nontrading model, slIppose that
virtual returns are governed hy a one-factor linear model:

rll = /1, + fJ,/t + E,t i = I, .. ,' N CU.I)

where f, is some lero-mean COllllllon factor and Ellis zcro-mean idiosyncratic

noise that is temporally and cross-sectionally independent at all leads and
lags, Sillce we wish to foclls on nontrading as the sole source of alltot'l>rreb-
tion, we also assume that the (01ll1110n factor It is lID and is independellt or

~JThr ca~e when' Irildil1~ is nllT('(at('d with viltHal IT\ltrIlS i:o. lIot without iIH('U'.,t, htll it j,
il1colI~istcnr with the spirit or the n01111"1uling- a:\ it killd of 1I1(';IStll"t'UlerH error. In tlU" IJlt· ... (·lIt ('
of priv4ltc informalion ant' Mratt"~ic h{'havior, trading anivily does typically dqu:nd on \'i(I\1,\\
l('l\ln\~ (~uit",bly defincd>. ;,uld ~trat{'gi(" Iradill~ COlli indllt:e ~crial correlation ill 01,'('1 \('<1
H'turm, hUl ,uch corr('lalioll fall hardly hl' ,li~1I\i",'d as -'pminus. Set' St'rlioll :I.I.~ lor
furl I..... di'Cll",ioll,
';Thi, "''llmpli<lll may he ldaxl'd 10 allow for slal""kpt'lldelll probabilities, i.t'., '"lIo( 0'-
rel"I('(~l()nlrading; s('e Ihe disCIl",ioll ill Section :I.I,~,
7 p, riotl I', relmn obviously depends Ull how lll<lny COllScfulive periocis prior 10 p .... io" I
Ihallh .ecurity did lIollracic. If illraded in prriod n, lh"l1 til .. period'l r(,~uIll is silllpl)' ('qu<ll
10 it' vi{lual return; if il did nOllr"d., ill perioc\ n hul dicilr,,",' in period -I, lh(,l1 P"! jotl 1__
oh~'f\"'~' u'turn "11w !i.1I1l1 of 1'(,1 ioel 0\ alld 1)('1 iotl I 's \'inll.tll('turns~ (·te.
 ,\ ,

3, I, No/t.\Yll rItlVllull s'fmrliug

H7
(",., for all i, I, and k.x Each period's virtual retlllll is ralldom
alld capture s
m()Vl'lll ents c;lIlsed by informa tioll arriv;t1 ;IS well as idimync ratic
noise. The
p<lrticul ar lit 11111.1< ling and rclurn-c umuLui oll process wc assume
capture s
til<' lag with wilicil lIews and noise is illcorpo rated illto security
prices dUl" to
illl'rcqu enllradi llg. The dynamic s oi'slIch a styli/ed lIIodel
an' surprisin gly
rich. and they yield several importa nt elllpiric al illlplicat iolls.
'IiI derive all explicit expressi oll lill' the observe d retlll'llS process
and to
d('(luCl' its tillie-ser ies propcrt ies wc illtrodll lT two related randolll
variable s:
I (no trade) with probahi lity n,
8" { o (trade) (:\.I.:!)
with probahi lity I - If,
X,,(II) (I-8i1)8i'_18/,.~ .. ·8,,_., I: > ()
with prohahi lity (I-lf/)lf ,'
(:1. 1.3)
with probabi lity I -- (I -If,)lf,·
where X,,(O) == I - 8 i " {8,d is assllmed to be illdepcl ldent of
{8jt} for i 1= j
a:1d tempora lly lID for each i = I, ~, . " . N,
The indicato r'v;lriab le 8" lakes on the vallie (Jlle whell seclirity
i docs
not trade in period I and is zero olherwi se, X,,(ld is also all illdicato
r variahle
and takes on the value one when sccurity i tr"dcs ill period
f but has nol
traded ill any of the Ii previou s (,OIlSl'!'IltiVl' I)('riods, alld is
1,('10 otherwi se,
Si'ICC If, is withill the Ullil illlerval , for large II the variahle X,,(Ii)
will he zero
with high probabil ity, This is 1I0t slII'prisillf.( sillce it is highly
unlikely that
s(,curity i shollid lrade loday but lIever ill the past.
I Iavillg defilled lhe X,,(k) 's it is 1I0W a simple 111.11 t ('I to d(')'iv('
all explicil
expressi oll for observe d returns 1;';:

00

r/~ = L X"Ud 'i,-.

.~()
I.,,,,N , (:U .4)

If security idol's 1101 trade ill period I. thCIIO,, = I which implies

lhal X,,(k)=O
liJr all Ii. alld lhus /';;=0, If i docs trade ill period I, thell its observe
d return
is equ.d to tlie sum ortoday 's virtual retllrll I',/ ;IIHI its past Ii,
virtual r('turns,
",Iinc titl' ralldolll variable h, is tlie IlIlml)('r or past ((I11,lfnll
ill!' periods that
i Ii<ls 1I0t tr;lcied, We ('all this tlie dllllllillll or 11(llllra<,lillg,
wliich 111<1)' he
ex pressed as

k, == ~ { ~J tI"_1 }
Althoug h n,I .'1) will prove to be Ilion' (,Ollvl'lIiellt IiII' suiJsequ ent ('aleula-
liollS, Ii, 111<1)' be IIs('d to give a sOllu'wIi;1I 1110)'(' illtlliti\'( ' defillilio
ll of the

XTh('~(' ... Irullg ;t~."iIlIllPIi()Il~ ~ll'(' IIl.Hlc' plilll.llil}' f"l t'XI'Il'lllltl l,d I fllI\"II"'II! C' .lIlff III.I}' he
1l'1.1~(·d
("oll,idt'rahl),. S('(' Scnioll :\.I.~ for hlllhl'l III" 11\'11111.
........ I. .\I(/tllI'I.\li"' ...I/nIl1,m·

ohs('rv('d 1I'llIrll~ procl'ss:

I,
,." I •.... N. CU.!)
" L'"
J.:~II

When'as (:\.1"1) shows Ihal ill Ii II' presenct' of nonlrading Iht' ohservt'd
n'llInlS procl'ss is a (siochaslic) fllllclion of till pasl ITIIII'lIS. Iht' t'C)lIi,'al('lll
rdation C\.I.li) rl'wals Ihal /';; Ilia), also ht' vit'wt'd as a ralldolll SIIIII wilh a
randolll nllllll){'r of 1I'I'lllsY
A Ihinl alld pnhaps llIost naillral way to view ohserved rt'llIrns is the
followillg:

0 wilh prohabililY Jr,

rtf with prohabililY (\-Jr,)~

1'" + 1'", I wilh probability (I-JrI)~Jr,

'~t I 1",1_ I + r,,_~ wilh prohabililY (I-JrI)~Jr;

,," (~.1.7)
"

1- "", k

Exprl'sst'd in Ihis wa)" II IS appan'lIl Ihal 1I01llradill/{ Gill illdllcc spmiolls

st'ri;1l corrdalion in ohst'rvcd rctllnts hecause each r;; conlains withill il
Ihc SIIIlI of pasl Ii ('oIlS('('Uli\'(' virlllal rClllrns for t'very k wilh sOllie pusilive
prohahilil), ! I - Jr,)~Jr,k.
'Ie) st'c hoI\' Iht' nOlllrading prohahility Jr; is rdaled 10 Iht' duralioll of
nOlllrading. ('ollsidl'!' Ihe llwan and variance of h,:
Jr , Jr,
1-:1 ",I ==
I - Jr ,
Varlk,l ==
(I - Jr,)~
C~,I,H)

If Jr,== ~ IhI'li S('(,II ri Iy i gOt'S wi Ih01l1 Iradin/{ lill' olle pniod al a Iilll(, on ;1\'('1"

ag(,; if Jr , == ~ Ih('11 Ih(' ;\\'('rag(' IlIlInhn of ('onst'flllivt' pniods of lIonlradillg

"Th,~ b "mH.u \" ~p;r'\ \1) ,Ill' S, holt-, .\1U\ \\'miam~ ('~)77) :\uhmtlill.l1C·" :\10('h;l~ti(' I"on'"
rq)l"('st'litalion 01 oh:\('I"\'('" 1I'llInl'. although \\'t' do 1101 rt':\trin tilt' trading lime's (0 Iilkc' \';dll("~
in .1 lix('cI lilill" illl('n,ll. \\'itll ~tllf,lhlt, nonl1~lli/~"ioIlS il
may Iw :\11O\v11 thai 0111' IHllllradillg
IIlCukl c'olln'lge''i wc·;tI... h IOliae'("(llIliIIlIOlh'lillH' POi."-MIil pron':\s ofSdlOlt·., ,uHI \Villi.IIII.' (1~177),
10'10111 (:\'1,,1) III(' OhM'1 nod 11'luI"II' III 01"('" molY abo 1)(' ("on~i,lc'r('d 'lIt illlilliu' ..ultl,·r lIIonllg
~'n'lag" ell \"illllall('l1l1l1\ \\'h('n' du' \1:\« 111'11 It il'lll~ an" ~lorh"~liL This i~ in ("olllra.'1111 (:011('11,
~1.liC'l. S, h\\';tl"ll, .IIHI \\'hil( IlIlIh (1 qHli. (:h;'pll'r f.) ill whirlt oh~('n'('d n'lIl1l1'i an' a'i'lIl11c·d Ie, hc'
;, lillih' ..uult'l ~L\ pIC II I'" with 1l01l .. llIch;I'lic nlC'lIil"i"lIh, /\!though 0111' nOlltl.uling Ilion· .... i..
11101(' g(·III'r,lI. Ihc'il 0),"'1 \'('d 1"1'111111' 1)lIIIT:\~ ill( IlHlt,:\ a hid-;Isk .. prt"ad ("01111)(1111'111; 0111" dot'S
1101.
3.1. .vul/.\.\"lIdIlUIIUII.\ nat/iug

is three. As expected, if the security trades every period so that1T; =0, both
the mean anel variance of kl are zero.

1IIIIIliraiions Jar individual Securily Rrlums

To see how nontrading can afTect the time-series properties of the observed
returns or individual securities, consider the moments of r;~ which, in turn.
depend on the mOlJlents of X'I(k).11I For the nontrading process (3.1.2)-
(.~.l.:{), the observed returns processes {r,~1 (i = I, ... , N) are covariance-
stationary with the following first anel second moments:

/1, (3.1.9)
t 21T; t
Var[r;~l 0+--/1 (3.1.10)

I
, I - 11; ,

-~;rr: for i = j, n>O

= 11-".)11-"1) fJ fJ ~ 1/
for i =1= j, n~O
(3.1.11)
I ".", ' J Of 1Tj

n > 0, (3.1.12)

where o,t == Var[r;ll and == Var[/tl. 0/

From (3.1.9) and !3.1.10) it is clear that nonrradingdoes notafTectthe
mean of ohserved returns bill docs increase their variance ifLhe security has a
nonzero expected return. Moreover, (3.1.12) shows that having a nonzero
expected return induces negative serial correlation in individual security
returns at all leads and lags which decays geometrically. The intuition for
this phenomenon follows frolll the faClthat during nontrading periods the
oliserved return is zero and during trading periods the observed return
reverts back to its cumulated mean return, and this mean reversion yields
negative serial correlation. When Il;=O, there is no mean reversion h<;nce
no llt'galive serial correlation in this case.

Mllximal S/mrious AuloforTelalion I

These momenL~ also allow liS to calculate the maximal negative autocorre-
1'lliOll attributable to nontrading in individual security returns. Sincei the
autocorrelatioil of observed retllrns (3.1.12) is a nonpositive continuous
function of 11; that is zero at IT;=O and approaches zero as IT; approaches
unity, itlJlustattain a minimum for some IT; in [0,1). Determining (his Iqwer
bound is a straightforward exercise in calculus, and hence we calculate it
only for the first-order alllocorrelatioll and leave the higher-order cases to
the reader.

IIITo ("OIlM'I"\'(" span'. w(" sllllIl1Iaril.t' lht' rt'MIIt~ ht'rt· and n:ft'T rt"adt"n 10 l.u and MacKinlay
( I !)!)O". I !)!)O("j I.... fllrtl ... r d.·I;liI •.
 90 3. Market Miovslmrlurr

Under (3.1.2)-(3.1.3) the minimulII first-<Jrder autocorrelation of the

observed returns process Irj~l with respect to nontrading probahilities IT, is
given by
t
M ·In Corr l·
,n,1
Tit' • 1=
T,I+I - (I~il)rn
I + v21~;1
where ~j == J1.;!ai. and the minimum is attained at
I
IT i = : : '
I + ./21~,1
Over all values of 11"; E [0, I) and ~i E (-00, +(0), we have
I
.~ Inf Corr[r,~, r~+IJ
I",,~,I
= -;-.
2
(~.I.I:)

whic I is lhe limit of (3.1.13) as 1~,1 [nneases without bound, bllt is never
allail{led by finite ~;.
Although the lower bound of - ~ seems quite significant, it is virtually
It' unattainable for any empirically plausible parameter values. For exalllple,
l if we\ consider a period to he one trading day, typical values for II; and
~ (1j ar1.05% and 25%. respectively, implying a typical value or 0.02 for ~,.
t Acco 'ding to (3.1.13), this would induce. a spurious autocorrehnioll or at
It most 0.037% in individual security returns and would require a nontradillg
i prob bility of97.2% to allain, which cOITesponds to an average nontradillg
~ durat on of 35.4 days!
~. lese results also imply that nontrading-induced autocorrelation is
~ magn fied by taking longer sampling intervals since under the hypothe-
sized irtual returns process, doubling the holding period doubles J1.; bllt
i" only ultiplies (1; by a factor of ./2. Therefore more extreme negative all-
tocor elations are feasible for longer-horizon individual returns. However,
this iSlnot of direct empirical relevance since the effects of time aggrega-
tion hflve been ignored. To see how, observe that the nontrading process
(3.1.2)-(3.1.3) is not independent of the sampling interval but changes in
a nonlinear fashion. For example, if a period is taken to be olle week,
Ihe possibility of daily nontrading and all iL~ cOllcomitant cffecL~ all weekly
observed returns is eliminated by assumptioll. A proper comparison or oh-
served returns across distinct sampling intervals must allow for lion tra<ii 11 14 at
the linest time increment, after which the implications for coarser-sampled
returns may be developed. We shall postponc further discussion of this and
olher isslles of time aggrcgation ulltillatcr ill this sectioll.

AS)'lIlmrlr1C CroH-A UIOfOlIar1anrrJ

Se\'eral olher important empirical illlplications of this nontrading lIlodd
are captured by (3.1.11). In particular. the sign of the cross-autoc()\'ariallct's
J. l. NUIIS.yndlHJ/UIll.I 'J/1UliIlK !11

is deterJllined by the sign of /1,/1,. Also, the expression is nol symmctric

with respcct to i and j: If 7r; =
0 and 7r} of 0, thcn there is spuriolls cross-
all tocovariance betwcen r;~ alld 1';; III but 110 lTOSS-;llItO("llVariance hetweell
Ii'; alld r;;+11 for allY H> 0. 11 The intuitioll for this reslilt is simple: Whcn
st~curilyj exhibils nOlllrading, the relurns to a constantly trading securilY i
call forecasl j due to Ihe common f;tctor it prcsent in hoth I·eturns. That
j exhibits nontrading implics that future obs('J"ved retllrns 1';;+11 will he a
weighted average ofal! past virtllal retllrns r,I+/I_' (with the Xil~lI(k)'s as ran-
dom weights), of which one lerm will he the l"llncnt virtual returll 1',1' Since
the cOlltemporaneous virtual returlls 1"" and 'l ' ;Ire UIITl'iatl'ti (beGl\lse of
the common factor). 1':; can forecast ';;4 /I' IloIVevcl", ,.;; is itself unforecastablc
bccallse 1';; = Ti' for all t (since 7r, = 0) ,Illt! r,l is II!) by assumption. thus Ij';
is uncolTdatcd with ";;+11 for any 11 > n.
The aSyllllllcll)' of (3.1.11) yields all empirically testahle restriction on
the crosS-;l\llOcovariallces of returns. Since the only source of asymmetry
ill (:\.1.11) is cross-scClional differences in the probabilities of Ilolllrading,
:nforlll<ltion regarding thcsc probabilities ilia), be extracted from sample
moments. Spccifically, denotc b), r;' the vector [ 1';', 'J, ... r~1 J' of ohscrvc(\
r('.urns of the N securitics and define the <Il1toc()vari<lnce lIIatrix I'll as

IL "= E[ r;'I. OU.Hi)

Dellotillg !l,e (i,j)th clelllellt of 1'/1 hy Y'j(II), we h,IVl' hy defillition

Y,,(ll) =
(I - lli)( I - ll,) Ii, Ii (J~/ Jr" (:1.1.17)
I-ll,ll, "

Ir Ihe lion trading probabilities ll, differ across securities, 1'/1 is asymmetric.
From (3.1.17) il is cvidel1llhat

(3.1.18)

Therefore relalivc nontrading probabilities lIlay be eSlimatcd directly using

r
sam pic autocovariances n' To derive estimates uf lhe prohahililics 7ri thelll-
selves we Ileed only estimalc olle SIIl"h probability, say lli. <lnd the remaining
probabilities may he obtained fmln the ratios (:).1.18). A consistcnt estima-
lo\" of rr, is readily cunstructed with salllple IIIcans and ;llItol"ovarial\(:cs via
(?..!.II).

II :\11 ;thCIII.lliv(' illtcrprct;lIioll or Ihis ;ISYIlIIHt'll y 111;1)' he 101ilid ill IIII' ,illH"~s("l if'S literaluu'
cOlln"rlling Cr~lIlgt'r. <:allsality (!\ee (;rangl'r II!Jh~)j}. ill whirl, ,;; IS :-."id 10 (;ranK"-((IIL" r;; if
Ihe relllrn to i predicts Ihe retllrn to j. III lilt, ,,,hove.' example, s{'("urily i (;'flnK"-<m.Hr.~ ~cllriry
j when j is s\l\~jc-(t to nontrading but i is noL Sillce our HOlllTddillg prO(Ts..~ fUlly he vi{"w{"d a.1Ii.
(\ form of \lll'a:-o\l1Tllwllt error, Ihe taCi Ihal Ih(' I"('11II1I."i 10 ollc "i('('111 i1r III;')' he l'xogellotl.,\ wirh
l'e:-opeC't to the ret\lrns of allother ha~ lW('1I ))IOpo.... (·(l ulldel' ;I diflt'n'nl glli.'\(' ill Sims (I!J71,
1~)77).
/1Il/,limlio/H jill' I'orlfolio Ul'llIT/I.I
Suppose securities are ~rouped hy their Ilontradillg prohahilities and eqllal-
weighted portll)lios are limlled hased on this grouping so that portfolio A
contai/ls N" set'llrities with idt'/lti("al /lolllrading prohahility TC", a/ld similarly
lill' pOrlli)lio Il. Iknott' hy ';~I and I~'I the ohserved time-t returns on these t\l"1
pOrl/illios rt'SIIt't'ti\'t'i)" whit'h art' approximately averages of the individll; I
n'turlls:
K {I, h.

where the summatio/l is over all securities i in the set of indices I, whirl,
t'omprist' pmtli)lio 1<. Tht' rl';lson (:\.I,19) is 1l0lexaCI is th;\! hoth o\)seryt'c\
and virtual retllms art' assumed to he continuously compounded, and tht'
logarithm of a sum is 1101 the sum of the logarithms. 12 Ilowever, if r:; t;lkt's
Oil slIIall vahlt,s allll is 1I0t too volatile-plausihle ,lssumptiollS for the shm I

returt! int!'l'vals thaI /lollsYllchrollous trading models typically focus 011-'

the approximatioll !'I'ror ill (:\,I,19) is IIl'gligible,
The timl'-seril's properlies of (:{.1.19) may be derived from a Sill'l,l,'
asymptotic approximation that exploits the cross-sectiollal ill<iepl'llt\cIl(,('
"fill<' dislllrhall('t's f". Similar asymplolic argulIll'lIlS ("all 1)(' /ClIlIle! ill lIlt'
Arhitrage I'ricillg Theory (APT) literature (see Chapter Ii); hellce ollr as·
sUlllption of illdept'lltlcllcl' lIIay ht, rt'laxt~rl to the same extent that it lIIay
he relaxed i/l studies of the APT in which portfolios are rcquired to he
"well·diversifil'd,"I'\ 1/1 sud. caSt'S, as the numher of securities in portfolios
A alld JJ (delloted hy N" alld N,,, respectively) intTeases without h'lUlld, the
·'(Illowillg equalities ohtain almost surely:

00

I', -\- (I -IT,)fl. LlT:fr-k, ('I.I~()

k=O

where
CU~I)

I:!.\ PIC" i,,' IIlh'llHt'l,lIioll 01 ':', j, tilt, 1('lIl1"n 10 i' pC)lllolio whOM' \,;,111(' is (".1)( 111;11('(\ .1'
all 11I1'\'C'lghh'd g"UIIH'lIil' ;I\'('lagt' 411 tht' ("(HIlPOllt'JH St.'flilitit·s' prin's, TIH' t'Xp('r!I'cI n'lllIll
01"~\\fh .., pontuhu \\,m ht· 10\\'\'1" 1h.m ,h . " t)f .\\\ t'(}\1/,\'~wt',ghtt't\ pontnho \... hn~t' u'\urn' ~\1t'
""kulah',l ;1.' IIH' arililllu'lil tIIe'HI.' of lilt' "implt' r('turns 01 Iht· (ompont'lll ~(·nlrili('s. This
i",,~ is ,·x;""i ..... t ill ~n';""1 d",,,il hv Mod.,s' ;"HI Sll,,,\;ort's,," (1'lH:I) ;"I<tl\,,," alltl I Lorl''''
(I~JHh) III tilt' ("01111",\1 01 liu' \'"hlC' l.illl' Indt'x whid. Wtl" all lIlIWI'ighlt'd g('olllc'lrir an'l ;I~(I
IIlllii I~'HH.
i"SSt'l". lUI ('X,I1I1I'''', (:h,tlllhc',I.,ill (I ~IH:\;t), (:halllhc'rI.,ill ;uHIH.Olh.'1 hilcl (I~IH:\). alld \\';lIlg
(I!II.I:\). Th(' ('."C'II( t' III tht,,,, wC';&k('r (1IlIcliliolh j" ~jmply lu alltl\Y tI I..IW of I.argt· (\;tllllh('", 10
ht, applic'd In IIII' ;1\'c'l;tgl' III II", di'llIl 11.11 liT.", ~o lia;1I .. itlio."ylH· ..."ir .. j,~" \',lIIbht,S almo", \111 (,1\'
'" 'ht, nn,~ "'11'1111 gun\·,.
for K = a. b. 'n.e first and second moments of the' poruqlio!s'feturns are
then given by

E[r:/ ] 11. = E[r./] (3.1.22)

Var[r:/l
a
2C-]'(')a~ (3.1.23)
ft. 1 +]'(. I

Cov[r:1' r: lh 1
a
fJ.2 -C-]'(.)
- - ]'(.n aI'
1+]'(•
2 n ~ 0 (3.1.24)

.!!. 7r,," , n ~ 0 (3.1.25)

Corr[r:l • r:l+ n)

a (l-]'(a)(I-]'(b) 2 n
Cov [r:1' r:l+ n) fJafJbal ]'(b' (~.1.26)
1- ]'(a]'(b I
!

where the symbol ~;;" indicates that the equality obtains only asymptotically.
From (3.1.22) we see that observed portfolio returns have the same
mean as the corresponding virtual returns. In contrast to observed i?divid-
r:
ual returns. the variance of 1 is lower asymptotically than the variarce of
iL~ virtual counterpart ral since !

1 1
ral :<::: -Lril = l1a + {Jalt + N Lfit (~.1.27)
Na lEI, d ie/. II
n
11. + (J.It, (3.1.28)

where (3.1.28) follows from the law of large numbers applieq to tte last
J,
term in (3.1.27). Thus Var[ rad ~ fJ;a which is greater than or equal to
Var[r: I ]·
Since the nontrading-induced autocorrelation (3.1.25) declines geo-
metrically. observed portfolio returns follow a first-order autoregressive pro-
cess with autoregressive coefficient equal to the nontrading probability. In
contrast to expression (3.1.11) for individual securities. the autocorrelations
of observed portfolio returns do not depend explicitly on the expected re-
turn of the portfolio. yielding a much simpler estimator for ]'(.: the nth
root of the nth order autocorrelation coefficient. Therefore. we may easily
estimate all nontrading probabilities by using only the sample first-order
own-autocorrelation coefficients for the portfolio returns. •
Comparing (3.1.26) to (3.U1) shows that the cross-autocovariance be-
tween observed portfolio returns takes the same form as that of observed
individual returns. If there are differences across portfolios in the nontrad-
ing probabilities. the autocovariance matrix for observed portfolio returns
will be asymmetric. This may give rise to the types of lead-lag relations
empirically documented by Lo and MacKinlay (1988) in size-sorted portfo-
!J4 J. M(lJ"krt M;n'U.IIl'llrlll/l'

lios. Ratios of the cross-autocovariances /IIay be forllled to estimate relativc

nontrading proba~ities for portfolios, since

rllft 'i,l.. + 11 I
C~ov I" ~ (rr/~
)" n.I.:l~l)
Cov[ ri:J't 1'::'+11) If"

III ~ddition, for purposes of testing the ovcrall spedfication of the 11011-
I~a{iing 1lI0del, these ratios give rise to many over-idelllifying restricliollS.
slll~'e
I
Y•• ,(n) y., •• (lI) Y•• K,(II)·" Y" ,.,(11) y.,1.(lI)
==
(lflo)"
- n.I.:)()
I Y.,a( n) Y••• , (11) Y.,K, (II) ... YK,., __ , (II) Yb., (1/) If.

for 6ny arbitrary sequence of distinct indices KI. K2 • ••.• K,. !l -I b. r ::: N,,,
whdre
\
N" is the number or distinct )lOrti()lios and YK<• I (11) == Cov[r"/. ,.u1<" ," n I. II{,

Th9refore. although there arc N,; distinct autocovariances in r ll • the restric-

tiolls implied by the nOlllrading process yield far fewer degrees of freedom.

TinT Aggregation .
Th~discrete-tillle framework we have adopted so far docs not require the
specIfication of the calendar length of a "period." This advantage is more
apP'Irent than real since any empirical implementatioll of the nOll trading
mod~1 (3.1.2)-(3.1.3) mllst either implicitly or explicitly define a period 10
be a panicular fixed Gllentlar lime interval. Once the calendar tillle interval
has been chosen. the stochastic behavior of coarser-sampled data is rcslrict('d
by the parameters of' the most finely sampled process. For example. if the
length of a period is taken to be one day, then the rnomen L~ of observed
monthly returns may be expressed as fUllctions of the parameters or the
daily observed returns process. We derive such restrictions in this sectioll.
To do tflis, denote by li~(f{) the observed return of security i at time r
where one unit of T-time is equivalent to q units of I-lime. tlIlIS:

'q

L
/=(,-llq+1

Then under the nontrading process (3.1.2)-(3.1.3), it can he shown Illal

the time-aggregated observed retllrns )ll'Occsses (r;;(q)} (i = I ..... N) arc
covariance-stationary with the following first and second lIloments (s('e I.\l
and MacKiIl!ay [1990a]):

E[r;,(q)] = q/l;

.) '2 IT ;(\ - IT () .)
= qa; + (\ _ rrY 11; n·I.:\:\)
3. 1. NOIlJy"dmmuu.\·. 'li"fUlillg

= -J1~ ITII/ II'ill (I - rr?)~ " > (I (3.1.34)

I , I - IT,

~;( I - IT?)~lT,I/'i 'il I

Cord r;; ('I), r:; ll/(q) 1 - ------------

X(I-lT?)~ i of j, 1/ > 0,
I - IT,

where~, == I(;/Oi as hefore.

Altho\lf!;h expected relllrns tilll<'-af!;f!;regate linearly, (:1.1.:13) shows that
\';Iriances do nol. As a result of the negative snial correlatioll in r;;. the
\'<lri;IlICe of a slim i~ less than the Slllll of thl' v;UiaIH'l's. Tillie aggregation
docs not .\ffect the sign or the ;tutocorreLitiolls ill CI.I.:I:) although their
Illagnitll<les do decline wilh the af!;gregatioll val Ill' 1/. As ill (3.1.12), the auto-
correlation or time-aggregated retllrns is a nonpositive continuous functiou
=
(l('lT, Oil {O, I) which is l,ero 'It IT, (I .111(1 appnl<lrJlcs 1.\'1'0 .IS ITi 'Ipproadws
unil),. and hClll'e it atuins a minilllulII.
To explorc the behavior of thc lirst-onlcr '1I1l0(,OITl'i;lIion, wc plot it as
;1 fllllCiioli of IT, in Figurc 3.1 \'UI' a variely o\' values 01''1 and ~: ,!takcs on lhl'
"allll's :), 22, (iG, alld 244 to correspolld to wcckly, lIIollthly, qllarterly, and
;\llIlII;J1 retllrns, respectively. since,! = I is takclI to he OIlC day, alld ~ takcs
on Ihl' val lies O.O~), O.lli, and O.211() rOlTcspond til <I.lily, wcekly, alH\lIlolllhly
I'Cllll'lIS, respeclively. H Figure :1.1 a plots tlte 111'st-0I dn autocorrelation Pt (f!)
J()l' the fOllr values of q with ~ == 0.09. The clirve lIIarked "q = !,,» shows that
the \\'eekly Iirst-onlcr autocorrelatioll illduc('(\ hy 1IOIIIIatlillg II ever ('xn'ctls
-5(}I, alld ollly attains that vahl(' with a daily 1I0ntr;Hling prolJ<lhility ill CXtTS~
or~lO%.
Although the alltocorrelatioll of coarser-sampled retllrns sllch as
IlJolllllly or quarterly have lIIore extrelllc minima, they ;\IT ;lltailled ollly
at highcr nOlltrading probabilities. Also, tillle-aggregalioll Ilced 1I0t always
yidd a lIlore lIegative autocorrc\atioll, as is apparclll frolll the portioll of
Ihe graphs to the left of, say, IT = .HI); in that I cgiolJ, all increase ill thc
aggr('g;ltiulI \'.lIl1e '/ leads to all alltllcorrcl;lIioll dosn to l(,I'O. IlIde(~d as If
ill(Tt';lSl'S without hOlilld the .1l11ocond;ttioll CI.I.:I;I) approaches I.cm for
fixcd IT,, alld thus Ilolltradillf!; has lill1c illlpatt Oil IOIlf!;('I'-hOlilOIl returns.

1"Vaill(" lor ~ well' ohl.!illl'li hy takillg lIlt' I'.,lio "lllIe ',lIl1pie IIl('alllo Ihe ,alllple .\[;)1111.11<1
d('\'ialioll for d"ily, w('l'kly, alld monlhly ('qnal-w('I~IIIl'd "0"
I'eltll,,, i"dex .... lor Iltl' .ample
period h'lll" 1~1t;:L 10 1\IK7 '" rl'pOI'Il't\ in 1.11 a"d ~1."·Kinl,,y (I\IKK, ·L,hl.·, L,-i·). Allhongh
tIH',\(' \,;llll(,~ 111.1)' he ilion' l('pn'S('n,ali\'(' of .,Ior).. illClt·x('.\ I;lill(" 11t.11I IIlfli\'idll.t1 .... l'("Ilfili(·.~.
w'n'\ tlwl{'~~ lor "H' ~;,k(' of illu~trtuiul1 "u'Y ~honld :-oullic (',
I
/. "
)
/'/ V.
~ "~

I;
I
I
- . -

In '.If
'"
1I••III·p' ...... '"\· '" ,,' Nil 'III III ;'11

(
:~
)
~ "~ '"
/
~

)'i) +:
~
:f
~ ~

,
I
'~

/;
r: iI
.. "-
j
I" < .'- .
~ I
I
- !
-

III' ;.tI 1.11

1II,'lq.III"OI'III\- '" '.11 111- l.u- 1.1r-
1I",wl·,II.'M·III\'
t u- '.11'
 The effects of increasing ~ are traced out in Figures 3.1 band 3.1c. Even
if we assume ~ == 0.21 for daily data, a most extreme value, the nontrading-
induced autocorrelation in weekly returns is at most -8% and requires a
daily nontrading probability of over 90%. From (3.1.8) we see that when
rrj = .90 the average duration of nontrading is nine daysl Since no security
listed on the New York or American Stock Exchanges is ina€live for two
weeks (unless it has been delisted), we infer from Figure 3.1 that the impact
of nontrading for individual short-horizon stock returns is negligible.

Time Aggregation For Porlfolios

Similar time-aggregated analytical results can be derived for observed port-
folio returns. Denote by r;, (q) the observed return of portfolio A at time r
where one unit of I-time is equivalent to q units of I-time; thus

'q
r:r(q) - L r:,t (3.1.37)
1=(r-l1q+l

where r:,
is given by (3.1.19). Then under (3.1.2)-(3.1.3) the obselVed
portfolio returns processes (r;, (q)) and (rb' (q)) are covariance-5tationary
with the following first and second moments as N. and Nb increase without
bound: i

a
E[ r:, (q)] qf-LK (3.1:.38)

Var[r:, (q)]
a [ 2rrK I-rr!]
q- I_rr K 13 22 K al

Cov[r:,(q), r:,+n(q)]
a
[I-rr.] [I -rr!r
l+rr.l-rr.
nq-q+ 1 f32 2
xrr • • al , n > 0

(l - rr!)2 rr;q-q+1
rr;) - 2rrK
a
Corr[ r:,(q), r:r+ .. (q)]
q(l - (l - rr!) ,

Cov[ T,:r(q),

n [I- q
b
T ,+II(q)]

".(1-":)(1-",)%+,,,(1-":)(1-"01']

(I-"e)(I-Jf,)
I-If.",
(I-If.)(I-",)

[~]
1-",
2
rr nq - q+1
b
f3 f3 a 2
n b
P.P'''t
I-".If,

I
for

for
n == 0

n > 0
(3.1.42)

for K == fl, Ii, q > 1, and arbitrary portfolios a, h, and time r.

98 3. Mmlifl Minollrurllln'

Equation (3.1.40) shows thattillle a~~re~ation also affecls Ihe '1II\oCO!"-

relation of observed portfolio relurns in a highly nonlinear f;lshion. 111
contrast to the alltocorrelation for ti/lle-a!{~reg-ated individual securities,
(3.1.40) approaches unity for any fixed I{ as 1(. approaches unity; IIIen,rol"('
the maxim,11 autocorrelation is one.
To investig.lle the behavior of the portfolio autocorrelation we plot il
as a function of the portlolio nontradin~ probability 1( in Fig-me :t Id Itll'
q = !i. 22. G6. and 244. Besides differing in sign. portfolio and individ-
ual autocorrclations also differ in absolute magnitude. the former heing
much larger than the bner for a givell nOll trading probability. If the non-
trading phenomenon is extant. it will be most evident in portfolio returns.
Also, portfolio autocorrelations arc 1JI00IOtonically decreasing in if so titat
lillie aggregation always decreases nontrading-induced serial dependence
ill portfolio relurns. This implies thaI we .Ire lIIostlikely to lind evidcllfc of
non trading in short-horizon returns. We exploit both these illlplicatiolls ill
Ihe empirical analysis of SeCiioli :1.4.1.

3.1. 2 l~xlensions and GPIleraliwlions

Despite the simplicity of the model of Ilonsynchronous lradill~ in Se(!ion

3.1.1. its implications luI' ohs('I"vcd tillle series arc surprisingly rkh. The
framework can bc cxtcnded and gencralized in many directions with lillie
dilllculty.
It is a simple mailer to relax the assulllption lhat individual virllt.tI rc-
lurn;lare lID by allowing Ihe COIllIltOIl faclOt· 10 be attLOcolTclaled allel the
diSH! "bances to be cross-sectionally correlaled. For example, allowill~ ji
to he a stationary AR( 1) is conceptll,tlly strai~htr()rward. although the t'al-
clllatilOns become somcwhat lIIore involved. This specification will yield a
dcco61position of observcd <\utocorrclations into two componenls: one due
10 thJ COlllmon factor and anothcr dlle to 1I01l1l·adill~.
Mlowing cross-section'll dependence in Ihe disturbanc'es also nllllpli-
cates lthc momenl calculations hilt docs not crcate allY intrartahiliti('s.I~.
Indeed, generalizations 10 lIIuhiplc l;tctors. lime-series depcndence of the
diSIlIlI><I1lCCS. and correlatioll hetweeni;lctors and di.~LUrbances arc only lilll-
ited h thc palicllce and perst'wranl'l' of the rt~adcr; the lIecessary lIlotnelll
(alcul t(iolls arc not intranablt" hilt lucrdy It·dious.
1> 'pelldcncc Gin he built into Ihe nontrading process itsclfhy asslllltin~
thattl e O,l'S arc Markov dlains, so II1<1ttl1(' conditional probability of Iradillg

I
'\\"iWt' tli.'nl~.,,(·d (';U1it'l, ,OIlU" Itll III (II t rO~.'·~l"t licltl.tl wc.".,}.;, dCpt·l1th-lIet· 11111."1 he illlJ)('~('cl
so thai (tht' as\"tuptotic ~1I"~lltnl·tlt~ of the port(oliu r('suh~ s.till ubtain. of ("UUt"S(', 'l1rh ,\t\
.\X\n1l1ppUI\ In.W nn1 alw.w'\ \w ,\pplilpri.\\t, .l~. tor t',,\.ul1ph-.ln the ra~p of n))npallit'~ "ilhil11lie
~.IIIW il1(lll~tly. whOM' n·~id\l.tl ri~k~ W(' l1lig.ll1 ('Spt'ft 10 Ilt' pn~ilin'l~ rnrn·ble(t. TIlC'It·ltu t·, till'
.,'\1\1\,\(:\\\\' ~'ppn.,\.in\.\ti\ln ,,'ill bt' 1\\n~t .\r(\\L\~\' hn \\TH--i;\\\\·\· ... 1tlt·l\ punt'oHo ....
3,2, '/'Ill' Hid-fbI! Sf/mid !I!I

tOll\orrow dqwllds 011 whellwl' 01' lIot ~I trad~' o<"nll'S tod"y, Ahl\()ugh this
specificatioll docs adlllit cOlllpact and cI('g~1I1i ('xpressions Ill!' the lIlonJents
of the obsel'ved r('tUI'IIS proccss, w(' shaillcave their derivalion to the rl'ael('1'
(Sl'(' Problelll :t:I), However, a bl'i('f slIlllm.II'Y of thc illlplications for the

lillle-snies properties or observed Idlll"\lS lIIay lit' worthwhile: (I) Individ-

ual SCCIII'ity retums lIIay he positively '1l1t()cond;ltcd and ponfolio IClllrns
ilia), be nq~alively aUlocol'l'c\alcd, hUl these possibilities arc unlikely given
empirically relevant paf'alllctcl' valucs; (2) It is possible, but IInlikely, 1(,1'
autocorrelation matrices to be sYlllllletric; alltl C\) Spurious index autocor-
relation illtluced by nontrading is higlll'r (or lown) whcn there is pIJsitivl'
(01' negative) persistence in uOfltrading, In principle, propeny (:{) might
be sufficiellt to explaill tlte lllagnitu(1c or index aUIO('olTdatiolls in f'Ccenl
stock market dala, However, sevcl'al calibralioll experilJlcllls illdicatc the
dq.;rce or persislellce in nontradill~ required (0 yield weekly aUlocorrcla-
tiollS or :{O% is empirically impbllsihlc (sec \.0 alld MacKill]ay [1990c] 1'01'
details),
Olle (illal directiofl for fllnher invcstigation is the possibility of depell-
dence betweefl the nontrading and virtual retuf'flS processes, If virtual rc-
tUf'flS are taken to he new inforfllation thell the exteflt to which traders
exploit this information in deterflliniflg whell (and wh'lt) to trade will show
itsc\f as correlation between r,( anti ,5 ,(, i'vLllly stralt'gic cOllsidn;ltions are
illYolwcl ill l1\odels of ifl(orfllalioll-hased tr<ldillg .• \lld ,\II empirical '1II;llysis
or such iss lies prolllises to he as challengillg as il is ('xciting,lh
Ilowcvcl', ir it is indeed the case that returfl autocolT('latiofl is iflduced
by illro)'matioll-i>ascd llol11r.ulillg. ill what ,,'liS" is this .1ll\o('oIT('latioll SPIl-
riolls? The prclllis~~ or the extensive literature Ofl flUfls),flcilrouolfs lradiflg
is that fI()fltrading is an outCOfllC or institutional features sllch as lagged ad-
jllslIlll'llts anel nonsynchl'()flously reported prices, I\ut if nOJlsYllrhrollicilY
is purposeful alld illlorlll<ltiollally llIotivated, thell tltc serial dependencc it
induces ill asset returns should he considered gelluil\(', since it is the result
of C(OllOfllic fill'ces rather than mcasurCfllent elTor, III stich rases, purely
st~llisli(,<I1 fll()(lcls of nontrading are dearly iflappropriatc .IIHI an econolllir
Illotil'l of'stratl'gil' illteraniolls is Ilceded,

3.2 The Bid-Ask Spread

011(' or Ihe mosl important charac\el istics th;1I ill\'('stors look for in all 0)'-

g;llli,,'(\ lill;\nri.d nlarket is li(plitiity. till' ;dJilitv to hili' \)\' ,ell significlIIt

IIoSOIlH' good iltll~tr.Hi()m. of tl\t· kind til Il,Hhng hell.I\I(1I 111.lI (.111 .lIi\" helm ""lIall'gi."
("oll\idt'l ;llioll~ .If"(' (oillaillt'd ill Adlllali ;11111 PI1t'id(,f(,1" , I~.HH. I~.H~)). Ikll\llII;l.\ ;111(\ 1.0 (1~~lh).
b"I",' ""d 0'11.",. (1!IH7, I!J!JO), K)it, (I!JH.'>l. ""d \I'",,~ (I'I!U, I!I!IIJ,
qualllilil'S oj a sl'nu ill I(lIiddr, '1I101l),IIHlllsly, and wilh rehllivl'l), lillie pricl'
illlpan. 'Ii) mailllaill liqllidity, lIIallY oq~allized exchanges USI' marketlllak-
l'I'S, individuals who stand rl'ady to lilly or sell whenl'ver the pllhlic wishes
Itl sl'll or hllY. III rl'11I1"II for providing liqllidity, markctlllakt'rs art' grallter!
mOllopoly righls hy Ihl' I'xchallgl' 10 post dilTerent prices for purchases alld.
sail'S: They IIuy OIl Ihl' hit! pricl' "" alld sl'lI al a higher fll/( price I~/ This
ahility to huy low alld sl'lI high is Ihl' Illarkeimaker's primary SOlll'Cl' of rOIll-
)ll'nsatioll /(11' providing lilluidil)', alld although the hid-ask spread I'" - Ph is
rardy larger thall (HIl' or two ticks-the N}'SI'; Fad /look: lCJIJ.I /)ala reports
Ihat the slHl'ad was $0.'2:) or Il'ss in 90.Kt;:, of the NYSE hid-ask qllott's frolll
I~)\H-o\'er a large nlllllhl'l' or trades Illarketlllakers can earn ellollgh to
comp('IISall' Ihl'lII for Iheir sl'I'vicl's,
Thl' dilllillluivl' Sill' or typical spreads also helil's thl'ir pOll'lItial illl-
portallcl' ill dell'J'lllillillg Ihl' lillie-series propl'rties of asset relurns. For
l'xaIII pll', Phillips alld SlIIith (I !'KO) show that lIIost of the ah II llI'lII a I r('-
turns associated with particlliar options lrading slrategies art' dilllin<lled
whl'n thl' costs associated with Ih!' hid-ask spre;ul arc inl'illckd, Blllme
alld Slalllhallgh (I!)l-tl) argll(' Ihal the hid-ask spread creall'S a sigllificallt
upward bias ill 11)('.111 )'('IIII'IIS cakllialed wilh IntllSanioll prices. More 1'('-
('('lIllr, Kdlll (1\IH\I) shows Ihal a sigllificalll portioll orlhe so-called./fll/1/my
('frl'n-Ihe f;Il'1 Ihal slllalln-capil.lli/alioll slorks seelJl to olll(ll'rforrll larger
capitalizalioll Slocks OVl'I' lhe It,\\, days SlllTOUIIClillg Ihe IlIrn or Ihe ),ear-
lIIay 1)(' allrihulahle 10 dosillg pric('s recorded OIl thc hid pricc OIl Ihl' clld
of [kcclIll)('r allel dosing prices rCl'(lI'<\('<1 al Ihl' ask prin~ al IIIl' begi1l-
ning of.Jannary. \<:\'('11 ir 1111' hid-ask spn'ad remains unchallged durillg Ihis
period, Ihe III ()\'C'III ('nI frolll hid In ask is ellough to yield large pOllfolio
rei urns, especially /i)r lowcr-priced stocks for which Ihe /lI'rrPlllagl' hicj·ask
spreael is larg{'r. Sillce low-priced slocks also lend 10 he low-{'apilalizatiol1
slocks, Kl'im's (f!'H!I) rl'suits do ofrl'l' a partial explallalioll fill' Ihe Janllarv
l'IkCl. 17
The pH'selln' of Ihl' hid-ask spread cOlllplil'aleS lIIallns ill sl'Vl'ral ways.
[lIsl('ad of 0111' pric(' for ('ach s('('lIrity, Ihne <Ire 1I0W Ihn~e: Ihl' hid pricl',
till' ask priel', alld Ih(' Ir'lIIsanioll price which need nOI be eilher Ihe bid
or Ihl' ask (all hough ill SOllll' caSt'S il is), 1101' J\eed it lie in helween Ihe Iwo
(all hough ill II illS I las('s il dol'S). Ilow shollld relurns he calculaled, rrolll
hid-In-hid, as);-lo-hid, ('Ie) 1\lol<'o\'l'I', as ralldolll huys alld sells arrivl' at
IIIl' lIlarkel, pritTs CIII houlI('(' hack alld fi)rlh helween Ihe ask alldlhe hid
prices, crealing spurious vol;lIilily and sl'I'ial corrl'lalion ill relurns, eVl'1l ir
Iht' e('(I\IIIIlIic value or the sl'('\lrit\' is n\lch.lllge<i,

17 ""jm (pn'~I) .11 .. 41 dIU I1I1H'II1'- 1\1(' Id.llil III h"1\\("I'IIII,hcl f,l}C-IU1.11 .llIolllali('.\ (tilt" \\'('(')"'('111\
dlt'\ \, huht\.'y dk, \ .... l'le) ."u' . . ". . h·II\.Hi, m"\\'lIu'ub ht'\wt'c.'l\ lht· hill ~\1H' ;\:'\k prin·~.
 .• '. ..."!i~~

J. Q..l Bid-Ask Bounce

To account for the impact of the bid-ask spread on the time-series prop~rties
of asset returns, Roll (1984) proposes the following simple model. Denote
by r; the time-/ fundamental value of a security in a frictionless econ~my,
and denote by s the bid-ask spread (see Glosten and Milgrom [1985~, for
example). Theil the observed market price PI may be written as '

• 5
== P, + 11-2 (3~2.l)

with probability ~ (buyer-initiated)

II lID {+I
-I with probability ~ (seller-initiated)

where II is an order-type indicator variable, indicating whether the tra~sac.

tion at time t is at the ask (buyer-initiated) or at the bid (seller-initiated)
price. The assumption that P;
is the fundamental value of the security
implies that E(Itl == 0, hence Pr(/I=l) == Pr(/I== - 1) =
~. Assume for
the lIIoment that there are no changes in the fundamentals oftl}e security;
hence P; = P' is fixed through time. Then the process for price changes'
t. PI is given hy

(3.2.3)

• and under the assumption that II is IID the variance, covariance, and auto-
correlation of t.PI may be readily computed

s2
Var[ t.PI 1 (3.2.4)
2
l
Cov( t.PI - 1 , t.Ptl (3.2.5)
4
Cov[ t.PI _ k , t.Ptl 0, k > 1 (3.2.6)

Corr[ t.PI _ 1 , t.PI J == (3.2.7)

2

Despite the fact that fundamental value P; is fixed, 6.PI exhibits volatility
and negative serial correlation as the result of bid-ask bounce. The intuition
is clear: If P' is fixed so that prices take on only two values, the bid and
the ask, and if the current price is the ask, then the price change between
the current price and the previous price must be either 0 or s and the price
change between the next price and the current price must be either 0 or -So
The sallie argument applies if the current price is the bid, hence the serial
correlation between adjacent price changes is non positive. This intuition
102 J. Markd ,HirTU.s/rurturr

applies more generally to cases where the order-type indicator I, is not IID,IH
hence the model is considerably Illore general than it may seeJJJ.
The larger the spread s, the higher the volatility and the lirsHmll'l'
autocovariance, oOlh increasing proportionally so that the first-onkr auto-
correlation remains constant at - b.
Observe from (3.2.0) that the bid-ask
spread docs not induce any higher-order serial correlation.
Now let the fundamental value 1',. change through tillie, 11111 slIppose
that its increments are serially uncorrclated and independent of 1,.19 Theil
(3.2.5) still applies, but the first-order autocorrelation (3.2.7) is no lonp;er
- ~ because of the additional variance of 6.P,. in thc denominator. Specifi-
cally if a 2 (6.I'.) is the variance of 6.1>,', then

< O.

Although (3.25) shows that a given spread.l implies a first-order alltoco-

vari)nce of _s2 /4, the logic may be reversed so that a givcn autocovariance
codlicient and value of /1 imply a particular value for s. Solving for J in
(3.2~5) yields
i s = '2)- Cov[M',_I, 6.1',] , n·'2·~)
hen(e s may he easily estilllated frolll the sample autocovariances of price
cha~ges (see the discussion in Section 3.4.2 regarding the empiric;!1 illlple-
mcn'lation of (3.2.9) for further details).
l:stimating the bid-ask spread lIIay seelll superfluous given the 1;l('t th;lt
bid-+k quotes are observable. Ilowever, Roll (1984) argucs that tile (I'loted
spre~d may often differ from the 1Jerliue spread, i.e., the spread between
the lual market prices of a sell order and a buy order, In many installces,
trans clions occur at prices wi/hin the bid-ask spread, perhaps hecause Illar-
ketm kers do nol always update their quotes in a timely fashion, or hecause
they ish to rebalance their own inventory and are willing to "beller" their
quot s momentarily to achieve this goal, or because they <Ire willing to pro-
vide liscollnts to customers th,lt are trading for reasons other than private
inforlnation (see Eikeboolll [1993], Gloslen anc! Milgrom l19H:, 1, Goldstein
119931, and the discussion in the next section for further details), Roll's
(19R4) model is one measure ol'this cfkctiv(' spread, anel is also a means I(JI'

I~}'or example, scrial (orrdatioll ill I, (of ,·ill\("1" ,i)(lI) do(" 1I0t chall)(" th,' Ian th,l! J,id-
a~k hOllon' indllces nc~alive ,('rial (onebtioll ill price chall)(e" altholl)(h il do(" .dlnt the
nlOlRni\mle. See Choi, Salandro, ;lI1d Shaslri (19HH) for an explicit allalrsi, of Ihi' C''''.
19Roll (19t\4) argues Ihal pricc chanf(c, IIIlI,t h .. serially lIlIcorrelated ill all illfollnatiollally
elliden! market. Ilowt"ver, I.eroy (1 117:\), \.\lcas ( 1~17H), ami otirers have shown thai Ihi.' 1I("'d
not be the {ase. NeverthelcS""" for ~hnn-hnril.()11 It'turns, f".g-., daily or inlradaily H'1ur1iS. il
i~ diflicuh to p,,,e all {'mpirirally pbllsihk "'1"ilihrilun 111",,,"1 of ."'('1 "'\lilli' Ihat ('xhihits
~iKnilic;lI1t serial correiation.
3.2. Thl' fJ/d-A\k ,\/Jrl'a{/ 103

accountillg fill' the effecL~ of the hid-ask sprcad on the tillie-series properties
or asset returns.

3.2.2 COIII/m/lt'llil o!tlu·/Jid-A,/i S/I/md

Although Roll's lIIodel of the bid-ask spread captllrcs OIlC illlportant aspect
of iL~ crfCu on transaction prices, it is by no lIIeallS a cOlllplete theol")' or
the ecollomic detenninanLS and the dynamics or the spn.'ad, In parlicul;lI;
Roll (I ~l81) takes .\ as given, hut ill practice the sit.l' of the spread is the
single most important quantity that marketm'lkCls cOlltrol in their strategic
interactions with other market participanL~. In bet, (;Iostl'n alld Milgnlln
(19R5) argue convincingly that .\ is d('lermi ned clldogl'nously and is unlikely
to be independent or P' as we have assumed in Sn:tion :1.~.I.
Other theories or the markcll\laking process have decolllposed the
spread into more fundamental UJIl1pOllellt5, .lIId thcse componcnts often
behave in din'erent ways through lillie and across securities. Estimating thc
separatc componcnts of the hid-ask spread is critical for properly implc-
IlIcnting these theorics with transactiolls data. III this sectioll wc shall turn
to somc or the econometric issues surrounding this task.
There arc three primary economic sources for the hid-'lsk spread: ordcr-
pr()ce~~ing costs, inventory costs, and adv('rsc-~elcctioll costs. Thc first two
consist of the basic setup and operating COSL~ or trading and rccordkeeping,
alld the carrying or undesired inventory subject to risk, Although these CoSL~
have been the main fucus or earlicr Iiterature,~() it is the adverse-selcction
compollcnl that has receivcd lIIuch recent atlention.~1 Adverse selection
cosb arise be calise somc investors arc beller informcd ahollt a sccurity's
valuc [han the markclfllakcr, and trading with such investors will, on av-
crage, be a losing proposition ror the lIlarketfllakeL Since IIl<1rketlllakers
have no way to distinguish thc inforllled from the uninfi>nlled, they are
rorced to engage in these losing trades and must be rewarded accordingly.
Therefore, a portion of thc marketlllaker's bid-ask spread Illay bc vicwcd
as cOllJpensalion for taking the otller side of potcnti;il inforlllation-based
tr;\{!cs. Bccause this information COlllp'1I1enl can have very different stalis-
tical properties from the order-processing ;\Ild invelltor)' conlponclIL~, it is
critical to distinguish betwcen them in empirical applications. To do so,
Glosll'n (I 9H7) provides a simple as)'Il11llcU'ic-ill ['onllatiol\ Illodel that cap-
tures the saliellt fe'lIllres or adverse sdertion fiJI' the COlllj)()nCllts or [he
bid-ask spread, ,Illd wc shall present an ablJre\'ia)cd version or his elegallt
analysis hl.'IT (scc, also, (;losl('11 and I larris [ I ~lHH I alld Stoll [ I ~IH~1 J).

"'Sec, 1( ... ""11111'\'" Alllilll"\ alld M(,II(lchOIl (I'IHO). tl.lgd",l (t~171l. Ikln""1 (l'lhll), I I"
'"1(1 Stoll (1~1I1).S',,11 (19711), '"1(1 Tilli\' (197'2).
tt See l\a~,.ltot (1971), (;"1',,\;11111 <111<1 (;,ll"i (I (IKI). Fo,,',,"y "nd 0'1 I.n,\ (I ~11I7), (;\"",'1\
(I ~I!\7), Clm),," "IHI I brri, ( I~IIIII), (;I",,,'n ,11111 Mllgmlll \ I ~III', l. .lIld S,oll \ I !III!I).
 J. ,l/tII/{'" AII/'/wlll/l'llI/1'

(;!t1l11'1I \ JIt'/mll/iII,1 1/1" "

Ikllott' Ill' /'" alld /'" 11)(" hid allc\ ask prices. respe('(ivdy. allc\ It,t /' Ill' the
"11'111''' or 1'/111/ 11/11/1·111/0/,11//11 iOIl lll;lI"kl't price. t he price t hat all invest ors ,\'i t h-
out private intilllll;lIioll (1IIIill/(m/ll'l/ investors) ap;rel' "pOIl. Under risk-
nl'lItrality. till' (,Olllllloll-int'lrlllatioll price is p;ivclI by J' == E[/"ISl] ",here
n c\I'noll's Ihl' ('0111111011 or pllhli(' illtill'lllatioll set alld I"~ tIl'lIot('S tlle price
thaI wOllld reslilt if l'VI'I)'Olle had access to all informalioll. TIll' hid ami ask
prices llIay thl'1I Ill' e"pressed ;IS the fol\owillp; sums:

[' - 1\" - Ct. C~·~.IO)

1)" [' + ;1" -I- (:., (:-\.~.! !)

/'" - ['" = (..I" + Ad + (COl + C,,), C).:1.I~)

",line A"+A,, is the ac\verse-selection component or thl' spreatl. til Ill' 11t--
le!'lnilll'd !wlo\\', allli ('>1-(;" illtllllil's Ihe onlcr-procl'ssillp; and illvt'lltory
COlllPIHlI'lIts whil'h (;toStl'l\ c;lIls the gmu /m1il compOIH'nt ;\IItI takes as
1')(qp;I'ntlUs.~~ !f II IIi II forml'd ill\'l'stors observe a pllrchase at Ihe ask, thell
they will revise their valliatioll of the ;Issel from /' to /'+A" to aCCOlIlI1 for
thl' possihilitv thaI Ihe tratll' was illlill'lllatioll-I\\olivaled. alld Sillli!;lrI:', if;\
sail' at the hid is ohsl'J'\'('d, tlH'1I /' will hI' revised to /'-/1", BUI how are II"
alit! AI. delt'l'IlIillnl;
ClostI'll aSSllIlIeS lhat ;111 pOlt'ntia! lIIarketlllakers ha\'(' alTl'SS to (,Olll-

I
I
111(111 iidill'lllalioll 01111', alld he defilles Iheir IIplblinp; rllk ill respolIst' 10
Irallsaniolls at \';lIioIlS possibll' hid alld ask pricl's as

I
I
II(X) 1':[ I"~ Sl U I illveslor hllys ;It xl ]
r[ I"~ Q U { inwstor st'lls at )'} J.
'\11 alld ",. art' Ihl'lI ).\ivl'lI hy lilt' follolVillp; rt'laliolls:

il., '" aU',,) - /',

lllllll'l' sllitahle n'slricli<\lIS li,r Ill,) alld f,(.), allt'ljllilihriulll alllollp; (,OIllJll't-
ill~ JIIal'k"llIIak!'l,s will d('ll'IlIIillt' hid alld ask pric('s so Ihat the t'''pl'l'ted
protils frolll ilia I kt'lllIakill~ aniviti(" will cover all coslS, inchuling (.',,+(.,.
alld tI,,+ . h: 111'11('('

['" //( [',,) + (:" [' + (,,(/',,)- I') + COl = /' + '\" + (.~, (:\.~. I Ii)
I',. == ['(/'J,) ... CI, -- /·_·([· .. f,(I'J,))-Ci. = /'-A"-C,,. (:\.:1.17)

:.''!S~'(· ,\lIIilllui ,II lit !\kllci('I,tlll ( P);-J.O); (:lIh(,lI. T\.LIit" r, Sdlh'.lrt/. ,11111 \\'1111('01111. (I ~)H 11; 110
aucl Sloll (I!IHI); ,lfld ."iloll 'I~J7H) Itll lIuldl'" 01 these co .. I.\.
J.2. The Bid-Ask Spread 105

An immediate implication of (3.2.16) and (3.2.17) is that only a portion of

the total spread, Cn+Ch, covers the basic costs of marketmaking, so that
the quoted spread An+Ab+Ca+Cb can be larger than Stoll's (1985) Mef_
fective" spread-the spread between purchase and sale prices that ~cur
strictly within the quoted bid-ask spread-the dilTerence being the adverse-
selection component A,,+Ab. This accords well with the common practice
of marketmakers giving certain customers a beller price than the q\loted
bid or ask on certain occasions, presumably because these customers are
perceived to be trading for reasons other than private infoonation, e.g.,
liquidity needs, index-portfolio rebalancing, etc.

Im/liiwlio1l5 Jor Transaction Prices i

To derive the impact of these two components on transaction prices, denote
hy 1\ the price at which the 11th transaction is consummated, and let i
I
I>'. = Pal" + Pbh. (3.2.18)
where I" (lb) is an indicator function that takes on the value one if the trans-
action occurs at the ask (hid) and zero otherwise. Substituting (3.2;16)-
(3.2.17) into (3.2.IR) then yields

I>,. = E[I'·Ir2 U All" + E[P"Ir2 U B1h + Cala - Cbh (3.~.19)

1'.. + C.. Q,. (3.2.20)

fl" - E[p·lr2 U AlIa + E[P"Ir2 U B1h (3.2.21 )

{c,. if buyer-initiated trade

ell - (3.2.22)
Cb if seller-initiated trade

{ +1 if buyer-initiated trade
Q,. - (3.2.23)
-I if seller-initiated trade
where A is the event in which the transaction occurs at the ask and B is
the event in which the transaction occurs at the bid. Observe that PI! is the
common information price lifter the nth transaction.
Although (3.2.20) is a decomposition that is frequently used in this liter-
ature, Glosten's model adds an important new feature: correlation between
1'" and Q,•. If P is the common information price before the nth transaction
and I'" is the common information price afterwards, Glosten shows that

Aa if Q,. == +1
Cov[!'". Q"IPl = E[AIPl where A:; {
Ab if Q,.=-l.
(3.2.24)

That I'" ,\Ild Q,. mllst be correlated follows from the existence of adverse
selectioll. If Q,.= + I, the possibility that the buyer-initiated trade is infor-
malioll-hased will cause an upward revision in P, and for the same reason,
106 3. Market Microstrurlurr

Q,.=-I will cause a downward revision ill P. There is only one case in which
Pn and Q,. are uncorrelated: when the adverse-selection componellt of the
spread is zero.

Implications fOT Transaction Price Dynamics

To derive implications for the dynamics of transactions prices, denote hy f"
the revisions in 1'.-1 due to the arrival of new public information between
tra(y~s n-I and n. Then the nth transactioll price may be wrillell as

\ 1'" == 1',,_1 + t" + A"Q". rt~.~:)

I
Taki/lg the first difference of (:~.~.~O) then yields

==
I
\ 1\"<2,, + ('II + ((;"Q" - (;,,_1 Q,,-I),
!
whiejl shows thattrallsaction price changes are comprised of a gross-profils
com mnent which, like Roll's (1984) model of the bid-ask spread, exhihilS
reverlsals, and an adverse-selection componelll that tends to be permanent.
The;fore, Glosten's allrii>utioll or the effective spread to the gross-profits
com onerit is not coincidental, hilt well-JIlotivated by the fact that it is
this omponent that induces negative serial correlation in returns, nol the
advc se-sclection component. Accordingly, Glosten (1987) provides alter-
nativf relations between spreads and return covariances which incorporate
this d,stinction between the adverse-selection and gross-profiL~ compollents.
In pa~ticular, under certain simplifying assulJlptions Glostell shows thal~:l
2
_ ys"
E(i41 = U(I + yfJ), Cov( lit-I, Tk 1 == -
4
(3.~.2H)

where

Pn - Ph C
y -
C+A ' fJ -

and where [4, Il, arc the per-period market and true returns, respectively,
and 7. is the continuously cOlllpoullded pcr-pcrio(l market return.
These relations show that the presellce of adverse selection (y < 1) has an
additional impact on \l1eam and covariallces of returns that is Ilot raptured
hy other models of the bid-ask spread. Whether or not the adverse-selectioll

2"Specificallr, he ."'llilles Ihac (I) Tnt" n'\lIll" an' ill(\<")I'IH\I'Il\ of all 1''''1 hi.'lor)": (:!)
The ~preact i~ synull("tric ahout (Ill' trut' }It"in'~ ,nul C~) The gr()S~prOlil COlUpOIlt'nl dot's nol
catl~e conditional drift in pri(C~.
J. J. Mudrlill/i '1l"tlllSartiulls Data 107

("()lllpOllell! i~ ('collomically important is largely all t'mpirical issue that has

yet to be detCl"mined decisively/ I neverthelcss (;Iostcil 's (I !IH7) model shows
that advcrse seicrlion call have very dilli-n'llt ililplicatiolls lill' the statistical
properties of trallsauions data than other COmpOII('IJls of the hid-ask spread.

3,3 Modeling Transactions Datil

Olle of Ihe most exLiting recent developments ill clilpirical linance is tlw
avaibhility oj" low-cost tm/l.\tlctioll.l datab<lses: historical pi ices, quantities,
hid-a~k quoles and sizes, and associated markct cOllditions, transaction by
transaction and tillie-stamped to the 1\(",II"('st sccolld. For example, the
:--JYSE's Trades and Quotes (TAQ) dalahasc contaills all equity lI'allsactions
reported Oil the CUIlJulidated °n/I,r from I !)!)2 to the presenl, which includes
alii rans<lnions on the NYSI':, AM EX, NASDAQ, and III(' regjollal exchange~.
Tht· l\erkelcy Optiolls Database provides silllil<lr "al,1 f()r options transa("-
I:ons, <lnd tr<lns<lctions databases for lIIallY other securities alld markeL~ are
being developed as interest in market mirrostructure issucs continues to
grow.
The advent ofslIch transactions datahases has given linancial economists
Ille Illeans to ,uldrcss a variety of issucs SlliTOUIUlillg IiiI' linc stl"ll("\lII"(, oj"
the tradillg process or I'ricr di.ICOlJI'I)". For ('xampl(', what ,lie detnmillants
of the bid-ask spread, <lIld is adversc sclc('\ion a ilIOn' important bllor Ihan
invelltory costs in explaining lIIarketmaking hehavior?~" Does the vcry act
of Iradillg lIIove prices, alld if so, how I,ll gc is this II/-irl' ill//,ad d fen alld how
does it vary with the size of the trade?~o; Why do prices tClld 10 bll more
oftell or: whole-dollar multiples than on hall~dollar multiples, morc often
OIl h~Il[-dollar multiples than on quartcr-dollar multiples, etc.?~7 What arc
the benefits aIld cosL~ of other aspects o[ a market's microstructure, such as
margin requirements, the degree of competition faced hy «(-alers, the fre-
qllency tliat orders arc cleared, aIld intra(lay volatility?~H Although nOlle of

:!01 RccC1l1 iHt(,lI1pl~ to qualltlfy the .dativl" ("(Hili ihlltions ofordcr.pron~s~iIlK/iI1Y(~nt(}ry r():'iL~
and ad,~IS" ,cit'dion CU,L\ to the ui<.l-ask 'pre,,,1 in(iUlit-: Allkrk-Grav"., 11t-)(<.Ie, ami Miller
(l!J!J4), GI",t"n and lIarris (1!J!!!!),Georl(e, "'",I, and Nilllal<"lIdrdll (I\I!JI), IIl1allg and Stoll
(I !J\15a). alld Sloll (I \I!!\J). Set' Section ~.4.2 f()r fllnher disUl"ioll.
l';Sl"e Alllihlld and M<"lIddsoll (I!J!!O), lIa~<"hot (1!J71), (;01'<"1,11,,1 and (;alai (19H~), lkm-
sell (1!Jti!!), Easkyand O'llard (I!JH7), (;lost<"11 (1\IH7), (ao""11 alld lI,mi, (19HH), (;IOMt'lI
and Mil~roll1 (I\IH;.), 110 alld Stoll (I\IH I), SIOII (1\17H, 1\11\\1). alld Tilli\ (I \17:1).
"I;See 11<"1 L,illl;1S and 1.0 (1!J!JIi), Chan ,II1d Llkoni,hok (1'1\1:\1>. 1\19:», and K"im ali(I Mad-
hd'<l1l (1\I\I:)a.i>.I!J\!t;).
27S<"e llolli. 'lillOIlS, and 'l,cho{'~1 (I\IW»): ehri.,li<". Il.llri,. ,11111 Sdillitl (I!J\H); Chr;"i,'
alld Scltllitl (1!J\11); (;oodhan and Cllrdo (1\1\10); f ian i., (1\1\11); Nied{'lholkr (IV!;:), IV!;(;);
Nied('rholll'1" illld (hhonu.' ( I ~JlHi); and ()~hor rH' ( I ~Hi'l).
'!HS Cl' <:oluol1, M;li("r, Schwart/.. and Whilnuuh (1!IH{i), ILIII i.\. Sofiallo" .1IIe1 Slhlpilo (1!'c),O,
11,lSl>rolirk (I \)\)1,1. h). Madhavan alld Sillidl (I \1\)1). ,11111 SlolI .tIId II'h,lh'y (1'1\10).
11/0 i. i\ltII/(1'I Mir/Os/nU"/III"t'

Ih('s(' qlll'SliollS an' IH'W 10 Ihl' n'(,(,111 lileralllre, the killd of allswers WI' call
pWl'id,' hal'(' challgl'd dramatically, thallks to transaniolls dala, En'lI the
C\,('lll stlldy, \\'hich traditiollally employs daily rcturtls data, has heclI applied
recl'lIlly to Irallsat'liolls dala 10 sift Ollt Ihl' impact of nl'ws allllOllllCl'mcllts
lI,i/hilllhe dOlI' (s('(', fill' I'sampl(', Barday alldl.itzclI!>ngcr 11!IHH]),
The ric!lIl1'ss of Ihl'sl' d:llascls dol'S 1101 COIlH' withollt a pricl'-tr:lIls-
at'liollS datascls al'l' cOllsid('raill), 11101'1' diflicull 10 malliplliate alit! all:dv!.('
heCIIIS(' of Iheir ,111'('1' sill'. For cxalllple, ill 1!l!14 the NYSE COllslIllllllat('(1
0\'1'1' ,1!1 IIlillioll lI'alls:lI'liolls, alld li.r 1':1c!1 Irallsaction, Ihe NYSE's Trad('s
alld QIIO((,S (TI\Q) d:llab:lsc )TCOllis sl'wr:l! )licn's of illforlllalioll: Ir'llisac-
lioll price, lillie of Iradl', VO!t III 11', alld variolls COlldilioll codes dl'scriilillg
Ihl' Irad('. Bid-ask qlloll'S alld dl'plhs a/'(' also rl'corded, EvclI fi.r illdi-
vidual sl't'llrili('s, a S'lIlIplt- si/.(' or 100,000 ohst'rvaliolls (i)r a sillglc ycar of
Iralls:lI'liolls dala is 1101 1IIIIIsIIai.

1. >. I fIIo/iIlII/illll
Trallsat'liollS dal;t POSI' a 11I1I1I1H'r of IIlIic]!l!' ('COIIOIlIt'lric challl'lIgl's thaI
do 1101 ('asil), Iii illio IIII' frolllH'work w(' have d('l'cloped so 1;11'. For 1')(:1111-
ph', t .. ans;tl'lioll' (lat<l <In' '<lmplt-,! at ilTl')::u!arly span'" rall,!olll illtl'rv;,h-
whl'IIt'I't,,, tradl's e>l,\,lIr-alid Ihis pn'sl'lIls a nllml)('r of prohlems for stall-
d;tnl ('CllIlOltll'lric Iltockls: oilsl'rvations are IllIlikt'ly to 1)(' idl'lIlically dis-
Irihllll'c\ (sillcl' SOItH' obs( 'rva Iiolts arc vcr)' doselyspaced i II Iillll' wh ilc 01 It crs
lIIay Ill' sql:uat('(1 hI' ltoUI SOl' davs), il is dil'flcIIlt to caplllH' scasollal !'Ifl'!'ls
(sllch as liItH'-ol:;I'I\· rl')!;lIlarili('s) wilh silllple indicator fllildiolts, all.! «'/'('-
caslill)!; is 110 loltger a ~Irai)!;hll(.r\\'anl exercise Iwealls(' lite Iransaction t;il\l'S
an' ranclolll.
I\lso, Ir'lIIs:lI'lioll prin's are always qlloled in dis\Tell' units or lido-
nIITCn"" $0. I:!:. Ii,,· I'qllilil's, $()'<)(;~:' fi,,· eqllil)' oplions, $().W. for fllllll'CS
conlracts 011 Ihl' SI.lIId.llIl alldl'oor'.; :.00 index, $O.O:\I~:, fi.r liS Trea,nrv
hOllds alld I\OIt'S, al\tI sc> 1))1. \I\'hilt- t\wr" an' no II/Iliori 1\II'oJ'\,ticalIT:lsons
10 I'll'" 0111 COlllilllle,," pricl's, tIll' tralls;tclions coSIS associall'd wilh qllol-
illg and p\l)n'~sing slIl'h prin's 1Il<lk(' Ihl'lII highly illlpra(,li('al.~" ()f (OllrSI',

'.!"llt"pih' 11H' ilHli, i'lliilllil" 11i.1I .It I Olllp.tll\ III itt' tli'in (·I('IH"~!'o. Ih('rt, '('C'III' 10 lit' gellt'I.,)
.lgll'{'UWHI ,lIliCllIg c" 1111111111,1, .1I1t1 1'1.t( Iii II IlIc'1.' .dil(· dial tht· dlie it'll( \' g.lill~ hU1I1 ii,,, H'h'
I"l( CO," 1.11 ClIII\\'('igh 1111' IH1!I'IIII,aI I n\h 01 illdid~ihlc.' Iradillg lOb. IIOht·\'C'r. ,Ill 1IIII"{',,,I\('(\
i'~lIt· j, tlu' oIl/m/ft I ""~"'I' til di"'I('I('IW", ,dlie II 1J.ll.tlln·~ IIil' ("osts of ilHll\·t~ihihtit·' ag;tin:-t Iht·
lu'udih lit «ii" 1("11'11(''''''. hll ("",lIlIpk. 1l1I11i(' NYSE. tlu- minimuJIII)!in' 1Il0\'('IIIC"1I1 flf~lorl,
","h Pl\t\" gU',\h'l Ih;\1\ IH t'l1't.I\ ,I)
'f.1 i" niH' ,if\.., hUllhi., minimulII jilin' \';nialioll W;\' SC"
\'t',lI~ .'go hdoll' lilt, .l«h(,111 III higil-'I"'c'" diglt.II ('ollllllllc'l~ ;lIld Ctli n'~p(lildillg «,I"flll !lIil"
Iractillg IIU" h.llli'III'. II j, IlIIt 1",11 ',",WIlIl'1 til IItll ;\11 t'iglllh 01 a doll.ll" i, tilt, oplilll,ll d("~It'c'
ul cli~c u'!t'w'" 10.1,1\ Illckcd, II" "III dl" ""IUII' 1."1\\'1'('11 Ih,' NYSF ;IIHI lIu' lIS . . . ,.( III Iii",
.uul F\f 1I.1IIgl' (:fllHlIlI"itlll """111 II) lIuli,.IIt'.\ 1110\'" IIJ\\';lIlh dn;mlllr:alul1IlIlIdt'r "'''iell 1'1 in',
anc.l '\HOh,'S ,In' (h-l\om'l\,\\\'~' HI ~\"\I'. Sn' 1\.\Il. T",uus, ;uHI "~("hot'g' t l~nFl): nll'llIl.HI .lIU'
(:upl'l,lIul ( jl,IHH): 11.1111' t (I)!II L .11111 lilt' "F(:\ ( I!I!I I) l\lmNd .?()(HhlllCh·11I1 1111 tllt'l iii" ""1011.
J.J. Motlt'/irl~ Transartioll.l /JII/a 'lOY

Tabid. I. SU71l71lmy j/lI/i~li(j Jor daily If/urns offive NY.'iE s/{)(/u.

Statistic MC APD CHS CCB KAB

/JIIl •tX 5.250 86.750 216500 629.750 7.250

J~1II11 1.375 40.fi25 I 29.()()() 3fiO.25() 2.!l7S

I' 3.353 !i.'i.!l78 173.924 467.H44 4.665

a(/') O.HII II.:{HO I8.H77 53.251 O.Hlfi

1'"", ('Yo) 21.4:{ fiAH 6.58 4.94 16.13

'"111111 ((X» -14.29 -5.49 -7.H3 -9.43 -12.50

Ii ('Yo) 0.12 0.11 0.02 -0.00 0.00

a(l/) (%) 4.88 I.!i I 1.45 1.46 3.48

SUllImary sialislics for daily relUrns clala from January 2, 1990, to December 31, 1992. for live
NYSE ,Iock>: Me"" Anacom,,; API) = Ah Proc.!uc!.O and Chemic.i.; CBS = Columhia
Broa(k"~lillg Sy~tl·m: CC\\ = C;lpi\al Citic...o;, Al\C; KAB = Kaneb St"rv1(es.

discreten('ss is less problematic for coarser-sampled data, which may be well-

approximated by a continuous-state process. But it becomes more relevant
for transaction price changes, since such finely sampled price changes typ-
ically take on only a few distinct values. For example, the NYSE Fact Book:
J99.J nata reporL~ that in 1994, 97.4% of all transactions on the NYSE oc-
curred with no change or a one-tick price change. Moreover, price changes
greater than 4 licks are extremely rare, as documented in Hausman, \.0,
and MacKinlay (1992).

j)jlrrfif1lfJs and Prias I

DislTetcnt'ss affects bOlh prices and returns, but in somewhat different ~ays.
With respect to prices, several studies have documented the phenome~on
of /nla rlus/nin{;, the tendency for prices to fall more frequently on cerp.in
valucs than on others.:\\' For example, Figure 3.2a displays the histograms
of the fractional part of the daily closing prices of the following five NYSE
slo('ks during the three-year period from January 2, 1990, to December,31.
1!l92 (see Tahle 3.1 for sUllImary statistics); Anacomp (AAC), Air Prod~cts
and Chcmicals (AP!)), C,oltunbi,l firoa<kasting System (CBS), Capital Cities

-'''S.·.·, tI ... <'Xalllp\t', I\an, T"wus, a",1 Tschnt'~l (19H:.); Coodhart and Curcio (1990); H~rri5
(I~I~I\); Ni"d.· .. h"lh·" (I'lli:•• I'lliIi); Ni .. d .... h"Ilt-.. and O,ho .... e (19Ii6); and O.horne (I9fi2).
Iy) 3. Mar/1ft Mi(/IJ.I/Illrllllf

Nk (CCll), and Kaneb Services (KAll). The histogram for CBS is a paltil-
uljlrly good illustration of the classic price-clustering pallel'll: Prices lend
to'fall more frequently 011 whole-dollar multiples than on half-dollar IIllll-
tijlles, more frequently on half-dollars than on qllaner-dollars, and lIIore
fr quently on even eighths than on odd eighths. Price-cilistering is ('veil
III Ire pronounced for transactions data.
The importancc of these pallerns of discretencss has been highlighted
by the recent controversy. and litigation surrounding the puhlicatioll of
tW) empirical studies by Christie alld Schultz (1 !l(1) and Christie, IlalTis,
al~1 Schultz (1991). They argue that the tendency for bid-ask quotes Oil
N SDAQ stocks to cluster 1Il0re frequelltly Oil even eighths thall Oil odd
ci hths is an indication of tacit collusion among NASDAQ dealers to maill-
t<li I wider spre;\(ls. Of COllrse, there are important differences between the
N1SDAQ's market structure and those of other organized exchanges, and
11\()re detailed analysis is required to determine if such differences can ex-
phlill the empirical regularities documented by Christie alld Schult!. (19!H)
anu Christie, Harris, and Schultz (1994). Although the otllcollle of Ihis
controversy is yet to be decided, all parties concerned would agree that
discreteness can have a tremendolls impan on securities markets.: 11

Discreteness and Retums

The empirical relevance of discretellessj<)J" relllrns depellds to a large extelll
on the holding period and the price level, for reasons that we shall discuss
below. For transactions data, discretelless is considerably more problematic
because the price change from one transaction to the next is typically (111)'
one or two ticks. For example, if the millimum price variation is all eighth of
a dollar, a stock currelltly priced at $10 a share can never yield a transactioll
return between lero and ± 1.25%. In fact, in this case, the transaction return
must fall on a discrete "grid" of integer multiples of 1.25%. For higher-
priced stocks, this grid is considerably liner. For example, the transactions
return for a $50 stock will (~\ll on a grid of integer multiples of O.2!i'Yo.
Moreovet, as the price level varies through time, the collectionllftr'llIsaction
returns obtained may seem less discrete because the grid correspolldillf\
to the entire dataset will he the slIperposition of the grids at each pric('
level. Therefore, if price levels arc high alld volatile, or if the timespall or
the dataset is long (which implies higher price-vari.lbility IIncler a ralldolll
walk model for prices), the discreteness of transaction returns will he less
apparent.
Table 3.2 contains a concrele example of this intuition. It reports Ihe
relative frequencies of transaction price changes ror the five stocks in Fig-

~IOlher cUlllrihllliun5 to Ih.· NASDAQ rontll""'r,y indllde Chan. Chri5ti.·. anti SrI,"h,
(I Y%). t"",hll,h ;\1\(1 Smilh ( I ~l7ti). (;\l\\t·k (1'39\;). (;n",m'l1l. Miller. Fi5chcl. (;"11". allli \{()"
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 I:!o :\1)11 . , - - - - - - - - -_ _- ' -_ _ _ _-,

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l'lll \. fl,\( ~I~II\ I\lr A1\<:

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n· t,LL,ll,.ll,.u.,u.,.u.,.Il,J:t,.J
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J'IUI'I-"I.lClitlllltll A"I) I',il" (.h,lIIgt· tllt'k ... ) Itll ,\I'n
:'Utl ---.---- ..- - -_____
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n Q91.-kr41.;u:;ll,lCjk,.y
II .1 'l.r, .:!!',,, .:i7!', . .r,Ot) .j;~:1 .7!,j) .K/.r, ._)0\ -Ii -1 -'l n h
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n..lL.,-.l-L,.-LL,-..w:::;=O..L.,-L.c;:::W-,-LL-,-JJ () -'Y-r-''r-.-''?-r9-r"Y-''''''''"T'9-,.-''i'-r"T'
(I .1:6 .:!~,O .:n;, .:,1111 .Ii:!!', .7;,1) .to!', _H ·1, -I -'1.
1'11((' FI.ltli'Iuiul <:(;1\

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llll!
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,--r-,--r- r-
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.l '.!:, .'.!~ln .:n~, 5UU .,;'.!~, .7~IH .X7!',

1'111 (. h.lc·U\)lIlol iV\B

(a) (ill

Figure 3.2. Ili.IIII/-''1"IIIIIII/LJllily P,lIP I';wlim/J 1I1/f11'riu (.'/11/111'/' /111 h"f NrSf SllKkJ /111111
January 2. 1991110 f)rmlll"'r ) I. 1 'J'J2
 ). ,ll{///wl,UUW.I/IIIl"/ur"

~
1
Tcll,/., 1.2. lidJ/(i""/"'I/'IJ'IIU,'" "/lll'il'( 1'/11,"/-:(.1 finlirk dlllll "f/i"f .• ,,,,in.
NlIIllht'1
Slllck ·1 -:\ --:! ·-1 0 +1 +:! +:1 ?: +4
.,1"1'",\11<-,

,\,\( : IH,W,li I),I)~ o.ln 1).17 I:!.·J.I 74.:\-1 I~':'H O.IH n.!).) O.IH

API) ~t}.~'o:, o.:\:! H.'II :\.~:! 1:IAH (i'1.·10 I '1.~:1 ;1.1·' 0..11 H.:N

( :IIS ~ 1,:11:, '2.~ I <i.lil 7.V. 7.:!<i :)~..1~ 7.'1:1 7.·1:! li.:11 ~.,t:1

(:( :1\ :!:\,I:!H 1:1.7:! 0.70 I.li!I :\.!lO :1:'.11 451i 1.1i!} 05H I:d~:.

I "An ~t,OOH 0.01 (l.(lO (1.1 Ii 11.77 7:1.7!1 IVJ.I O.t " 0.00 fl.07
\

\ ltt-Luin' Irl'(f1H'Jlf~' COIIIII, ill P(,H"t'JlI, lor ,,11 1~)~)1 tr;Ulsactioll prin' challg('.'i in ricks lor Ih'e
NYSE slOt''': AM :~'\II'\I'''ml': ,\I'l1=Air I'rod."", "lid (:hemjc .. I,: (:IIS~( :.. 11 ,,"hi .. llro:ldc,,'ill~
\ SI'''''''': 1:( :11" (:"l'il •• 1 I :i'\l" AliI:: K.\I1~ KoII\l'" S.. n·ice,.
\
I
"n' :I.~ "sill~:l1I 011111' slocks' 1""IIS:lCliolls dllrill)!; Ihe I!l!ll call',"I",. Yl'a,..
Th .. low<'I'!" il .. d ,It I( ks-K,\l\ .1\111 AA( :-h,\V(' V.' I)' f.. w l,.allSal'lioll pricl'
I'hall)!;l's "<'\'wld IIII' - I lick 10 + I lick rail)!;"; these thr .. e vallil's aC('Olillt
fCl' !1!1./i';', a"d !I!I.:II;', IIf :111 thl' tr.ldl's (CII' KAn alld AAC, r"spl'clil'dl'. III
(·01I1"I.~t, fill' a hi).(hl'l-I',icl'd sllIl'k likl' CCH, with all aVlTa)!;(' price or $4(iH
<lmill)!; I!I!II, Ihl' rallW' (Will -I lick to +
I tick accollllts ror (i:I./;I;', its or
tr;l(l('s. Whill' dislTl'tl'lIl'SS is relalil'e1y Il'ss prollOllllCl'd (II' CCH, il ;s 1IC1'I'r-
Ihl'kss slilll'\'(·s\'1I1. EI'I'II 11'111'111\'1' 111m to daily data, Ihl' his((»)!;rams u( daill'
pricl' chall).(,s ill Fi).(I1\,(· :\.~h shol\' Ihal discr('I('/lI'ss can slill hI' importalll,
('spI'cially lor lower-pricl'd slol'ks SIII'Ii as KAI' alld Me.
MIlI'I'mTr. disn"I<'IlI'SS Illay Ill' mol'l' I'vidl'nt in the ((I1II!iliol/{(! and jail/I
dislrihlltilln 01 hi~h freqlll'ncy l'I'tmn" ('veil if il is dirtlclllt III delect in Ihl'
/I"f/l/ltlili,,"/I! or IIII/Igill/l! distrihlliions. For exalllple, consider Ihl' graphs
ill Fi)!;lIH' :1.:101 ill which pairs of adj'II'I'nt daily silllple '"('I urns (H" /{,+ I) 011'''
plolll'd 1<,,, 1""'11 of 1111" Ii\'(' siocks in 'n,hk ~,I OWl' the thrcl'-y .. al' salllpll'
pl'riod. TIIl'sl' 111-";1/111';1'.\ (lIl'rl', III = ~) are ortellllSl'<i to detect strllctllre ill
nOllli/II'ar dYllamical SVSII'ms (SI'I' (:hapter ! 2). Thl' scalt,s Ihe two axes or
are id"lIlil'.tI (Cll' ,III lil'e siocks 10 makl'\Toss-stllck comparisons mcaningflll,
and rall~1' (rom --[,,;', to :.'}{. ill Fi~llrc :t:l;I, -10% 10 I 'X, in Fi~llrl' :\.:Ih, o
and -20'}{. to 20'}{. ill Fi~lll'l' :I.:k.
Fi)!;1l1'1' :1.:1:1 sholl's Ihal tlH'\,(' i~ cOllsidl'rahle stnlClllre ill thl' n'llln" of
Ihl' lown-pril'ed slocks, KAB alld t\A(:; Ihis is a radially S)'IIII'II'lric Si/'llllll\'('
Ihal is ,~old\' alII ihlll"hlc 10 dis\TI'II·III'SS. III conlrast, no SII'III'IIII'I' is ('\'idcnl
ill Ih" 2-hislOI il's of IIII' l,iglll'l'-l'rin'd slOcks, CBS alld (:( :1\. Sinn' "I'D's
illiliall"i ... · i, iJlIIl'III'I,(,Jllllosl'ofllic 01111'1' fOllrslo .. ks. il displays less Slrlll'-
.rt / ..
; .~.-.-.---~~-----,~.~-~- , .......
.......
!ffiTIJ"
J
i ./." , '
! .: ",
l:-----~
1

:
...
.~ "'~
,-'--..~..-/
'"
I;
I ", - ",.. '\
_..... : '._--'.
,"
. .
I ",
.
.. ,",,"
.
,;< 1;-'--
'.-- :~ t ~:.':"':';

....... -- .:
!
... .... -......
i
2-Hi.tory of AAC Remrn., P = $~B5!1

.
~;. .

,'.,,:(.F
,
..
,

;--:.~-:.~~~ ...... -- :
2-History of APD Return., f> = $55,878

. .
,
J. ,
I.

. ....... - ..... 2-Hi.tory ofCSS Returns, f> = $17S.924

I; ,·.::f5~~s~~;::·> ','.' ;.,"

...,_\0
,,:~,

...... -- :
2-Hi.tory of CCB Return., P= $467,844

..... .......

.'.,....'. ..

.
'

l" ,/ "I .. '-....

",' ,
,',
" ,",__ .' '
1 ~~-"'£"-':.A"'~~.-;'-u.-
--~"""'...:,;;-r-""""~"If ........ -- :
2-Hhtory of KAB Return., f> = $4.665
(a) (b) (c)

Figure 3.3_ 2-J/is/or1es of Daily Siock llelurns for Fiv, NYSE Stocks from january 2, 1990
III J)frnllbrr 3/, 1992

ture than the lower.priced stocks but more than the higher-priced stocks.
Figures S.;!h and S.Sc show that changing the scale of the plots can often
reduct, .mel, in the case of APD, completely ohscure the regularities associ-
ated wilh discreteness. For further discussion of these 2-histories, see Crack
ancll.ecloit (1996).
 114 3. Markrl Miov,llrul'lwl'

These empirical observations have motivated several explicit models or

rice discreteness, and we shall discnss the strengths ;md weaknesses of each
of these models in the followinl{ sections.

3.3.2 Uoundillg and /Jamer Models

ever;il models of price discreteness begin with a "truc" uut unobserved
cplltinuous-slatc price process PI' and obtain the observed price process 1';'
by discretizing 1'1 ill some fashion (sec, for example, Ball [1988), Cho and
Frees [1988J, and Gottlieb and Kalay [1985 J). Allhough this may be a conve-
nient starling point, the usc ofthe term "true" price for the continuous-stale
price process in this literalllre is an unfortunate choice of terminology-it
implies that the discrete observed price is an approximation to the tme price
whell, in fact, the reverse is true: continllous-state models are approxima-
tions to actual market prices which arc discrete, When the approximation
errors inherent ill (,OlltillllOlIS-SI<llc Illodels arc neglected, this call yield mis-
Icilding inferences, especially for transactiolls data. n

Rounding Errors
To formalize this notion of approximation error, denote by X, the gross
return of the continuous-state process PI between I-I and I, i.e., XI ==
I'd PI_I' Wc shall measure the impact of discreteness by comparing XI to
the gross returns process X," =- P," 11';_1 corresponding to a discretized price
process P,".
The most common mcthod of discretizing PI is to round it to a lIlultiple
of d, the minimum price variation increment. To formalize this, we shall
require the floor and ceiling functions

LxJ greatest integer < x (!Ioor functioll) (:L1.1)

rxl least integer ~ x (ceiling function), (:-l,:U!)

for any real number x. J ) Using (:l.3.1) ,lIId (3.:'\,2), we call express lire three
!lIost common methods of discretizillg 1'1 compactly as .

,nThc question of which prirc is Ihe "In\('" p. in' III"Y lIolh .. (n.ci •• 1for Ihe ~lalisllr,,1 ~"I)('(ts
(If 't()(II,t~ of lli~rcl(,Il('.s-"hcr all, whelher 0111' is .u. "pproxim,'lion 10 lhe olht·) III vi. ('-\'(" ',I
31th- t~ uilly the sign of the approximation ('lTor, nut its f\hsolutt!' magnitude-hut it i~ c(,Htral
to t 1e motivation and illtcrprcto.ttiu1\ uf thr- Te:mlt'\ (Sl'l' the discllssion dt the l'lId 01 Sl'niott
:I.:t¥ for examples), Therefore. although we ~hall atlopl .111' lerlllinology of this lill'r",,,," luI'
lhc ,noment, the reader is a.c:.ked 10 kt·(·p thi." amhiguity ill tHind whlle rcadi .. ~ \hi!'i :,\('( 1iol1.
~'\Fur rurther propf'rties and app1ications of tlu.-sc intl:gl:f functioJls, see Graham, Knuth,
3nd'l'alashhik (1989. Chapter 3),
I
i
3.3. ModrlinK '/ImllafliollJ iJatll

(3.3.4 )

p",

where thc first method rounds dlllol/. the se(,(>IId n>llnds IIfl. alld the third
rounds to the lIearest multiple of d. For simplicity, we shall consider only
(3.3.3), although our analysis easily cxtcnds to the othcr two methods.
Atthc hcart of the discreteness issuc is thc difli:rence betwecn the retllrn
X/ based on continuouS-Slate prices and the return XI" based on discretile<1
prices. To develop a sense of just how different these two returns can he,
we shall construct an upper bound for the Ijuantity IXI" - Xtl = Ill; - 141.
where H/ and R;' denote the simple net return of the continuous-state and
discretil.ed pritT processes, respectively. I.et x and y he allY two ,lrhitrary
nonlH~gative real nUlnbers such that .v > I, alld observc that

x- I lxJ x
--- < -- < --- (3.3.6)
y lyJ y-
Subtracting x/y from (3.3.6) then yields

lxJ x x
--<----< CD.7)
Y ly J Y y(v -- 1) •

which implies the inequality

< -I Max [x
- - - , I ]. (3.3.H)
Y y-I
Assuming that 1'/ > d for all t, we lIlay sct x '" 1',1 tI,.r == 1',_11 d and substitute
these expressions into (3.3.H) to ohtain the following upper bound:

(3.3.!1)

where 0,_1 == til P,_I is defined to be the K'rid .Iizr at tillle t-I.
Although the upper bound Ct3.!J) is a strict ineCJuality, it is in fact thc
least upper /JO II nd, i.e., for any fixcd d and any f > O. there always exists sOllie
combination of 1',-1 and X/ for which III;' - Uti exceeds 1.(0. X/o I',-tl - L
Therefore, (:t3.!l) measures the worst-rase deviation of II;' from N,. and it
is the tightest of all such measures.
Note tilal (:t:t!l) docs not yield a unif(lI"IlI upper hound in r/, since I.
depends on 'i:

CU. 10)
 J, /lilli/Wi MiI7'IJ,I'Il'Ilrllll'l'

Nevel'llwlt,ss, it still provides <I IIseflll gllidelinc for the illlpan ofcliscJ'(,tt'JH'SS
Oil rl'llIl'I\s as prilTs alld retlll'J\S vary, For exalllple, (:t:{,!l) limllalizes Ihe
illtllitioJl that dislTl'tl'Jll'SS is I('ss prohklllalic lill' highn-priccd stocks, sillce
I, is all ill('J'l'asing fliJIlIiOIl or o( , aJld, thercforc, a dccrcasillg funclion
(If /', "
II is illlporl~11I1 10 "('('P ill nlind thaI (3.:t!l) is ollly an IIpp!'r hO\llld,
,\111\ while il dol'S I" oviel(' a II lI'aSIlrl' of Iht' Ill(Jn/-flI\e disl'l't'palll'y h('I\\'I'(,11
Il, alld U;', il is 1101 a IIwasur!' of lite discf('P<lIIl:y itsl'lf.:11 This dislillc(l()1I is
I)('sl IIl1der,IOl .. lllv grappling wilh l\1e Etn Ihat Ihl' I'XP!'CIt'd lIpper hO\llld
El/.I X" iii_I 118, I I is all increasillg rUIIl'lion ol'lhe lIlean alld varianc!' of X,-
the large)' lite eXpl'l'll'd n'llIl'J\ alld volatility, the large\' is the average value of
thc upper houlld, This SIT IllS paradoxical becallsc it is gcn(,rally presulIlcd
that dislTl,tl'lIl'SS is less prohlemalic Ii II' longer-horillln reI urns, bill these
havc highl'r Jlll'allS allc! variancl's hy cOllslruction. The paradox is readily
resolvt'll bv obsnvillg tllal although Ihe I'xpccted IIppl'r hound incrcascs
as thl' IIll'all ;lIId v;tri;tll(,(, ill\T!'asl', tht, probabilily lIlass of IH;' - Uti IIcar
thl' upper hound may al'lnally declinc. Therefore, althongh thl' expected
worsl-cast' disn!'f)alll'\' ill('l't'ascs \\'ilh Ihe lIlean allel variall<'t', IIll' prohahililY
that snrh dislTl'palll'il's arc rl'alill'd is smaller. Also, as wc shall sec hl'lo\\',
Ihe \'''(>I'I'l<'d ltpP('" boltlld S,"'IllS to Ilt' relatively illsl'lIs;I;\,(' 10 cIiallg(" ;11
Ill<' lIIeal\ ;1Ilt! vari'lIln' or x,. so lIial whl'lI measllred as a IH'rn'l\lage or till'
('XIIl'CIl'd 1'1'1111'111-:1 X,I. Ihl' n:pl'I'lt'd IIp(lt·\' hOllnd dol'S declinl' for IOllge\,-
horizon retllrns.
I\y sp!'firyillg a pallicl1iar proCI'SS fi,r /'" \\Ie call ('valllate the expl'q~llillll
of /.(.) 10 dl'velop sonll' Sl'nSl' lill' the lIIagnitlldes of !'xpeflec\ diSlTl'l!'IICSS
hias E[ln;' - Udllhal an' possihk, For example, kt /', filllo\\l a gl'olw'lric
randol\l walk wilh drift /1 alld diffllsion fO!'Ili!'i!'''1 a so lhat log 1',/ /'(-1 arc
III> nonnal randoll\ variahles wilh IIl('all /1 ant! variance n~. III litis fas!', W!'
hal'!'

1':[ /.( rI, .\" I', I) I /'( I ]

_8_ { (JI I '4 (I> (

,)

log( 1-8) - /1
n ) 1, CD.II)

wit!'r!' cfJ(·) is Ihl' 1I01illai CDF,'I"

:111''''011''', w,· \..ollitt lik .. '0,11.11 ... I'" ill' III;' -, lid ,Ii ....... ')'. hll\ il is '"1'1" isill~lv dimr"l, ,.. tin
~ow11h .\H~' ''''gu''' 01 gC'lIt'1 .ili1)', 110\\'1'\'1'1, ','c'lIl(' cli,,'I1~!'\ioll heluw n.·~."<li"~ 'Iw llH1Hding ,tlHI
h.1I1 in lIIo,ld'-IIIUI('I ',H'C IIi,' p.1I ;1111('11 it ;t .... 'IIIIIIHion..; for XIt mun' ptt·t+."" fh;u;tncri/.lIioll!'l
01 fht· tlisnc'h'IH'!'\' III;', an' :lv,lil.,hl,',
·'t:'NolI' Ih" ,illlil.1I j". IWIn-tTI! rs.:~.II) ;11111 11i(' Hlack-Srholt·s ('all-uplioll pfidll~ 101"l1l1l1a.
3. J. Moddillg TransurtionJ Data 117

Tahles 3.3a-c report numerical values of (3.3.9) for price levels Pr-I =
$1, $5, $10, $50, $100, and $200, and for values of IJ. and (J corresponding
to anllual means and standard deviations for simple returns fanging from
10% to 50% each, respectively, and then rescaled to represent daily returns
in Table 3.3a, monthly returns in Table 3.3b, and annual returns in Table
:-\':-k.
Table 3.3a shows that for stocks priced at $1, the expected upper bound
for the discreteness bias is approximately 14 percentage points, a substantial
hias indeed. However, this expected upper bound declines to approximately
O.2:l percentage points for a $50 stock and is a negligible 0.06 percentage
points for a $200 stock. These upper bounds provide the rationale for
the empirical examples of Figures 3.3a-c and the common intuition tliat
discreteness has less of an impact on higher-priced stocks. Table 3.3a also
shows that for daily returns, changes in the mean and standard deviation of
returns have relatively little impact on the magnitudes of the upper bounds.
Tahles 3.3b and 3.3c indicate that the potential magnitudes of discrete-
ness bias are relatively stable, increasing only slighlly as the return-horizon
increases. Whereas the expected upper bound is about 2.5 percentage
points for daily returns whcn PI_ 1 = $5, it ranges from 2.8% to 3.9% for
annual rctllrns. This implics that as a fraction of the typical holding period
relurn, discreteness bias is much less important as the return horizop in-
crcases. Not surprisingly, changes in the mean and standard deviation of
returns havc.more impact with an annual rcturn-horizon.

ROllI/ding Models
Evcn if E[jR," - Rtl] is small, the statistical properties of P," can still differ in
subtlc but important ways from tbose of PI' If discreteness is an unavoid~ble
aspect of the data at hand, it ITIay be necessary to consider a more explicit
statistical model of the discrete price process. As we suggested above, a
rounding model can allow liS to infer the parameters of the continuous-State
process from observations of the rounded process. In particular, in much of
II\(' roundinv; literature it is assuITIed that PI follows a geometric BroWJ;lian
Illotion ell' = J.l.Pdt + a PdW, and the goal is to estimate J.I. and a fiom
thc obscrved price process P,". Clearly, the standard volatility estimator iJ
based on con tinuously compounded observed returns will be an inconsisten t
(·stimator of a, converging in probability to /E[(Iog ~+I - log P,')2] rather
than to jE((Iog PI +1 -log PI )2] • Moreover, it can be shown that will be a
an oVfTestimate of a in thc prcscnce of pricc-discreteness (see Ball [1988,
Tablc I] and Gottlieb and Kalay [1985, Table I] for approximate magnitudes
of this upward bias). nail (1988), eho and Frees (1988), Gottlieb and Kalay

Thi, is 110 acridc"l. sillce Max (X,. I-Ii) ",ay be rewrillen as Max( XI - (J -Ii), 01 + J -Ii; hence
Ih,' "pP"r houlld Illay h.....•.. 'L'I as Ih,·payolf of a call oJllion on XI wilh slrike price J.
 Table J.Ja. F.xl'frifd 1I/11'fT bOlilUt. fllr tii.mrlf//(ss him: daily l'flllll"

In .<=: 10% .1=20% .. = ~O% ,= 40% .1 = r,O'Yt,

1'1-1 =: $1 ._"_.. -._--
10% 14.2895 14.2H95 14.2H95 14.2H9:1 14.2H9~,
20% 14.2930 14.2930 14.2930 14.2930 14.2!)30
30% 14.2961 14.2961 14.29fi1 14.29(i\ J.).2!Hll
40% 14.2991 14.2991 14.2991 14.2991 14.2!)!1I
50% 14.3018 14.301H 14.301H 14.~018 l'UOIH

1',-1 =: $5
10% 2.5648 2.5650 2.5li76 2.5721 25772
20% 2.56:14 2.565:, 2.5672 2.570\1 2.:,7!)!"1
30% 2.5660 2.5660 2.5671 2.5701 25711
40% 2.5665 2.5t;()5 25(i72 2.:)t)9!) 2.57:\0
50% 2.5670 2.:,fi70 2.5fi74 2.:>692 2.5721

PI-I = $50
10%' 0.2511 0.2:,16 0.2520 O.252!l O.2:12!)
20% 0.2511 O.251!', 0.2520 0.2524 0.252H
30% 0.2511 O.2!l15 0.2519 0.2523 0.2:127
40% 0.2511 0.2:,15 O.251H 0.2522 O.2!'12ti
50% 0.2511 0.2:/11 0.2:>lH O.2!'121 O.2!'12!'1

1"_1 = $100
10% 0.1254 0.1256 0.1259 0.1261 O. 12{j~
20% 0.1254 0.1256 O.12:lll O.12tiO O.12ti2
30% 0.1254 0.1256 O.12511 0.12fiO 0.1262
40% 0.1254 0.1256 O.125H O.12(i0 0.12(;1
50% 0.1254 O.12:,(i (J.1257 0.1259 O.12til

I~_I = $200
1%I!O%
0 O.Ofi27
0.0627
O.O(j2H
0.Ofi2H
0.0629
0.0629
O.O(i30
0.0630
O.0/i31
O.()(i:\\
~O% 0.0627 (l.Ofi2H (1.0629 0.Ofi30 0.O(j3\
~O% O.Ofi27 O.()(i2H O.t){WI 0.01;29 O.O(i:\O
~lO% 0.0627 O.1l62H O.O(j211 O.OG29 O.Oti:\O
1
I
l-:xpeclrd upper bound~ for tlisrf(·(l'nc.·~s hi;L' ill siu\I,h.' n.·turn~ Ill;' - ntl x 100 lindt,,, a gc.·\\11lt'tric.
r;1I~ltlm w-dlk fnr prices 1', wilh drill <1",1 lIill'lI,;olll''Ir'lIlIl'I'''-' I' anll" c"hh.-al(·d 10 .1111.",,1111<'''11
all(\ standard devialioll of simp I!' relmn~ In ,11111.1. "·'I"·l'li\'(·ly. ""ch r""Hill!: frolll IH% 10,.0'7<,.
"11(\ lhen rescaled to malch daily 1I,lla, i .••.. I'/:\r~). 17/J:liiii. LJiscrcli/.('.t prin" I';' E lI',ldJd.
d ~ f). I:!!'" ... c IIscd III fakll!;"!' n'III' ' " U;' : (/';'11';'_ I) - I.

\
1
 1,.,,11' J. Jb. I,'x/lfflnl 1I/'I1t',./1II1I1II1., 1m ";11.,,-11'//1'.11 h;m.' /I/lII,lhly,I'II1I71.I.
_." .. _-_.... -----
III .1 = IWX, .\ = ~Wy" 1= :\()'J" .1 ~., ·III'Y., .1 =!,O%

!',. I == $1 -_.._----- - .. __ . __ ._ .. .. _-_._-

10% I,U9\Hi 14AOI,7 1·1.'17HH I·Lld 17 14.7(j~I'
20% 1·1.!i011 14.:.0M J.I.:,.J('~ I·LIi·I·!') 14.77~:~
:~O% 14.I'OI!i 14.1iOl9 14.li~I!) I·LW07 14.7!)44
·10% 1·I.I'!!1 !I 14.(i!I~O 14.7011 1·!.7·!m I4.H~n
!iO% 14.771i7 14.7767 14.7HO·j 1·1.HOHI JoI.HIiHH

I',. I ':"_$_:,____ .... ~ .------ - - .. _ - ..- - -

10% ~':'!I4!i Vi~~H 2.li:,O I ~.I'7!i!) ~.7004
~O% :1.li07!i Vi300 2.lifi1:, :1.1i7H~ :1.71110
:~()% 2.(i~~~ Vi3H:. 2.(1:)~J~J ~.liHII' ~.70~7
·10'7<, 2.(,:171 Vi4H~ ~.lil'I'1 ~.IiH:.') ~.7O:.3
!iO% 2.lifi~3 Vi!iH!! 2.(,73H ~.mll ~.70HH

P"I = $:.0 --_._------_.._-

!{)'X, O.~:.44 {).~:.ti!l (1.~:.!)01 II.~I'I!) ().~(i4~
~O% 0.:6:11 0.~:.71; o.:!,.!)!) O.~I'~I O.~(;·13
30% O.~:;(j(i O.~!iH1 II.:I(;(H O.:I(j~·1 (1.~(j1:.
10% O.~:.HO O.~!i!I:\ 0.2(,10 0.:l1;~'1 0.~Ci17
:.O'Yc, O.~:.93 O.~IiO~ O.21i17 O.:lli:\1 O.~Ii'"

1',.1 = $100 ._--- ._--------

10% O.I~70 0.I~H3 O. I 2% 11.1 :~IIH 0.I:H9
~O% 0.1~7Ii O.I~Hli 0.12!IH 11.1 :\0<) O.I:I~O
30% O.I~H:I O.I~!lO O.I:~OO 11.1 :111 0.13~1
10% O.I~HH O.I~!I!i O.I:IIH II.I:~U 0.13~~
!i0% 0.1 :m!i O.I:~OO 0.I:m7 0.1 :{I:. 0.1:{2·!

1".1 = $~~12. ___ -------- _._--- -------

10% O.OW:. 0.llI,11 0.111,,17 0.01;:.:1 0,01,:;9
~O% 0.01,:17 0.1)(,4:1 O.llIioIH O.llIi:I'I O.llIi"\)
:10% 0.llIi10 0.01,1:. 0.111;:.0 11.111;:.:, O.OI,IiO
40% 0.01,14 0.01,17 0.111;:,1 II. Oi;r,(j 1).0til,1
!i0% 0.111;,17 0.I)(i1!1 1I.III;r,:1 0.01;:,7 1).0til;1

Expected uppel" hound., fOI'c1i.~crt·tl"lIt·s .., hia.'\ ill o.;illlj)lc- n·(IIII1 ... tU;' ... /(11 )( 100 Hlult'r il gl'olHl'lI if
randolil walk for pricco'\ 1'( with drift and dillllSilIU p.1I ;11111'1('1.\ II ;11,,1 (1 (,llilu.II«,d to 0I1I1H1.111l1t·;1II
alld !Iotandard d('viatioll of~illlpk r('turll' m alld \, J(· ... ,H·(·li\(·k. (',If Ii r;lIlgIlig Irolll 1orf.., 10 ;)(J'}f"
and tliell 1"<: .... (.II('cI (0 JIIatch mOl/lh~)·d.If;t. i.t,., Il/I~. n/JI"":!. 1>1'.( I (·II,,·d IHi(c . . I};' == If'(/dJd.
d = O,I~:)"lI(· tI .... l'd loralrulalc r('tlInl\ U;':, (/';'/I',"' 1) - I
 'Ii/MI' J. k 1~.\/.,.tll'd 11/1/11'1 Ilfl/lllt/Ijill t1iv/,rlr//I·.1I hill.l: /11/1111111 Iflllrl/.I.

11/ I=- III'Y,. I'" :.'1l'Y" .1 == :10% .1 == .1f)'Yc, \ == :)()I~,

.------.
}', 1. == $1 -------~-.-------.--.-.-. -- .. ---

10% 1:•. 7:.'W. Ili.IH!)H Ili54:.'4 17.1).):1!) li.:.:!·17

!!Of}{, 17.1·1:111 17.:!:."'7 17.!i:~:!0 17.!I~HH IH.:H'iH
:10% IK':'71·1 IH.:lH:17 IH.7':tn IH.!IHH!I I!U:!o:1
.IO 'Y" :.'0.0000 :.'0.001·1 :!1J.()4Ii.J 211.1!157 :!().42!1!I
:1(1(.~) 21.I:.'Hti :.' 1.·I:.'Hli 21.·!:i!lIi ~150HII 21./;:.·11

}".I .::'. $:. 0" _____ - - - - -

lillY" 2.H:17:! 2.'11 W. 2.!)!)!'.H ::l.OHI:. :1. I li·1-!

20% :1.077H :U07li :1.1677 :i.2:lW. :1.:lIIH
:\0% :1.:1:1:1:1 :1.:1·\07 '1.:{7:ili :1.424H :1.·II\'Hi
·10% :15H!I7 :15!lO!I :i,li04li ::l.li:~Ii·1 :I.tiH07
r)()(,~. :I.H-Iti! :1.H·lti:1 :1.H:lOli :Ulti7:1 :1.H<l\iH

/'/ I = $:.11
10',1" 11.:.'77:. 1I.:.'X·lIi 1I.2!)~!) 0.:1111:1 0.:10"·1
~Uf,v.) O.:IOO~I 0.:10:1'1 1I.:IO!I7 O.:lltili 0.:12:1:-\
'IH'X, 1I.:12'IH n.:12Iili n.:i2!IH O.:I:I·IH O.:H07
'I(II:{, H.:V,Ol) o.:l:d H O.:I:.~·I II.:F.:.:. IU:ml
r)O(){, 1l.:I7'," IUllin 11.:I71i·1 1l.:l7HIl IUHO!)

I~'_I_==- S~ UU - - - - -------- _.- -- - - - - - - - - ----

I (}(){. tI.I:IHli (1.1,12 I O.I1Ii:l O.I:.or, H.I !l'l"l
!!t)(}{J 0.1'.0:.' 0.1:,) 7 0.1:.·17 II.I:,HI O.lIi I 7
:\0% H.lfi:.'7 1I.lli:11 H.lli"7 0.1 Ii?:! 11.1701
.«.lYc, O.17'.~ 0.17'.:1 11.1760 0.177:. 0.17!17
!)f){Yt, 1I.lx77 H.IH77 II.IHHO o.IHHH o.I!)()2

/' 1 = $21111
.' -------.--- .".-------"-----
'rI 111% H.llii<l2 lI.mlll 0.07:11 0.07'.2 0.11772
! ~t)(X, 11.07:>1 1I.07 r ,x 0.077:1 0.07!)0 O.OHOH
:\0'1" II.IIHI:I II.HK I:, O.OH2:1 O.OH:lli O.OW,II
·111'.'(. H.IIH7Ii II.HK71i H.OK7!) 0.IIHH7 1I.0K!IH
:,0';:, lI.o'nK O.II!):IK O.O!I:I!) O.O!)·I:\ O.O!I:, I

Fxl'(" Ic'd "PP'" I'

htllllul," eli" 1('!c'IU',:\ hi.I' 11I.,illll'''· n.-turliS IU;'- Uti x 100 lIIult· .... gt'Ollle'lriC"
I~UH'''''' \,·.,l~
h'I pile \, .. /', w'lh ,1I ,h ~'1H1 ,liU" .. ",,, par;Ulwtt'I"SII ;\lul n ('~,lihrah·tI10a1\I\\I;t1 \\It'~'1\
\ and., •. lIu1.ln) ct"\i.llic III 01 ,11111'1" Ic'IUl"l1' lII.lIul " n'~p("'fliv('Jy. t'ad. rangillg' from 10'::, 10 ~IO%,
Hi" n'ti,,'" 1'1 Ie C" I';' ,::. t /',1 did. d .-.' 0.1 :1:-.. ;tf{' ",c'd (0 (aiculalc n'Uull' U;' =: (/J;'/ I';'. 1. I' -
\
I
\
3.3. Modfiin~ TranJ(l(/iu7Is /)a/a 121

( I !lR5), and Harris (1990) all provide methods for estimating 0 consistently
from the observed price process P," .:11;

Ill/nlY)" Mot/fis
A slightly diITerent but closely related set of models of price discreteness has
h('('n proposed by Cho and Frees (I9HR) and Marsh and Rosenfeld (l9RIi)
which we shall call barrier models. In these models, the continuous-state
"true" price process 1', is also a continuous-time process, and trades are
observed whenever P, reaches cerlain levels or barriers.
Marsh and Rosenfeld (I9Rfi) place these barriers at multiples of an
eighth, so that conditional OIl the most recent trade at, say 40~, the waiti.ng
time until the next trade is the first-passage time of P, to two barriers, one
al 40~ and the other at 40~ (assuming that P, has positive dfin).
Cho and Frees (19R8) focus on gross returns instead of pric.esand define
stopping times Til as

f/. (_1 ,I+d ) } . (3.3.12)

I+d

Therefore, according to their model a stock which has just traded at time
Til_I at $10.000 a share will tracle next at time Tn when the unohserved
cOlltinuolls-state gross returns process Pt/$IO.OOO reaches either 1.125 or
1/1.125, or when P, reaches either $10.125 or $8.888. If P, reaches $8.88R,
the stock will trade next when P, reaches either $10.000 or $7.90 I, and so
OIL
This process captures price-rliscreteness of a very diITerent nature since
the price increments defined by the stopping times arc not integer multi-
ples of any fixed quantity (for example, the lower barrier 1/1.125 does not
correspond to a one-eighth price decline). However, such an unnatural def-
initiol\ of discreteness docs greatly simplify the characterization of SlOpping
limes and the estimation of the parameters of P" since the first-rliITerence
or T" is lID. i
I
Under thc more natural specificltioll of price discreteness, not COl\sid-
cred hy Cho and Frees (19HH). the stopping time hecomes

{
T,; = inf I > T,,_I: - - ' -
,
P
I'(T,,_I)
rt (1-d
1'(1,,-1)
d- )}
- - - ,I + - -
P(T.-Il
(3.3.13)

which reduces to lhe Marsh and Rosenfeld (19Rfi) model in which the in-
crcments of stopping times are 110t lID. i
,
:\11110\'0'('\'(''', ~t"f: lh.: diSCII.It'\ioll ,at tlw I:lul of Section :t:t2 for ~om(" C3\'eab about (he mod-
\\uiUIl for tht's(" mudds. ,,. ...
 ]22 3. Market Microstructure

Limitations
Although all of thc prcvious rounding and barricr lIlodcls do capturc pricc
discrctcncss and admit cOllsistent cstimators of thc paramctcrs of the IInol)-
scrvcd continuous-statc price proccss, they suffer from at least three illlpor-
tantlimitations.
First, ror unobscrved price processes other than geomctric Browniall
motion, these models and their correspollding parameter estimators be-
cOllie intractable.
Second, the rounding and barrier models focus exclusively 011 prices
alld allow no role for other economic variables thatlllight influcnce price
behavior, e.g., bid-ask sprcads, volatility, trading volumc, etc.
Third, and most importantly, thc distinction between the "true" and
obscrved price is artificial at best. and the econoJllic interpretation of the
two quantitics is unclear. For example, Ball (lUSH), Cho and Frees (I!IHH),
Gottlicb and Kalay (1985), alld lIarris (I U90) all provide methods rO/" es-
timating the volatility of a continuOUS-lime prke process frpm discrele' 01>-
selved prices, never questioning the motivation of this arduous task. If lhe
continuous-time price process is an approximation to actual market prices,
why is the volatility of the approximating process of interest? One lIIight
arguc that derivativc pricing models such as the mack-Scholes/Merton for-
mulas depend on thc parameters of stich continuous-time processes, hut
thost'i models arc also approximations to market prices, prices which ex-
hibit ~iscreteness as well. Thcrefore, a case must he made for lhe ecollomic
~ rc\cv,!nec of the parameters of continuoUs-slate price processes to properly
~' motiVate the statistical models or discreteness in Section 3.3.2.
,;~ h~ the absencc of a wcll-articulated model of "truc~ pricc. it secms U\I-
natur~lto argue that thc "truc" pricc is continuous, implying that ohserved
discre~e market priccs are somchow less genuine. After all, the economic
dcfini~ion orprice is that quantity oflllllllerairc at which two mutually COli-
scntif~economiC agents are willing to consummate a tradc. Despite thc f;ICt
that if stitutional restrictions llIay rcquirc prices to fall on discrete values,
as lon' as both buyers and sellers are aware of this discreteness ill advance
and af still willing to engagc in trade, thcn discrete prices correspondi\lg
to ma tct trades arc "true" prices ill every sense.

I J.J.J The OI1/rrl'd l'mbit Modrl

To ad1rcss the limitations of the rOllllding and barrier lIlodels. Hausmall,
Lo, anf'! MacKinlay (1992) propose ,11\ altern'ltive ill which price rlulIIgr.\ arc
1lI0dclkd directly using a statisticallllodel known as ordered !)Tobit. a technique
used niost frequently in empirical studies ofdepe\ldent variables that take on
only a finite mnllbcr of values possessing a \IaluL,1 ()nlering.~7 Heuristically,

'7For cxal1\pl~. Ih~ dqwml"111 \'ariahlt- lIlif(hl h,' Ih .. kwl Ill' ,-,Iucllion. as 111<"""1<'" h\'
,Int·(· ('t\l(·goric.·~: I(·~.'\ Ihan hif.!,h !'(huot, hi~h ~fhool. aTIC) ("(llIq~t' (,duration, Tht· ,It'IU'lUlt'Ut
 3.3. Modeling '/hlllJ(l(liiJlls Dala
12~

ordered prohil analysis is a gellerali /,alion or lile linc;lr regressi

on lIludei
10 cases where lhe dependc lll variable is discrelc
. As such, ,11110111{ lhc
exisling models or slock pricc dis('lTI( 'I\('SS-(' .g., lIall ( I !)HH), (:ho
and Frces
( 198H), COlllieb and Kalay (198:)), I Iarris ( I !)!)()), ;lIId Marsh and
Rosenld d
(19H(i) -orderc d prohil is Ihe only specifica lioll lh;11 elll easily
Capll\l"e Ihe
illlP;I('( of "explan alory" variahle s on pri(T eh;III),((" whik abo
accounl ing
f'II' pritt' dis(I'cl(: ness alld irregula r lransacl ion inll'n'als ,

niP /Jrl.\ir S/)f'('ijiwlion

Specific ally, conside r a scquenc e of Iransat'l ion pi ices 1'(1,,), 1'(11),
... ,1'(1 11 )
sampled al limcs 10, II, .,., III' and dellOI(' hy VI, }'~, ... , I'll Ill!'
corresp ond-
ing price changes , where Y. == 1'(1.) - 1'(lk .. l) is ;\S,ullled 10
be an inlcgn
llIulliple or SOllie divisor, e.g., a lick. I ,1'1 r ' d('1I01l' ;11\ ullOhsl'
k lvabk con-
linnous random variable sllch Ihal

r; = X~rj + <k, 0, CI.:U4)

",h"n' lhe ('I x I) vector X. == [ X.. ,'\'" J' is a veClor of explana lory
variable s lhal delermi nes Ihc condilio nal mcan of and "INID" indicate s 1';
thai thc E. 's arc indcpcn dclllly hUI nol identica lly dislrihu led,
an imJ>or-
tall! diffcren ce from standard econom clric models
whit'h we shall relurn 10
shortly. NOle Ihat subscrip ls arc used to dcnote Imll,\(/rli '!Il lillle,
whereas
time argullle nts I. dcnotc calenda r or r1urh tilile. a COnV('lllion we
shall follow
through ollt Sectioll :1.33.
The hearl of Ihe ordered prohil lllodel is the assllillpl ioll that
ohserve d
pricc changes Y. arc related to the cOlllillUOUS v;uiabks ill Ihe 1()lIowing 1';
llIanner :
.II if )" E ;11
•
if )" /I~
y.
,\~
•E (~.:\.15)

J", if }"k c ;\",>

wherc the sets AI furm a /Hlrliliull of the statc spale S' of 1'; . i.e.,
S' = U;'~ I Aj
and Ai n Aj = 11 for i 'I j, and the ~/s arc the diMTl'le valul's
that compris e
the state space S of J'.,
The motivati on for the ordered probil specific alioll is to ullcover
thc
mappin g lJetween S' and Sand relale il 10 a sel of ('Con 0 lIlic
variable s. In
Hausma n, I.o, and MacKill lay (I~1~12), Ihl' ,\,\ arc defilled as:
0, -k, +k.
variable is uisncw awl is 1I<11ur<llly onl,:,!'<1 ,ill("(' rolkg" ,,<I'I(;lIioll
"lw<lYs follows high ",-h'H,1
(,ee M.. ddal<l [ I \)11:\) for funher d"lails), Th" 01<1," "d !,,,,hilllll
,,ld IV,I.' "nd,,!,,'" by Ail(hi.,oll
and Silvey (1957) "II" A,ltf("d (I \):,\)). alld ge,",,;.li/, ,,I,o ", ""101111.11 "i.,1111 h,IIICt'" hy (;'"\;11111,
/."", and Dalllll (1\,11;0). For ilion' nT,'1I1 ,'x ... ",io",. "'" ~L"ltI"J.1
(I\IH:I). M,CIIII,,~1t (I!IHO).
""tlTlti,,, ·,, (I!I!II),
 -~. +~. and so OIl. For sinl(llicilY, Ihl' slale-span.' partilion ofS' is usually
ddil)('d to 1)(' illft'l va).;:

:1 I - (-00 , atl (:L\.Ifi)

;\~ - {!XI ' U~ I (:13.17)

A, - (U,_I , 0', ) CU.IK)

1\ '" (0' 111-' , (0). (:t:~. I ~))

Althou~h the ohser\'('d price chall~1' call be allY nUlllber of ticks, posi-
live or n<'l!;alivl'. WI' aSSllllle Ihal //I in C~,:~,I:)) is finile 10 keep Ihl' Illlmller of
unknClwn parallH'I('I'S Iillil(', This (loses 110 diffICulties sinct.' we Illay always
leI SOIl\(' slall's ill S r"l)J'('s('1l1 a lIIultiple (anc! possihly counlably illlillile)
nlllnlll'r ofvallll's for lIlt' o!ls!'fvl'd prin' change, For example, in Ihe empir-
ical applicalion of lIauslllan, Lo, ;\Ild MacKinby (19~12), .II is deflnec! to be
a price dlangl' of -,I licks orlt'.I.I, ."1 to hI' ;1 price change of +4 ticks or /II0rf,
anc! .I'.! 10 .IX 10 he pricl' changes or -:~ ticks to +:~ ticb. respectively. This
parsimollY is ohlaillt'd al Ill<' ('osloI' losillg t,ria 11'.\Olul;OIl. ThaI is, lIlldcr
this spl'('ifil'atioll JIll' onll'n't\ prohil model docs not distinguish hetwel'1l
priCI' changes or +,1 alld price changes grealer thatl +4, sinCl' the +4-tick
'r! oUlcOllle anc! Ihe gl'ealer Ihan +4-li('k oUlcome have Ileen groupec! logether
inlo a cOlllmon eVt'nl. The same is IrIIC for price changes of -4 licks ;lI1d
!
,
I price Changes less Ihan -4, This partilioning is illustrated in Figure ~,4
whirh superimposes thl' parlition boundaries lail on the c!ensity funClipn
of 1';. and till' sill'S of the regions enclosed hy the partitions detl'rmine the
prohahililies 71, oflhe discrele ('\'l'nts.
Moreover, ill prillcipll' Ihe resollliion lIlay he lIlade arbilrarily flllCJ' hy
simply introC\willJ.( ilIOn' Siall's, i.e" by illcreasing' 111, A~ IOllg as (~3.14) is
cOITl'nly spt'dlil'll, illtTl'asillJ.( prin' resoilltion wiJlllot allen the ('stilllal(~(1
{-J asymptolicallv (allllou).!;h lillill'-s;\llIpk pmperti\~s may lIilfl'r). Ilo\\'e\'<'r,
ill practicl' 1111' clal;1 will impos(' a lilllil Oil Ihe fllleness of price resolulioll
simplY hecause Ihen' will he 110 ohS<'rv;tliolls in IIII' I'xln'lIl(' siall's \\'111'11 111
is tllO larg(,. ill whirh CISI' a sllhsl'l ollh(' parallH'll'rS is 1101 idclltilkc! alld
call1lOI III' "SliU\;\ll'd.

'fill' COl/di/iol/lIl ni'/libll/iol/ 0/1'1';11' (;},(/I/,I;I'.I

Ohsl'r\'l' that Ihl' f. 's ill (:\.:-1.1·1) arc asstlllll'd 10 be lIolli(\(,lIlicaIlv clis-
Irihlllt'll, I1l1Hli1i1l1l1'l1 ollthl' Xl's. The 111'('(1 for Ihis sllnll'WhalllOllslalllLlId
as~umplioll COIIII'~ Irolll IIIl' irrl')?;lIlar anc! r.ltldolll sp'King of Ir"t1~',\"lioIlS
(\;lIa. Ir. Ill!' 1',(;lIl1plt-, Irall'aniol! prin" wcn' (it-tcntlilll'd hy thl' Illodd ill
Marsh alld RO'l'llldd (](IHli) whl'n' 1111' l't\ an' illCn'lIH'1l1s of arilhllll'lic
J.J. Modtling 1ransactions Data 125

y'k

Figure 3.4. 'f7te Ordered ProW Malhi

BmwJlian motion with variance proportional to !'>.I. == I. - I.-I, a;

must he
a lineal' function of !'>.Ik which varies from one transaction lO the next.
More generally, to allow for more general forms of conditional het-
eroskedasticity, let us assume that a; is a linear function of a vector of pre-
determined variables W. == [ WI •... Wu ]' so that

Ek INID N(O, aJ) (3.3.20)

2 2 2
Yo + YI Wlk + ... + YL Wu, (3.3.21)

where (3.3.20) replaces the corresponding hypothesis in (3.3.14) and the

conditional volatility coefficients IYJ} are squared in (3.3.21) to ensure t~at
the conditional volatility is nonnegative. In this more general framework.
the arithmetic Brownian motion model of Marsh and Rosenfeld (1986) can
he easily accommodated by setting

(3.3.22)
(3.3.23)

III this case, W k contains only one variable, Ill. (which is also the only •
variable contained in X k ). The fact that the same variable is included in
hOlh X k and W k does not create perfect multicollinearity since one vector
affl'l'ls the conditional mean of Y;
while the other affects the conditional
variance.
126 J. Mmkf'/ AlilTo.l/rttrlw('

The dependence structure of the observed process Yk is clearly ilHluced

by that of Y; and the definitions of the A) 's, since

As a consequence, ifX. and W k arc temporally independelll, the observed

process YA is also temporally independent. Of course, these are fairly IT-
striclive assulllptions and are certainly not necessary for any of the statistical
inferences that follow. We I'equire only that the Ek'S be rOluJiliol/a'(v inde-
pendent, so that all serial dependence is captured by the Xk'S and the W. 'so
Consequently, the independence of the <. 's docs not imply that the V;'s arc
independently distributed because no restrictions have been p\an'd Oil the
temporal dependence of the Xk'S or W. 's.
'~ The conditional distribution of observed price changes Y., clllI<litionl'l1
Ol~ X. and W., is determined hy the partition boundaries and the particular
distrihlllion of E •. For normal fk'S, the (onditiollal distribution is
\
1'( r. .I,/X., W.)

\
I =I

I
r(X~f3+E. :::: 0'1 Xk,W k ) if i
\
P( 0',_1 < X~f3 + <k :::: 0', I X k , Wd if I < i < 11/ C\.:I.~(;)
\ = 1'( a,._1 < X~f3 + f A X k , W. ) if i = III

I\~ :((:~:;))_¢(U"-X;f3) :::i~i<m

",(W,) ",(W , )

I ....
-'>'
(u •. ,-x;f3) .(.
1
,
1= Ill,
\ ",
whe\·e aA(W.) is written as all aq~umellt
ofWk to show how the conditioning
varilbles enter the' conditional distribution, and <I> (.) is the standard normal
cUlllulative distribution functioll.
To develop some inlllilion for the onlcn~d probit lIlodel, ohserve lhat
the probability of any particular observed prin~ change is d{'tCl'mined hy
where the condition<llmeanlie~ rdative to the partition boundaries. There-
fore, for a given conditional mean X~{3, shiftill~ the boundaries will alter
the prohahilities of observing each state (see Fi~\lI'e :~.4).
In (;\CI, by shifting the boundaries appropriately, ordered prohit Gill (it
any arbitrary multinomial distrihutioll. This illlplies that the assumption of
normality underlying ordered probit plays no special role in determining the
prob'lhilities of states; a logistic distriblltion, for example, could have sCfved
equally wei\. llowe\'er. since it is (ollsiderabl!' more difficult to capt\lJ'c
J, J, /'v/{)(iPlillg TrllIBllrlivl/.l' DIIIII 127

condilional heteroskedasticilY ill the ordered logil lIlodel, we have chosell

the normal distribution,
Civell the partition bOllndaries, a higher condition.II 1I1ean X~r~ implies
a higher probahility of observing a InOIT extreme pmitiw st'lte, Of course,
the labeling of states is arbitrary, but the {)llirmi prohit model makes usc
0(' the natlll'al ordering of the states, The regressors allow us to separate
the dl'ccts of various economic bums that influl'llcl' the likclihoo<l of one
state versus another, For example, suppose that a large positive value of
XI usually implies a large IIcgative ohsCl'ved price ch;lnge alld vice versa,
Then the ordered probit coefficient til will he n('gatiV!' in sign alld large ill
magnitude (relative to ak, of course),
P>y a\lowing the data to oetet'minc the partitioll bOlllldaries 0, thc co-
cnicicnts (3 orthe conditional JIIl'an, and the cOllditiollal variall(,c ak~' the
oJ(kred probit Illodd captures the elllpirical rl'latioll Iwtwl'cn the unob-
servable continuous st;lle sp;lce S' ;uHllh(' observ('d di"'J'('Il' state space S
as a i'lIl1C1ioll of' the economil' variahles X k ;Illd W",

M,:xilllllllll.ihrlilwod I~Sli1/llllioll
Let hCi) he an indicator variable whirh takes Oil the value one if the IT-
alizalioll of' the hth observatioll Vk is the ith state ,Ii, and zero otherwise,
Theil the log-likelihood function C (il!' the vel'lOl of' price changes Y
I 1', y~ l'" j', conditional Oil Ihe expl<lllatory variahles X
I X, X~ '" X" j' ;lIld W = [ WI W 1 '" W" ]" is giv(,11 hy

L(YIX, W)

(3,:t28)

Althmlgh 0;is "llowed to vary lillcarly wiill Wk. lit('l'(' ar(' SOllie constraints
that 11I1lst be placed 011 the parameters to ;ll'liieV(' idelltilication since, for
example, doubling the o's, the {3\, ;\l1l1 Ok kavcs the likelihood unchanged,
A typical idelltilil'atioll ;lssulIlptioll is to S('t Yo = I, Wc are Ih(,11 1I'l't with
tilrcc issllcs tltat llIlist bc resolvcd hl'll)\(' l'sti\ll~ltioll is possihle: (i) tlie
lIumber or states III; (ii) lhe specifiratioll of' the rcgll'ssors X k ; and (iii) the
spcci licatioll of' Ihe cOllditional varialll'C a;,
In choosillg Ill, we 11I11st ha\an('l' prire rI'SOlllli,," ag~lillst the practit'al
cOlIstraillttilatlOo large all //I will yield 110 observatiolls ill thc I'xltTIllC states
'I alld s"" For ('xample, ir we sct /1/ to I () I alld ddille the stalcs ~I alld 5101
 J. J\!lIrkl'l J\!inmlrwllllf

sYIIIIllI·trically to Ill' price dI<IIIW'S of -!lO ticks and +!lO ticks. rl'spenively.
Wt' wOllld lind no I'k's alllong typical NYSE stork lransaClion~ falling into
eilher of Iht'st, slalt·s, .IIHI il wOllld hI' illlpossihie 10 eSlilllale Ihe paralllelers
associaled wil II Iht'se 1\\'0 sl<III's. Perhaps Ihe easiesl nH'llIod for dl'lcrlllininR
III is 10 lise the 1'lIIpiricti I'l'l'tllll'lIry dislrihlllioll of IIII' dalasel as a !!;uide,
Sellilig /1/ as large' as possible, IlIlI lull so largt' that the ('xtn'lIl1' states h"ve
110 ohsl'rvatiolls ill thelll.:\~
The rl'lIIaillilig t\\'o issue's "'list hI' resolved Oil a casl'-hy-rase hasis silln'
the spl't'ilil'''lioll for lhl' rq!;ressors alld a;
art' dictaled lar),!;e1y hy lht' par-
ticlliar applicllion al han(\. For I'on'raslill),!; pnrposes, lagged price challges
0111(1 ",arkl'l indl'xl's III"Y he "ppropriale regressors, hilt for t'Slilllalillg a
stl'lll'tllral Inodd of llI'IIkl'lm"kcr IIlOlIopoly power, olhcr varia hies mighl
III' IIIOI'l' appropriall'.

3.4 Recent Empirical Findings

Tlrc clllpirical 111.11\..('1 IlIicroSll'lll'llIrt' lilcratllre is an cXlI'nsivc Olll', slrad-

dling hOlh ac"dl'mic "lid indllstr), p"hlications, and it is difficlllt if nOI im-
possihl(' 10 provide ('V('II " supl'rfici"l rcvil'W in a li~w pa),!;cs. IlIslead, we
shall p\'t'S1'1I1 Ihn'l' spl't'ilk III"rkl'l lIIicrosll'llctllre "pplicaliolls ill this sec-
lion. cach in SOIlH' dqllh, 10 ),!;ivc rcadcrs a more COII('I'('IC illllstration of
empirical n's('"rdl ill Ihis l'XCilillg- "lid rapidly growill),!; lill'ratllre. S('ctioll
:1.'1,1 provid('s all ('lIlpirical '1I1OII),sis of lIonsYllrhronolls tradill),!; ill which
the lIIa)!;lIitudt, of lht' nOlllratiin),!; hias is mcasllreli llsin),!; daily, weeki)" ·md
nHlIllhly slock rl'tlll'l\s. SI'('\ioll :t4.~ reviews the empirical all;\lysi~ of d~
fl'Clivl' hid-ask sJl('('ads hased Oil Ihl' modd ill Roll (19H4). Alief St'uioll
:1.4.:1 prl'SelllS all applicllioll or Ihl' ordered prohil modd 10 IrallsaCliollS
dala.

1. ,I. I NI>II\y"rllIllI/lIll.1 TTl/ding

Bt'li l\"(' \'(\I\~idl'l'i 11),\ I hI' \'III pi rica I I'vidl'lIl'I' 1'01' !lOll I raeli IIg clTI'('\s WI' SIIIl \ I\la-
rill' Ihl' qualitativ(, illlplic;Iliolls or thl' lIo11lradillg model or Seclioll :t 1.1,
Althollgh 111;111\' or th('s(' illlplicatiolls are cOllsisl('1I1 wilh olher models of
IIOIlSYlldlrollOllS Iraelillg, Ih(' sharp comparaliv(' slatic r(,sllll.~ alld \'xposi-

'1"'1"01" (·"tllllph-. I Lu',IIl:lIl. 1.11, ;11111 i\l.lfl\illl.l)' (I!I~)!!) ~('I III == !J lor Ihe 1;lrgl'r .,Iorks,
implying- ('xII 1'111(' SI;t1,'" 01 -·1 lid•., 01 It"", .lIId f··1 tid.s or 11101'(', and ,"'" III = :) f(,r 111(' ~I11;1IIt'r
sllll 1..'" illll'lvillg .'\In'III(' '1.lIe', 01 :! Ii. ,,-, III Ic'" ;lIul +:! lid;..'i or mon', NOI(' (11;11 ;dlhutlgh
till' fldilllllllil 01 ~1.11c, IIl'"d IItll be '~IIIJlH'lIil ( .. I.IIt' 'I I ;111 I", -Ii Ii, k!ll til Ic~!\. illll'l~'iTlg Ihal
Mah' "I j .. -f '.! IiI ,,-, 01 IIIfll('), lilt, !\yllllllt'!I\' 01 Ihl' hi'logralll 01 prin' (·h.,"g('~ ill their d.lla'i('1
~1I~~t'sts;, \\'111111('11 it ddlllilioll 411 III" \, \.
3.4. UfI"fllt l~mJJirj((l1 Fiuding! •
129

tional simplicity are unique to this framework. Under the assumptions of

Section ~.I.I, the presence of nonsynchronous trading

). c10es not alTect the mean of either observed individual or portfolio re-
turns.
2. increases the variance of observed individual security returns that have
nonzero means. The smaller the mean, the smaller the increase in the
variance of observed returns.
3. decreases the variance of observed portfolio returns when portfolios
are well-diversified and consist of securities with common nontrading
probability.
4. induces geometrically declining negative serial correlation in observed
individual·security returns that have nonzero means. The smaller the
absolute value of the mean, the closer is the autocorrelation to zero.
5. induces geometrically declining positive serial correlation in observed
portfolio returns when portfolios are well-diversified and consist of se-
curities with a common nontrading probability, yielding an AR( I) for
the observed returns process.
Ii. induces geometrically declining cross-autocorrelation between observed
returns of securities i and j which is of the same sign as fJ,flj' This
cross-autocorrelation is generally asymmetric: The covariance of current
observed returns to i with future observed returns to j need not be the
same as the covariance of current observed returns to j with future ob-
served returns to i. The asymmetry arises from the fact that different
securities may have different nontrading probabilities.
7. induces geometrically declining positive cross-autocorrelation between
observed returns of portfolios A and B when ponfolios are well-diver-
sifted and consist of securities with common nontrading probabilities.
This cross-autocorrelation is also asymmetric and arises from the fact
that securities in different portfolios may have different nontrading
probabilities.
H. induces positive serial dependence in an equal-weighted index if the
betas of the securities are generally of the same sign, and if individual
returns have small means.
9. and time aggregation increases the maximal nontrading-induced neg:
ative autocorrelation in observed individual security returns. bUl lhi~
maximal negative autocorrelation is attained at nontrading probabili~
ties increasingly closer to unity as the degree of aggregation increases.;
10. and time aggregation decreases the nontrading-induced autocorrela-l
tion in observed portfolio returns for all nontrading probabilities. \

Since tile effects of nOllsYllchrollollS trading are more apparent in se-

curities grouped by nontrading probabilities than in individual stocks, our
empirical application uses the returns of ten size-sorted portfolios for daily,
 )30 3, MllIlut MirllJ.ltm(/lIr,.

weekly, and mOllthly data from 1962 to 1994, We use market Glpitali/.a-
lion to group securities because the relative thinness of the market for
any given stock is highly correlatcd with the stock's total J\lark{~t vahl{';
h 'lIce stocks with similar market values are likely to have similar nontraclilll-:

l
p 'obabilities,39 We choose to form tell portfolios to maximi/.e the hOll)o-
g neity of nontrading probabilities within each portfolio while still main-
taIning reasonable diversification so that the asymptotic approximation ur
d.1.20) might still obtain, ~o
i
Df.ily Nontrading Probabilitifs Implicit ill A u/ocorre/ations
T~ble 3.4 reports first-ordcr autocorrelation matrices rl for thc vector of
fopr of the ten size-sorted portfolio returns using daily, weekly, and monthly
d*a taken from the Cemer for Research in Security Prices (CRSP) database,
P9rtfolio'l contains stocks with the smallest market values and portfolio 10
cO~llains those with the larges1. 41 From casual inspeClion it is apparent
thfl these autocorrelation matrices arc not symmetric. The second colUl1111
of\matrices is the autocorrelation matrices minus their transposes, and it
is ~videnlthat elements below the diagonal dominate those above it. This
cO\lfirms the lead-lag pattern reported in 1.0 and MacKinlay (l990c),
\ The fact thaI the returns of large stocks tend to lead those of sl11aller
stolks does suggest that Ilonsynchronous trading may be a source of cor-
rcl4tion, However, the magnitudes of the autocorrelations for weekly ;\lId
monthly returns imply an implausible level of nontrading, This is lIIost evi-
(lcilt in Table 3.5, which reports estimates of daily nontrading probabilities
implicit in the weekly and monthly own-alllOcorrclatiolls of Table 3.4,
For example, using (3, lAO) the daily nontrading probability implied by
all estimated weekly autocorrelatioll or 37% for portfolio I is estilllated to
be 7I.7%,~2 Using (3.1.8) we estimate the average time between tracks to

190nly ordinary cummon shares arc included in this analysis, Exchukd an' Alllni",,"
Depository Receip15 (AORs) and other specialized secllrities where lIsing market val\l~ to d,,"-
acteri/.e nontrading is Ie.., meaningful.
""The returns 10 these portfoliusarl' n)lltinuOIlslycOIlII)(Hllldcu relurns ofitldividtl.,1 ~il1\I)It·
returns arithmetically averaged. Wt' have repeated tht, curr("l;tlion analysi:t. for ('oUtiIl1l0US)Y
con'pounded rf'turn~ of p()rtfolio~ Wh05C value.ra. 4lre calculateLl as unweightC"d RCOlllt.'trir av..
{'rdg{'s of included securities' prices. The result, for these portfolio returns arc pr"rtically
identical to those for the continuously compolllHkd returns of c(l"al.wciglll(·d pol"l1011O\.
"We report only a ,ullset of four pnru"lios for the sake of hrevity,
41SIandard error. fm alllocorrl'l,uioll,h,l,.. d probability aud lIotl\r"dinH duration ("ti",,"("
<If" obtained by ;'Pplyill\: a firM,unlt- .. 'E,ylor ""I"II"ioll (Sl'" Sl'ction A.4 of the Apl'l'ndix) to
(:1.1.11) and (3.1.40) using heleroskeda,ticity- and aUlucorreiatiOlH;unsi'\c1l1 ",,,ul,, ... 1 en ors
I(If daily, weekly, alld llIolithly firsHmlcr autl)(uncl,lIioll coelliciellt•. These laner Mand,ml
errors are compllted hy regressing retlll'llS 011 " conslant alld lagHcd returtl~, alllll\sin~ Newl')'
.\lut \\'est"!. (19H7) procedure to fa1clllat<· lu"t("H)skc(\C\s\\dty... nel .unororr("!ctlioll·nHlSi~Il·lIl
~u~lIulanl errorS for the slupe {ol'Uldt'n\ (",'hid, i~ !FIimply the fiut'''ordC''r ,IUIO«lI rt"l.\thm nwf-
ficietu of r("turn~}.
 J.". NUI'IlI 1~'IIII)itiral Findings
131

7able 3.4. A 1/11)(()n~I(lljl/1l 1II111";l'r.1 JilT .1;1.I'-.11/I"lr" f"'I"'folio I/"I/nll.

J\ 1'1 -i"1
I <1 7 10 I ,I 7 10

Daily
,I
7
10
, (""
.11
AO
.:H
.~~)

.:H
.~H
.:\ti
.~I
.:1!)
.~~
.:14
'>7)
.11
.I!>
. I ~)
, (""
<1
7
10
.1:1
.I!)
.~7
-.1:1
.00
.O!)
.:.!:.
-.1 ~)
-.m)
.00
.1'1
-")
-.~:)

- 1'1
.00
1'1 i'l - f'1
I 4 7 10 I 1 7 10

T' _II') , ("" -")

.19 .1:1 -.1:) -.~O
Wcekly 4 .:'11 .:11 .15 -.00 4 .15 .00 -.OH -.IV
7 .:1:1 .:1:1 .17 .0:1 7 .~o .OH .00 -.14
10 .:11 .19 .15 .01 10 .~ti . I ~) .14 .00
1', -,
1'1 -I',
1 <1 7 10 I 4 7 10

Monthly 4
7'(" .:1H
.:10
.10
.16
.IV
.Oti
.11
.14
(1)
.0,1
.05
4
, (""
.IH
-,,~O

.00
-.:1!>
-./IH
-~')
-.14
7 .:14 .OH .00 -.09
10 .:17 .IH .14 .0:1 10 .~ti .101 .O~I .00
S;Ullple lir~I~)nll'r;lIl1ororrcLlIi(lIlIJl.HJ"ix i",'ol"tlw (-I x I) slIln'('( lor I ,;' '.~'
,; 1;'111' of ohs('I"\'('"
fl'ltlfll:-' lD tell eqllOlI-weig-htcd sile-~orted pOrlfolios w
.. illg d~'il)'. week.ly. alld monthly NYSE-
AMEX (0111111011 stock returns data from th(· CRSP lilt·s
for Iht' lime pt:riod .lilly :l. 1962 In
Den'mllei" :~(). I!)~H. Storks ;uc assiglled to portfolios
'lT1ll1lall>' lIsing th(~ IH01rket value.1t the
cnd urlhe prior }'(·;If. If this market value is missil1K Ihl"
cud 01 year markt,t \'.dut' is used. IflxHh
mark('1 val lit's ,II"(' IlIis..... ill~ lil(' stork is 1I0t illt. Itlflt'd.
()lIly .\t'nll ilu':-, Wllit nllllpl('I(' daily 1('1(11 II
hi!'lloril':-' withiu a gi\'('IJ mOllth arc inrilHh-d ill Ihe d'lily U'WIIiS
f.lklll.tlio ll ..... ,;' i. . th(' U'tlil It 10
the portfolio containin g securities with tilt.' smelliest menkel
",,,III('s <uul,;'" is tilt· return tn the
ponfolio ofs('curiti{'s wilh thc lar~csl. Th('I(~ ,lit' approxilll
<udy cqu,.1 Illlml)('ls of sCfuritics in
each portfolio, The t'ntry ill the ilh row and jIlt (011111111 is
Ihl' (01"1 elatioJ1lwtw('CIl ,;; I' .uHI';; .
To gauge tlit, dt'glt'l' of 'L~ymlJletry in IlleSt' CllltocOIIl" latiulI mati i(t'.o;" the- dillt'n'lIfC (.... 1-
t'l
is abo r{'pont·d.

be 2.5 days! The corresp onding daily nontrad ing prohahil ity is
HG.(i% using
monthly returns. implyin g an aver;lge lIolltrad illg duratiol l ofG,:,
days.
For compar ison Tahle 3.5 also reporls estimate s of th\' lIolltrad
illg proh-
abilities using daily dat,l and using tr;1(1e informa tion from th('
CRSP files. In
the abSCtll'C or timc aggrq~atioll OWIl-.lutocolTdatioIlS of porlf(,li
o returns
are consiste llt estimato rs ofllontr ading probabil ities; thus the
clltries ill thc
columll orTable ::I.5lahe lled "rr.(q = I)" arc sill'l)ly takclI rrom
the diagolla l
of the autocov ariallce matrix ill Table :t4.
For the smallcr securitie s, the poilll cstim.lle s yield plausibl e Ilolltrad
illg
duration s. hut the estimate d duratiol ls declille (111)' 'lI;lrgill;l
Ily for larger-
 .l. II/a/Ii,,/ MU'/m/m(/w"l'

'1lIhle J.5. 1·.~\/iIl/1I1,·\ "/ tlllil\' lItH/lrmli,,/{ Im,l",bilili,.I.

K fr, ir,('1= I) f.:1 ii, I ir,(f!= 5) 1~lk,J ir,(f! = :!2) LI h, J

.~~!") . :I!I·I (IN• .717 2.:.-1 .Hlili li.!7
(11.111:1 ) (O.O:!li) (IHI7) (O.O:H) (0.·12) «1.0:!!l) (Ui·!)

·1 .o;.:! .:\.1:1 O.:,!! .:.1iI) I.:!H .1-\:17 :.. 12

(O.OIH) (0.02:1) (O.W.) (O.W.!I) (0.:11) (11.0·1:1) (1.1i I )

7 .01!1 .:I:!H IH~I .·I!I7 O.!I!I .HI!I 1.:-.2

(O.OO:!) IO.Oilil (fI.o·1) (O.Oli:!) (O.:!:.) (O.O·IH) (I.·lli)

III .Oll:! .IHH II.:!:I .I:I!I O.lli .!") I:) 1.IIIi

(0.11111 ) 10.111'1) (0.0:1) (O.i:!li) (11.17) (ll.·lti I ) (I.'IIi)

I':\lim~'h'~ of(.bily uoutLHhng pruh.dlilitit·:o, impli('it in (c.'1\ wt'c:ldy ~'nd monthly \i/c.'·\ortc:d port-
Inliu n'unn ,\\lh.)( unt'I.H\tH\S-. r""i,'\ '" lin- ('ulumn l~\I)C.'tlc.·(t "rr ... ~Ul' ~\\·(·r~,~(·\ofthc.· harti(ltl of
,to, \U','it'~ '" pUllluhu /rt, lh.u ,1ill lin' tLH\t· uU \'~U h 'ra"in~ ,t,y. Wht'H' tht· ~\"t'ri\At' ,\ rnmp\1h't\
U\Tr "~II lr.uhng Il.,y, h om.}u\\-:t EU)~ to' h'n'mlu'r :\U. 14J94. Enll't'~ in tht· "rr .. ,,/ = 1)" fplumll
~'n' 1ht· Iii \H lICit·, aHtonJlIt'1.lIion fodlidt'llb of (lail), ponfoHn f('\nrl\!'\, \"hit h "ft' fOJ)!'oisu'ut
("!\lim;lIu"~ of 'bil\' IIOllll,ulill).,{ proh;thililit,."i, EIII ..it-S ill Ihe.' '"if" (,/ = :,)" ;lIul "n,. (q == ~~) ..
1"1111111"" ,It" ('~lilll,IIt-!\. 01 ,tlil\' lIolllr;uling I)luh.lhililit's ohtailU'«\ Irolll li""I-ol(lt-r wn'kly ;IIHI
monthly pUlllulio 1"1'111111 ,11110("01 Id.lIiOIi ('udlid"UIS, "!'Iillg Iht' lilll(, ag-gu'g'lIioli rd.llion' III
~k('lioli :\,~ ('1 ~ :1 101 wc',,}"'1\' It'tunl' .IIHI 'I = ~~ for IllOlUhly n'IIII"II." ;o.i 1I«."t' the.'f(' an':1 ~1I1(\:!~
fr.ulillg 1I;t\'s ill a \\'(·(·k awl,lllIullth, n"IH'( li\'t'ly), Enlrit';o. ill (·Ohllllll."i l;tlwlled Mf:f k/l" alt' ('sri-
male.'s of Ih,' e.'Xp('fu'd IIl1mh,'" of nHt",'nlli\"(' days withour Ifading" implic.'d hy lilt' prohahility
('Mim;,"';o. ill rUIIlIllIl!\ to lIu' illlllu'di;III' It·fl. Standard ('nors an- r('porle'lI ill pal(·11111(·;o.(·": all
;an' hC.·h'I·'Js"(·(Ia.,IH·ily- ;'1111 illlltH', In(·l;lticIIH·(HI.'ii.... I(·,11.

sil(' portli.lios. A dllral iOIl of lIt'ad)" Ollt' lillirth of a day is IIIlIch 100 Iarl!;c
«II' s('cllriti('s ill til(" lall!;t'sl portJ(,li, •. More direct evid(,lIc(' is provided ill
th(' ("{)hllllll lahdlt-d n" which rqlllr\s the awrage !i'actioll ofs('cllritics ill
a giv('n portfolio Ihal (10 not Irade dllring ('acll trading day.n This ;Iv('l";Ige
is COllllllllt'd OV('I" alllra<lilll!; days rrolllJllly :~. I!Hi2 to Ikn'lllhn :1(), 1!191
(HI7!) !lhS{"("\'<Iliolls). COIIIIl<\I'illg tIlt' (,lIlries ill lhis COIIlIllIl Wilh thost' in
11H' othns sholl'S lht' lilllil;lIiolis of lIolitrading as an t'xplallation for the
alllo("orrcl;lIioll~ ill III(' <1;11;\. Nonlr;lding llIay he responsihl(' lill' SOllle of
11H' lillH'-s('rit·s propt"ti.-s .. f stock n'tllrllS hilt (;1111101 ht' til<' !lilly SOllrn~ of
<111« .correia! iOIl.

nTh" iulium.Hlon" IBU\'"l,'" HI '\11' (J{Sl' ",Illy hh·!\tn ",hit'll "11' (luo;,tng pdcT nl;, ,('nully
i, "'pol1t'C' 1o ht' Ih,' ,H·g.II"".,l IIII' .I\·C'J ;Igc' ot Ih,' hill alltl ask prin'!'i (lJI (I.ly~ wht'll th,11 .'C'C IIril)'
Ilid 1101 II.U"', SLuul.lld "1101 ... 1111 proh.lhilil\' ,',lim.lit'S .tlt' h,l."i('(\ olllht· d.lily lilll{' '(Til" 01
Iht' iI~lnitlll ni 110-11;111(-,. 1"1,,' stalld.lnl ('nul's an' h(·I(-ro!;,k(·daSlkil~'· ,nul ;1Il10fOIT('Lllillll-
nlll,hlC'lIl.
J.4. Ilfcmt I~",piri((ll Findillg.~ 133

Table 1.6. N(Jl/lmt1il/~-illll,lif(/ wffkly i,ll/ex flulocomlnlions.

Implied Index PI ('Yo) Implied Indt;x PI ('Yo)

Estimator of If i
(Ill == 1. /ll" == 1) (Ill = 1.5.13111 = ()5)
Nq~ative Share Price 1.4 I.H
Daily AUlOcorrelatio" 4.H 5.9

IlIIpli .." firsH>rtier autocondation PI ofw"ekly relurns of an equal-weighted portfolio o(ten

si/t·-"'rt~" portfolios (which approximales all equal-weighted portfolio of all ~curitie.). u~iJlg
two difkr~nt t'stilllators of daily lIontrading prohahilities for the portfolios: the aver.tge frdnion
of n~~ati\'(' sl"lrt' pric .. s reportt'd hy CRSI'. and daily nontr.tding prohahilities implied hy lirsi-
ordl'r aUlororrdalion, of d;lily returns. Sinet' the index autocorrt'lation depends on the IX-tas
of till' tt'n portt(>lio,. it is colllputed tilr two set' of betas. one in which all beta.~ are set w I.U
;lIId anoth"r in which tht' hetas decline linearly fmm III = 1.5 to Pili = 0.5. The sample weekly
""t"r""r~hlti()n for an "'lual-weil\htecl portfolio of the I('n portfolios is 0.21. Results are ha",,"
on ,1"la frl)IlI.1nly :>. I\l\i:.! III nec.ember :>0. 1\1\14. .

M!l!5ynfitron()1L5 1rading and Index Autocorrelation

Dellote by r,~,( the ohserved return in period 110 an equal-weighted portfolio
of all N s(·curities. Its autocovariance and autocorrelation are readily shown
to he
(' r(n) (
(3.4.\1)
~
where r" is the contemporaneous covariance matrix of T," and ( is an (N xl)
vector of ones. If the betas ofthe securities are generally of the same sign and
•
if th(' Illean return of each secnrity is small, thell r~, is likely to be positively
alltocorrelated_ Alternatively, if the cross-al1l0Covariances are positive and
dOlllinate the negative own-au(Ocovariances, the equal-weighted index will
exhibit positive serial dependence. Can this explain Lo and MacKinlay's
( 19RRh) strong rejection of the random walk hypothesis for the CRSP weekly
(,qual-weighted index, which exhibits a first-{)rder autocorrelation over 20%?
Wilh little loss in generality we let N = 10 and consider the equal-
weighted portfolio of the ten size-sorted portfolios, which is an approxi-
malely equal-weighted portfolio of all securities. Using (3.1.36) we may
calculate the weekly autocorrelation of r;;,( indnced by particular daily non-
tracling probabilities 7f; and beta coefficients {3;. To do this, we need 10
sel(,ct ('JlIpirically plausible values for IT; and 13;, i :::: 1.2 •...• 10. This is
don(' in Table 3.6 \Ising two differ(,nt methods of estimating the 7T;'S and
IWo dill't'J'enl aSSlllllptioll5 for the 13,'5.
The first row corresponds 10 weekly autocorrelatiolls computed with
lhe nontrading prohabilities obtained from the fractions of negative share
prin's J'<'portet\ by CRSP (sec T~lbie 3.5). The first entry. 1.4%. is the first-
 3. Markel MimH/l"Ilrlurr

qrdcr autocorrelation of thc wcckly cqual-weighted indcx aSSlIllling tklt all

twcnty portfolio bctas arc 1.0, and the second entry, 1.8%, is cOlllputed UII- .
dcr thc altcrnativc assumption thatthc bctas declinc linearly frorn III = 1.:>
f~)r thc portfolio of smallest stocks to IlIU = 0.5 for tl!c ponlc>lio of the
11rgcst. The sccond row rcports similar autocorrclatiolls implicd hy 11011-
l~ading probabilitics cstimated fmlll daily autocorrclations using n.IAI).
The largcst implicd !irst-order autocorrelation for the weekly equal-
w ightcd returns indcx reported in Table 3.6 is only 5.9%. Usillg direct
f.
c. timatcsofnontrading via lIegativc sharc priccs yields an autocorrelation of
I~' s than 2%. Thcsc magnitudcs arc still considcrably smallcr than the '21 'Yv
s· IIlplc autocorrelation of thc e<Jual-wcigllled indcx retUnI. In SIlIllIll,II")',
tl e rcccnt cmpirical cvidence provides lillie support for nOlllrad'lIlg as all
important source of spllrious correlation in the rcturns of common stock
o~er daily and longcr frcquencies. 41

3.4.2 1~,\tiIlUllil/li till' I:J/rrlivc Bid·A~" .'>/))"('(1/[

In implementing thc model of Scction 3.2.1, Roll (1981) argucs that thc
percentage bid-ask spread s, may bc more easily intcrpreted than thc al)-
solute hid-ask spread s, and he shows that thc Ilrst·urdcr 'lIl1ocovari'lllcc of
simple returns is relatcd to .I, in the following way:

.\; .\~1 s,~

Cov[ R - l H, I --
4
--
Hi
~
4
(:H.'2)
'

s, - JJ>1I 1',. '

(:H.:\)

where 5, is defincd as a pcrccntage of thc geometric average of the avcragc bid

and ask priccs Po and Ph' Using the approximation in (3.4.2), thc pcrcentage
spread may be recovercd as

(:H.4)

Notc that (3.4.4) and (3.'2.9) arc only wcll-deflllcd whcn thc returtl al1to-
covariance is negalive, sincc by conslruction the hid-ask bOllllce elll only
inducc negative !irsl-order serial correlation. Ilowever, in praclice, po~i­
tive scrial correlation in returns is lIot IInCOllllllon, and in thcse cases, Roll
simply defines thc spread to he (sc(' footnotcs (l ,lIld b of his Tallk I):

Hnuudollkh, Richa,.dsoll, alld Whit,·law 1199:», M"('h (I!I!I:I) alld Sias alld Sta,b (I!I!I-!)
prt·~ClIl additional empiricfll results on l1onlra<iillJ,{ as ;,\ soun:(" of iUltoccll"u·hl1ioll. \\-'hilt- lilt,
p"pf'r~ do nut a~re(" on the I('\'l"i of auto("(lITf.'laliun indu('('d hy nOll trading'. all 1111"('(' l),Ip('r~
rO"rltHl" thatllolllradilll: ,';,"lol rompl("I<"I), "e<'<>II1l1 Ii,,· Ill(" 01>"'1'1'("<1 ;\lU()('o"rl"li"m.

1,
3,4, Recmll:III/,irim/ Findings

This conv('ntion seems dirticuh to .iustilY 011 ('('onomic ~rolll\ds-ne~ative

spreads arc typically associated with lI1arkdll1;",i\l~ aClivity, i.e., the provi-
sion ol'liqui<lity, yet this seems to have lillie connection with the presence of
positive serial cOlTebtion in rClul'lls, I\. more plausible ahel'llative interpre-
tation of cases where (:-1.4.4) iscollIplex-valllnl is Ihallhe Roll (I!)!H) model
is misspecilied and that additiollal structllre IIllisl be illlposed 10 an:ounl
for the positive serial correlation (sec, for example, (;eol~e l't a!. [1!191 J.
Glosten and l'brris [1988], l'luall~ and Stoll [I !)!):)a I, alld Stoll [I 9H9)),
RolIl'stilllatl's the c!1Cctive spreads of NYSl': and i\MEX stocks year by
year usin~ daily rclllfllS data from 19G3 to 198~, alld (inds the overall avera~l'
effective slHead \0 be O,'2!)8% for NYSE slocks ;\lHI 1.7,\')(, I'll' AM1':X storks
(recall that AMEX stocks tend to he lower-priced; hell(,(, they oll~ht to have
larger percentage spreads). However, these ligures II111St be interpreted with
caution since '2-1,3:)/l of the -17,414 eSlimated dknive spreads were negative,
s\lggestin~ the presence ofsubstalllial spccific<llionl'l'rors. Perhaps another
symplom of these specification errors is the bctlhal estimales oflhe effeclive
sFreaci hased on weekly data differ signilicanlly from Ihos(' based on daily
datJ. ~everthcless, the llIa~nitudes of these dkCls arc dearly important for
cmpirical ;'pplicatiollS of transactio\lS dat,\.
Glo~ten and Ilanis (1988) rcline ,lIId eSlinlatl' Clostcn's (1987) de(olll-
positioll or Ihe hid-ask sprcad using trallsaniollS data ror '2:)() NYSE stocks
and conclude Ihat the perman('nt advers('-selection compollent is indeed
pn:sellt in the data. Stoll (19H!)) develops a similar decolllposition of the
~pread, and usin~ transactions data Ii)r Nalional Markct System s(,curities
011 the NASDAQsYSll'lII frolll Octohn to lkc('Inhl'l' or I!ItH, he concludes
that 43% of the quotcd spread is due to advlTse sel(,ction, 10% is due to
inventory-holding costs, and the relllainin~ 47'}(, is due to order-processing
costs, Georgc, 1<..;1\11, and NimalelHlran (1991) ;,lIow the expected retllfll of
the ullobservable "true" pricc (1',. in Ihe notation or Section :t~.l) to vary
through timc, and using daily and weekly data for J'I.'YSE and I\.MEX stocks
from 1963 to I ~)!:l5 and NASOI\.Qstocks alld frolll I!JH3 to I!)!:l7, they obtain a
much smaller estimate for the portion of the spread allrihutabk to adverse
sckction-8% to l:-I%-with the relllainder due to order-processing (,oSL~,
and 110 evidence of' inventory cosls. IllIang alld Sloli (I !I!I!'>a) propose a
[\\or(' gCllerallllodcl th,ll cOlltains these (lthlT specilications as special cases
and estimate the ('()lllpOllellts or tile spread to be \!l 'X, adverse-selection
costs, 14% iIlVl'lIlOry-holdin~ n)sls, alld (i:)'X) ()nln-plO('('ssi\l~ costs usin~
199:ltrall~<IClions data for I!) ofllH' '20 slorks ill till' t\L~jor Market Index,
'1'11(' raI'l Ihal Ihese ('slinlat('s v;lry so nlllrll ;llTOSS slueli('s makes it e1il'-
fiulit 10 regard any single stlldy as (,(lIIriusive. Th(' dilkn'lll'('s (,ollie /i'OIll
two SOllrcl's: dilkr('nl specifications I,ll' thl' e1ynalllio of the hid-ask spr('ad,
and the lise of dilkrent dalasets. Th('ll' is clearly a nl'l'd I,ll a 1II0rl' dl'laikd
amI (olllpn:hl'IISiv(' allaly~is ill whi('h all of Ihl'sC sp('('ilicaliollS arc appli('d
10 a \':lIil'll' (II d:llaS('ls 10 ~allgl' tlte I'xplallalOry pow('r alit! st:lhilit\, 01 ('ach
lIIodd.

,. -1.1 nt/I/.lt/dill//.\' nolll

III I tlllSlll:lIl, 1.0, :11111 /'bcKin!;I\' (I~)q~), Ihrl'l' spl'cilic aspl'ns of Ir:lllsa('-
lions data arl' I'xaillilll'd \Isillg thl' ordl'rl'd prohil modd of Sl'niOll :\.:\.:\:
(I) Do('s thl' parliclIl:tr II',{III'IIO' ollratll's affl'cI till' cOlldiliollal dislriblliioll
of prin' changl's, I'.g., dOL's Ihl' Sl'ljlH'llCl' of three pricl' challgl's -I- I, - I, -I- I
ha\'l' II Ie S:\1 III' dIi'('( Oil the cOlltiitiollal distrihution ofthl' III'XI price change
as Ihl' S('qtll'IIII' -I, + I, + I? (~) DOL'S Iradl' sizl' alTecI priet, chall!-\cs, alld
if so, wh:11 is thl' pritT illlP:I('\ pn Ullil volullll' of Irade frolll Olle IrallSac-
lioll 10 Ihl' III'XI? e\) Dol'S pricl' disITell'Il1'SS l\Ialln? III particular, ell \
Ihl' cOlldiliollal di~lrihlllioll or pricl' chall!{l's he 1II0deled as a simple lillcar
rl')~rt'ssioll of pricl' r11:lIlgl'S onl'Xplallalory variables withotll accolllltillg for
dislTl'll'llI'SS al "II?
Til acldn'ss 1IlI'sl' Ihn'l' qllesliolls, Ilatlsmall, 1,0, alld MacKillLi), (I !)92)
('stimall' Ihl' o,dl'l;'t\ plllhil II10clt'I for 19HH IrallsaCliolls dala of o\'er a
hUlldrl'd slod.. s. 'Iii ('{IIISI'r\'I' span', wc rOnts (111)' Oil Iheir sllIalln ane!
IIlIIr(' d('I:lilnl s:lIl1pll' of six ~1()cb-lnll'rllali()llal IIl1silH'ss Machilu'" Cor-
pmat i()n (\HI\!) , (.2"antllll (:lu'lllical (:orporation «:U E), Foster Whcl'kr
Corporation (F\\'( :), llalle!v alit! Ilannan COlllpany (I INl \), N:l\'isl:lr 111-
Il'I'llaliollal Corporalioll (NAVj, aile! American TI'I('plloll(' and Tc'lcgraplt
IlIl'orpor:llt'd ('1'), For !iIl'SI' six slocks, Ihey foctls ollly Oil ililmtit/y Ir:lItsac-
lion prin' dlan~l's since illt:IS IWl'lI wdl-docIIIIII'llled Iltal overnight relurns
di/kr sllhslallliall), /'rolll illlrad:l), J'('llInts (SCI', for c'xalllpk, Alllihlld atlel
Ml'llclt'lson II!lH7I, Sloll and Whaky [19!1()], alld Wood, Mdllish, ancl Orel
[ I!)H!, I), Thl'v also impose sl'vl'ral oliter filters 10 l'IilJlin:ttl' "prohklll" lrans-
anions and qllOlt'S, which ~'idclt-cl salllpll' sizes rangillg frolll :1,17,1 Iracles
«II' IINlllo ''!Ot;,7~)'(lralks ror IBM,
Thl')' ;dSIlIISI' hid alld ask pric('s i II Iheir :llIalysis, alld since hid-:lsk qllOlcs
arl' I'I'Jlortl'd olll\' ",hl'lI IIII'\' an' r('vis('cl, SCllIIl' efrorl is J'I'qllirl'cl 10 Ilialch
qllOll'S 10 Ir:\lI~:ll'liolls, :\ natural algorilhm is 10 lIlall'h each Ir:lllsaniol\
pric(' 10 Ihe 1I10~1 1'1'1'1'11111' reported qllOI(' /willr 10 Ihl' Ir:lIIsauion; howevcr,
Brollfrllan (Ill!)!) :11111 1,('(' alld Rl'ad)' (l!l!ll) have shown llial prices or
Iradl's lIial prl'cipilalt, qlloll' r(,visiolls art' SOllll'lilll(,S report cd wilh a lag, so
Ihal Ihl' onlt-,' or qllOl1' r(,vision and IrallSauiol\ price is reversed in ol'licial
r('conls sllch as Ihl' (:ollsolid:lIl'd '1:11'('. To addl'('ss Ihis issll(" J lallsillall,
1.0, alld M:ld"illl:1\' (I'lc)~) 1I1:,td, trallsaclioll prices \0 qllotes Ihal arc set
til Imlt/i1,/' \/'/II/ld, {"i",. 10 IhI' Irallsacl iOIl-Ihe c'vidl'ncl' in 1.1'(' and Ready

(1!1'1I) sllggC'SIS Ihal Ihis will accolllII for 1II0s1 01'1\1(' Illissl'C(II('IICilll!;. This
is 01111' OIl<' \'x:lIl1pk of till' killd of IIl1ill'll' challengc's lIi:11 Iransaclions dala
po.~(',
J.". /It'ct'lll Empirical Filldings 137

To provide some intuition for [his enormous dataset, we report a few

slIllllllary statistics in Tahle 3.7. Our sample contains considerable price
dispersion. with the low stock price ranging from $3.125 for NAVto $104.250
for \HM. and the high ranging from $7.875 for NAV to $129.500 for IBM.
1\[ $219 million, HNH has the smallest market capitalization in ollr sample.
and mM has the largest with a market value of $69.8 hillion.
The empirical analysis also requires some indicator of whether a trans-
action was buyer-initiated or seller-initiated, othenvise the notion of price
impact is ilI-defll1ecl-a 100.000-share block-purchase has quite a different
price impact from a 100.000-share block-sale. Obviously. this is a difficult
task because for every trade there is always a buyer and a seller. What we
hope [0 capture is which of the two parties is more anxious to consummate
the trade and is therefore willing to pay for it by being closer to the bid price
or the ask price. Perhaps the most obviolls indicator is whether the trans-
action occurs at the ask price or at the bid price; if it is the former then the
transaction is most likely a "buy" and if it is the latter then the transaction
is most likely a "sell." Unfortunately. a large number of transactions occur
at prices strictly withirl the bid-ask spread. so that this method for signing
trades will leave the majority of trades indeterminate.
Hausman. Lo, and MacKinlay (1992) use the well-known algorithm of
signing a transaction as a buy if the transaction price is higher than the mean
or the prevailing hid-ask quote (the most recent quote that is set atlea~t five
seconds prior to the trade); they classify it as a sell if the price is lower. If
the price equals the mean of the prevailing bid-ask quote, they classify the
trade as an indeterminate trade. This method yields far fewer indeterminate
trades than classifying according to transactions at the bid or at the; ask.
Unfortunately. little is known about the relative merits of this methOd of
c\;\ssific;ltion versus others such as the tick lesl (which classifies a transaction
as a buy, a sell, or indeterminate ifits price is greater than,less lhan, orequaJ
to the previous transaction's price. respectively). simply because it is virtually
impossible to obtain the data necessary to evaluate these alternatives.

Thf J~ml)iriral Specification

To estimate the parameters of the ordered probit model via maximum likeli-
hood. three specification decisions must be made: (i) the number of stales
111, (ii) the explanatory variables Xk • and (iii) the parametrization of the
. 2
vartance G k •
In choosing In, we must balance price resolution against the practical
constraint that too large an In will yield no observations in the extreme states
·\1 and .1 m • For example. if we set m to 10 I and define the states SI and SIOI
syml\lctrically to be price changes of -50 ticks and +50 ticks, respectively,
WI' would find no Y. 's among ollr six stocks falling into these two states.
Usin~ the empirical distribution of the data as a guide, Hausman, Lo, and
138 3. Markel Mirm.IITllrlllTf'

TableJ.7. Summary stnti.,tirJ fOT tmll.lflrtiollJ Ilntn cif.lix .• /orh.,.

Variable IBM CUE FWC IINII NAV T

\Low Price 104.250 6:,':'()() 11.500 14.2:,0 ~.12:' 24.12:,

,lIigh Price 129':'()0 IOH.2:,O 17.250 HI.500 7.H7:, :\0.:\7:,
'Markel Value (SBmiolls) ('9.HI" 2.1t17 0.479 0.219 H.9!J1-\ 211.\I\lO
\

.% Trades at Prices:
;> Mid'luote 4:1.81 4~.19 :'17.13 22.:,3 40.110 :12.:\7
= Mid'luole 12.ijij 18.67 2~.',8 26.2K 11-\.11 2:J.~)2

< Mid'l"ole 43.5:\ :lK.14 39.29 51.20 41.0!l 41.71

Price Change. }.
Mean: -0.0010 O.OOJ(' -().0017 -0.0021l -O.1l002 (1.000 I
SId. Dey.: 0.7530 1.23:>3 O.l'~!JO O.74!l2 0.644" 1l.!i:,40
Time Belweell li-ade•• "It

Mean: 27.21 20:1.,.2 2\1(,.:.4 1129.37 :1~L\(; :11.00

Std. Dey.: :14.I~ :l1l2.lij 416.49 1497.44 7(i5:1 :\·1.:\\1

Bid-A.<k Spread, AB.

Mean: 1.9470 3.2909 2.01'30 2.4707 l.46lti l.Ii,.1;4
SId. Dey.: 1.462:, \.(,203 1.1682 0.8994 0.(,713 0.79%
S&P500 FU(llres Return
Meall: -0.0000 -(LOOO4 -0.0017 -0.0064 1).0001 -(WOOl
Std. Dey.: 0.0716 l1.l3!l7 0.147,. 0.1903 O.103K 0'<171;:.
Buy-Scllindicalor, IRS.
Mean: 0.00211 O.!I:,W, -0.(2)(; -0.2!llj7 -O.I)02H -0.0\1:1:1
Std. Dey.: 0.9:146 H.900'. 0.8739 0.8095 0.9(Wl O.K:1:'(;
Signed Transformed Volume
MeaR: O.IO',!) 0.:\:,74 -1l.O:,23 -1.%43 0.0332 -0.42,.(;
SId. Dey.: 6.1474 ".6643 6.27911 6.0I:l!lO 6.\)70:, 75H4!i
Median li-ading Volume ($) 57,37,. 40.900 (;,1:,0 ",:\(;3 3,O()O 7.\1,.0

Summary statistics for lr~ll.\a(tiOl) priet· . . alul «)rn'sIHlIHii1Jg '>rdercd probj( ('xpl'lIldlc)I y \'~II i·
able. oflnlernationaillusinc.., Marhincs Corporation (IUM. 20(;,794 trades). Qllantutll <:l>t'lII-
kal C.orpor~\ion (CUE, 26,n7 lraclesl. Foster Whet'ler Corporation (FWC, IH.I\''I tradt's).

peri r
Handy and Harman Company (IINII, ~.174 t,-adt'sl, Nayi<lar International Corpmatinn (NA\'.
!/f),11'
trddesl, and Am~rican TcI .. phone and 'Icle)(raph Cotlll'.my (T. HIO,721i lracles)./o,. rhe
from January 4, 1988 to Dccemht'r :10. I \lllll.

I
I
MacKin lay (1992) set m =: 9 for the larger stocks, implying extreme Slates
of ~4 ticks or less and +4 ticks or more, and set m = 5 for the two smaller
slocfs, FWC and HNI-I, implying extreme stales of -2 ticks or lcss and +2
lick1 or more.
1fhe explanatory variables Xk arc selected to capture several aspccls of
traJlrction price (hanges: dock-time cfTeCls (such as the arithmetic IkoIV-
 3.4. NI'("('nll~lIIfiiriflll FindinK-'

nian mol ion model). the cfleCls or hid-ask houn("(' (silln' many
transact iolls
are mCl'el)' II10VenH.'lIls rromthc hid price 10 III(' ask pritT or vice
versa).l he
si/.e or Ihc Irallsacl ion (so prin' illll'al'l (";111 lit' delcl"llIill('(1 as a function
or
Ihe fjllalllilY Iraded). alld Ihe illll'acl or "SYSlclllalic" or Illarkelw
ide 1II0ve-
menL~ olllhc cOllditio nal dislrihll iion of an individll;1
1 slock's pritT challges .
These aspens call for the followin g expiallalOlY val iahlcs:
61k: The lillie clapsed betweell transaCl iolls Ii-I alld It.
in seconds .
An k _ l : The hid-ask spread prevailin g al lillie Ik __ I. in licks.
Yk -,: Three lags [l = I. 2. :~J orthc dqH:lld ellt v;uiahk r • J{ccalith
h atl(lI-
III = !l. price changes less than --4 licks
arc sel eqllal 10 -·1 licks (slalc
.\1). and price changes greater thall +., licks are scI e«lIal
to +4 ticks
(Slate -~l). and similarly for 111 = [,.
V k _,: Thrce lags [I = 1. 2. :q of Ihe dollar volllllle or Ihe (It-I)th
trans-
anion. ddinc:d as Ihe price of the (il-/)Ih Iransact ion (in dollars.
nol
tic ks) lillles the nlllllber of shares Iraded (dellom illated in hundred
s of
shares); hcnce dollar volume is ckllollli naled in hundred s of
llollars.
To reduce the influenc e of oUlliers. if the share volume or a trade
ex-
ceeds the (19.5 percenti le of the empirica l dislrihu lioll or share
volume
for that stock. it is set equllllo Ihc !I(l':' perccilli le.
SP500 k __ ,: Three lags [I = I. 2, :1 I of fivc-lIlinule continu
ously COIII-
pounde d rctllrllS of the Siandar d alld Poor's (S&l') [,00 index
futures
price, for Ihe conlrac t maturin g in the c10scsll llonlh beyolld the
lIIonlh
in which transact ion It - I occurre d. where Ihc: [('Iurn is compul
ed with
Ihe: flllures price recorde d OIl(' minule hC'fore IIle nearcsl roulld
millule
firiur 10 Ik-' alld the price recorde d five millules hcf()Jc this.
mS k _ / : Three lags [I = I. 2. :Ij of all illdicato r variahle:
that takes Ihe
vaillc + I if the (It - /Jth transact ion price is grcaler Ihan the average
or
Ihe qlloted bid and ask prices al tilll!' Ik _,. Ihe vallie -I if the
(It-I)th
transact ion price is less th,1I\ the average of Ihe bid and ask prices
at
lime I.-I. and zero otherwis e. i.e.,

IBS h _ 1
! II
-I
if
if
if
I'. I > ~ (/'k'-,
1'._1 ~ U'h'_1
I'k I < W'k'-I -I- 1';_/)'
The spccific ation of X~fJ is then givell by the followillg expressi
+ I'~'_I)
+ 1':'_1)

on:
X~fi = fil 61h + fi~ Yh- I + fi:1 Yh--~ + fi·1 Yk-:I + /I,.SI':,OO._I + fib SI'500.- 2
+ fi7SI'500h_:1 + fiXIlISk-1 + fi!,IIIS k- 2 + fiIOIBSh-~
+ filiI '/i..(Vk-!l· IBS H I + fil~ 1·I!.(\'k_~) .IIIS._ 2 )
+ fil:11 T), (Vk_:l) . IIIS k -:1 ) .
The v,lriablt- 61h is illcillde d in .\. 10 allow fill clock-lilll!' df(-cls Oil Ihe
 J. All11kl'l MiOI lJ/III r·/III l'

rOlu lilio llal lIIeall of I·;. II plic

es an' slah le ill Irall saCl ioll lillie
Ihall doc k lillII', Ihis (odf icin ralh er
ll shou ld 1)(' zel'O. l.a~~l'd prir
arc illcl ilded 10 aC("OIlIlI lor sni;t e chall ~(,s
1 dq)( ,lIc1 enci es, and la~~ed reI
SJ(-I':)"/) illd( 'x fllll lln prin ' an' lints 01 Ill('
illci llded 10 acco unl for mark ('I-w
011 prir e challg-(·s. ide dkC ls
'Ii) m('asU((' Ihe prir e ililp acl or
a Irad e p('r unil \'olll llle, Iht'
'1;,(V~_tl is indl lded , whi 1('I"In
dl is doll al volll llle Irall sllll' l\l('d
ac("ordill~ 10 the
Box alld Cox (1!lfi·l) Ilalls ll'I"I lIatio
ll '1;,(·);

'1;.(\ )
x" -
I'
whe re I' E 10, II is also ;1 para
lll('l er 10 he eSlil llale d. The Box
f()l"Jllalion allow s doll ,lr voltlll\(' -Cox IrallS-
10 ('n(( 'r into Ihe cond ilion al lIIea
('arl y,;, parl intla rl), imp orta nt ll lIoll lin-
inllo valio n sinc e cOll llllo n intll
Ihal plic( ' illlp arl ilia), exhi hil ('CO ilion sugg esls
IIOllli('s of scal e with resp eC! to
11111('; i.('., alth oug h IOla ll'ric e doll ar \'01-
imp arl is likely to incr ease with
lIlar~inal pric( ' illlp;'!'1 proh volu me, the
ahly do('s no!. The Box -Cox trall
slim nati
IlIn' s the lil)(' ar sp('c ifica lioll (I'
= I) and conc ave spec ifica tion s lipoll cap-
to alld
illrludin~ till' lo~arilhlllic
rlillClioll (I' = 0). The eSli mate
Ihis IraIl Sf(.n llalio ll will pl;,y all d cllrv atur e or
illlpol"lalll rolt- ill Ihe 1II('''SIl)"{'I
illlp act. I)(,1I1 of pric e
The Irall sforl ll('d doll ar \'Ollllll(,
vari ahk is inle ract ed with IBS
indi calo r of ",hel hl'l" Ih(' Irad (' k _ I , an
was hll)TI~illitiated (IBS = I), selle
IIBS~= - I \. or il)(I( 'I('fl llina h r-ini tiat( ,d
ll' (IBS k =/)) . A posi live fill wou
hlly( 'r-in ilial ed Ilad( 's tl'lId 10 pllsh ld illlply thaI
pri('(~s up and selle r-ini tiate
10 driv e prir es dow n. Such a rela d tlad es t(,lId
lion is pred icte d hy seve ral info
has( 'd lIIod eis of Iradill~, e.g-., rm"l .ion-
Easl ey and O'H ara (I9R 7), Mor
lIIag llilll de of /ill is II ... p('r-IIl1il eove r, Ihe
\'0111111(' illlp act Oil Ihe cOll ditio
of r~', whic h lila), he f(~adily Ir.lII llal lIIeall
slale d into the imp act Oil the ('oll
proh ahil ilics of ohs( 'rv('d pric( dilio llal
' chan~('s, The sig-n and lIIa~nit\l
alld fll:! lIH'aSllr(' 1111' p('rs isl(, lIn' <lt's of fll~
of pric (' illlp act.
Finall)" 10 ("(11111'1('11' IIH' sp('c ifica
YI~ t- LY,~ "~k III11S1 III' par;lIl1(·lIi/e(
lion Ihe cOll ditio llal varia lllT
1. 'Ii) allow for cloc k-lil ll(, !'ff('
a; ==
illl"illd!'d, and sinc (' IIH')"{' is son cls (\,,/. is
I!' ('\'il l('lIn ' lillk ing hid- ask spr(
fill"lllalioll C()III1'nl alld \'"Ia lilil\ 'ads 10 IIt(' ill-
' "II" ic(' chan~('s (SCI', for ('xam
II!IH71.1 b~llIolII"k II'IHH, I(I~II pl(', Clos ten
;I,hl. alld l'el('rS(,1I alld
lagg ('d spre ad All!. I i., al,,) i"cl Ulll iauf I I!I~IOI). lite
"ded , A"d sill!'(' Ih(' para llll'l I'r
(-J, and I arc unid !'lIli fi('d Wilh \"I'nor,; 0,
olll addi lion al r('sl rinio ns, Y,~
This )"idd s rlH' sp(·c ifica lioll is SCI 10 olle.

III ""'"" ;Ir\" , Ih .. 'hl"I (" S;lI'l iIi,

,lIioll 11''I "ires rill' ('slil llali' "1 of:!·
tns: Ih(' p;lrl ili .. II """,, cla,· il" UI f l'"r;I I"I'-
• ... , (rH, Ih(' vari ance
p;lra lllel crs YI alld Y~,
 I
J.4. UI'I'l'nl Empirical Findin~ ~ 141

Table}.Ba. l~.'limfllf.\ if ordn"fd !J/1Jbit partition boulIdarUs.

i

Paramcter IBM CUE FWC HNH NAV TI

al -4.670 -6.213 -O71l -4.456 -7.263 -IUJ73
(-145.65) (-IIl.92) (-25.24) (-5.91l) (-39.23) (-56.~5)

O':! -4.157 -5.447 - 1.712 -1.801 -7.010 -7.270

(-157.75) (-11l.99) (-25.96) (-5.92) (-36.53) (-62.40)
u:\ -3.109 -2.795 1.679 1.923 -6.251 -5.472
( -171.59) (-19.14) (26.32) (5.97) (-37.22) (-63.~)
a. -1.344 -1.764 4.334 4.477 -1.972 -I. .0
(-155.47) (-11l.95) (25.26) (5.1l5) (-34.59) (-61.4H
a~ 1.326 1.605 1.938 1.977
(154.91) (11l.1l1) (34.66) (62.1l2)
ali 3.126 2.774 6.301 5.371l
(l67.IlI) (19.1 I) (36.36) (62.43)
a7 4.205 5.502 7.742 7.294
(152.17) (19.10) (31.63) (57.63)
aH 4.732 6.150 1l.631l 8.156
(131l.75) (11l.!14) (30.26) (50.23)

Maximulll likelihood estimates of the partition boundaries of the ordered probit model for
transaction price changes of International Business Machines Corporation (IBM, 206.794
trades). Quantum Chemical Corporation (CUE, 26,927 trades). Foster Wheeler Corporation
(~WC. IH,I99 trades), Handy and Hannan Company (HNH. 3.174 tr..des). Navi'Ulr Interna-
tional Corporation (NAV. 96.127 trades). and American Telephone and Telegraph Company
(1'. I HO,7'.!ti tr.. des). for the period from January 4. 1988 to December 30.1988.

the coefficients of the explanatory variables fl •. _... fl.3, and "the Box-Cox
parameter v. The 5-state specification requires the estimation of only 20
parameters.

'J'hf Maximum Likelihood Rslimales

Tables 3.Ha and 3.1 Ob report the maximum likelihood estimates of the or-
dered prohit model for the six stocks. Table 3.8a contains the estimates of the
houndary partitions a, and Table 3.8b contains the estimates of the ·slope"
coelTIcients /3. Entries in each of the columns labeled with ticker symbols
are the parameter estimates for that stock; z-statistics, which are asymptot-
ically standard normal under the null hypothesis that the corresponding
cocfficient is zero, are cOn\ained in parentheses below each estimate.
Tahlc 3.Ra shows that the partition boundaries are estimated with high
prl'cision for all stocks ancl, as expected, the %-Statistics are much larger for
thost· slOr.:ks with many more observations. Note that the partition bound-
i
 ."

Table3.8b. H,lill/l//i·., o/mdrmllJlobil .... ,01" .. mrijlt'iml.,.

Paramclcr mM CUE ~wc HNII NAV T

YI : AI/100 0.3\19 0.'199 o:n!i O.Il37 O.42H O.:IH7

( 1:>.:>7) ( 1l.G2) ( 11.2(i) (1.07) (HUll ) (H.H!I)
Yt :AIL 1 0.:>15 I.\IU 0.72:1 \.109 O.HW (l.HliH
(71.0H) (l5.3!1) (145'1) (4.4H) (\\1.\1:1) elH. IIi)
III : A/flOO -0.11[, -0.014 -(l.OI:\ -IU)IO -O.O:I~ -0.127
( -11.12) (--2.H) (-:1.:,0) ( -Vi!)) ( -:tH2) (-!151)
111 : Y.. 1 -1.012 -0.:1:13 -l.:tl:, -0.740 -2.liO\I -2.:I·lli
(-13!i57) (-13.41i) (-24.49) (-[>.I H) (-:\(i.:{2) (-ti~.7'1)

fl:, : >'-t -0.:,:12 -(l.OOO -O.G:{H -0.40G -1521 -1..112

(-HS.OO) (-tI.03) (-IGAr,) (-4.O(i) (-31.1:1) (-:,(;.:,21
fll : 1'.:. -0.211 -0.0211 -O.~~:I -(l.III; -OSH; -0.:.01
(-17.1:,) ( -1.42) (-!I.~:{) (-U14) ( -31.1;3) (- -I7.!1I )

fl:. : 51'500_ 1 1.120 ~.2!1~ 1.359 0.472 0.41!1 tUi2 c,

(54.22) (1:1.:.4) (I :~.49) ( I.:~{j) (li.Wl) (17.12)
{Iii : S1'500 .. t -0.:2:,7 1.:173 0.302 O.14H 0.1:.0 0.177
(-12.!Hi) (!l.(iI ) (~.!13) ( I.~O) (2.H7) (·I.!/(i)
fJ7 : S1'500_ 3 O.OO!; 1I.(i77 O.~04 O.:lHH 0.1 r.!J (/.1.1\
«(l.~(i) (5.1:.) ( 1.!J7) ( 1.13) (:\.(l~) n.!/:\)
fJK : illS_I -l.I:n -UH:> -0.7!JI -O.HO:l -0501 -0.7·1\)

fJ' : mS~2
(-('3.1i4) (- " •. 31i)
-O.:l1i!/ -0.~79
(-7.HI) (-2.H!J) (-17.:{H) (-2:1.01)
-O.IH1 -O.IH4 -0.:\70 -0.:1-10

fll : l
I
\
ms_~
(-~I.:,:,) (-:1.:\7)
-0.174
(-1O.2!J)
tU)79
(1I.!lH)
(-:\.fiG) (-0.75) (-I:>.:\H) (-IH.II)
-0.177 -0.022 -0.3111 -().~!l!l
( -:l.Ii'l) (-0.17) (-I :,.:17) (-I!/.7HI
fJlj : 't~(V _I )IBS_ I 0.122 0.~17 (l.W,() O.03H tUII.1 0.0:12
(47.37) (12.97) ( I.HO) (U.5:,) (~5ti) (·I.rll I
i
tJl~ : ·t;, (V -2)[85_ 2 U.!H7 (l.O:lt; 0.01:, (1.03(i 0.011 0,1/1·1
(IH57) (2.H:'» (1.:,4 ) (O.!iS) (~,:,'I) ('U!1)
IIJ : ·t;,(V .. ,)IB5_ 1 O.III!/ (l,007 tUlI " -o.()(/(; 11.000, II.OW,
(7.70) (0.5!1) (15Ii) (-0.34) (\1.()9) n.m!)

"'T
MOlX;IHll1U likdBu)(){l l·~timat('!\of the ":-.Iopc,''' ("odJiril'Ht!O.ol thl' oH.h.'ICd I)lohit moth'llu .. lIall!'o~

QII" Hum
111.1 19
pO". II "~'" ':' """'~"h'...~, ~'.""'~'~ M.,,,,, ...., 0"',, .... ,,," II "". "",."" ....,
Ch<'IIIII',,1 (AlI'l'oralloll (CUI'., ~h,~1~7 lI;uk,), ~"'I"r Wh""\pr (.01'1'01;\1'0" (n\( ..
Irade~).
lIandy ""d II,Hl""" C""'P;\I,)' (I INII, :1,174 II'"des). N",;sl,,1' Inl<'I'II",i"II"\
"e '.
Co,! oralion (NAV, 96,127 ,r;u\~,). a"d AlIIl'I'ir;", 'li'I"I,hOl\(' ;\lId TcI<')~""ph Co",I'''''\' (I'.
IIlO,7:lC, Ira~\e'), for 11\('I"'l'i",1 trolll.l;llllla ..\, ·1, 19KK 10 llt-r'·lIIb.. 1' :111, l!IKII.
arie, arc not cvl'nly spaced, e.g., ja:\ -a.a! = 1.7(i:/. whereas ja'l-a,.j = ~.(i7()
(it can hc shown that these two values arc statistically <lifkrent). One im-
plication is that the eighths-harrier model 01' dislTete prices, e.g., that 01'
Marsh and Rosenfeld (I DHG), is not t'llIlsistent with thcsc tr<lnsanions data.
Another implication is that the estim,lIed ((JI/I/ili(JI/!I/ prohahilities of price
changes need not look normal, hut may (and do) di"play a clustering phe-
nomenon similar to the clustering of the 1l1l{,(lIl1lili(Jl/u/ distrihution of price
changes on even eighths.
'!:lble 3.Hh shows that the conditional means ul'the rk' 's li/l' all six stocks
arc only marginally affected hy t.1k. Moreover, the z-statistics are minuscule,
especially in light of the large sample sizes. Ilowevel', t.l does enter into
the a,~ expression significantly-in bct, since all the parameters for a; are
significant, hOllloskedasticity may he I'~iected-and hence clock-time is im-
portant for the conditional variances, hut not fi/l' the conditional JIleans of
Y;. Note that this does not necessarily imply the same I'or the conditional
distribution or the Yk's, which is II(JI//ill('{lr/y related to the (,(lIulitional distri-
lJutiOlI or the r; 'so For example, the l'<lIlditional nl(";ln or tile Yk's may well
depcnd on the conditional variance or the Y; 's, so that clock-time can still
affcct the conditional mean of ohsCI'ved pricc changes eVt'n though it docs
not aflect the conditional JIlean of r;.
On]/,/, Now, /)i;(I'plplIl'.B, awl I'ri((' /111/Hlfl
More striking is the significance and sign or the lagged price change coeffi-
cients fit, fi:\, and E'I, which arc negative f(lI' all stocks, implying a tendency
towards price reversals. For example, ir the past three pricc changes were
each one tick, the conditionallllean or r; change~ hy IJ~+~:d'~I' lIowevCl',
ir thc sequence of price changes was 1/-1/ I, thell the dli:l'l on the condi-
tional mean is ~~-fiJ+fi" a quantity closer to I.!TO fill' cach orthl' security's
parameter estimates.
:-.Iote that these coefficients llleasure reversal tendencies bryolld that
induced by the presellce of a cOllstant hid-ask spread as in Roll (\9H4).
The effect of bid-ask bounce on the conditional mean should be captured
by the indicator variables mS A_ I , ms •. ~, alld IBS • .:\. III thc abscllce of
all other information (such as market 1Il0VCIlIellts or past pricc changcs),
these vari,lbles pick up any price dkcts that bu)'S alld sells might have Oil
the ronditioll,d mean. A~ expel'led, the l'stim,llc(l coe/lidents arc gener<llly
negative, indicating the presence of rev(')'s,tis due to lll(}\'l'lIlcnts from hid
to ask or ask to bid prices, Ilausinan, 1.0, ;lIul MacKilllay (1!/!/2) compare
their magnitlldes rorm<llly and cOllcludl' th,1l the cOllliitiollalmcan of price
changes is /l(llit.dl'/IPlu/rnl with respl'<"l to past price ch;lllges-the S('I/IIPI/{'I' of
price challges or nrdPl'jlrm' malleI'S.
Using these parameter estimates, llallsillan, 1.0, ;lIul Mad';'inlay (1!/!l2)
arc also able ;0 address the sccolld two <jllestiolis the)' pUI forward. Price
 . ' " " .• " . , , I U / t

illlparl-IIII' dkn 01 a Iralk Oil IIII' lIIark('1 prire-fall hI' 'Illantilied wilh
rdalivdy high prl'ci~ioll. il dol's illITl'ase wilh tralll' sizl' althollgh lIot lin-
I'ady, and it dilfns 1'111111 slock to ~tork. The ll10re liquid stocks sUfh as IBM
t('ntlto 11;1\'" rd,lIi\'t"l\" 11,11 prin'-illlpan fllnctions, whereas less liquid ~torks
sllch as IINII .111' Ilion' s('nsitivl' to tradl' sizl' (SCI', in particu!ar. I {allsmall,
1.0, alld IIla(Kill!a\" II!I!I~, Fi!-\lIn' ,11).
Also, disnt'«'IIt'Ss dOl's lIIaUl'r, ill Ihl' SCIlSI' that Ih,' cOllditiollal di~lIihll­
lioll orpricl' challgl"s illlpli('d by IIH' ol"ll('n~d prohil SllI'cilicalioll call caplure
("('I"laill 1I01lIillcalilies-prin'-t"!lIsl('I"illg Oll,~vell eighlhs Vl'I"SIIS odd eighlhs,
fill' ,'xampll'-Ihal oill<'r 1I'("lIl1iqll(,s Sllt'h as ordillary least sflllares call not.
While il is slill 100 t'arlv 10 say whelher Ihl' ordered pmhit mOlk! will
hOI\'!' hroadl'r applicatiolls ill llIarkl't microstructllre sltlliil's, it is cllrn'lItl),
th,' ollly II10dd Ih'lI call capilli"!' t1isnett'ness, irrcglll<lf trad(' illtervals, alld
lIlt' df('('\s of \'COlllllllic variahks 011 transactioll prin's in a rdatiVl'ly parsi-
moniolls Etshillll,

:·\.5 Conclusion

Then' an' III.UI\" oUlslandillg c("ollolllic aud l'COIIOIlIt'trit" issues Ihat call now
hI' n'sol\'l'cI ill III .. "1"1",'1 lIIi.-rosl IIII'I 1111" lilt'rallll"l' thallks 10 Iht' plelhora or
I),'wly a\'ail,IIII<' Ir'1I1sa ... ioIlS ,LII"hasl's. III Ihis chapter WI' have 10IH'h('(1 Oil
ollly Ihn'" of th,' issul's Ihat an' pari of the hurg"(lIIing markt,t microstruc-
ture Iiter.Hure: 1I01lS),llt'itrollOtlS Irading, the hid-ask spread, alld modeling
transactiolls dala. IlolI't'ver, lIlt' t'olllhillalion of transactions dalal>ast's and
ever-increasing t'OIlIPUtillg )lower is surc to Cfeate many new direCliolls of
research, For ,'xalllple. th,' nlt'asllrt'menl anti cOlltrol of trading costs has
hel'lI of prilllar)' COIII','rn 10 largt· institlltional inveslOrs, hili thefe has 1,"1'11
rdalil'dy !illle acad,'lIli(' rest'arch dl'votl'd to Ihis importalll topi,' b"elus,'
Ihe lH't't'SS'II'1' dala wt'n' 1I11.1\·"ilahlc IIlIlil rccelllly, Similarly, meastlres of
markel trallspan'IH'Y, liqllidit\', alld t'oIllJl('titiveness all liguI"I' promillelltl),
ill 1'1'(,('111 IIH'on'lit'al lIIodds of senility prices, hilI it has het'll \'irtllally im-
possihlt' 10 illlpll'III1'1I1 allY of Ihl'sC Ilworks IInlil rl'cemly I){'causl' of a lack
of dala. Tilt' t'x!lt'rilllt'llIal markt'ls lilerature has also cOlllrii>lIll'd mallY
illsights illiO lIIad,el IlIitToSlrllctlln' issllt's hilI ils ('1I0r1llOIlS P(lIt'lIlial is ollly
I){'~illllillg 10 Ill' It·ali,,·d. (;il't'li tiH' growillg illltTl'st ill mar"t't IlIin()~lntC­
Illn' hy aCldt'lllics, iIlV"SIIIH'1I1 pl'oit'ssiollals alld, 1I10st n'tTully, policYIIl;lk-
t'I'S ill\'olved ill n'\\'/ ilill),!; secllrilics lIIalkcls regulalions, Ihl' lIext I'cw n',lrs
\ art' surt' 10 I){' ,til t'xllellH'lv t'x!'ilillg and fertile period for Ihis art'a.

\ /lmMI'IIIS-C!lUpter J
\
I
\ :~.l l>tolin' lilt' 1IH'<lII, \·ari:ult .... :l1I1'WOI'ariallct', alld ;lulocorn·lalioll 11I1It'·
\ liollS ct 1.~I)-n.l. 1'2) .. I'I ht' "h"'rwd 1't'lllrtlS prm'('ss I r;; I for the 110111 radillg
\ lIlodd ofSt'(lioll :1./. Ililll: [',,·Ih .. rqm's"lItalion CtIA).
I
I
" luvi"CIIU
145

3.2 Under the nontrading process defined by (3.1.2)-(3.1.3), and assum-

ing that virtual returns have a linear one-factor structure (3.1.1), show how
nontrading affects the estimated beta ofa typical security. Recall that a secu-
rity's beta is defined as the slope coefficient of a regression of [he security's
n'lurns on the return of the market portfolio. .
3.3 Suppose that the trading process {8 il l defined in (3.1.2) were not 110,
but followed a two-state Markov chain instead, with transition probabil\ties
given by 8il !
o !

(3.~.1 )
I

3.3.1 Derive the unconditional mean, variance, first-<>rder autocovari-

'lIlce, and s~eady-state distribution of Oil as functions of 1rj and 1r;.
i
3.3.2 Calculate the mean, variance, and autocorrelation function of the
observed returns process Ti~ under (3.5.1). How does serial correlatio'1 in
8il affect the moments of observed returns? I

3.3.3 Using daily returns ror any individual security, estimate the paJm-
(·ters rri and rr; assuming that the virtual returns process is 110. Are the
estimates empirically plausible?
3.4 Extend the Roll (1984) model to allow for a serially correlated order-
type indicator variable. In particular, let I, be a two-state Markov with -1
and I as the two states, and derive expressions for the moments of 6P, in
terms of s and the transition probabilities of I" How do these results differ
from the llD case? How would you reinterpret Roll's (1984) findings in
light of this more general model of bid-ask bounce?
3.5 How docs price discreteness affect the sampling properties of the mean,
standard deviation, and first-Qrder autocorrelation estimators, ifat all? Hint:
Simulate continuous-state prices with various starting price levels, round
to the nearest eighth, calculate the statistics of imerest, and tabulate the
("('Ievant sampling distributions.
3.6 The following questions refer to an extract of the NYSE's TAQDalabllJe
which consists of all transactions for IBM stock that occurred on January 4th
and 5th, 1988 (2,748 trades).
3.6.1 Construct a histogram for IBM's stock price. Do you see any ev-
jc\t-nce of price clustering? Construct a histogram for IBM's stock price
rJUlIlj;I'J. Is there any price-change clustering? Construct the following
1\\1(, histograms and compare and contrast: the histogram of price changes
conditional on prices falling on an even eighth, and the histogram of price
changes conditional on prices falling on an odd eighth. Using these his-
146 J. Markel Miomtrurtllrp

tograms, comment on the importance or unimportance of discretl~ prices

for statistical inference.

3.6.2 What is the average lillie hetween trade$ for InM? Cunstruct a
95% conCidence intel"al about this average. Using these quantities and
the central limit theurem, what is the probability that IBM docs 1101 trade
in aflY given one-minute interval? Divide the trading day into olle-lIIinule
intervals, and estimate directly the unconditiunal and conditiol/al probabil-
ities of nontrading, where the conditiunal probabilities arc conditioned
on whether a trade occurred during the previous minute (hilll: think
abollt Markov chains). Is the nontrading process independent?

3.6.3 Plot price and volullle on the same graph, with tillle-of·day as the
horizontal axis. Are there any discernible patterns? Propose and perlonn
statistical tests of stich patterns and other patterns that might not be vi$ihle
to the naked eye but are motivated by economic considerations; e.g., block
trades are followed by larger price changes than nonblock trades, etc-Y'
3.6.4 Devise and estimate a model that measures price impact, i.e., the
actual cost of trading n shares of IBM. Feci free to use any statistical

1 methods at your disposal-there is no single right answer On particular,

ordered prohit is not necessarily the best way to do this). Think carefully
: ahoutthe underlying economic motivation for measuring pric.:e impact.
3:7 The following questions refer to an extract of the NYS['s '//\Q /)1I/alm,11'
W\ich consists of bid-ask quote revisions and depths for IBM stock that were
d splayed duringJanuary 4th and 5th, 19HH (1,327 quote revisions),
3.7.1 Construct a histogram for IBM's bid-ask spread. Can you conclude
from this that the dynamics of the bid-ask spread are unimportant! Why
or why not? You may wish to constrnct various conditional histognllns to

~
roperly answer this Cjuestion .

•7.2 Are there any discernible rclatioll$ between revisiollS ill the bid-ask
uotes and transactions? That is. do revisions in hid-ask quotes "cause"
rades to occur, or do trades motivate revisiolls in the quotes? Propose
tnd estimate a modclto answer this question.
*.7.3 How are changes in the hid alld ask prices related to vulume, ir at
all? For example, do quote revisiolls c.:allse trades to occur, or do trades
IllOtivate revisiuns in the quu(es? Propose alld estimate a modclto answ('\'
this Cjucstion.

3.7.4 Consider an asset allocation rule ill which an investor invests fully
ill stocks until experiencing a scquence of three consecutive dedilles, .tfter

"'The NYSE deline> a block trade a, any tr;lde (O",;,tillK of 10,000 ~har("' or mor,·,
 147

which hc will switch complet ely into honds lin til cxpcricncin~ a
scquenc e
of six rlJlI.ll'(ul iw advance s, Implelll ent this rille for .111 inilial investm
ent
of SI 00,000 wilh the transacl ions data, hill do il two ways: (I)
lise the
avera~e of the bid-ask spread fi,,· pllrchas es or
saks; (:!) lise the ask prilT
for pllrchas es ancl the bid price (('I" sales. Ilow IIlllch do YOIl have
left at
the end of two days of trading? YOII may a"I1I1I<' a I.ero riskfrcc
rate ((, ..
this exercise ,
 •
4
Event-Study Analysis

ECONOMISTS ARE FREQUENTLY ASKED to measure the effect of an economic

event on the value of a firm. On the surface this seems like a difficult
task, but a measure can be constructed easily using financial market data
ill an event study. The usefulness of such a study comes [rom the fact
that, given rationality in the marketplace, the effect of an event will be
reflected immediately in asset prices. Thus the event's economic impact
("all he measured using asset prices ohserved over a relatively short time
pcriod. In .contrast, direct measures may require many months or even
years or observation.
The general applicability of the event-study methodology has led to
its whle lise. In the academic accounting and finance field, event-5ludy
IIlcthodology has been applied to a variety of firm-specific and economy-
wide events. Some examples include mergers and acquisitions, earnings an-
nouncemen!S, issues ornew debt or equity. and announcements of mac roe-
[onomic variables such as the trade deficit. I However. applications in other
fields are also abundant. For example. event studies are used in the field of
law and economics to measure the impact on the value ofa finn ofa change
in the regulatory environment,2 and in legal-liability cases event studies are
used to assess damages.~ In most applications, the focus is the effecqof an
event on the price of a particular class of securities of the firm, most often
common equity. In this chapter the methodology will be discussed in \erms
of common stock applications. However, the methodology can be applied
to debt securities with little modification.
Event studies have a long history. Perhaps the first published study is
Dolley (1933). Dolley examined the price effects of stock splits. studying
nominal price changes at the time of the split. Using a sample of 95 splits

IW.. will rurther discuss Ih,' firsllhr~.· "xamples laler in Ihe chapler. McQueen anrl,Rolry
( I ~I~):~) provide an ilIusfration using macrocconomic new.IIi annnuncement5.
~S~~Schwnl (19HI).
"See Milchell .1Ilt! Neller (1994).

149
15U

frolll 1921 to 1931, hc found th<ltthe price increased ill [)7 uflhe cast's and
thc pricc dcclincd in only 2(\ instances. Then~ was no effecl in thc other 12
cascs. Over thc decades from Iht' early 19:10s ullliithc late I!1I\()s the lcvl'1 of
sophistiration of evellt studies incrcased. Myers alld Bakay (I!HH), Bar\;("I"
(I!l!ili, 1957, 195H), and Ashley (1%2) are examples of sl\ldil's during this
time period. The illlprovclllenL~ inclnde rellloving general sl\)("k lIIar\;et
pricc movelllents and separating out confounding evenl~. In (he late I!l(;Os
seminal studies hy Ball and Brown (I !}(iH) and Failla, Fisher, .I(·nsen, ,Iud
Roll (1969) introduced the IIICtllOrioloh'Y lhat is essenlially still in use (oday.

~
all and Brown considered the information content of earnings, and Failla,
I' isher,Jensen, and Roll studied the C!fecL~ of stock splils aftcr rCllloving Ihe'
dfccts of simultancous dividend incrcases.
\ 111 the years since these piolleeriug studies, severallllodiiiratiolls of til\"
hllsic lIIelhodoloh'Y have Iwcn snggested. These modifications h,l\\(lIe COIII-
plications arising from violations of the statistical assumptions used ill the
e,r1y work, and they call accollllllodate l1Iore specilic hypotlwS("s. Browll
al~d Warncr (19HO, l!IH:.) arc useful papns that discllss til{' practical illl-
pl~rlancl.' or lIIany of thcsl.' nloditications. Thc I VHO paper considers illlple-
IIIpntation issues ror dala sampled al a monthly intcrval and the I!lH:) paper
dials wilh issues for daily data.
I This chaptcr explains the ecollolllclric IIIcl/todoioh'Y of evellt stndies.
~e\liOIl 4. [ hriclly outlines the procedmc for conducting an event stndy.
Se ·tion 4.2 selS up an illustrative ex'llllple of an cvcnt study. Celltral to
an evenl study is the mcasuremcllt (;r the abnormal returII. Section 4.:1
de ails thc first step--measuring the normal performance-and Senioll 4.4
fol\ows with thc necessary 100ls for calcnlating the abnormal retllrn, \\lak-
ing! stalistical inferences about lhese returns, and aggregating over lIIany
evehl observations. In Sections 4.:1 and 4.1 the discussion maintains the
nul', hyp~thcsis thalthe cvent has no impact on the distribution or ret.urt1s.
Section 4.5 discusses modifying the null hypothesis to focus only on the
mean of the return distribution. Section 4.6 analyzes of the power of an
event study. Section 4.7 prcscnL~ a nonparametrk approach to event sl\l(l-
ies which eliminates the need for parametric structure. In SOIllC Glses thcory
provides hypotheses concerning the reI.llion between the lIIagnitllde of the
event abnormal return and linll characteristics. I n Section 4.H we consider
cross-sectional regression models which are lise fill to investigate slI('h hy-
potheses. Section 1.9 considers SOll\l~ fnrther issues in event-study design
and Section 4. I () concludes.

4,1 Outline of an Event Study

AI Ihe outset it is nsefnl to gi\"(~ a brief ollllinc of the structure of an ('\"('111

study. While thcr!' is no uniqut' strtl('lun~, the ,lIIalysis ("an he \"inwd
4.1. O/ltlill~o/alll~vf1lt Stw/.V
l!il

as h,lvin!{ seven steps:

I. 1:'wllt t/llil/iti()l l. The initial task of cOllductill!{ an ('velll stlldy

is to de-
fine the l'vcnt orintere st and identify the period over whirh the
security
prices of the firms involved in this I'\'l~nt will hI' l'x,lInin l'd-the
I'llf'l/t
willlimll. For example , if one is looking at the illf<)rJnation content
of
an earnill!{S announ cement with daily data, the event will he the
earn-
illgs announ cemelll and the l'Wlll window might he the onc day
or the
annOllll celllenl. In pr.lcticc , thl' event window is ofkn expand
ed to
two days, the day or the anllOlln Centent and the d,IY after the ,1IInOUIK
e-
Illt'nl. This is donc to captllre the price errects ofannou nlTml'n ts
which
occllr after the stock lIIarket closes on the announ cement day.
The pe-
riod prior to or after the evcnt lIlay also he or interest and included
Sl'par'llely in the analysis, For example , in the l'arnin!{ s-annou neemen
t
case, the market may aCfJuire informa tion about the ('arnin!{s
prior to
Ihe actual announ cement and one call illv('stigatl' this possihili
ty hy
l'xaillinin!{ pre-even t returns.
~ . .)l'lrrliol1 rrilrria. After identify ing the evellt
or illtCn.:st, it is Ilcccssar y
to determi ne the selectio n criteria for thc inclusio n or a given
linn in
tltl' study. The criteria lIIay involve restriCliolls imposed by data
avail-
,lhility such as listing Oil the NYSE or AMEX or ma), involve restricti
ons
such as llIembe rship in a spccific induslly At this stage it is Ilseflll
10
sllllllll'lrir.e some characte ristics of the data sample (e.!{., finn
market
capitaliz ation, industry represel ltation, distribu tion of events
through
time) ,Ind lIote allY potentia l biases which m'l}' hav!' 1)('('11 illtrodu
ced
through the sample selectiol l.
:1. NOn/wi al/d almo17l1lli 7l~tllnlS. To appraise the I'\,('nt's impact we n'lltlire
a measure of the abnorm al relllrll. The abnorm al return is the
actual
"X /lost return of the security over the event
window minus the normal
return orthe firm over the event window. The normal return is
defined
as the return that would be expecte d if the e\'l'nt did not take place.
For
each firm i and event date r WI' hav('

<, = il" - E[lI" I X,]. ('1.U)

whl're <,, I!", and E(il,,) arc the abnorm al, anllal, and normal returns,
rcsplTti vdy, for tillle period t. X, is the l'IlIlditionin!{ inl()J'Itla
tion for
the norlllal perform ance lIIodel. There al'l' two COlllnlOU choices
for
lIlodeliu g the nonn;d rt'llIl'11 -the rOl/.lt{/I//-III1'III/·I('/lIrJ1 lIIodl'! whnl'
X,
j, a constan t, and the lIl(l1krl lIwdl'l where X, is the
IIlarket return, The
COl1stanl-IIII';tn-return model, as the n,lIne inlplil's, as,ulII('s
that the
IIlcan return 01'.1 given secllrity is constan t through tillll'. Th('
mark('t
nlodel assumes a stahle linear relation betwcl'n t h!' IIlarkcl return
and
till' secllrit)' rl'turn.
 4, /:1'1'111-.'11111/,1' :\//(//)'1;1

'I. /':,1;111111;"/1 /W/(/'dllli', (JIIl'1' a lIonnal pI'I'lill'lllallCl' lIlodl'l has hl'l'lI SI'-

"'I"II'd, Ihl' p;ILlnll'lns ol'lhl' nllHlcllllllSI Ill' \'Slilllatt'd \lsillg a suhSl'1

01'1111' I\;(LI \..11011'11 ;IS IIII' 1'.\1;lIIl1lill// W;IIt!Ol/l, Tht' mosl CtlllllllOlI r\wict',
WII<'III",I,iblt-, is lOllS,' IIII' 1'1'1 iod prior 10 IIII' 1"'l'III willdow I'ollhl' I'sli-
Ilialiollll'illdOl", For I'X;lIl1plt-, ill all 1"'1'111 SIllIly IIsilig Ilaily lIala alld Ihl'
lIIarkl'l IIH1,kl, iiII' 11I;II'kl'l-llilHII'I param{'ll'ls cOllld 1)(' ('slimall'd oVl'r
IIII' I:!() davs prior 10 Ihl' ""1'111. Cl'lIl'rall: Ihl' l'I'I'1I1 pl'l'iod ilsdf is 1101
illdlllll'li illdll' I'slilllalioll plTiod 10 prl'VCllllhl' l'V1'1i1 I'rolll illflllelicillg
iiII' 1101'111;11 111'1'101'111;1111'1' 1I11.d'" l'arallll'll'l' l'slilllall'S,
:1, '/i'llillg/",/(,'dllli', \\'ilh Ihl' P;II;IIIII'II'I' l'slilllall's IiII' Ihl' lIonll;a! pnli)l'-
IIlalln' IHodel, IIII' ;lilllormal rl'lurllS I'all hI' calculall'd, NexI, \I'{' IIlTd
10 dl'sigll Ihl' (l"lillg I'rallll'\\'oll. lill' Ihe alllloflllal rl'llIl'IIs, ilnporlalll
l'ollsidnaliollS an' ddillillg 11ll' 111111 hYjlotlll'sis alld dl'll'rlllillillg Ihl'
1('dllliqlll'S lill' aggl'l'galing IIII' allllol'lIIal relllrns Orilldividllallinlls,
Ii, /':I11/Jiriml li'IIIII" Thl' PI'I'S"III:!lioll of Ihl' t'mpil'ical I'{,SlIlts rolloll's Ih{'
formilialioll 01'1111' ('COIIOIIII'll'ic dl'sigll, III addilioll 10 PI't'St'lIlillg IIII'
basir I'mpil it"al n'sillts, III<' Pl'l'Sl'lIlalioll of diaglloslics call hI' I'I'Uilflll.
(kclsiollalh-. ,'sl)('('iallv ill sludil's wilh a limill'd III IIII her 01"'1'1'111 obsl'l'-
";lIiollS, IIII' ('llIpirie:!1 I'('SlIlts call be hl'oll'ily illlhll'lHTd by OIH' or Iwo
linns, Kll1lldl'dg" or Ihi' is illlportalil fi.1' J!;auJ!;illJ!; Ihl' illlport;III<T of
Ih,' rl'sil It s,
7, (1II"I/m'lali'"1 (lilt! "lIldllli"",, Idl'ally Ih,' "mpirical n'slilts will lead 10
illsighls aholll IIII' IlIl'l'hallisll\S hy which Iht' t'V"1l1 "fl'l'cls sl.'l'IlrilY pi in's,
Addiliollal allah'sis 111,1\' Ill' illriudl'd 10 dislillguish \)1'111'1'1'11 COU'lwlillg
I'Xplallali('IIS,

4.2 An Example of an Event Study

'1'111' Fill<lllci<ll ,\'TOlllllillg' SI;lIl1Ltnls l\o<ll'd (FASB) alld Iltl' Senllilil's Ex-
challgl' (:Ollllilissioll siril'l' 10 SI'I n'porlillg n'gulaliollsso Iltat JlIIOIllcial Sial\,-
II 11'11 Is alld r"'all'd illl'Ol'llialioli r"'l'asl's al'l' illli)rJnalil'(' ahollt Ihl' valliI' or
IIII' firlll, III Sl'lIillg sl<lII<I<lr<ls, Ihl' illl('l'lllalioll cOlIlI'lI1 or Ihl' lill<lllci;ai dis-
doslIl'l's is "I' illl('\'('S!. 1':\'('111 sllldi('s prol'ide all idl'alltlol Ii II' !'xamillillg Ihe
illlill'llIaliull ('01111'111 or Ihe disdoSlIl't'S,
III Ihis SI'!'Iioll "'I' dl'snilll' all I'xalllple S('lcCI('d 10 illllsll'al(' Ih!' ,'\'('111-
sllldv 1111'1 hodology, (lilt' pari iClllar II'PI' or disclosllre-qual'l!'r'" l'al'lI i IIgs
allllolltll','ml'lIls-is ('ollsill,'red, INc illl'l'sligale 1111" illlin'llIalioll ('01111'111 of
qllalll'd\' 1';llItings allllllll\lI'I'IIII'lIls I(n' Ih(' Ihirly {irllls ill lite Do\\' .I"IlI's
ItltIIlSlri;llllld", ovcr IIII' li\'I'-\'I'<lr pl'l'iod from.laullary \I)X() 10 Ikn'llIlll'l'
I~)~n, Tltl'sl' ;lIl1lollltn'lIll'lIls ('onrspolld 10 IiiI' qllarll'ri\' I'<lrllillgs 1'01 IiiI'
IaSI '111;11'11'1' "I I~IHH 1III0ligh till' Ihird qllarll'l' or l~)~J:\, Tltl' fi\'1' \'(';Irs or
dala lor Ihirl\' linlls l'rO\'idl' a 101<11 "lIlIpll' of (jO() allllOlllln'lIlt'lI", For
4.3. M()(/,lJ Jar Mrasunng Nanna/ Prrjonnanrr

each firm and quarter, three pieces of information are compiled: the pate
of the announcement, the actual announced earnings, and a measure of
the expected earnings. The source of the date of the announcement is
Datastream, and the source of the actual earnings is Compustat. .
If earnings announcemenl~ convey information to investors, one wiuld
expect the announcement impact on the market's valuation of the firm's
eC]uity to depend on the magnitude of the unexpected component of the
announcement. Thus a measure of the deviation of the actual announced
earnings from the market's prior expectation is required. We use the mean
quarterly earnings forecast from the Institutional Brokers Estimate System
(I/R/E/5) to proxy for the market's expectation of earnings. I/8/E/S cO[ll-
piles forecas15 from analysts for a large number of companies and reports
sumlllary statistics each month. The mean forecast is taken from the last
month of the quarter. For example, the mean third-<Juarter forecast from
September 1990 is used as the measure of expected earnings for the third
C]uarter of 1990.
In order to examine the impact of the earnings announcement on the
value of the firm's equity, we assign each announcement to one of three
categories: good news, no news, or bad news. We categorize each an-
nouncement using the deviation of the actual earnings from the expected
earnings. If the actual exceeds expected by more than 2.5% the announce-
ment is designated as good news, and if the actual is more than 2.5% less
than expected the announcement is designated as bad news. Those an-
nouncements where the actual earnings is in the 5% range centered about
the expected earnings are designated as no news. Of the 600 announce-
ments, 189 are good news, 173 are no news, and the remaining 238 are bad
news.
With the announcemen15 categorized, the next step is to specify the
sampling interval, event window, and estimation window that will be used
(0 analyze the behavior of firms' equity returns. For this example we set the

sampling inten'allo one day; thus daily stock returns are used. We choose a
4 I-day event window, comprised of 20 pre-event days, the event day, and 20
post-cvent days. For each announcement we use the 250-trading-day period
prior to the event window as the estimation window. After we present the
methodology of an event study, we use this example as an illustration.

4.3 Models for Measuring Normal Performance

A Illllnbcr of approaches are available to calculate the normal return of a

givcn security. The approaches can be loosely grouped into two categories-;-
statistical and economic. Models in the first category follow from statistic~1
assumptions c.oncerning the behavior of asset returns and do not depend on
.-
154 4. Event-Study Allfllysi.l

any 1conomic arguments. In contrast, models in the second category rely

on a~sumptions concerning investors' behavior and are not based solely on
stati$tical assumptions. It should, however, be noted that to use economic
models in practice it is necessary 10 add statistical assumptions. Thus the
poteintial advantage of economic models is not the absence of statistical
aSsUiPtions, but the opportunity to calculate more precise measures of the
nor al return using economic restrictions.
or the statistical models, it is conventional to assume that asset re-
turn arejointly multivariate norlllal and independently and identically dis-
trib ted through time. Formally, we have:

(All Let R, be an (N x I) vector of aJset relllrns fur calendar time Ileriuti t. R, i.l
inde endl'1ltly multivariate )!anllally distributed with mean /1. and COIJarianfe matlix
n fot flll t.
l
This distributional assumption is sul'ficient for the con~tant-lIIean-relllrn
modrl and the market model to be correctly specified and permits the de-
velopment of exact finite-sample distributional results for the estimators
and statistics. Inferences using the Ilormal return lIIodels are robust to
deviations from the assumption. Further, we can explicitly accol1lmodate
deviations using a generalized lIlethod oflllOlllenL~ framework.

4.3.1 CUll.llrmt·Mrnll-Ul'tunl Model

Let /1.;, the ith element of /1., be the mean return for asset i. Then the
constant-mean-return model is

(4.3.1)
El slI ] = () Var[s,tl

where Il;" the ith clement ofR" is the period-t retun! on security i, ~" is the
disturba/lce term, and a~~ is Ihe (i. i) clement of n.
Although the constant-meall-return model is perhaps the simplest
model, Brown and Warner (I9HO, 1985) lind it often yields resu1L~ simi-
lar to those of more sophisticated models. This lack of sensitivity to the
model c1lOice can he attributed to the faCl that the variance of the abnormal
rel\lrn is frequently not reduced much by choosing a more sophisticated
model. When using daily data the model is typically applied to nominal
returns. With monthly data the model can be applied to rca! returns or
excess returns (the return in excess of the nominal riskfree return generally
measured using the US Treasury bill) as well as nominal returns.
".3. lVIIJ!lrLI.!;J/· MPtl.llllillg NIJnnall'njll/lI/f/I/i/' l!i!i

4.3.2 Mil/hI'! MIJ"d

The market model is a statistical modd which rdatcs the retlll'll or allY
givell security to the return of the lIIarket portfolio. Thl' lIIodel's linear
Sl)('cificatioll f()lluws from the assllmed joillt Ilormality of asset rcturns:1
For any security j we have

H" = (X, + {l,U"" + E "

where Ji alld N"" are the period-t rc!lIl'11S Oil scclII'ity i alld the market
"
portrolio, respectively. and f;, is the zero meall disllIrhallcc term. (X" fi;.
alld (1f~ are the parameters or the market model. III applirations a broad-
hased stork illdex is used ror the market ponf()lio, with the S&P!iOO index,
the CRSP valllc-weighted index, alld the CRSI' eqll;li-weiglitcd index heilll-:
popular choices.
The market model represellts a potclltial illlJ)rovemellt over the CUIl-
stant·mean-return mudel. By remuvinl-: the portiun uf the return thal is
related to variatiull ill the market's returll, the variance of the abnormal
rCllIl'Il is reduced. This can lead to increased ahility to dcteCl evellt effects.
The h(,lIdit from using the market model will depelld IIpOIl the Ji2 of thc
lIlarket-lllo(kl regressioll. The higher the Ji~, the greater is thl' variallce re-
duction of' the abnormal returll, and Ihe la, gcr is the gain. Sel' Sel'lion 4.'!A
for nlore discllssion of this poillt.

".3.3 ()thrr S/Illi.ltira/ Mo"dl

A number uf other statistical mudds have hc('n proposed Ii)r mudeling
the nurmal return. A general type of statistical model is the Jar/or model
Factor models putentially provide the henefit of reducing the variance ur
the abnormal return by explaining mure of the variation in the norl1lal
return. Typically the ractors are portfolios of traded securities. The market
model is an example of a onc-f;\ctor l\Iodel, but in a \\Iultifactur model one
mi~ht include industry indexes in addition to the market. Sharpe (1970)
and Sharpe. Alexander, and Bailey ( I \195) discuss index models with factors
based un industry classification. Anuther variant uf a bctor model is a
procedure which ca!culates the abno\'\\Ial retul'II hy taking the difference
between the a(\ual retul'll and a ponfolio of [inns of silllilar sit.e, where si/.c
is mcasllrcd hy market value of <,<)uity. III Ihis approach typically tell Sill'
groups arc cunsidered and the loadill~ Oil the sil.e portfolios is restricted

"The spt·rilircttion OIctl1<tlly reqllin's the asset wc.'igills ill th" 111.\1 kt'l portfoliu to u'lIIain
constant. However, rhanxes over timt" ill tilt' markcr pOlIi"nlio weights 011(' small t'II01lXh th,U
they h"ve lillie dkct Oil ('lllpirical work.
to Hllit)'. This pmcetllll'l' implicitl\' aSSllmes that expected r('tlll'lI is t1irl'nl\
rdaled 10 Ih(' III;uk!'1 \';1111(, of eqllity.
III praclic(' Ih(' gaills from cmployillg milltifactor models for ('I'CIII silld-
it'S arc limit!,(\. The n'ason t(lI'lhis is Ihal the llIar~illal explanalory power of
ad(litiollallil('\ors 11I'yolld Ihl' market factor is small, and hcnce there is littlt'
r('duClioll ill Ihl' 1':1Ii;IIHT of III<' ahllormal I'l'l Ill'll. The variallce r('dunioll
will Iypically h(' g;rl'alt'SI ill cases 1\'111'1'1' Ih(' sample linns hal'<' a COlllmOlI
charat'lnislic, for example Ihey aI'(' all 1I1('mhcrs of one indllslry or Ihey art'
all linns con('('lIlrall'(1 ill OJle market capitalization grollP, 111 Ihese casn
Ihc lise or a mllltif;\('lor mod .. 1 walTallls cOllsideralioll.
SOllll'lilll(,s lilllil('d dala al'ailahilily lIlay diclalc Ihc IIS(' of a reslricled
llIodd sllch as Ihl' I//m!w/-llIljIH/nl-rrllll'll IIIIIt/rl. For som(' ('vellts it is lIot f(:asi-
hk to haw a pn'-('I'('nl ('stimatioll pniod for the normalmodd par:lllletns.
alld a market-adjllste(1 almorm:ll retlll'll is IIsed. The markehl<\jllslcd-rCI\II'1I
modd can hc I'iew('d as a reslricled lIIarkcl model with ex . cOllslraillt'd 10 he
() and fl, conslrained 10 hI' I. Since Ihe llIodel cocfficients arc prespedfied.
all cstimatioll pniod is lit)! required to oht,Iill parameter estimates. This
modd is oftcn IIsl'd 10 stllt!y Ihe IIlIderpricing of initial pllhli(' offerillgs.'·
A g('lIt'1'al I'('comnH'IHlation is to tlS(' stich reslricled models only as a last
resort. alld to keep ill lIlilid that hiases lIlay arise if the restriclions arc false.

Economic Illodcls reslrict Ihe parameters of stalistical models \0 provide

\\lore conslrained norlllall't'tlll'li IIH)(lds. Two common cconomic models
which provide restrictions are the Capital A~scl Pridn~ Model (CAPM) and
exacl vcrsions of Ihe Arhitrage Pricing Theory (APT). The CAI'M, (hie to
Sharpe (191;1) alld I.illll\('r (I!}(i;lh), is all e(JllilihriulII thcory whne Ihe
expccled retlll'll of a gil'clI assel is a lillear functioll of its covariall('e wilh
Ihe 1'('1111'11 oftl\(' \\Iarkel port/illio. The AI'T. dill' to Ross (197G). is all asset
pricing' Iheory whl'I'(' in Iht' ahsellcl' of asymptotic arhitra~e the cxpl'ctl'd
r('tllrn oC'a gil'l'n assl'l is dl·tel'lnined hr its nll'ariances wilh multiple bClOrs,
Chapt<'l's !'i and Ii plOvidl' ('xll'nsiv(' treatnwlI\S of these IWO Iheories.
Tht' Capital Asst't I'riring Mot\1'l was ('()(Jllnonly used in evellt studies
durillg the I !170s. Durillg Ihe last 11'11 years, however, deviations from lhe
CAI'M have he('11 discOl'I'll'd. alld Ihis casts doubt on the validity or Ih('
restrit'liollS imposed hy lIlt' CAI'M 011 tht' markel mode\. Sillcc Ihest' IC-
striniolls CIII 1)(' rdax('(1 at lillie ('osl hI' IIsillg Ihl' IIIarkel IIIodd, the liSt' or
the CAI'M ill e\'(,111 stlltlil's has allllOst c('ased.
SOIlI(' silldi('s haw IIsed IlIlIltirat'lor norlllal performallce 1II011cis 1110-
tivated hI' the Arhilrag(' I'l'it'illg Th 1'0 II', Thl' APT call he lIIade 10 fil lilt'
-1.-1. Mealunllg and Analyzing Abnonnal Returns

,
Tillie Line:
\
est~malion ] event ] po~t~venl ]
( wmdow ( window ( Window

o
r

• Figure 4.1. Ti= l.ine Ja,. an Eumt Study

cross-section of mean returns. as shown by Fama and French (1996a) and

others. so a properly chosen APT model does not impose false restrictions
on mean returns. On the other hand the use of the APT complicates the
implementation of an event study and has little practical advantage relative
to the llnrestricted market model. See, for example. Brown and Weinstein
( 19R!i). There seems to be no good reason to use an economic model rather
than a statistical model in an event study.

4."4 Measuring and Analyzing Abnormal Returns

In this section we consider the problem of measuring and analyzing abnor-

mal returns. We use the market model as the normal perfonnance return
model. bllt the analysis is virtually identical for the constant-mean-return
model.
We first define some notation. We index returns in event time using
r. Defining r := 0 as the event date. r = 1'1 + 1 to r = 1'2 represents
the event window. and r == To + 1 to r = 1'1 constitutes the estimation
window. Let LI = T t - To and l.Jl == 71. - 1'[ be the length of the estimation
window and the event window. respectively. If the event being considered
is an announcement on a given date then 1'2 == 1'1 + 1 and L;. = 1. If
applicable. the post-event window will be from r == 1'2 + 1 to r = 1', and its :
leni!;th is L:\ = 1~ - 71.. The timing sequence is illustrated on the time line .
ill Fi~\lrt· 4.1.
We interpret the abnormal return over the event window as a measure
Oflh(" impact of the event on the value of the firm (or its equity). Thus, the
Illcthodology implicitly assumes that the event is exogenous with respect to
lhe change in market value of the security. In other words. the revision in
V<l\Ul' of the firm is caused by the event. In most cases this methodology is
'lppropriate. bllt there are exceptions. There are examples where an event . dAi ri .'
is triggered by the change in the market value of a security, in which case J..~-~;f. ..
,,':··~~.;t'
.;;~~.

r;~'
.~:.
158 4. HlIflll-SIIll!y illI(/!y.\i~

the event is endogenous. For these cases, Ihe usual inlerprelalion will be
incorrect.
It is typical/or the estimation window and the event window lIotlo over-
ap. This design provides estimators for the parameters of the normal return
odd which are not inlluenced by the event-related returns. Including the
vent window in the estimation of the normal model parameters cOllld lead
o the event returns having a large influence 011 the norlllal return Ille<l-
ure. In this situation both the normal returns and the abnormal rei urns
ould reflect the impact of the event. This would be problemalic since the
I~lethodology is built around the assumption that the event impact is (';'1)-
Lured by the abnormal returns. In Section 4.:' we consider expandin!-( the
null hypothesis to accollllllodale changes in the risk of a linn around Ihe
event. In this case an estimation framework which uses the event window
returns will he reqllin~<I.

'1.4. J blilllfllillll '1',hr I'vIflr/{1'l Mudd

Recall that the market model for security i ami observalion r in event time
is
U" = u, + Ii,RIIIT + (", (4..1,1)

The estimation-window ohservalions call he expressed as a regn'ssioll sys-

tem,
R, = X;O, + {"
where Ri ::::: [R;7i,+ I ... Ri'li l' is an (1'1 xl) vector of estimation-window re-
turns, Xi::::: [L R.,] is an (1'1 x2) matrix with a vector of ones in the lirst col-
ulHn and the vector of market return observations R,. =
[U,.7i,+I·' ,Il"'/i J'
in thesecondcolulllll, allll (), =:: [u,fi,l' isthe (2x 1) parameterveclOr. Xhas
a subscript because the estimation window lIlay have timing that is specific
to firm i. Under general conditions urdinary least squan:s (01.5) is a collsis-
tent estimation procedure for the market-Illudel parameters. Funher, /-(ivelJ
the assumptions uf Section 4.3, 01.5 is efficient. The 01.5 estimalors of Ihe
lIlarket-model parameters usill/-( all estimatioll window or LI oilserv<ltiollS
arc

0,

= ---ti. (1.4.4)
1-1 -~ , '

X,B,
II Vade,]
R, -
(4.4,ti)
I
\V~ next show how to use these OI.S estimators to l1leasur(' Ihe slatistical
I
i
 '1. ·1. Mf'{/.\IIl'ill~ (II/(I AI/(I~l'Zill~ tlil/Ilml/( I/ /{('/l/m.1
1!i!1

propcrti es of ahnol"ln al rdurns. First w(' consid(, r till' "hllornm

l return
proJlcrti es of a given security "nd tlll'n we aggrq;a tl' "lTIIliS senlrilic
s.

4.4.2 S[ali.llim ll'm/wr/il 'J I{ A/IIIII/I/lft! N,'IIIIII.I

(;i\'('ll Ihl' lll<lrkct -Illodd parame ter estimale s, we can measure
alld allalyze
Ihe ,11)1101"111<11 returlls. Let €;
he the (i~~ x I) S,lIlIplc v('("(or of ahllorm al
1('llirm lilr lirm i frolll the evcllt window, TI + I to ·/~. Theil
usillg th('
Inarkel Ill(Hkl to IIlcasure the nortnal rclllrll alld Ihl' Ol.'i ('stimato
rs frolll
(·1.·1.:1), II'l' h,I\'(' lilr the allllortu al n'llIl'Il v('rlor:

== R'I -X'O
I /. (4.4.7)
wh('l'(' R; = I U,r,+1
... UI/'1' is all (i,!x I) V('("(OI' of ('I'l'lIt-w illdow returllS,
X; == It R;"I is <In (/'l x:l) matrix with a \'('('tOI' of olles ill the lirst columll
a.J(lt\)(' v('ctOI' oflllaJ'k el returll ohseJ'va tiolls R;" =c lU",r,. I'"
N"'/11' ill the
~e( ond ('Ohllllll, alld OJ == [a, II, I' is Ih(' (:!x I) pal'<llIl('t('1' I'("('(or
estimate .
COlldili on.d Oil Ihe market rdum over th(' ('vellt willdow, thl'
ahllorlll allT-
ttll'ns will he jointly normall y distrihu ted wilIt a zero cOllditi
ollalme an alld
conditio nal covari,\I \(T lIlatrix V, as showll ill (-I.'l.l'l) alld
(-1.'1.9). resp('c-
liwl)'.

E[R; - X;O, I X; 1
I':[(R; - X;O,) - X;(O, - 0,) I X; 1

o. (4.4.8)

I is Ih(' (I . ! x I ..J identity matrix.

From (·I.·l.l'l) we sec Ihatth(' ahllol'lll<d n'lIinl \,(·('tOI, wilh all
expecta -
lion of 1.('1"0, is unhiase d. The co"ariall <T Illalrix of Ih(' <lI>IIoJ'lI
Ial return
vector frolll (-I.·U)) has two parts. 'I'll(' lirsl I('r11 I ill th(' Slllll
is Ihe variallc( '
due to lhl' futllre disturha llces alld th(' '('C() III I tnlll i~ lIte addilion
al vari-
anc(' dll(' 10 IIt(' salnplin g l'rror ill (),. This .'<lIl1plillg ('1 I'or, which
is COlIllllOll
fill' allthc dCIIH'IIIS olthe ahllonllalrctllrn vector, wililcad to s('rial corre-
lalion of Ihe ahllonll.d reI urns dcspile lhe bet lhal lhe lrue dislurbances
arc indqlCndellt Ihrollgll lillie. As Ihl' length of the cstilllatioll willdo\\' 1,1
Iwcolllcs large, IiiI' second lerlll will approach zero as till' salllpling clTor of
lhl' paralllell'l's vallishes, alld Ihe abllorlllal relurns arross lime periods will
hecolllc illliq)(,lIdclIl ;tSl'lIIplOlicalll'.
1I11dl'l' tlie lIull hl'polhesis. 11 11 , Ihat the givcn ewnl has 110 impaci Oil
IIH' nlt'an or variancc of 1I'lurns, wc call lise (4.4.H) and (4.4.9) and Ihcjoilll
normalily of Ihe ahunrmal rei urns 10 draw inferl'lIces. Ullder Ilu, for the
\'cflol' of e\'l'lll·window salllpll' ahllol'lllal rt"lIlnlS Wl' 'have

('1.4.10)

F(luation (,1..1.10) gil'es us IIJ(' dislrihution for any singk ahnormal rl'tul'll
ohsl'I'l'alioll. We ncxl hllild on Ihis resul! and cOllsider Ihe aggregalion of
ahnOrlllall'l'turlls.

·1. '1.1 :\g.t:'fl'gillillll II/ Abl/lInllll[ Urlllnls

The almonnal rt'llIrn ohsn\'aliolls mllsl he aggregated in order to draw

o\'erall inli-n'lln'o; ItH' III<' ('\'elll or ill\<·I'l's\. The aggregalion is alollg two
diml'nsiolls-through time and across securities. We will (irst considcr ag-
gregalioll Ihrough lilll!' for all iuliil'idual secllrity alld Ihell will consi(\er
aggregalioll hOlh across S('('urilies and Ihrough lillie.
We inlroduCl' Ihl' l'Iulllllali\'c ahnormal reI urn 10 accolllllHHial1' Illulti-
pk salliplilig illll'l'\'als withill the eve II I window. Defille CAR/(rl, r~) a~ the
1'llllllllaliVl' ahnol'mal relllm fill' security i from rl 10 r2 where '1'1 < rl ::::
r~ :::: ·/~. l.l'I, he all (I 'J X I) v('clor with Olil'S ill posilions rl - '1'1 10 r~ - '1'1
;lllI\1.l'rm's ds('wlwfl'. Th<'11 Wl' ha\'e
,-. ('1.4.11 )
1"/
V"r\(:A\{'(TI. T~)\ = O/~(TI' r~) = ,'ViI' (4.4.12)

I! ii,\Iows frolll (·1.·1.10) Ihal ulHlcr II",

VI'., (';111 cousln, .. 1 a It'sl (.1' II" 1'01 se .. ulily i from (4.'1.1 :') lIsing th., SI,lIld,ll'd-
i/l'd nl'lnillali\'(' alHlol'llial 1<'111111.

CAR,(rl' T~)
SO\R,(rl. r~) (.1. .!.l.! )
(T/(r\, r~)

",herea/(rl, re) iSl'OlkuLlled wilh o,~ frolll (4.4.4) SlIhSlilUll'd li)r(1,~. L'nder
lhl' nlll1 hVl'ollll'si'; IIII' dislrihulioll ofS{:AR;(rl' r:!) is Sludelil I wilh 1.\ - 2
4.4. Mfll.'iuring and Analyting Abnonnal Returns 161

degrees of freedom. From the properties of the Student t di~tribution.

the expectation ofSCAR;(rl. r2) is 0 and the variance is (~). For a large
estimation window (for example, 1.1 > 30), the distribution ofSOO;(rl. r2)
will he well approximated by the standard normal.
The above result applies to a sample of one event and must be extended
for Ih(' uSIIal case where a sample of JIlany event observations is aggregated.
To "ggregate across securities and through time, we assume that there is
not any correlation across the abnormal returns of different securities. This
will generally he the case if there is not any clustering, that is, there is not
any overlap in the event windows of the included securities. The absence of
any overlap and the maintained distributional assumptions imply that the
abnormal returns and the cumulative abnormal returns will be independFnt'
across seCllrities. Inferences with clustering will be discussed later. !
The individual securities' abnormal returns can be averaged using i;
frolll (4.4.7). Given a sample of N even ts, defining f· as the sample averitge
of the N abnormal return vectors, we have

(4.4.15)
\

!
(4.4.16)

I
We can aggregate the elements of this average abnormal returns vectpr
through time using the same approach as we did for an individual security's
vector. Define CAR(, •• '2) as the cumulative average abnormal return fr<\m
'I to ,~ where TI < " :5 '2 :5 1~ and 'Y again represents an (/1), xl) vect~r
with ones in positions " - T. to '2 - T. and zeroes elsewhere. For the
cUlIIulative average abnormal return we have

(4.4.17)

(4.4.18)

Equivalently, to obtain CARCr •. r~), we can aggregate using the sample

cUlllulative abnormal return for each security i. For N events we have

(4.4.19)

(4.4.20)
162 4. J~III'11I.SllUly '\I/(/IY.I;'I

In (4.4.16), (4.4.18), and (4.4.~O) we use the assumption that the event
windows of the N securities do not overlap to set the covariallce terllIs t<)
zero. Inferences about the cumulative abnormal returns can be dra\"llllsill~

(4.4.~ 1)

since under the null hypothesis the expectation of the ahnormal returns
_2
is zerD. In practice, since a- 2(TI, T2) is unknowll, we can lise a (TI, r~) =
;& L::I u;(rl, r2) as a consistent estimator and proceed to test II" using
CAR(rl r2) a
11 == 2 • I ~ N(O,I).
[J (rl' r2)p
This distributional resuit is for large samples of events and is lIot exact
because an estimator of the variance appears in the denominator.
A second method of aggregation is to ~ive equal weighting 10 the indio
vidual SCAR;'s. Defining SCAR( rl. r2) as the average over N secnrities frol\l
event time II to T2, we have

SCAR(Tt. T2) = * N
I)fu,(TIo r2)'
,=1
(4.4.~3)

Assuming that the evellt windows of the N securities do not overlap in

calendar time, under 11o, SCAR(r,. r2) will be normally distributed in large
samples with a mean of zero and variance (N;C:1)' We can tesl the null
hypothesis lIsing

12 = (
NU., - 4»); __ I

,SCAR(r,. r2) .::. N(O. I).

1.1 - ~

When doing an eventsllldy one will have to choose betweellllsing 11 or 12

for the test statistic. One would like to choose the statistic with higher power,
and this will depend on thc alternative hypothesis. If the tflle ahnormal

l return is constant across securities then the better choice will give more
weight to the securities with the lower abnormal return variance, which is
what Jl docs. On the other hand if the true abnormal return is larger for
\ securities with higher variance, then the beller choice will give e(l"al weight
i to the realized cumubtive abnormal retllrn of each security, which is what 11
Idocs. In most sllldies. the result.~ ,Ire notlikcly to be sensitive to the choice
of 11 versus /~ because thc variance of the CAR is of a similar magnitude
across SeCllnl1es.
I
\ 4.4.4 .\'cIHililll(V 10 Normal Ul'lllni I'vlodel
I\we have developed reslllL~ using the market model as the Ilormal retLlnt
model. As previollsly noted, Ilsing the market Illodrl as oppmcd to the
-I. ,1. Mm.\111711K mul AII(llyzi"K AIJlltlnll{/llIl'lllru,1 IIi:!

,I
constant-mean-return model will Ie,HI to redlldioll in Ihe ahnormal re-
t\lrn variance. This point call he shown hy C()nlp'lrin~ the ahnormal rclul"\l
variances. For this illustr,ltion we take the llormal returll model parameters
,IS gIven.

The variance 0(' the alJllortnal rellirn l(lI' the market model is

a,~ Yar[ [(" - (x, - fl, Um ,\

Yarl RII I - Ii; Y,III Umll

(I - U;lYar[UIIJ. (4.4.25 )

where U; is the /{2 of the markel-lIIodel regressioll for security i.

For the cOllstant-mean-rellirn model, the variance of the abnormal re-
tUI'll ~" is the variance of the uncolHlitional retul'll, Yar[ U" J. that is,

o~~ := YarlU" -II,! := Yar[Uill. (4.4.26)

Combining (4.4.25) and (4.4.2li) we have

(4.4.27)

Since H; !;es betwccn zero and one, tbe variance or the abnormal return
using the market model will be less than or eqllal to the abnormal retllrn
variance using the constant-mean-return model. This lower variance for
the market model will Gln'Y OVCI' into all the av;v;n-v;atc abnormal retlll'll
lIleaSllres. As a result, usinv; the ",arkel ",,,dd .-all lead 10 llIore precise
infl~rellres. The v;ains will he v;reatl'st for" '''ll\plc of "'<:Ilriti,'s with hiV;h
lIlarket-model U2 statistics.
III principle further illcreases in U 2 cOllld h(' achieved by using a Illulti-
ractor model. In practice, howevCJ', the g.lins in /{2 fwm adding additional
ractors are usually small.

4.4.5 C1R.I for the 1~'(/rnil/g\-AII1/oll/l(flllfllt Exam/lie

The earllin~s-anno\lllcement example illustrale, the use of sample abJlor-
rnal returns and sample cumulative ahnormal retUrlls. Table 4.1 presents
the abnormal returns averav;el! across the :~() lirIllS as well as the a"cra~ed
cIIllItdative almormal relUnl I()I" each of Ihe IhnT earnings news categories.
Two norlllal return models are considered: the Illarket model and, for
comparison, the constant-Illean-rctlll'n llIodel. 1'1015 of the ctllnulative al)-
normal retul'llS arc also included, wilh the CAR" hUIIl the market lIlodel
in Figure 1.201 and the CARs frolll the cnmlallt-IllI',lI\-1('tUl1l model ill Fig-
ure 4.2h.
The results of this example ar(' lar~ely nJllsisl(,lI1 wilh the exisling- lit-
erature on the inforlllation ronll'nl of' earllin~s, The ('vidcnce slrongly
Table 4.1. ..lhI/lJUI/I/III'IIIu/' /111" (/1/ (1'1'111 ,111111' "lIlit' ili/iJUI//lliulI rolllfill "l('(lft/illg' /111-
11011111""""'11/\,

\1;1It...'1 \I"cld

(:.\1( C,\I( • :.. \I( i' C'\I{ i' C'\I{ i'

-~II .I~I:\ .1I~r\ .IIXO .Will -.lOi --',1117 .10:1 .10:, .OI~1 ,fll~) -.Oi; -.07i
-I~I --,177 - "HI (lIH ,(I!IH - IHII ·-.'.!xli -.'!.:\r) -,I'!.~J -.I).IX -.II'!.!I -,I'I~ -.'.!I~I
-IH ,(lHH ,11(11 (l1~ ,11(1 U'.!~I - .:!!".H .clti~) --.lUill -.IIHh -.11:1 -,11-1:1 -.:!Ii:!
-17 .O~I .O",!q .Fd - .1).11 -.1I7~1 -,:\:17 -.O'!.ti -.OXli -.1'10 -.'!.:.:. -.W,i -.:q~J
-it. ",(lIH .1111 - .UP) .tIt~) -- 11111 -'.:\11) -,IlHli -.172 ,1I:m -,~lIi -.lIi:1 -,:I!1I
-I:, -.0111 -.II',!'I 111'1 ,II 17 Wd -,'1111 -,IX:I -.:\'.', ,1l!1!1 -,117 -.0:(7 -,-1:11
"II O:lx n()~ 010 007 -.II'.!1 _. I'!. I -.O'!.O -.:nr, -.1:111 -.'!.Iili -,1111 -.~':\:.~
-1:\ .W,1i ,OIi·' - .W.7 ... 00i:1 ,11.17 -, III -,02:, -.:i!I~1 -. nil -..1:IM - Oljq -.tiOI
··1!! OIi!"1 .I:!!I .1·lli .fUil .•. O~)l1 -.:.01 ,11l1 -,~!IH .1:1:1 -.:I~:. -,IIIIi -,7117
-II .00ill .1~lq -.f1'!o ,Olil -,IIHH .... :I~J'!. .1~li -,172 ,lIl1ti -,:II!I -.lIj~1 -.:-til;
-1(1 .O'!H .'.!'!.7 .II'.!!", .wn -.O~J'.! - .liM:' ,1:1-1 -,II:IX ,111:1 -,~II • -.OO~) -.:·U":'
-~) .I!".!I .:Uf:! .II~) .'!o';! - ,11,111 -,nl ,~1lI .In ,1I2~ -,I!I'I ,1111 -.:i7-t
'·H .W,7 .·I:\M .1170 .'.!.7'!. .1I7'!. -.ti:I'.! ,lIIti ,~7X ,WI - ,11:11 ,1:4:, -.i:\X
-7 -,(1111 .·I'!.M -.101t .ltiti -.O';!li -,li77 -.11112 ,n7 ,1I1~1 -,Iln -,tI:!i -.7H:)
-ti
-:.
.1111
.OW,
,:1:\:1 .1I'!.ti . PI'!.
.Idt! oW, 107
-,111:1
lid
-.ti~IH
_ r,'!7
,1l11
.tlhl
,~HH -.1I2!1
.:H~I -.lItiX -.I'!.U
-,I"" ,11:\\1
.:\:!O
-.7:\:)
-.·11:.
--I O~I·.I .'it:, ,II III ,117 .- T\'I - .hhl\ ,U:II ,:I7~1 ,UK'.1 -,U:II -.:!():' -.(i:!H
':1 .117 .!'f\',! .tUti IM'\ .!lIIH -.:lliH .I11i7 ,H7 ,1l1:1 -,IIIH .m6 -.:".:\Ii
IItIIl W\X '.!~ti 1(1'1 II'.! tiXfI .1110 .·Vlli '\II .'.!~II - .:!t,li - .i!)!
-I .lld 11101 .IIoH '!.II .11'111 .XIM .HIM .fi!",·' -.170 . I'.!·' -.'.!:!i -I.IIIH
II .~lIi.r) I.Qhtf -.O!" . FlO 1.1l:1-1 LtiHH -, 1Ii,1 - ,<1-111 -.li·l:\ -l.lilil
.:!rd !!.:!17 flUx II:! ~II'I 1.71'1 ,:1,.7 2,11-1:. -,1711 -,2111 -,~12 -L~i:1
011 '.! ',!In ,11117 IIH .lIi'!. l.ti7'!. -.0 I:~ '!..II:t\ .or...
-.1 :lli .H7X -I. 7~r)
:. Ihl '.!U'\I' ,HI'! I liB (l}t,:\ ,r.K'1 -IIMK 1'11,1 -,I~I -,~77 .i·tlt -\ I;\K
I -.1111 :!.O'.! I ,(HIli J!1I1 ,III.. I.IH'I '()·II I.~IX:, .o'!.:~ -,.'!.:.:\ .I·I~I -: .·lq~1
.1:\:1 '.!.ltill E)~
-.It:'X 1111 -I.'.!XI.J .2·IM '!..'!.:t\ -.mrs -.'!.!.ti .:!~ti -1.:!J.I
Ii --.O~)'.!'.!.1t17 -.:\II'.! -.1:,0 lIili ··I.'.l.I:\ -.0:\:) '!..I~IM -.:\I!I -}17!", .(J70 -) '·1:\
7 OliO'.! Iti7 -.PIII -.\I!I ,I~II "I.II!I:I ,1117 2,~a:. -,II~ -,liH7 ,III~ -1.11-11
X . F/') '.!.:\".!:\ IHK
I:)'; - 1111 -1.1:11 ,112 ~,:I~(i -,IH7 ,X71 tI:,h -.qxl.
'.I - ,HIIH '.!:\I~. I Iii .locH ··.Uhq I.'!.II:\ .o!",'!, -.WI7 -.!I:\I
~.:n·1 -.1171 -1 I/.-,Ii
III .Ihl :!.1711 ,IIX:! .rl:!1 I :~II - 1.07'\ ,1-17 :!.·I'.!I .!tln .7:!H ,'.!Iii - 7XQ
II ·IIXI '.!.:\'1H 1110 ·IHI ... 01l~1 ·I.IIH'!. -.01:\ :!.·HI7 .0.1:. - .fiX:' .Ollti . IX:\
I:! - .WIH '.!:\ II.'.! Iii - .'!'VI - ,II:IH - 1.11'1 -.II:,-t ~.:':)·I .!!~~I - :\X I .1117 -.ilili
1:1 .ttt~1 '!.17l\ .1I It '1'1" ,1171 --I.IIIH -,2,Ui ~,11I7
-(\(i7 -,,\:.1 ,11,1 -,ti:I'.!
1,1 -.O!'il '.!.Ut):1 .IIIJI .:H'.! .uP) -I.II'!." -.011 '!..o~lt;
-.O'!.I ·... 17:, .ox'! - .~IIH
I ~. ,,11117 ~ IIXX -- 11111 --.:111 -,111:1 • 1.117~ -.017 ~.OtiM -.U:I~I -':1:\·1 -.II:!:! -.:,WI
Iii Olir,:! FI:\ - II'.!!) .:U I -.OMI; - I Jrl!' ,111:1 ~,171 -,II'lii -,',HII -,IIHI ·-.(jiB
17 .OX) '.!.:!'\j .017 .:\17 .0:,0 1.'.!II!'i .lI(it; !!.:!:n -.OHM ·-.ti77 -,11',,1 - i:!·1
IK .\7'! '.! .. \("' .W" .~h:~ .1":'1) . ,."'! ,I HI ~,:\,17 ,(\21 --,''''(i -,11,1 _."ill:,
PI -'.11-1:\ :!:\Id 11'1 - 11,1 -.fJX!'i .. I.'!.·W -.O:,~, ~.~J!! .flMX -.!"IIIX .O:!1i -.ili~1
:!o 111:1 ~,:177 II~I' ·.WIO - .11'!.!'i I.'!.r,x .ol~1 ~.:\l1 ,111:\ -.~I:d -,II'• -,~x'i
---------- ---- ----- . - ---"----,,------------

Tlw :-""uph· ,u""", HI ~, t\l\.,1 01 I~UI '1'1.\\ \\" Iy ;\1HHIUUn',u,'u\:\ fur ,In- Ihi1 'Y rump.""", iu ,I",
IlUII'.IUIII" 11I<I1I,lri,(1 111<1", lUI II,,· Ii"··,... ,,, 1"'1 iu<I JII,"ary I !IH!llo ))"(,('1111)('1' I !)I):1. Twulllutl·
t·\~ ~\H' nln ... ,tl,'u'd h" tht' HOtU,,\t l~'lUlI\"'. It", m~u ~(:, Inudt,t \I~in~ tht, (:RSl' v.\hH'-\\'l·iglu(·tl
iudex 'I1Ullh(' n,.. ... I;ull·IIU', .. I'I'('11I11I lIIeu",!. '1 lit' :IIIIHHllln'IIH'IIIS an' r.llc'god/c.·d illin IlIn'('
grollp\, ~ou(ll\("\'~. WI tU'\\':\, ,Hul h.HlIU'\''', c-· i .. th ... :-':Utllllt, ,\\'C.'I';.,~c.' ~\hIlUnl1;lllI.,t\lrH hll tltc.'
'Iu"'ili('cl ct.v in ('v('1I1 lillll' ;111(1 ~ i, lilt, !'o,IIlII'It' ;I\'I'raw' C'WllIltlliv(' "hltollll.1I 1'1·1\11'11 101 d;,y
-':!O ttl 'ht' ... "t'c. iht'd el.l\'. F\('ut lime i .. mc.·"'lIll't\ in dO\y!<i rt'l.uin' hi the ;HlIHllllU'(,l1It'Ht d,\h',
-1.-1. MI'llSWillg mul A1wlyz.ing A/manllal Returns
,
165

0.03

n.o:? ."

6
0.01

0
\ ....... . Nn-NC'WI Fir"1I

-0.01

-0.02

~.03~~~~ww~~WW~~WW~LUWW~WU~~
-20 -10 o 10 20
Event Time

Figure 4.20. Plot of Cumulative Market·Model Abnormal Return for Earning Announce-
111m I.'

0.03

0.02
Couci·Nt.,W!\o Firm~
"
.,.
~
(j
0.01

()
\.-- ..... . No-Ncws Firml

-0.01

8ad·Nr~ Firms
-0.02

-20 -10 o 10 20
Event Time

Figure4.2b. Piol of Cumulatillf COll5lanl·Mffln·Rdurn·Model Abnormal Return for Earn·

I
ill~ AIlIWWICfllU'1ltS I
i
SlIpports the hypothesis that earnings announcements do indeed convey i~.
fill'lllation IIseful for the valuation of firms. Focusing on the announcement
clay (clay zero) the sample average abnormal relUrn for the good-news fir~
I

•
166 4. Ellellt-Slud.~ A 1I1/(~sis

using the market model is 0.965%. Since·the standard error Ilf the one-day
good-news average abnormal return is O. I 04%, the value of 11 is !1.~H and
the null hypothesis that the evellt has 110 impact is strongly n:iecled. The
story is thc same for the had-news finns. The event day sample ahnorJnal
return is -0.679%, with a standard error of 0.098%, leading to 11 eqllal to
-6.93 and again strong evidence against the null hypothesis. /\s wOllld he
expected, the abnormal re\Urn of the no-news firms is slllall at -o.ml1 %
and, with a standard error of 0.098%. is less than one st'UHlanl error frolll
zero. There is also some evidence of the announcement e1lect on day OlW.
The average abnormal returns arc 0.25 I % and -0.204% for the good-news
and the bad-news firms respectively. Both these values are more than two
standard errors from zero. The source of these day-one effects is likely 10 be
that some of the carnings announccmcnts arc made on cvent day zero after
thc c10sc of thc stock markct. In thesc cases the cffects will he caplured in
the return on day onc.
Thc conclusions IIsing the abnormal returns from the constant-Illcan-
rcturn model arc consistent with those from the market modcl. Ilowever.
there is some loss of precision Ilsing the constant-Illean-return lIlodel, as Ihc
variancc'of the avcragc abnormal rcturn increascs for a)) thrcc categorics.
When measuring abnormal rcturns with the constant-mean-relllrll model
the standard crrors increasc from 0.104% to 0.1300/0 for good·news finns,
from 0.098% to O. I ~4% for no-ncws firms, and from 0.098% to O.I:H %
for~)ad-news finns. Thesc increascs arc 10 bc cxpcctcd whcn consideril1g
a s~mplc of large IInns sllch as those ill the Dow Index since Ihese slOl'ks
ten~1 to have an important markct compunenl whosc variability is elimillated
using the market modcl.
!The CAR plots show that to SOIllC cxtent thc markct gradually Icams
abo~1\ the forthcoming announcemcnt. The avcrage CAR of thc good-news
fil"Ofls gradually drifts up in days -20 to -I, and the avcragc CAR of thc
bad ncws firms gradllally drifts down over this period. In thc days after the
am unccmcnt the CAR is relatively stahlc, as would be expcctcd, although
the c docs tcnd to hc a slight (hut statistically insignificant) increase for the
bad news firms ill days two through eight.

4.4.61I1jl'll'II(f.\ with Clll~/l'rillg

In a lalylillg aggrcgatcd abnormal returns, we have thus far assullll'd Ihat

thc hnorrnal rcturns on individual securities arc uncorrc!ated ill titl' cross
sect 011. This will gellcrally he a re.lsonahlc 'ISSlllllption irthe evcnt windows
of tHe includcd securities do not overlap in calcndar tilllc. Thc assulllption
allows us to calculatc thc variancc or the aggregated salllple clllnulativc
abnormal returns wilho\lt concern .Ibotlt covarianccs betwcell individual
sample CARs, sincc they arc I.cm. Ilowcver, when the cvcnt windows do
4.5. Mor/ijrillJ.: 1111' NlIllll)'jJIIlhrJi.1 l\i7

OIlTtip, the covarianccs betwc('n th(' abnorlllal r('lurns lIlay dilfer 1'1'0111
Z(TU, and th(' distributional results preselll('d Ii) .. Ih(' a~~rq~al('d almormal

r('lums art' uot applicable. lkmanl (1~IK7) dis(lIss('s SDIll(' "I' tl\(' prohlems
relaled 10 c1ustcrin!{.
\"'hen thcre is onc evcllt date in calendar tillll', dusterinv; call he ac-
com1ll()(\atl'd ill two dilkrcnt wa),s. First, thl' abnormal returns Gill he
aggr('g;llcd into a portfulio dated using (,\'(,lIt tillll', and thc sccurity ieI'd
analysis ofScnion 4.4 can be applied to the porth)lio. This ;Ipproach allows
for cross correlation of thc abllormal retllrns.
A sccond way to handle clustering is to analyzc th(' almurmal relllrns
wilhout <Igv;regation. Qne can test the null hypothesis that the evellt has ilL'
impact Ilsin!{ lIna!{wegated seclIrit),-hy-secllrit)' (\at,\. TIll" basi, appro,lCh is
an application of a lIIultivariate rc!{r('ssioll lIlodel wilh dUlllnl)' variables fur
the cvent date; it is c1usely related to the lIIultivariate F-test of the CAPM pre-
scnted in Chapter ;}. The approach is developed ill the papers of Schipper
and Thompson (I !IH3, 19H!i), Malatesta and Thompson (I !IH:)), and Cullins
aII'I Dent (I !lH4). It has some advantav;es relativc to Ihe portfuliu approach.
First, it can arculllmutlate an alternative hypothesis where sOllie of the linns
h,l\'c positive ahnormal returns and some of the firms have nev;ativc al)llor-
m,d returns. Second, it can handle cases when' thne is partial dustcrin~,
Ihat is, where thc CVCllt datc is not Ihc same across linlls bllt tlane is overlap
in the evcnl windows. This approach also has SOllie drawbacks, however. In
t1\;II\Y CIS('S till' tl'sl statistic h,ls poor tinite-sample propnties, and oftl'lI it
h;I' liuh- power against economiclily rcasonahk altl'rnatiws.

4.5 Modifying the Null Hypothesis

Thus Ell' we have focused on a singl(, null hypolhesis-Ihat Ihe given event
has no imp,'Cl on the hdlavior or secllrity relurns. With Ihis 111111 hypothesis
either a mcan effect or a variance elfel:t rq>n'sl'lllS a violation. Ilowcva.
ill sOIl](, applications we lIlay he inl('resled in testing only for a lIlean effect.
In these cases, W(' lleeci to expand the llullhypolhesis to ,Illow for challv;ing
(usually increasin!{) variances.
To accomplish Ihis, we need to elilllinate all}' rcliallc(' Oil pasl returns
in {'slimalill!{ the variance ur the a!{!{rcg,lted clIlIIltiative ,tilllonnal returns.
Instcad, we lise the cross section of flnlllllative almonn,tl returns to form
all eSlilllator of Ih(' variance. Boehmer, J'vlllsllilleci, ;\1111 PoulsclI (I!I!II)
discuss lhis Illcthotiolov;y, which is bes\ appli('d (Ising tite const<lnl-lIl('all-
retllrn model 10 IIlCaSllre the abnormal reI urn.
The cross-scuion<ll approach to ('stilllalillg the \'<lrian((' can be applied
to both the avcrav;e ClllIlllLttive abnonnal return (CXR(TI. T~» and the av-
nag(' slalldanliled cUlllulative al)llOllll;llll"tll1"ll (.~( :XI{( TI. r~») . Using Ihe
 -I, J:'1'1'II1-SllIIly A/I(//y,li,

cross senitlll 10 1<11'111 eSlimalors of lilt' vi\I'hll":t's wc havI'

(-1,:1,1 )

v
I ' --- '"
N~ I)SCARj(TI. T2) - SCAR(TI' T~»", (4,:,,2)
I":"')

For Ihe,~e I'slilllalOr~ of Ihe v;lriant'l's 10 he consistelll WI' require the

ahllormal relll!'llS III hI' IIl1coITl'I;lll'c1 ill the cross sectioll, An absellce of
clllstering i~ sunicil'lIl for Ihis reqllirclIlcnt. NOlc thai cross-scctiollal ho-
lIIoskedaslicil), is 1101 n'qllirl'd iill' (ollsislt'ncy, CiVl'1I Ihese variallcc eslilll;!-
(or~, Ihe !llIlI hypolhesis Illal till' nllllul"liw allllol'lllal n'lurn~; arc I.I~ro Gill
Ihl'lI hI' It'stl'd usiug lar)!;I' salllpll' thl'ory giVl'1I thc l'Ollsislellll'SlimalOrs Dr
11ll' variancl's ill (.I.:).~) alld (·1.:),1),
~I 0111' ilIa), also hI' illll'l'l'stl'c1 ill IIIl' impart of all ('VI'1I1 on Ihl' risk of a
finJl, Thl' rdevalll llIeaSlIre or risk 1II11St hI' ddilled hdi)rt, this iss\lc (all
I hI' addressl'd, 011(' dlOil'!' as a risk IIlCaSllre is the llIarkl,t-lIlodcl bela as
I
t implil'd hy Ihl' Capilal Assel Priring Model. Givcn this choict', the markel
lJIollel rail Ill' fOrllllll;lIl'd 10 allow Ihl' hela 10 change over Ihe cwnl window
alld Ihe siahilil)' of Ihe hela call he I'xaluillt'ti, Set' Kalil' alld Unal (I \lHH)
(ill' all applicalioll til' Ihis idea,

I 4,6 Analysis of Power

'Ii) illll'rprl'l all 1'1'1'111 silldy, 11'1' 1I1"l'd III kllow whal is our ahililY 10 ([('ItTI
Ihl' pn'sl'lIn' of a noulero ahIlOI'lIl;\I relurll, III Ihis seuioll WI' ask ",hal is
\ IIII' likdihood Ih"l ;llll'VI'IlI-SllId)' It's I rcjcl'ts the 111111 hypolh('~is for a gin'lI
I
level or aillloflllal 1'('1111'11 associaled Ivilll all 1'1'1'111, thaI is, "'I' ('vaillal(' i11t'
\
I) POIl't'!' or Ihl' It'S!.
I
I '\'1' cOllsidl'r a two-sided lesl "('Ihl' 111111 hypothesis \Ising Ihl' l'\Il\1ulalil'l'-
'1IlIIOl'lllal-n'lllrll-h"~I'd slalistil./I ('rolll ('1.'1.~2), WI' aSS\lIlll' Ihalthc ;Ihll!)r-
lHall'l't\lrns arl' \lllrlllTdall'c! a<TOSS s('cllrilies; thlls Ihe variallct' of C:"\R is
- " rl, r~ l, wlll'l'l' ,7'(
(1-( - " rl, r~) == 1/ N-" \L;~ ~ v"
1(1;( rl, r~) aliI IN'IS Ihl' s'\llIplt: Slfl',
,
Ulltier Ihl' 111111 hypolhl'sis Ihl' dislrihlltioll 0(' JI is stalldard norlllai. For a
IIVO-silil'tilt'SI ofsiJ('11 WI' rl'jl'rl Ihl' 111111 hypollwsis if.!1 < ¢-I(a/~l or if
,It > I\} I ( I - u /~) 11'111'1'1' 'I) (,) is I he st;lIllianl IIormal l'IlIlllllal ivl' tiisl rihlll ion
IIIIII'Iioll (CI>F),
4.6. AllalY.fiso/Power 169

Given an alternative hypothesis HA and the CDF of 11 for this h~pothesis.

we Gilltahulate the power of a test of size a lIsing I

Pea, H A) Pr(jl < <l>-I (~) I H A)

+ Pr(jl > <l>-I (1-~) I HA). (4.6.1 )

With this framework in place. we need to posit specific alternative hy-

potheses. Alternatives are constructed to be consistent with event studies
using data sampled at a daily interval. We build eight alternative hypotheses
using four levels of abnormal returns. 0.5%. 1.0%. 1.5%. and 2.0%. and two
lcvels for the average variance of the cumulative abnormal return o~ a given
sccurity over the sampling interval. 0.0004 and 0.0016. These varia~ces cor-
respond to standard deviations of2% and 4%. respectively. The sample size,
that is the number of securities for which the event occurs, is varied from
I to 200. We document the power for a test with a size of 5% (a = 0.05)
giving values of -1.96 and 1.96 for <1>-1 (a/2) and <1>-I(I-a/2), respectively.
In applications. of course, the power of the test should be considered when
selecting the size.
The power results·are presented in Table 4.2 and are plotted in Figures
4.3a and 4.3b. The results in the left panel of Table 4.2 and in Figure 4.3a
are for the case where the average variance is 0.0004, corresponding to a
standard deviation of 2%. This is an appropriate value for an event which
does not lead to increased variance and can be examined using a one-day
event window. Such a case is likely to give the event-study methodology its
highest power. The results illustrate that when the abnormal relUrn is only
0.5% the power can be low. For example. with a sample size of20 the power
of a !l% test is only 0.20. One needs a sample of over 60 firms before the
power reaches 0.50. However, for a given sample size, increases in power
arc suhstantial when the abnormal return is larger. For example, when the
abnormal return is 2.0% the power of a 5% test with 20 firms is almost 1.00
with a value of 0.99. The general results for a variance of 0.0004 is that
whcn the ahnormal return is larger than 1% the power is quite high even
for slllall sample sizes. When the abnormal return is small a larger sample
size is necessary to achieve high power.
In the right panel of Table 4.2 and in Figure 4.3b the power results
are presented for the case where the average variance of the cumulative
abnormal return is 0.0016, corresponding to a standard deviation of 4%.
This casc corresponds roughly to either a multi-day event window or to a
one-day event window with the event leading to increased variance which
is ;ICcol\1l1loc!ated as part of the nllll hypothesis. Here we see a dramatic
decline in the power of a 5% test. When the CAR is 0.5% the power is only
0.09 with 20 firms and only 0.42 with a sample of200 firms. This magnit\ude
II 4. Event-Stut/.v All11~VJiJ

Tat1e 4.2. Power of roml-Jlml)' Ir.<1 .1/f/1;.<I;r./i 10 rrjr<1I11, 11111/ ")'/loil".I;.1 111,,1111,' "/,,/(,, 11/,,/
"film is ZLm.

i
Sample Abnormal Return Abnormal Return
ISize 0.5% 1.0% 15% 2.0% 05% 1.0% 15% 2.0''',

I (I =2% (I = 4%
I 0.06 0.08 0.12 0.17 0.05 0.06 0.07 0.011
2 0.06 0.11 0.19 0.2!1 0.05 0.06 0.011 0.11
3 0.07 0.14 0.25 0.41 0.06 0.07 O. ((l 0.14
4 0.08 0.17 0.32 0.52 0.06 O.OS 0.12 0.17
5 0.09 0.20 0.39 0.61 O.Ofi O.ll9 0.1:1 0.20
6 0.09 0.23 0.4!> 0.69 0.n6 0.09 0.1!> 0.2:1
7 0.10 0.26 0.51 0.75 n.06 0.10 0.17 O.2ti
8 0.11 0.29 0.:)1) OJ\! 0.06 0.11 O.I!! O.2!1
9 0.12 0.32 O.f,1 IU\;, 0.07 0.12 0.20 IU2
IU 0.12 U.35 O.fil; 0.119 0.07 0.12 D.22 0.3:,
II 0.13 0.311 D.70 Il.!ll o.m 0.13 1l.24 0.38
12 0.14 0.41 0.74 0.93 0.07 0.14 n.2:, nAI
13 0.15 0.44 0.77 0.95 0.07 0.15 0.27 0.44
14 0.15 0.46 O.!!O 0.96 0.08 0.15 0.29 0.41;
15 0.16 0.49 0.83 0.97 0.08 0.16 0.31 0.49
16 0.17 0.52 ON, 0.98 0.08 0.17 0.32 0,!',2
17 lUll 0.54 0.117 0.98 (I.OH (l.~H 0.:14 0.;"1
III 0.19 0.56 0.119 0.99 (1.011 0.19 n.:\(; 0.:,1;
19 0.19 0.59 0.90 n.99 (l.OIl 0.19 0.:\7 ()59
20 0.20 O.fil 0.92 0.99 O.O!) 0.20 n.:I!1 IUil
25 0.24 0.71 O.9\i LOO (1.1 0 0.24 0.47 lUI
30 0.211 O.7B O.!!II LOO 0.1 I n.211 0.:,4 0.711
:lr. 0.32 H.1I4 O.!l!l 1.00 0.11 0.:12 n.w CUI·l
40 0.35 O.II!! 1.HO 1.00 0.12 0.3:. CUili CUI!1
45 0.39 0.92 1.0H 1.00 0.13 0.39 0.71 H.92
50 0.42 0.94 1.00 1.00 0.14 0.42 1I.7h II.!H
60 0.49 0.97 I.on 1.00 O. ](; 0.4!) 0.8:1 0.!)7
70 0.55 0.99 1.00 1.00 0.18 0.:):) 0.1111 n.!'!)
80 0.61 0.99 1.00 1.00 0.20 0.61 1I.!)2 II.!)!)
90 0.66 1.00 1.00 1.00 0.22 0.6ti O.!)4 LOll
100 0.71 1.00 1.00 1.110 0.24 0.71 O.!)I; 1.00
120 0.78 1.00 1.00 1.00 0.211 0.711 O.!!II 1.00
140 0.84 1.00 1.00 1.00 0.32 0.84 O.')!) 1.00
100 0.S9 1.00 1.00 1.00 0.35 O.S!I 1.00 I.I~I
1110 n.92 1.00 1.00 1.01l 1l.:19 0.92 LOt) 1.00
200 0.94 1.01l 1.00 1.00 042 0.94 I.Ot) 1.0\1

The pow~r
is reportc(1 for a tcst with a !'lilt" of' 5%. Th(' sample sil.c is the IHlIl1h('1 of t'\'('rH
uh~crv"tionsincluded in the study. Olnd rr is the sqllal't' root of the average \'~tri"I\('(' of the
abnormal return ",cro~'" f\nu~.

of abno~mal relurn is difficult to delect with the larger variance of 0.00 IIi.
In conlraSl, when the CAR is as lar~e as 15% or 2.0% the 5% lCst slill has
reasonable power. For example. when the abnormal return is 1.!'J'Yo and
4.6. Analysis ,,/Powl'r 171
0

'" 0

<D
<; 0
" .,.
0
c..

0'1
6

'-~-'--....L.--'-~-'---'--''--'-~--'--'--L.L-.1_-'.-l.-'--'
I)
\0 :.!l) :10 40 ;.(1 1;0 io HI) ~IO 1(10
S.IIIII,Il" Sill'

(Oil

co

Xi
0

<D
0
:."c
"-
.,.
::0

-
-_.--"\ .\1'11'01'11..1 H. 10,," I II'"
:';'! -~--------
co
------.-.. -.-~-- ..
:\IJlIIIIIII,IIl{,"tllrll It ~I';{'

() L....~...L..-'-....L-L-l.-'.....J'-L.....l. . ..-L---1-.1..-.l_-..J..-l~.

I0 ~I) :111 ,10 ;,1) W 70 HI) ~II) 100

Sallll'i,' Sill'

(h)

Figure 4.3. 1'0"''''' "l ElII'II/-S/wly '/i'.11 SllIliM;"./1 (II Ufjrrl tllf' NlIlI IIY/I(II/t,.li.\ l/tal tiff
AbllOnluzlllPillfll i.I /.I'IlJ. ~\?lfl! Iii, S'/IUII' illlllt "J rI,,' '~!"''''r;r \'II;f/I/,r IIf Illr Abllormal
liflum Arml.' i'ima i.\ la) 2% f/Tlff IIJ) 4%

there is a sample sizc of :'0. thc power is 0.:>'1, Generally ir lhe abnormal
return is large one will havc little dif'/iculty n~ectillg th(' lIull hypothesis of
IlO abnormal return,
We have calculated power analytically using distributional assumptions,
If these distributional assumptions are inappropriatc thcII ollr power calcu-
lations IIIay be inaccuratc_ llowcver. Brown and Wamcr (1 9H:)) cxplore this
 ./. J:lII'lI/-S/III/y .. II/(//pil

issu(' ;lIl1llilld Ih'll III(' ;III,III'li(al (OIIlIlIlI,lIiO\lS a\ld Ih(' "lllpil'icII }l()\\'(T ,\I'l'
do,,'.
\'('1'1'

" i\ dillin!ll 10 \(',uh gnl('lal (ollclllSiollS rOIHTl'lIillg till' Ihl' ,Ibilill'

Ill' 1'\'I'llI-SIIIII, IlH'lho<lol<>gl' 10 <I('It'l'1 lIollt,ero a"lIonllal \"l'llIrIlS, \-\'h('11
COlldlll'lillg .111 ('\1'111 ,lIldl' il is IH'c('ssary 10 I'Vallial1' Ihe pow('r gin'lI Ille
parallll'lt'\,s ;llld ohj .. t lil'l's 01 II\(, SllIdl', If Ihe PO"'l'I' SI'I'IIlS slIlIilil'lll Ihl'll
Ollt' elll I'l'oll'('d, <>lh(,I'\\'is(' 0111' ,hollid sl'arch ICII' ways of illlTl'asillg' III('
PO\I'I'r, This clIll)(' dOli I' 1)\' illlT(';Jsillg Ihl' sa III ph- sizl', shorll'llillg' Ihl' ('1'1'111
willdo\,', or hI' dl'l'l'lopillg l1Iol'e spl'cilir prl'din iOlls of I h e nil II IlI'poll H'sis,

4.7 NOllparametric Tests

TII(' IIIl'I IIn(h disllI"I'd 10 til is pOill1 ;111' parallll'l ric ill lIallln', ill tklt spccilic
aSsllIllptiollS hOI\'(' h('('I1 Illadl' aholll lIlt' distrihulioll of ahllol'lllal 1'1'\ II \'Il S,
,\\tnllalil'l' lIollparallll'lri(' approa('hl's an' availahle whi('h an' rn'l' or SPI'-
dliras'lIll1pliolls ('OIIlTlllillg thl' distrihulioll 0(' 1"('llIl'IIs. III lhis s('('(ioll W(,
disCII's 1\\'0 1't1l\\I\\t)\II\tlllpal'alllt'lri.- lI'sts for ('\'I'llt slIulil'S, Ihl' sigllll'si alld
lhl' I'allk II'S\.
Th .. sigll 1.. ,1. ,dlidl i, hOlS('" Oil Ih(' sigll of lilt' allllClI'Ill;tI \'('1111"11, n'-
l(uin's lhal IIII' ahllol"l\lal rl'llIrllS (or IllOn~ gl'lll'rally (,1I11l1l!alil'l' abnormal
n'III\'IIs) 011'1' illdq)('IHll'1I1 ;tlTOSS sl'Cllrili('s and Ihal IIII' n:pl'('ll'd propor-
tioll of positiw allllOlIIl.tll'l'llII'IIS 1I11dl'\" I he \lull hypolhesis is 05. The basis
of Ih(' II'SI is Ih;1I IIl1d .. r 111(' 111111 hl'pOlh('sis it is equally prohahll' tlnl 111('
CAR will hI' (losilil'l' or IIq~ati\'l'. IL ((II' l'xample, Ihe altl'rnalil'l' !t"pothl'-
~is is Ihal Ihen' is;t pmitil'" ~Ihllonllal r('turn associated witll a gin'lI ('\'l'lIt,
Ihe 111111 hl'(lollll'sis is Ilu: II ::: 0,:-. alld Ihl' altt'rnativl' is 11.\: II > lUi IdH'rc
/, == I'r(C,\\{, ::: (1.11). 'Ii. calnll'III' IIII' II'SI sialisli .. WI' Ill'l'd Illl' 1l1l1ll1H'1' oj"
(';lSI'S 11'11('1'1' IIII' ahllolillal l'l'tlll"ll is POSilil'I', N'\ , ane! Ihl' 101011 1IIIIIIhl'r of

casl'S, N. I.cltillg ,It hI' Ihl' tl'st slatislic, 1111'11 asymptolically as N illlTl'aSl'S
11'1' h,ll'!'
Vf ] N'/~
/1 = -'- - 0.:-. - - ~ N(o. I) ,
, [ N 0.:1

For ;III'sl "I"sil(' (I .. tr), Ilu i, n:j('("\('(1 if/:! > 4)-1(0').

t\ II'l'akll(,ss of Ih .. sil-:II \('SI is thai it llIay 1101 he well specilit,d if Ilw
dislrihlliioll ot' allllol"lllal I"I'IIII"IIS is skl'wec!, as call he till' case wilh claily
dala. With sknl'l,d al)lHllllIOIi \('IIII"IIS, IIH' ('xIH'C!e!l proportion 01" positive
ahllllnnal I"I'IIIIIIS 1.111 dill('\" hllill lllll' h,llt' l'l'l'll IIllder thl' 111111 hl'(lOlhl'sis,
III I(,SPOIIS(, 10 IlIi, I'0s\ihl(' SIlOlI('OIl1illg, (:orrado (I~)H~I) proPOSI'S 01 11011-
1'00Iallll'II"ic 1"'lId, 11,,11"1" ;11'"111"111.\1 1"'1 II)nl1.IIKt' i111'V1'1I1 sllIdil'S, 1;\'1' III idly
d('snilll' hi, 1t',1 "I IIIl' 1I111111l'pOI\wsi, Ihal Ih('n' is 110 OIlIlIol'lllal 1'('111111 Oil
4.H. Cross-Sectional Modtls 173

event day zero. The framework can he easily altered for events occurring
over lIlultiple days.
Drawing on notation previollsly introduced, consider a sample of LJ
abnormal returns for each of N securities. To implement the rank test it
is necessary for each security to rank the abnormal returns from I to loIJ.
Ddine KIT as the rank of the abnormal return of security j for evenl time
period r. Recall that r ranges from Tl + 1 to T:z and T = 0 is the event day.
The rank test uses the fact that the expected rank under the null hypothesis
is¥. The test statistic for the null hypothesis of no abnonnal return on
event day zefo is:

14 = N
I~ N ( IJl +
K~l - ~ /s(ld
I) (4.7.1)

s(lJl) = ~ t
Ll r='1i+1
(~t (K
N ;=1 IT
_ loIJ +
2
I)Y (4~ 7.2)

:
Tests of the null hypothesis can be implemented using the result that the
asymptotic null distribution of J~ is standard normal. Corrado (1989) gives
further details. . I
Typically, these nonparametric tests are not used in isolation bllt in
conjunction with their parametric counterparts. The non parametric tests
enable one to check the robustness of conclusions based on parametric
tests. Such a check can be worthwhile as illustrated by the work of Campbell
ami Wasley (1993). They find that for daily returns on NASDAQ stocks
the non parametric rank test provides more reliable inferences than do: the
standard parametric tests. I

4.8 Cross-Sectional Models

Theoretical models often suggest that there should be an association~be­

tween the magnitude of abnormal returns and characteristics specific to
the event observation. To investigate this association, an appropriate tool
is a cross-sectional regression of abnormal returns on the characteristics of
interest. To set up the model, define y as an (Nx 1) vector of cumulative
abnormal return observations and X as an (NxK) matrix of characteris-
tics. The first column of X is a vector of ones and each of the remaining
(K - I) columns is a vector consisting of the characteristic for each event
ohservation. Then, for the model, we have the regression equation
(4.8.1 )
when' 0 is the (Kxi) coefficient vector and fl is the (Nxl) disturbance
wC\or. A~suming E[X'fll = 0, we can consistently estimate (1 using OUi.
174 4. El/t'1ll-Sllli(V 1I11f11.\',li,1

For thc OLS estimator wc have

Assuming thc c\clllcnlS of 1/ arc cross·sectionally uncorrclatetl allli hOlllo-

skcdastic, infcrcnccs can be derived using the usual OLS standard errors.
Dcfining (J~ as thc variancc of thc clcmcnts of 1/ we have

(4.H.3)

Using thc unbiascd cstimator for a~,

.~ I.,.
a 1/ -- 1/1/ , (4.HA)
(N - K)

wherc r, == y - xiJ, wc call construct I-statistics to asscss the statistical si!{lIili-

GIlIce or the clelllel\l~ or 0. Alternatively, without assuming hOl\loskcdastk-
ity, wc can construct hctcroskcdasticity-colISisten t 2-statistics usin!{

\ \
Var[9] = .!. (X'X)-I
N
[t XIX;r,;]
i=1
(X'X)-I,

I
wherc x; is thc ith row of X and i'i is th<; ith element of r,. This cxpression
for \he standard errors can be dcrivcd using thc Gencralizcd Method of Mo-
me~lS framework in Scction A.2 of the p.ppem\ix and also follows rrOIll the
rcs Its or Whitc (1980). The usc of heteroskedasticity-consistent standard
err rs is adviscd since therc is no rcason to expcct thc residuals or (4.H.I)
to b homoskcdastic.
quith and Mullins (19HG) provide an examplc of this approach. The
tw lay cumulative abnormal rctufll for thc announcemcnt of ,III equity
offe ing is regrcsscd on thc sizc of the offering as a perccntagc of the value
of tl e lotal cquity of thc firm and Oil the cUlllulative abnormal relul'II ill
thc leven months prior to the annollnccmcnt month. They lind that the
mag itudc ofthc (ncgative) abnormal rcturn associatcd with the allllOllllce-
mcn~ or cquity offcrings is relaled to both thest' variables. Llrger pre'Cvcllt
cuml.lalivc abnormal rcturns arc associatcd with less negative abnormal
rend-ns, and largcr offcrings arc associated Wilh lIIorc ncgativ(' ahnormal
retll~ns. Thcse findings are consistent with theoretical prcdiclioJ1S which
thcy discuss.
Onc lIIust be carel'ul ill interpreting the results of the Cfoss-senional rc-
gression approach. In many situations, the event-window abnormal r('llIm
will he relatcd to firm characteristics not only through the valuatioll effects
of thc cvcnt but also through a relation between thc linn characteristics
and thc cxtcnt to which the cvent is anticipated. This call hapJl('1l wht'll
 4.9. FIII"//I/'I" lUIIt'.!"

illve,tor s ratiollall y IIS(~ firlll characte ristics to f'II'('clst the likeliho

od of the
evcllt oeCllnil lg. III these cases, a lillear rl'l"tion IwtW(,{,1I til('
linn charac-
teristics ;11)(1 the valuatio n e1kct of the ('vellt C;llI 1)(' hiddell.
M"latest a alld
Thulll PSOll (I ~JH:J) alld I.anell and Thomps oll (I !)HH) provide
example s of
this situation .
Technic ally, the relation betweel lthe linu ch;ll<lct nistics ami
the degree
of anticipa tion of the event introduc es a selectio n bias. The
assumpt ion
that the regressi on residual is IIIKorrc lated with th(' rcgresso
rs, E[X'71 J = 0,
breaks down and the OLS estimato rs arc inconsis tellt. COllsist
ent estimato rs
can be derived by explicitl y allowing f(Jr the sdel'lio n hi~ls.
Adlarya (IY!:!H,
10!J:1) and Eckbo, MaksinlO vic, and William s (I ~)!)()) provi(le
example s of
this. Prabhal a (19!)5) pruvides a good discussi on of this problell
l and the
possible wlutiol\ S. He argues that, despite misspec ilicatioll
, ulldn weak
conditio lls, the OLS approac h can be uscd for illfnelln~s and
the I-statistic s
can he illtcrpre ted as lower bounds Oil the Iruc signilic llln'
level of thc
estimatc s.

4.9 Further Issues

A IlIunllCr of further issues OftCII aris(, whell cOllduct illg an

('\'Cllt study. We
di~cuss sOllie of these in this section.

4.9./ Rolf o/lllr Slllllj}/ill f; Ill/i'/HI!

If the timing of an evellt is known precisely , thell tht' ability
to statistica lly
identify the effect of the event will be highn ((Jr a shOrln samplin
g interval.
The increase results frOIll reducin g the varianec of the aiJnonn
al relllrn
willH)lll changin g the mean. We cvaluate the enlpiric d importa
nce of this
issue by cUlllpar ing the analytic al formula for the power of
the test statistic
JI with a daily salllplin g interval to thc pO\\,l'I' with a w('ekly and a monthly
interval. We assUllle that a week cOllsists of liv(' days and a month
is 22 days.
The varianc( , of the almorm al return for an individu al evellt
observa tion is
assumed LO bc (4%)~ on a daily hasis and lillear ill tilll(,.
[II Figu,!: 4.1, we plot the power of the test 01
110 ('vellt-e llen agaillst
the alternat ivc of all abnorm al rcturn of I % fiJI' I to 200
securitie s. As
olle \\'ould expect givell the allalysis of S('( tioll 4.(;, the d('(Tcas
e in power
going frolll a daily interv~d to a mOllthly illterval is se\'('I('.
For example ,
with :JO sentritie s lhe (lower for a !i% test using d;lily data is
O.!J4, whereas
the power using weekly alld IIIonthly data is only O.:FJ ;llld 0.12,
respcetiv ely.
The clear llIessage is that there is a substant ial payolf ill terms
of increase d
power from reducill g the lellgth of til!' ('VI' II I willdow. 1'"lors(' (
I !JH1) prescnts
detailed analysis olthe choi(:l' of daily V('l'SUS IllOllthly data
alld draws the
same COII( lusioll.
 -I. 1:IJrI/I-Sll/fly Al/aly.I;.!

'~.

t --
c:.-
.- •••• " - O, ... ·W,·,·k III'm.,1
-
---
- - - - - -
--~
--- OJl('-MlIlllh Inh'l\,11

! ,
(I
:!II .(0 fill HO 1110 1:!O 1-10 1fill 1HO :!OO
S;lIIII'''" Sill'

Figllre 4.4. 1',,/1 1,"1 "/ 1-."1'1'II1-SllIIly 'li'll Slal;I/;I".h III Jlpjrd Ihp NIIII "Y{i(llhl'.lil Ihal Ihp
:lhllllnllal JlpllIlIl il I,·m . ./111" /Ji//i-mll Sfllll/J/iIlK IIIIPlVoll. II'lim Ihp S,/lIf11P /llIot lit IIII'
AI'rllIK" I inial/II' II/thl' ..\11/1111"11/111 HI'IIII"II .. lfllI.\I Finll.1 1.1 ,,'X. fill" Ihp /Jail\' 1IIII'nllli

A sampling illll'II';ti of OIl(' d;I\' is nol Ihl' shorll'sl ililer"al possible,

Wilh Ihl' inITl'aSl'd al'aibhilill' of 11;lnsa('lion dala, re('elll sllIdies hal'l' used
ohselvalion illll'll'als of dUlalion slioller Ihan Olll' day. The USl' of' inlra-
daily Iiaia in\'oll'l's SOIlll' ('oJllplicalions, however, or Ihe sor! dis(wsecl in
Chapin :\, and so lli{' 111'1 \ll'ndil of wry shon inlervals is IIndear. H"l'rlay
and [.ilt"II\wlgl'l' (Il)HH) discllss Ihl' IISl' of in Ira-daily dala inl'l'elll sllIdies .

./, f). 2 III/m'IIn'1 willi FIIf'III-f)(Ilf' lIlIl"rrlaillly

Thlls br Wl' kll'l' ;\SSII\\l('(llklllhl' ('\,(,111 d'lIl' call he idl'lIliliec! wilh n'naillil'.
Ilowever, ill sonll' sllllli,'s il Ill;\\, he difficult to idelllify Ihl' exan dale. 1\
l'OIllIllOIlI'X;lIl1pll' is when ('olkclinJ,!; "I'l'nl dates fromlinanrial puhlicaliolls
sHch as Ihl' Ilidl SIIi'I'I.!m//'IIal. When IIJ(' I'Vl'llt anllOlllll'l'lllent appears ill
Ihe III'WSpa!H'!' onl' ,all 1101 !)(' l'l'l'laill if the markl'l was inlilrllled Iwji)l'"
IIII' dose 01 III(' 1II;lIk"1 IIII' priol Irading day. If this is Ihl' ('ase Ihell Ihe
prior d;w is II\(' ('WIlt ,\;tv; if lilli, Ihl'lI Ihl' (,UITl'nl day is Ihl' eVl'nl day. The
uSllal nll'lhod of handling 111i\ 1'1'0111"11\ is 10 expa\\d Ih .. 1'\Tnl wi Ild 0\\" 10
111'0 days-dal' 0 and ,b)' + I. Whil .. Ihel'l' is a ('osl 10 ('xp;llldillJ,!; th .. ('\'('111
windo\\', IIll' Inll!" ill S'Tlion 'I.ti illdicall' Ihallhe pOlI'I'r propl'rties or 111'0-
day ('Will willdows ;11,' still gOlld, ~lIgg,'slillg Ihal il i~lI'orlll h('aring 1111' ('oSI
10 ;lvoiclllll' risk Ilr Illissillg Ihl' 1'1'1'111.
-I. '.J. Furtiu-r Issues

flail and Torous (1988) investigate this issue. They develop a maximum-
likelihood estimation procedure which accommodates event-date uncer-
tainty and examine resull5 of their explicit procedure versus the informal
procedure of expanding the event window. The resull5 indicate that the
informal procedure works well and there is little to gain from the more
elahorate estimation framework.

4.9.3 Possible Biases

Event studies arc subject to a number of possible biases. Nonsynchronous
trading can introduce a bias. The nontrading or nonsynchr~nous trading
effect arises when prices are taken to be recorded at time intervals of one
length when in fact they are recorded at time intervals of other possibly
irregular lengths. For example, the daily prices of securities usually em-
ployed in event studies are generally "closing" prices, prices at which the
last transaction in each of those securities occurred during the trading day,
These closing prices generally do not occur at the same time each day, but by
calling them "daily" prices, we have implicitly and incorrectly assumed that
they arc equally spaced at 24-hour intervals. As we showed in Section 3.1
of Chapter 3, this nontrading effect induces biases in the momenl5 and
co-momenl5'of returns.
The influence of the nontrading effect on the variances and covariances
of individual stocks and portfolios naturally feeds into a bias for the market-
model beta. Scholes and Williams (1977) present a consistent estimator of
beta in the presence of nontrading based on the assumption that the true
return process is uncorrelated through time. They also present some em-
pirical evidence showing the nontrading-adjusted beta estimates of thinly
traded securities to be approximately 10 to 20% larger than the unadjusted
estimates. However, for actively traded securities, the adjustmenl5 are gen-
crally small and unimportant. i
.Jain (1986) considers the influence of thin trading on the distribution
of the abnormal returns from the market model with the beta estimated
IIsing the Scholes-Williams approach. He compares the distribution of these
ahnormal returns to the distribution of the abnormal returns using the'usual
01.') betas and finds Ihat the differences are minimal. This suggesl5 that in
gcneral the adjustment for thin trading is not important.
The statistical analysis of Sections 4.3, 4.4, and 4.5 is based on the as-
sumption that returns are jointly normal and temporally liD. Departures
from this assumption can lead to biases. The normality assumption is im-
portant for the exact finite-sample resull5. Without assuming normal!\)', all
results would be asymptotic However, this is generally not a problem for
event studies since the test statistics converge to their asymptotic distribu-
tiolls rather quickly. Brown and Warner (1985) discuss this issue.
 4. Euenl-Sllu(V tll/f/ly.\is

There can also be all upward bias ill cumulative ahnormal returns wh('11
these are calculated in the llslIal way. The bias arisdi frolll the ohservalion-
by-obselVation rebalancing to equal wcighL~ implicit in the calculation or
the aggregate cumulative abnormal retum combined with the lise or trans-
action prices which can represent hoth the birl alld the ask side or the
market.. Blume and Stambaugh (1983) analyze this bias and show that it
can be important for studies using low-market-capitalization finns which
have, ill percentage terms, wide bid-ask spre;lds. III these cases the bias Gill
be cjminated by considering cUllIulative ahnormal returns that represent
bUY-ind-hold strategies.
I
1
I
4.10 Conclusion

In c1jsin g, we briefly discuss examples of evelll-study successes and limita-

tions. Perhaps the most successful applications have been in the are,1 of
corp rate finance. Event studies dominate the empirical research ill this
area. lmportant examples include the wealth effects of mergers and acqui-
sition! and the price elTects of financing decisions by firms. Studies of these
evellllltYPiCall Y [ocus on the ahllonnal return around the date of the lirst
anllOl ncelllent.
II the 1960s there was a paucity of e!npirical evidence 011 the wealth
elTecL<;! of mergers and acquisitions. For example, Manne (196:,) discllsses
the vaJious arguments for and againstlllergers. Al that time lhe d(,hate ("('11-
tered ~n the eXlenllO which mergers should be regulated in order to foster
comP9lilion in the product markets. Manne argiles that mergers represent
a natural oUlcome in an efficiently operating market for corporale control
and consequently provide protection for shareholders. He downphlys the
importance of the argumenl thal mergers reduce compelition. At the con-
clusion of his article Manne suggests that the two competing hypotheses
for mergers cOllld be separated by studying the price eflects of the involved
corporalions. He hypothesizes thal if mergers created markel power one
would obselVe price increases for both the target and acqnirer. In contrast
if the merger represented the acquiring corporation paying for control of
the target, one would obsen'e a price increase for the target only and 1I0t
for the acquirer. However, at thal time Manlle cOllcludes ill refen'I\C<~ to
the price effects of lIlergers that " ... no data are presently availahle on this
subjecl."
Since thaI time an enormous hodyofempirical evidence on mergers and
acquisitions has developed which is dominated hy the usc of evelll studi(·s.
The gellera! result is that, given a successful takeover. the abn,onnal retllrns
ufthe targets are large and positive aud thc ahnormal returns of the aClJllircr
ue close to zero. Jarrell and Poulsen (19H~) lind that the average ahnorlll;ll
 4.10. COllrill.li oll
179

retul'll li>r larf\el shareho lders excenls ~()(X, li>r a s'"l1pk of titi3
successf ul
takeover s frolll I~Hi() 10 19H5. III cOlllras llhc "lmOl"III,1I relum
(ill' acquirer s
is close to zero OIl 1.14%, and evell nef\,lliv(' al -1.10% in Ihe
19HO·s.
Eckbo (I ~IH:1) explicitl y addresse s Ihe role of increase d markel
power
ill explaini ng nlergcr- related ahnorm al r('lurIlS. I Ie separate
s nH~lw~rs of
competi nf\ lirms rrolll other merf\ers and linds no evid"n'T that
thc wealth
circus for cOlllpeti nf\ lirms arc differen t. Furtllt'r. he linds no cvidenc
c that
l'iV,lls of' linns IIIt~rf\in!{ horizont ally "xperit'I HT lIegativc abnorlll
al I ctllms.
FrOIll this hc concllld cs that redllced cOlllpct itioll ill the prodllrt
markct
is not an importa nt explana tion ror III'T!{Cr gains. Thi.~ leaves
(t)lnpcti tion
for corpora lc control a more likely cxplana tion. Much addition
al empiric al
work in thc arca or mergers anti acqllisit ions has Iwen conduct
cd . .Jensen
alld Ruback (I !lH3) and.larr ell, Brickley. alld Netter (I ~IHH) provide
detailed
survcys or this work.
A number of robust results havc bcclI dcvelop cd from cvent
studies
or financil lg dccisioll s by corpora tiolls. Whcn a corpora tion
announ ces
tI.'lt it will raise capital in external lIIarkcts there is on average
a negative
abnorm al retul'll. The magnitu de of the abnorm al rcturn depends
on the
sourcc or cxtcrnal financin g. Asquith and Mullins (l~lH()) study
a sample of
2GG firms ,1I11l011llCillg an equity issue in the pniod I~)W to 19HI and
filld
that tile two-day average ahnorm al rt'l1ll'1I is -~.7%, wllil,' on
a sam pIc of
80 finns for the period 197~ to 19H~ Mikkels on and Pal tch (I!lHfj)
find that
the two-day avcra!{c ahnorm al relurn is -:{,;>!i'X,. In contrast
. when lirms
decide to usc straight dcbt linancin! {. Ihe averag'~ ahllorlll al rcturn
is doser
to I.ero. Mikkels oll alld Partch (1!IH(i) lilld tht'
;IWLlg" ;\I>11orlllal return
for debt issues to be -O.~3% for a sample of 171 issues. Finding
s such OIS
tllesc provide thc fud for the dcvelop ment of new theories . For
example .
these external financin g results Illotivatc thc pecking order theory
of capital
Siructur e develop ed by Myers and Majluf (1~IH'I).
A major success related to thosc in the corpora le fillancc area
is the
implicil accepta nce of event-st udy methodo logy hy Ihe lJ .S. Suprem
e Court
for dctCl'm ining material ity in imider trading cases and li>r
determi ning
appropr iate disgorge lllent amollnt s in cases of fralld. This implicit
aCtTp-
tance in lhc I ~IHH Basic, Incorpo rated v. J .cvinsoll case alld its
importa nce
for sccuritic s law is discusse d in Mitchell and Neller (1~194).
TIH'rc havc also been less slltTt'ssful applicat iolls of cvent-st udy
IIlcthod -
oIOh'Y' An importa nt characte ristic of a slIcccssful e\'t'nt stud),
is the ability
to idellliry precisely Ihc date of the cvelli. In cascs \\'hne the date
is difficult
to idelllify or the evcnt is partially antirip'i lcd. eVCIII studics have
been less
useful. For cxample . thc wealth dferls of n'!{uIator), changes j(>r
alkned en-
tilics can hc diHicult to dClect usillg t'\'t'nt-st udy IIlelhodolol-.'Y- The
problem
is that regulato ry challgc.~ arc often dcbated in Iht' polilic" ,IITlla
ovt'J' time
alld any aC(,(>lllpanying wealth cf(('((S will he ineol porated graduall
y inlO
 Ihe vahlt, of a IOIPOl;lIioll as Ih(' probahilily of Ihe change heillg adopled
illcreascs.
\);11111 alld .lallH's (1~IH:!) discllss Ihis isslle ill Iheir sludy of Ihc illlpaci
of t\cposil illll'n'sl ralc t"\'ilillgs Oil Ihrili illSlilllliolls. They look OIl challges
ill ralc ('(·jlillgs, hili dccidc 1101 10 cOllsider a changc ill I!173 hecallsc il was
lhlt' 10 Icgislalivc aClioli aud 11('11('(' was likely 10 have Iwcll anlicipalcd hy Ihe
market. Schipper alld TIIOIllPSOII ( I !IH:{, I !IH5) also ('nCO\llller Ihis prohll'lIl
ill a sllidy or lIIergl'l'-I"I'lall'lI rcgulaliolls. They allclIlJlI 10 cirnllllvc:nl Ihe
problelll of allticipated reglllatory changes by idenlifying dalf's when the
I'rohahilil)' of a IcgUiatol'l' challgc illcrcascs or decreases. Ii owevc 1', lhcy
find largely illsigllilicalll n·slllts.lcaving 0JlCJI Ihe possihilily Ihallhc absellce
of dislinn evelll datt's accounls {ill' I h(' \;tck or wealth effeclS.
Much has I)('clilcal'll('d frolll Ih(' hody ofrf'sf'an:h thaI uses ('V('llt-sludy
lJlt'llloC\ology. Mosl gCJlnally. ('venl sllldi('s have showll Ihat. as we would
(')(.)1('('( ill a r;lliOlI'.llllIarkt·lp!a('(·. prin's do r('sJlond 10 new inrOI'III;lIioll. We

('''1)('('\ Ihal CV('llI~llIdi('s will (,Olililllll' 10 Ill' a vaillable allel widely IIsed 1001
ill I'UllIOlllics alld lillaIH ....

4,1 Show Ihal whellllsillg till' 1\I;1I·1;.('IIIIOd('IIO nu'aSlllT allllol"lllal retlll"\lS,

Ihe salllple ahllol'lllal rellll"JlS frolll eqllalioJl (4.4.7) an' aSYlllplolically illc\e-
pt'llIl('1I1 as Ihe knglh 01 lIlt' ('slilllalioll ",inllow (1. 1) ill('J'('as('s 10 inlinily.

4,2 YOII are giv(,11 Ihe li,lIowillg illlimnalioll for an eW1I1. AhllorJllal I'l'-
IIlI'llS an' salllpkd al all illl("l"val of 0111' day. Th(' (,vcnl-window Ienglh is
Ihn'(' days, Th(' IIll'all ahnol'ln,tI relllrn owr Ihe f'V{'nl window is (I.;\'}{, pn
da)'. '1'011 ha\'(' a salll)llc oi" :,0 ('VI' II I ohservations. Tht' ahnorJllal r('lllrns an'
int!('p(,lld('11l across thl' ('\'('nl observalions as well as across ('Vl'llI days for a
giv(,1l CVI'III ohs('I"valion. For :?:, o/Ihe ('\'('nl ohservalions IIII' daily slandalCl
d('vialion of Ihl' alllHlllllal 1'('1111'11 is :~'y,) and lilr llle rl'mainillg 2:, OhSI'IT;I-
\ liolls Iht' flail), siandard dl'vi;lIioll is li%. Civclllhis infilrmatioll, whal would
I
1)(' 111(' pow('\" of Ihe leSI for ;111 ('v('nl sllldy IIsing Ille clIlIllllaliVl' ahllormal
\ rl'tllrn test statistic ill (''1l1alioll (·1.·1.2~)? What would hI' Ihl' pOWl'l' IIsillg lhl'
stalldanii/('d C1mlllialiv(' ahllol'lllal n'llIrII lest slalislic in eqllation (4.4. ~·I))
For Ihl' pow('r (,;licubliollS, aSSIlIl\(' lilt' st;IIHbrd dl'viation Ilf II,ll' abnol'lllal
\ rt'llIrllS is knolVlI.

4.3 Whal wOllldl)!' Ih(' answl'I's III qlll'Slioll '1.2 il'lhe IIll'an ahnllrmal r('llIrn
is O.li'Y., pl'r dav f(,r Ihe ~:, linll.s willi Ihe larger siandard dcvi;llion?
 The Capital Asset Pricing M0ge1

ONE OF TilE IMPORTANT PROBLEMS of modern financial economics is Ihe

CluantifIcation of the tradeoff between risk and expected return. A1tho~gh
common sense suggests that risky investments such as the stock market will
generally yield higher returns than investments free of risk, it was only 'tith
the development of the C~pital Asset Pricing Model (CAPM) that economists
were able to Cluantify risk and the reward for hearing it. The CAPM implies
lhatlhe expected return of an asset Illust be linearly related to the covariance
of ils return with the return of the market portfolio. In this chapter we
discuss the econometric analysis of this model.
The chapter is organized as follows. In Section 5.1 we briefly review
the CArM. Section 5.2 presents some results from efficient-set mathemat-
ics, including those that are important for understanding the intuition of
econometric tests of the CAPM. The methodology for estimation and testing
is presenled in Section 5.3. Some tests are based on large-sample statistical
theory making the size of the test an issue, as we discuss in Section 5.4. Sec-
tion 5.5 considers the power of the tests, and Section 5.6 considers testing
with weaker distributional assumptions. Implementation issues are covered
in Section 5.7, and Section 5.8 considers alternative approaches to testing
hased on cross:sectional regressions.

5.1 Review of the CAPM

Markowitz (1959) laid the groundwork for the CAPM. In this seminal re-
search, he cast the investor's portfolio selection problem in terms of ex-
peeled return and variance of return. He argued that investors would opti-
mally hold a mean-variance efficient portfolio, that is, a portfolio with the
highest expected return for a given level of variance. Sharpe (1964) and
l.intner (I !l65b) built on Markowitz's work to develop economy-wide im-
plicatiolls. They showed that if investors have homogeneous expectations

IRI
182 5. The Capital And 1'lirillK M{)(M

a~d optimally hold mean-variance ellicient portfolios then, in the ahsclKl'

o market frictions, the portfolio of all invested wealth, or the market port-
~ lio, will itself be a mean-variance ef/lcient portfolio. The IIsllal CAI'M
e~uation is a direct implication of the mean-variance efficiency or the mar-
k~t portfolio.
. The Sharpe and l.intner derivations of the CAl'M aSSllllle the eXisH~IIlT
o~ lending and borrowing at a riskfree rate of interest. for this version or
tlie CAPM we have for the expected return of asset i, •

I E[R;] =: Ilj + fiilll(E[R",] -- IV) (:;.1.1)

~
Covlll" Nm ]
{Jim =: , (:).I.~)
Var[Ntn ]
wi erC Il m is thc relltrn on the market portfolio, and Ilj is the return 011 the
ris free asset. The Sharpe-Lintner version can be most compactly expressed
in ~erms of returns in excess of this riskfree rate or ill terllls of ,xrru n·lum.l.
Le\ lj represent the reUlrn 011 the ilh asset in excess of the riskfree r,lle,
Z; := H. - Hj . Then for the Sharpe-Lintner CAPM we have

E[l,] iJimml",] ([d.:1)

Covl1.j , 1.111 J
Plln Var(l,n)
(:>.1.4 )

where l,. is the excess return 011 the market portfolio of assets. Because the
riskfree rate is treated as being nonstochastic, equations (5.1.2) alld (!d.4)
are equivalent. In empirical implementations, proxies for the riskfree rate
arc stochastic and thus the betas can differ. Most empirical work rebting to
the Sharpe-Lintner version employs excess returns and thus uses (5.1.4).
Empirical tests of the Sharpe-Lintner CAPM have focused on three im-
plications of (5.1.3); (1) The intercept is zero; (2) Beta completely captures
the cross-sectional variation of expected excess returns; and (3) The market
risk premium, E[z..J is positive. In much of this chapter we will foclls on
the first implication; the last two implications will be considered later, in
Section S.B.
In the absence of a riskfree asset, mack (I ~172) derived a more general
version of the CArM. In this version, known as the Black version, tht' ex-
pected return of asset i in excess of the l.era-het'l return is linearly related
to ito; beta. Specifically, for the expected return of asset i, E[ R,l. wt' havc

E[N,) =: Elll"",] + fl,,,,(Elll,,,1 - E[ll. .. ).

ll,. is the return on the market portfolio, and It .. is the return on thl' um·
brla portfolio associated with III. This portfolio is defined to he the portfolio
that has the minimullI variance of all portfolios nncorrelated with 1/1. (Ally
5.1. 1I1'l/jl'w oflhl' CAI'M 18;\

other 11l1('olTdatcd ponfolio wOllld have till: same expcctl'd retlll'll, hilt a
highl'l'variancl'.) Sincc it is wealth in n~.d tnms th"t is relevant, lill' the
Black Illodcl, retllrns arc gener.lily stated on ,III inll.lliOll-"djusted hasis and
fI"" is ddilll'(t in tt'nns of real retllrllS,
Cov I N,. N", I
fi,m = -----.-.
V.u"[l{", I

Econoilletric analysis of the Black version or the CAI'M treats the I.('IO-h('ta
ponfolio rellll'll as an u1Iobserved qu.,ntit)', making the 'lll'll),sis more con.-
plicatcd than that of the Sharpe-Lilll1l('" vl'l'sioll. The Black vlTsion Gill he
tested as a restrictioll on the re;!I-retul'll market III(HIl'I. For the real-retltrn
m'lrkct model we have

E[N;] = u""+/i""E[N,,,I,

"Ild tht' ill'lllicati()11 or the Black vt'l'sioll is

ex"" = E[N"",] (I - fI",,) Vi. Ud.Hl

III \I'ol'ds, the Black model restricts thl' ;I~set-spt'cilit illtlTt't'j>l of the real-
retul'll market modcl to be equal to the ('xlH't'tt'd l('lo-Ill'ta portli,lio retul'll
tilll('s olle minlls the asset's beta.
The CAI'M is a single-period Iliodd; hence (:',.1.:\) and (:,.1.:1) do lIot
h'll'c .1 tilllc di mellsion. For ecollometric analysis of till' Illot kl, it is nefessary
to add an asslllnption concernin!{ the time-series heh<lvior of returns and t's-
tim,lte the model over time. We assume that retllrllS arl' independe1ltly ;md
idcntically distributed (110) throltf.(h tinle and jointly lI11dtivariate 1Iormal.
This assllmption applies to excess retllrns for the Sharpe-Lintller version
and to real retllf'llS for the lllack version. While the "SSlllllption is strong,
it has the bendit of being theoretically consistent with the CAl'M holding
period by period; it is also a good empirical approximation for a Illolllhly
ohservation interval. We will discllss rclaxinf.( this assllmption in Section !'l.G.
The C..AI'M can be useflll for applications requirinf.( a measure of ex-
p('cted ,tock returns. Somc applit"atiolls illdude cost of capital estimatiOll,
portfolio performance cvaluation, and event-study 'lIIalysis. A~ all eX<llllpll',
we hriclly discuss its lise jill' estilllatill!{ the cost of npital. The cost of equity
G1pilal is required for use in corporate capital hlldgetillf.( decisions and in
tile dl't('l'lIlill<ltion of a fair rate of rctllJ'll for 1'('f.(ul;lIl'llutilities. IlIIpl('lIIcu-
t;lIion of the lIlodd rcqllires three inpltts: tite stock\ heLl, thl' market risk
premiulll, and the riskfrl'e return. The uSII;1I estilllator oflll'ta of the equit),
is the OI.S eMimalO1' of the slope codlicit'llt ill tite ('X('('SS-rt'llIf'11 market
model, that is, the heta ill thl' n'f.(rt'ssioll ('qllatioll

(.rI.I.!)
\\'11('1"(' i d"lIoles llie ;!sSC'1 and I d,'lIo«'S Ihe lilllC period, I = I, ... , 'f. /."
alld /."" are II,,' rl';,li/l'd ex\'css n'IIII'IlS ill lilll!' period I for asst'l i alld lile
lIlarkel portt(,li", /l·'I)('clil'dy. 'I)'pically Ihe Sialldard alld Poor's !iOO Illd,'x
s('rves as a prox\' 1(.1 11f(' Illalkel portlellio, alld tlie US Tr('asury hill r;lIe
proxi,'s li.1' III(' riskIn'" n'llIl"/I. 'I'll,' eqllalioll is lIlosl cOlllIIIOllly ,'stilllOltl'd
IIsillg :. ye;lrs "rlllotllltl" dala (.,. ::::: (iD). (;iwll all eSlilllale of Ihe beta, the
cost of capital is caielllalt'd IIsillg a liistoric;.1 average lell' til(' excess I'l'l Ill'll
011 the S&'-P :.00 0\,('1' 'licaslll"Y hills. This sort ofapplicatioll is olllyjllstilied

if Ihe (:AI'1\1 II/m'id,'s a good desniplioll of tlic dala.

5.2 Results from Efficient-Set Mathematics

III this secliotl lI'e 1('I'ie\\' Ihe IlIath('fllatics of lIleall-variallcc cfficielll s('h,
The illln,'sll'd Il'adn is I'l'fiolTcd 10 MlTlolI (I \J7~) alld Roll (l \In) lill'
d('tailed 111';11 II 1('11 Is. :\11 IIt1dclslalldillg of this topic is IIselitl for illierplet-
illg IlIlIrl! of th,' 1'lllpiric;t\ITsl';lrch rdatillg 10 the CAI'M, hecallse Ihe key
tcslahle ill'l,lical iOIl of lite (:1\ I'M is 11t;,t Ihl' markel porlldio of risky assels
is a lIH'all-l'ari;IIII'1' <'IIi, i"111 portfolio. Effici"IlI-set malhemalicsalsoplal.s a
mit- ill lltl' ,tl\;tlysis "f Illltllibclor pridllg mOllels ill CIt;lpln 'i.
\\'e slarl wilh SOIllI' 1I0laiioli. 1.1'1 there he N risky assels wilh JIlean
VCI'lol' It ;\1111 cO\';lIiallll' IIlalrix 0. t\ ss III Ill' lhat II\(' l'xlll'ned n'III\"I\S of al
It'asl 1\\'0 assl'lS dilkl ;l1l1llhal Ihe covariance malrix is of filII rallk. Define
w" as the (Nx I) \'ector ofporti()lio weights for an arbitrary portfolio II \I'ith
weip;hls sllInlllinp; to \1\1 it)'. Portlellio a has llH'an return /1" =
w,,'J.', and
I'ariance (1,; = w"'Ow,,. The covariance hctwcen any two portfolios II 'Illti
b is w,,'f!w/,. (:i\'{'11 till' poplIl;ltioll of assets wc IICXI ('ollsitin minimulll-
variance I'0rtli.lios ill Ihl' ah"'IHT of a riskfn'e asset.

Defillitioll. ['fIIl/i,lill /, i.1 till' illilli))/u))/-T'llfitlllff /)()rljc,/io of a/l/)()rlf()/ios wilh '11,'11t!

/1'11/1'11 /11' il ill /J(I"I/iJ/ill 1I 11'ij;ltl Tl('f/or i.1 Ihl' .m/ll/ioll 10 Iltl' f()lIl1lllillj; {Ol/.I/milll'li
Il/i/illliwlilll/:
lIlillw'nw
..., (!•. ~.I )

.whil'l"ll()

w',. 1.

·Ii. sol\'(' thi~ 1'1"11111,'111, WI' ".nullll' I.agl'all(!;iall functioll I., dil"!i-relliiale with
rl'spl'ct 10 w, Sl'1 IIIl' r(,~\Ilti/l).( Cq\l;It'IO/lS 10 zero, a/lCilhl'1I solve for w. For
Ihe I.ap;rall),(iall fllllClioll \\,t· h;\I't'
5.2. Ur.lIIlI.I /IT!1It i-Jfirifllt-.'ifl MalitfllUllirs 185

whnt' L is a conforming vector of ones and 0I and lit are l.agrange m\lltipli-
ers. Differentiating L with respeC! to wand selling the result equal 10 zero,
we have
2nw - Oill. - 02L = O. (5.2.5)

COlllbining (:).2.5) with (:).2.2) ane! (5.23) we find the solution

(5.2.6)

whnt' g and hare (N xl) vectors.

g = (5.2.7)
,
\
. h = (~.2.R)
!
anel.A == L'n-IJ-L, n == /l.'n-I/l., C == L'n-1L, anel D::::: Be - A2,
Next we summari7.e a. number of resU!IS from efficient-sel malhen1atics
for minimum-variance portfolios. These results follow from the form of the
sohllion for thc ~ininHim-variance portfolio weights in (5.2.6). .
i
Result 1: The minimum-variance frontier can be gcnerated from any two
C\islinct minimum-variance porlfolios.
Result I': Any portfolio of minimum-variance portfolios is also a minimum-
variance portfolio.
Result 2: Let p and r be any two minimum-variance portfolios. The covari-
ance of the return of p with the return of r is '

Cov[H,,, H,] = D A') (/J.r - CA) + C'1

C ( /J.p - C (5.2.9)

Result 3: Define portfolio g as the global minimum-variance portfolio. For

portfolio g, we have

wi: -In-I L (5.2.10)

C
A
f..l x (5.2.11 )
C
1
Ox
2
-C (5.2.) 2)

Result 4: For e,tch minill1l1l1l-vari,\llce portfolio /1, except the global mini-
lilt I Ill-variance portfolio g. lhere exists a unique minimum-variance porl-
lil!io that has zero covariance with /1. This portfolio is called the zero-
1I("la portfolio wilh respe<.:t 10/1.
 B6 5. The Capital A~set l'rid111i Modrl

t
esult 4': The covariance of the return of the global miniIlIlIlJl-Variallc('
portfolio g with any asset or portfolio of asseL~ a is

I
Cov[llg'I1,,} = C.
Figure 5.1 illustrates the set of minimum-variance portfolios ill the
a sence of a riskfree asset in mean-standard deviation space. Minimum-
v riance portfolios with an expected return greater than or eqll<ll to the
c~pected return of the globalminillllll1l-variance portfolio arc efficient pOIl-
fulios. These portfolios have the highest expected return of all portfolios
wilh an equal or lower variance of relUrn. In Figure 5.1 the lIIinimulIJ-
variance portfolio is Ii. Portfolio /) is all efficient portfolio. Portfolio 0/) is
the zero-beta portfolio with respect to p. It can be showlI that it plots ill
the location shown in Figure 5.1, that is, the expected return 011 the zero-
beta portfolio is the expected return 011 portfolio I). less the slo[>(' of Ihl'
millimulll-variance frontier 011/) limes Ihe standard deviation of ponli)lio I).
Result 5: Consider a multiple regression of the return 011 any asset or [Joll-
folio ll" on the return of any minimum-variance portfolio l?p (exrept for
the globaiminilllllm-varianfe portfolio) alld the return or its associat{'([
zero-beta ponlolio R'1"

(!i.2.14)

For the regression coefliciellt.~ we have

Cov[ Un. RI,I

Ih 2 {Ja/,
Op

COV! Un' I~,)

{JI I - {J"p (:).2.17)
2
Oof·

fin == 0 (!>.2.1H)

where l1al' is the beta of assel (j with respect to portfolio I).

Result 5': For the expecled return of a we have

, Ii" = (I - fia/,)Il,,/, + /3,,/,/J./,. (!).2.1!1)

'1wc J1~xt
introduce a riskf"ree asset into the analysis alld consider portfi>-
lios Fomposed of a combinatioll of the N risky assets and the riskfree assel.
Witl, a riskfrce asset the ponlolio weights of the dsky assets are not COII-
slraj~led 10 slim to I, since (I - 'w' L) Gill be invested in the riskfree asst't.
I
5.2. UI'S II lis from FJjirielll-Sfl Malhl'/lwlirJ 187

I'

I'

" _. - - -' - - _ •• - - - - - -'" If}

(J

Figure 5.1. MilliJlllllll·\'rllilll/(f'I'orl/oliol lVii/will fli.lk/i,·e A.ufl

Given ;\ riskfree asset with return UJ tilt" minillllllll-\'ariance portfc"fio with

expected return ill' will be the solution to the constrained optimization
mill w'Dw
w

sul~iect to
(5.2.21)
As in the prior problem, we form the Lagrangian fUllctioil I., differentiate
it with respect to w, set the resultillg equations to zero, alld thcll solvc for
w. For the Lagrallgian function we have
<-
I. == w'Dw + 8 (PI' - W'IL - (I - w'L)IIJ ). (5.2.22)
Differentiatillg I. with respect to wand settillg the resllit equal to I.em, we
have
2 nw - 8(IL - II,L) = O. (5.2.23)
Combinillg (5.2.23) wilh (5.2.21) we have
(J.l.p - 'V)
----'--;-"---- n -I (IL ... 11/,.).
{JL - IVL),n-1 (IL - Il/ i)
NOh' that WI' elll I'xprl'ss Wt, as ;) scalar whirh depends on Ihe lllt'all of /1
lillH'S a portfolio w('ighl v('nor which does nol depend on Ii,

where
(:I,2,~t;)

alld

Thlls wilh;) riskfnT aSse'1 alllllilliIlHIIIl-I'ariall('e ponli,lios an' a COlllhillalioll

ofa J..:il'l'll risk" assel pOll ",Iio wil h weighls propOrlionallo W ;lIlcllhe riskrr('c
assel. This pOI'lf()lio of risky assels is callecllhc tanJ..:t'llCY pOI'lI()lio anel has
wl'iJ..:hl 1'1'('(01'
I
w'l = I rrl(/t - HIt},
d! (/1 - Uti)

WI' IIS(' Ihe sllhsnil'l 1[10 id('lllil~' till' lallJ..:I')I('Y portfolio, Eqllalioll (!" .. ~,2K)
divides Ihe d('llH'IlIS or W hI' tllI'ir slim 10 gel a veclor whose elelllellls SIIIll
III 0))(', Ih;11 is, a pO 1'1 fill ill wl'iglll I'(,(,(OJ'. FiJ..:llre :),2 illllstrales 1111' sel of
lIlillillllllll-variann' pOllllllim ill IIII' presellce or ;1 riskl'n'(' assel. Wilh;\
riskrn'(' assel all dlil'i('111 pOrlfi,lios lit' alollJ..: tlw lille frolll Ihe riskfre!' assel
thrtlllJ..:h portti,lio I"
The I'XIIl'C\('d l'Xcess )'('1111'11 pn IIllil risk is IIsl'lirllO prol'id(' a hasi~ ror
ecollomic inlerprelalioll of lesls or 11ll' CAPM. The Shmj'P m/in ml'aSI')'('S
Ihis qllalllilY. For ally assel or pOrlli,lio II, Ihe Sharpe ralio is IIdilled as Ihe
1111'0111 exn'ss 1'1'1111'11 dil'ided hy til!' slalldard (\t:viatioll of relllrn,

I'" - lit
\ : :;:
'~j (:I,2,2~l)

III Figure :I,:! Ihe Sh;ll"!lC r;\lio is Ihl'slopl' orlh(' lillt: frollllh(' riskfrt,(, rl'lurll
(Ill' 0) 10 IIII' portfolio !II,,. n,,), Tlw lallgelJcy portfolio q can he character-
ized as Ihl' portfolio lI'ilh Ihe Illaxi 11111 III Sharp!' ralio orallportfolios or risk\,
assels, '11'sl illg Ihe Illt'arr-I';lrialll'c cfficicllcy of a J..:ivl'I1 pori folio is eqlliva\err I
10 ICSlillJ..: II'lwlI\('r Ih(' Sharpl' ralio of Ihal portfolio is IIH' IIIaxinllllll of Iltc
sci of Sharpl' ralios of all possihk pOll fol ios,

5.:) Statistical Framework for Estimation and Testing

Illilially 1\'1' IISC till' ;1\SIII"l'lillll Ilral ill\'cslllrs call horrow alit! !clld al a
riskfn'c rail' or 11'111111, alld \\'c l'ollSit\n lire Sharpc-Lillillcr v('lsioll of'llrl'
CAI'M, 'I'lli'll, 1\'(' c1illlill;IIC Ilris a~Slllllpli()" ;1Ilc\ analyzt' 11r!' Black versioll,
. 5.3. St(lti~tim{ Fmmt!luorhfor Estimation and Jesting 189

"
"
-' "

"

"
.
" ,,'"
,

R /",
I
o

Figure 5.2. Minimum·Variance Portfolios With RUkjne Ami

5.3.1 Slw1'/Je-Lintner Version

Define Z, as an (Nx 1) vector of excess returns for N assets (or portfolios
of assets). For these N assets, the excess returns can be described using the
excess·return market model:

z, = 0: + (3 lm, + f/ (5.3.1)

E[ftl = 0 (5.3.2)
E[f/f/l =:E (5.3.3)
E[l.. ,] = Jl .. , E[(l,., - Jlm)2] = ..
0'2 (5.3.4)
Cov[l.. " f,l = O. (5.3.5)
{3 is the (Nx 1) vector of betas, lin' is the time period t market portfolip
excess return, and 0: and "', are (N x I) vectors of asset return intercepts and
disturbances, respectively. As will be the case throughout this chapter wb
have suppressed the dependence of 0:, (3, ancl "" on the market portfolio or
its proxy. For cOllvenience, with the Sharpe·Lintner version. we redefine I!
10 refer to the expected excess return. .
 90
5. The Capital Asset Priring Melilri

The imp licat ion of the Sha rpe- I.int

ner vers ion of the CAI'M fi)r (:J.:t
i~that all of the elem ellts of the vect I)
from com pari ng the unco ll<li tiona
Ct
or are zero . This imp lkat ion
/iJllows
l expe ctati on of (!i.3.1) to (5.1
form s the prin cipa l hypo thes is for .3) and
tesL~ of the mod e!. If all
arc zero then In is the tang ency clem ents o/" ( l
pOI-tfolio.
We usc the maxilJlulll like liho
od appr oach to deve lop estilll.lto
the unco nstr aine d mod el. Ord inar rs of
y leas t squa res (OL S) regr essiu lls
by asse t lead to the sam e estim asset
ator s for Ct and f3. To star! , we
the prob abil ity dens ity func tion <:<JIIsider
(pdf ) of exce ss retu rns cond ition
exce ss retu rn of the mar ket. Give al 011 the
n the assu med join t norm ality uf
retu rns'f or the pdf ofZ/> we have exce ss

and sillc e exce ss retu rns are temp

oral ly liD, give n T obse rvat ions
prob abili ty dens ity func tioll is , the join t

J(ZI , Z2, ... , Z-r I 7.",1, Z",2 •... , Z",T)

-r
== n
,=1
tJ(Z, I 7.,.,)

T
== n(27T)-~I~I-~
1=1

~
Given (!i.3.M) alld the exce ss-re
turn ohsel-vations, the para lllet
th' exce ss-re turn mar ket mod el ers o/"
call be estil llate d usin g maximum
Th's appr oach is desi rabl e beca li/{r/ilwori.
use, given cerla ill regu larit y cond
1II1xirlllllJllikclihood cstil llato rs ition s,
are cons istel ll, asym ptot icall y c/lic
asym ptoti cally norm al. To defi ielll . alld
ne the lIIaxilJlulIl like liho od estim
form the log-likelihood JUllctioll, that ator , we
is, the loga rithm of the join t prob
del1sity func tion viewed as a func ;lhil ity
tioll of the unkn owll par; ullet ers,
~'IDenotillg £. as the log- likel n, /3, ;Ind
ihoo d fUllction we h;i'vc,;:
I NT
r(Ct.f3. E) == -T log(27T) - -;zT logl EI
I I T .
- ~ L(Z, - (} - (:J7.,,")'E- I(Z, - Q - f3%ml)' (!i.:t !l)
~I
.
5.3. Slllli.lliml Fm7llflllorkjor l~lilllllli(}11 a/l(l 'jfJlil'K HII

The maxilllulll likelihoud estimators are the values of the parameters which
maximize L To find lhese estimators. wc differcntiate L with respeClto 0:.
(3. alld :E. and set the resulting equatiolls to I.ero. The pallial derivalives
arc

ilL.
iJo:
1;-1 [ t(Z, -
,=1
0: -/;z",,)] U·,.:t 10)

ilL
iJ{3
:E- 1 [ ta, -
'=1
0: - r:11.",,)Zm,] ([/.3.11 )

ilL
iJ:E

(5.3.12)

Selling (5.:t 10). (5.3.11). alld (!i.:t 12) to l.crO, we (',Ill solve fur the maxi-
IIIUIll likelihood estimators. These arc

ii. - ihi. m (5.:~.13)

'L;=I(Z, - M)(Z"" - {i m )
,,1' (.
L...,,=I Z",I -
A) .•
Jim ....

(5.3.15)

where
T

JL =
A
TI "L..,Z, alld /Ill/
,=1

As already Iloted. the~e are just the /()\'JIlUlas fill' OLS estimaturs of the
parameters.
The distrihutiuns of the maxillllllnlikdihood estimators conditional on
the excess return of the market. 1.",1, I",~, ... , Im/.lilllow from the assumed
joint normality or excess n:ltIrns and the II D assumptiun. The variances and
covariances uf the estimaturs can he derived using the illverse of the Fishrr
infonnatioTl lIlatrix. As discussed in the Appendix, the Fisher information
matrix is minus the expectation of the secolld old('l' derivative of the 101{-
likelihood fUllction with respect to the wetOI or the paramcters.
 .1. II/t' (,1/1'1/1/11\.1.\1'1 I'Hfll//!. /1//1111'/

Tht' (,(lIl1liliollal dislribuliolls arc

.tV (0'r~ [I + Ii;',]

G,;,
I:) (:l.:t Hi)

(:d.IH)

where /i", is as pn'vious\1' .!dill(·d all.!

r
- '.
11.;. = TI 'L.."(Z",,
" .
-
_ ,.
/1",)-.
,~I

The nOlalion W.v( r-

~. ~) illdicalt's Ihal Ihe (N x N) malrix TY;, has a
,,,'ishan dislrihlllioll wilh (T - ::!) degrees of freed 0 III and covariance ma-
Irix I:. This disirilllllion is a 1I11tllivarialt' generalizalion of Ihe chi-square
dislrihillioll. Andl'l'soll (1~IH·l) allel Muirheael (\9R::\) provide discussions of
its propeni('s.
'I'll(' ctl\'ari;lIICl' tI( c"\ alld ii is

_~ [ii.III]~.
'f a~
II
E is inekpt'lldelli .,rholh c"\ alld j-J.
Using Ih(' lIJ\colIslraillt'd cSlimalors, we call form a Wald It'SI slatisti': of
Iht' nllll h),polhcsis,
II,,: n = 0
against the ;Iltnllat in' hypot hesis,

The Walcll('sl slalislic is

'J' [I -I- - /i;,,]-I (\-'",,-I n,

n:!II. L,.,

WIl('ITW(' kl\'('slIhslillllnl (rolll (r.. :I.I(i) forVar!c\!. Ulltler Ihe lIuli hypolh-
esis./" will have ;1 chi-s'l";"(' dislrihlliion wilh N degrecs of frcedolll. Sillce
~ is ullknowlI, 10 lise ), «II" leslill),.; II". W(' SUhslilule a ("oll\islelll eSlilllalor
Ill!" ~ ill (:l,:\.~~) alld tllI'lI asvlllpiolically Ih(' lIull dislrihulioll will 1)(' chi-
square wilh N elegn'('s of Ircceloll\. Till' llIaXillllllll likelihood eslilllator of
I: fall S.TV., as a fonsis\('111 ,'slilllalor.
5. J. St(ltiltira{ Framnllork Jor /,!itilll(ltio/l Ilmi Tflting

Ilowever, in this case we need 1I0t resort (0 large-sample distribution the-

to draw inferences using a Wald-type test. The finite-sample distribution.
01)'
which i~ developed in MacKinlay (I9R7) and Gibbons, Ross, and Shanken
(19WI), can be determined hy applying the ()Uowing theorem presented in
Muirhead (19R3): '

Theorem. 1.1'1 "If m-lIl'clor x VI' di51riiJull'li N(O, D), il't thl' (rnx m) matrix A hI'
I

di.\IJ-ivu/ni W",(n, 0) with (71 ~ 111), and lrl x (lnd Ave indepmdrot. Thm: I

(n-m+l) I _I '
-'------xA x ~ 1-", ... _ •• +1.
111

To apply this theorem we ~et x = JT[I + Ji;./a;1-1/2 ,A :: 7r'E, a

/1/ = N, and n :: (T - 2). Then defining JI as the test statistic we havel

J1
= (T-N-l)
N [
I Jl.'2m
+'2
J- 1
"i-- I
QL.JQ.
•
(5.3.23)
am I
I
Under the null hypothesis, JI is unconditionally distributed central F with
N degrees of freedom in the numerator and (T - N - I) degrees of freedom
in the denominator.
We fan construct the Wahl test Jo and the finite-sample F-test JI usi:ng
only the estimators from the unconstrained model, that is, the excess-retll-n
market Jllodel: To consider a third test, the likelihood ratio test, we need
Ihe estimators of the constrained model. For the constrained model, the
Sharpe-I .intner CAPM, the estimators follow from solving for (J and E from
(:).:'\.11) and (5.3.12) with Q constrained to be zero. The constrained esti-
m;ttors arc

13' :: (5.3.24)

,
E
. :: TI " ..
T
.•
~(Z/ - f3 Zm/)(Z, - f3 Z.. /)'. (5.3.25)
'~I

The distributions of the constrained estimators under the null hypothesis

arc

N({3'+['21111l+I GJE) 2
III
(5.3.26)

T'E' (5.3.27)

(:in'lI bOlh the unconstrained and constrained maximum likelihood esti-

1\l,llors, we can test the restrictions implied by the Sharpe-Lintner version

; : ...
•. ~~!~
,.~.tl'"
194 5. The Capital Asset lJriejll/{ /Hodel

using the likelihood ratio test. This test is based 011 the lo'garithm of the like-
lihood ratio, which is the value of the collstrained log-likelihood function
minus the ullconstrained log-likelihood fUllction evaluated at the maximum
likelihood eSlimators. Denoting CR as the log-likelihood ratio. we have

CR c-£
T -. -
-~(logIE I-IogIEI]. (5.:t~H)

whcrc C reprcscnts the constrained log-likelihood function. To derive

(5.3.28) we havc used the (act that summation in the last terlll in hoth
thc unconstrained and constrained likelihood function evaluated at the
maximum likelihood estimators simplifies to NT. We now show this for
the unconstrained function. For the summation of'the last term in (5.3.9),
evaluated at the maximum likelihood estimators, wc have
T
1
})Z/ - 0: - j3z,.,)'t- (Z, - 0: - /37./n') (5.3.2~)
1=1

T
= L trace[t- I (Z, - 6 - j3ZIII')(Z, - it - 137... ,)'] (:•. 3.30)
1=1

trace E --1"" T
L,.(Z, - '
Q - (3Zm')(Z, - Q - (3Z",,)' ] , (5.3.31)

\
[
,=1
• -1 '
I; = tracc[E (TE)] = Ttracc[l] = NT.
1
The step from (5.3.29) to (5.3.30) uses the rcsultthat trace All == trace EA.
a~d the step to (5.3.31) uses the result that the trace of a SUIIl is equal to the
sl\m of a trace. In (5.3.32) we lise the result that the trace of the iC\clltity
mttrix is equal to its dimension.
The test is based 011 the asymptotic result that, under the null hypothesis,
-r times the logarithm of the likelihood ratio is distributed chi-square with
d grees of freedom equal to lh(' IIlllJlher of restrictions untler II". That is,
w call test 110 using

1 I
J~ -Z£R

I
I. Interestingly. here we need not reson to large-sample theory to con-
duct a likelihood ratio test. JI in (5.3.~3) is .iL~e1f a likelihood ralio test
statistic. This result, which we nexi develop. follows from the fact that JI is
a monotonic transformation of J'1' The constrained maximum likelihood
5.3. S/(//islim/ FramnuorkJor /,:I/i/llu/ioll tlllt! Tr.l/iIlK I!I5

('stimators call be expressed ill terms of the UIHollstnlillCd estimators. For

;1' WI' have
... It", ...
!-J + ~--.-~ n.
J.l", + ° 111

T
. •
~ TI L(ZI
'""' .• .•
-/~ £",,)(Z, -('1 £",,)'
1=1'

I
~ ~ [ (ZI- n.- 'In",,)
L . -I- ( I - Ii '"
-:-~--':!
£",1 )
u. ]
I ,=t . ILm +(1",

X
. . ' . +(I -
fJ1,ntl fi '" Z"'I ) .] I
~--'i a (5.3.35)
[ (ZI - 0: -
lim -t- (fm

Notin~ that

1
'""'(Z
L T
1
- 0:. -fJ' Z-..1 )' (
1- '1 ", 1.-ml• ~ )
_~
•
0: 0, (5.3.36)
'=1 111/1+0,.

we have
~
-. = ~• + ( _~ a;' . ~ ),_'
au. (5.3.37)
J1. m + am
Taking the determinant of both sides we have

(:>.3.313)

where to go rrom (5.3.37) to (:).3.313) we factorize "E and lise the result that
II + xx'I = (I + x'x) for the identity matrix I and a vector x. Substituting
(5.3.38) into (:).3.28) ~ives

CR = -:- 17 /;' ) n...1:,-1.0

T log [( ~i + I] . (5.3.39)
2 11,.+01/1

and for./I we have

JI =
(T - N - I) (
N exp
[t]·i - I ) (5.:UO)

which is a mOllotonic transformation of J~. This shows that JI can be inter-

preted as a likelihood ratio test.
Since the finite-sample distribntion of./I is known, equation (5.3.40)
can also be used to derive the finite-sample distriblltion of./l. A~ we shall
 /. "It' I.<l/,lialll.l.lr( 1'l1flllg ;\/lJilt'/

see, ulldl'r IIII' lIull hvpollll'sis IIII' fillill'-sample dislrihulion of)~ rail diffl'r
frolll ils laq~I'-salllpl(' dislrilHllioll, JohsoJl alld Korkic (I !IH:!) suggesl all
,UljllSlllH'JlI 10 .h whirll has ht'lIl'1" fillile-sample properties, Dl'iilling JI as
Ihe llIodified slalislic, \\'1' 11;1\'1'

(J' _. ~ - ~)
.h ---.,-.-.h
(r--;¥-~)llogrt'I-logltl]:' X~,

\Vt' will visil IIII' isslI!' of Ihl' fillilc-sample propcrtics of .h alld JI III SI'C-
liOIl rIA.
A II st' I'll I !'rolloillic illlnprl'lalioll can he made of Ihl' II'SI stalistic Jt
IISing results fronl I'flid('nl-sc( ma(h('malics, Gihbons, Ross, and Shankl'n
(1!1H!») show IhOlI

_ CJ'- N - I) ,i;
;;: - '.~)
n!
/1 - - - - - ,."
. N ( I+~
n;;,

Wh('H' Ihl' portfolio dl'lI1111'd II\' If rl'prl'S('lltS Ihl' t'x /10.11 l;\ngl'lll"y portfolio
cOllslnrrll'l1 as ill (!·I.~.~H) rrOlIl IiiI' tV illrlllded assets /1/111 tlie markel port-
fillio. RI'r;11l frolll Sl'l"Iioll :I.~ (hal IIII' pllr(fillio wilh (Iw maxillllllll sqllared
Sharpe ralio of all pOrl/lllios is thl' \;Illgency portfolio, TilliS whell 1'.': /lu11
(he llIarkl'( (lort/illill is Ihe langl'nry ponfillio JI williII' l'qllallo 1.('ro, and
as Ihl' sqllOlrl'd SharpI' ralio of Ih(' lIIarkl'l dccreases, .It will increas!', illdi-
cating slrongl'l l"\·id('lllT "gainsl Ihl' I'fficiellcy of the lIIark!'1 jloll/illio. III
S('l"liOIl !i.7.~ W(' pn's('lIt ;111 I'lIlpirical l'XOlJllpic using ./1 afll'r cOllsidl'ring
IIIl' Black versioll or IIII' CAPM ill IIII' IIl'xl sl'ction,

'i. ,.2 1111/111 Vt'nillll

III Ihl' allS('lllT of a riskl"nT asset WI' cOllsicll'r Ihe Black version of Ihe CAI'1'\'1
ill (:1. I.!"! ). TIll' ('Xp('("\1'I1 1'1'1111"11 1111 Ihe I('nl-ill'''l porllillio EI /{,,'" I is In'ated
as all 1.1II0hsl'l \"ahl(' alld hl'lIn' h(,("(III1I'S an unknown lIIodd paralllcll'J".
Dl'Iilling IIII' Ino-Ill'\;1 )lortlillio ('xI)('cll'd 1'1'1111'11 as y, Ihe I\brk vl'\"sioll
is

FIR,I I.y + (~(El a,",l - y)

(I-fi)y +,I3EII("'II,

Wilh Iht' mack Illodd, lire 11l1("ollstraill('c11ll0l1l'l is thl' ("('al-relurn markl't

5.3. SIIIIi51irlli Framework/or E51imation lind Te51ing 197

lIIodel. Deline R, as an (N x I) vector of real returns for N assets (or port-

f()li().~ of asseL~). For these N assets, the real-return market model is

R, =: a: + {3R mt + ft (5.3.44)

(5.3.45)

(5.3.46)

E[Rill' 1 =: /lin' (5.3.47)

Cov[Rmt> Ed =: O. (5.3.48)

{3 is the (N x I) vector of asset betas, Rot is the time period t market port-
folio relllrn, and a: and f, are (N x 1) vectors of asset return intetcepts a,nd
disturbances, respectively. '
The testable implication of the Black version is apparent from compar-
ing the unconditional expectation of (5.3.44) with (5.3.43). The implicatipn
IS

Q = (~- (3)y. (5.3,49)

This implication is more complicated to test than the zero-intercept restric-

tion of the Sharpe-Lintner version because the parameters {3 and y enter
ill a nonlinear fashion.
(;iven the lID assumption and the joint normality of returns. the Black
version of the CAPM can be estimated and tested using the maximum like-
lihood approach. The maximum likelihood estimators of the unresuicted
Illodel, that is, the real-return market model in (5.3.44), are identical to the
estimators of the excess-return market model except that real returns ar~
slIbstituted for excess returns. Thus jJ., for example. is now the vector of
sample mean real returns. For the maximum likelihood estimators of ttt
parameters we have

= {l- {3[J.m (5.3.50)

'L.:I (R t - jJ.)(R ml - ft •• )
= 'L.~I(Ulnl - ftm)2
(5.3.51 )

= + T
L(Rt -
1=1
ex - j3R,.t)(R, - ex - {In,,.,)', (5.3.52)

where
1 T
-"-R
T~ mI'
1=1
198 5. The Capital Asset Priring Me}(M

Conditional on the real relllrll of the markel, R"", U",~, .. , , U,. /", the distri-
butions are

where
T
•2
am ::: T1 \.""""""'
L(I~.I -
•
JIm
)2
•
~ ~I

Tle covariance of it and jJ is

I
I,, • ., It .. ]
Cov[a,i3J = - [ ~
. E.
am

\ For the conslrained modd, that is, the Black version of the CAI'M, the
log-likelihood function is

NT T
• C(y. i3. E) = -T log(2JT) - "2 log lEI

T
-21 'L" (R , - y(t - m - i3R ml ) ' E- ,
1=1

)( (R, - y(t - m - i3R",I)' (5.3.57)

Oil crcntiating with respect to y. i3. and E. we have

(5.3.!iH)

:~ == E-
1
[ t (R , - Y{L - m - i3U ml ) (Hm, - y)]
iJL T I [ "1'
== -- E- 1 + - E- 1
(}E 2 2 S (R, -
'" yU - (J}--- (JJ{ml)

X (R, - y (t ~ m- i3Rmt)'] E- 1• (5.3JiO)

5.3. Slatistirtll Fmllll'work Jor /::ltilll(lfiOIl lIwl ·/"Ifill!!. 19!1

Selling (5.:!.!)!)), (:).:1.59), alld (~).:\'(i()) to {<TO, we ralllio~'for lhc lII01xi-

mUIll likelihood estilllOltors. TIJ('sc arc:

I -.
(it - (j Ii.,,)
y' ~. ...... I " ..
(r,.:Uil)
(~ - li)'1: (I, -, 0 )
L:~I(RI - Y~L)(/?"" - y')
i/
L,'~tU{,,,( - y')~

t' +. t(R 1- Y' (~- b') - /3' Uml)(R , - Y' (L - i~') -- /3' U>nl)'. e',.:t()3)
I;J

Equations (5.:I.GI), (:).3.()2), alld (!1.3.G:\) do 1I0t allow liS to solve explicitly
for the maximum likelihood estimators. The nl<lXimll1l\ likelihood estima-
tors can be ohtained, given initi,,) cOllsistent cstilllalOrs of (3 and :E, by
iteratin):; over (5.:~.GI), (5.3.62), alld (!I.:!.h:1) 11lItii ('ollvcrgellce. Thc 1111-
t
cO:lstraincd estilll<lLOrS j3 and can serve as the initial Lllf1sistent estimators
of (:J and :E. respcctively.
(;ivcII both the constrained alld ullconstrained mOlxilllulIl likelihood
estilllators, we can construct an asymptotic likelihood ratio tcst of the null
hypothesis. I The Ilull alld ,lIternative hypotheses ,11<'

(~ - {j)y (!).:H4)

(:1.:\.65)

A likelihood ratio lest can be cOllstructed ill a lIlallll\T analogolls to the test
constructed 1'01' the Sharpe-Lintner versioll in (:).:1.:tl), Ddillillg Jl as the
test statistic, we have

(5.3.G6)

Notice that the degrees of freedoJll of tbe null distributioll is N - I. Relative

to Ihe Sh'lrpc-l.illtller vcrsioll of the model, the Black versioll loscs OIlC dc-
gree of freedom hecausc the zCJ'(>-heta expected return is a frcc paramctcr.
In addition to the N(N - I )/2 parameters in tile residual covarialH:e matrix,
the IIIH"Ollstrailled model has 2 N paramcters, N parameters comprising the
venor Q and N comprising the vector p. The constrained model has, in
additioll to the sallle lIulllber of covariance llIatrix par;uIlClcrs, N paralllc-
ters cOlliprising the veri or f3 antlthc paranH'\n lor 11](' cxpeclnl/,cro-hct<l
portfolio retllnt y. Thus the IlIlCollstraincd model has (N -- I) Illore free
paramcters thall the constraine<lmodd.

1111 lil(' ("(>IIleXI (If Ihl' HIOlrk \'t'rsion 01"111" (:APM, (;,1,1.011\ (I q~:!l fit \1 dC'veloped lhi~ ('!<of.
Sh'"IKl'1I (t\IKClh) pm,"ill," d"I,liI"1I '"I;(\y,i,.
 ). 1 ht' (;II/JlIIII ,Iul'/ I',-irillg ,1/lIdt'1

WI' rail also ~\lli",t ./1 to improve IIH·lillitt·-samplt· propt,rtit's. Ddillillg

.f;. as thl' ;lIli"~tl'd tl'St ,tatistic I\'C han'

"
X.V-.I·

lillillite salllplt-s, till' 111111 dislrihlltiollor). willillore dosdv lIIalch the chi-
sqllarl'distrihlltioll. (S('(' Senioll :•.. , 1'01' a Clllllparisoll ill tl)(' COli text or tl)('
Sharpl'-I.itllIH'I \'('rsioll.)
There are t\\'o drawhacks to tht' IIIt'tltods wt' Itavejllst discllssed. First,
the t'stilllatioll is sOIlH'\\,hattcdiollS sillcc olle mllst iterate ovcr the Iirst-ordn
fllllditions. St'cond, tht' t('st is hased 011 largt'-sample theory and call haw
wry poor flllite-salltpk properties. We 1'.\11 \lse tite res\llts of Kandd (1~IH4)
alld Shallkell ( I!)Hli) 1(. O\'l'rCOllle Ihes(' drawharks, Thes(' alit hoI's show how
to ('akllialt' cxact tllaxilllllm likelihood estimators alld how to impl('lI\clt!
all approxilllate tcst with good lillite-salltple perli>rtnanCt',
For tht, \lllcollstrailled mode\. cOllsidt'r the market lIIodel cxpressl'd ill
tt'flllS of r,'lItrlls ill I'xct'ss of Ihl' \'Xlll'(·t,'d 1.,'1'0-1)('1;\ relllrll y:

R, .- )'1. "" It·/ (J(ll"" - y) + 10,. (!i.:UiHl

ASSlIllle y is kIlOWIl. Theil Iht' IItaxilllllJII likelihood estimators fi.n the IlIt-
cOllstraitll'(IIlIOdcl an'

j1. - YI. - /3(it", - y), (5.:t!i!l)

r • •
L,=I(R, - p.)(RIII , -/1",)
(:i.:DO)
L:~I(/l.,., - il",)~

alld
./

E= +:LIR,-it-/J(/(m,-ilmlIIR,-iL-{3{1l""-(I,,,)J'. (:).:DI)
'~I

Thc lIlIcomtrailled I'slilllators "I' {J alld E do 1I0t dept'lld 011 tht' vaillt' or y
hili, as indirated, tht' estilllator or n dot'S, The vallie or tht, IIncollstraillt'd
log-likelihood rllllctioll ('\,alll;lIl'<I at Iht' JIIaXi1ll1l1l1 likt'lihood t'stitllat"r' is

NT 'J' • NT
I"g(~rrl- IOlfIEI- -
0)
~ h ~

II'hirh dOl's Ilot dl'pl'lld Oil )'.

5. J. Slfllisli{(l[ Frmnt'l/Jork for r.Jli/llflliOIl (lwl 'IrSlillg 201

Constraining 0: to be zero, the constrained estimators are

~.
i
= (5.3.73)
!

I
I
"")( (RI - y(~ - 13·) - 13· R,.I)'. (5.~.74)
and the value of the constrained likelihood function is
NT T,. NT
C(y) == - - log(2rr) - - logl~ (y)I--. (5.3.75)
2 2 2
Note that the constrained function does depend on y. Fonning the loga-
rithm of the likelihood ratio we have

CR(y) == C(y) - [.

::: -~ [log IE\Y)l-log lEI]. (5.3.76)

The value of y that minimizes the value of the logarithm of the likeli-
hood ratio will be the value which maximizes the constrained log-likelihood
fUllction and thus is the maximum likelihood estimator of y.
Using the same development as for the Sharpe-Lintner version, the
log-likelihood ratio can be simplified to

CR(y) = T
-2'log
[( a~
(tlm-y)2+a~
)"o:(y):£, - I o:(y)
,
+.I]

-~2 log [( (-11m _ a~2 • ~) [jL -

y +0 ..
yL - (3 (il .. - y)l' E-
1

X [jL - y~ - 13 ([i... - y)] + I] . (5.3.77)

Minimizing CR with respect to y is equivalent to maximizing G where

= (' _ a~2 + -2) 1

G [jL-YL-13(tlm-y)l'E- [jL-YL:"'(3(il ... -y»).
J1... yo,.
(5.3.78)
Thus the value of y which maximizes G will be the maximum likeIihpod
estimator. There are two solutions of aClay = 0, and these are the real
rools of the quadratic equation I
!I( y) = A y2 + By + C, (5.3j79)
202 5. The Cal)i/a/ Anl'l I',irillg Mill""

where

I -,--I -
-;-;z (t
(J HI
-
','-/.
m 1.:
-_ (i",
(It - {3/1",) - -::-:; (t - {3)
am
1.: (t - m

( 1+ .;
ii~)
(t-f3)':E
- --I -
(t-f3)- .~
I - ·-1 •
(p.-{3(;.",)':E (jt-{-J(J.",)
Om alii

- (1+ am..;' )
/1 ~ •
(t - j.3)':E
- -I •
(ji. - {3,i",)

I
l + ii",.
a;;' (J1. - {3"
1(",)
, {, -- I .
L.-
'J -
(,l- ("I",).

t
If is greater tilan zero, the lIIaximulll likelihood estimator y' is the largest
rot, anel if A is less than zero. the II y' is the smallest rool. A will he
gl ater than zero if ii", is greater than the mean return on the sample
glll!>,,1 minimulll·variance portfolio; thai is, lhe lIIarket portfolio is (lIl the
c1~\lcient part of the constrained mean-variance frontier. We can suhstitute
Y'I into (5.3.62) and (:1.3.63) to obtain (-J' and -t' without resorting to an
itclrativc procedure.
I We can COllStruct an approximate test of the lIlack version using relllrns
in \bx(ess of y as in ([1.3.GH). Ir y is known then the same methodol0h'Y us(·d
to ~onstructlhe Sharpe-l.intnC!' version F-test in (5.3.23) applies to testing
the null hypothesis that the zero-heta exn'ss-relllnl nl<lrket-Illodcl intenTpt
is zero. The test st.llistic is

(T-N-I)[ (ji.",_y)~]-I. ,·-1 . .

],.(y) = N 1+ .~
am
a(y):E a(y) ~ /'.'1./-.'1-1.

(:I.:tKO)
Ikcause y is unknown, the test in (:,.:tHO) GUlnot he directly implementcd.
But an approximate test can he implelllented with ],,(y'). Because y = y'
minimizes the log-likelihood ratio, it minimi/.es ],,(y). lIellce ],,(y') 5:
],i(y,,), where Yo is the unknown true vallie of y. Therefore a test ll~ing
],;(9') will acccptlOO often. If the null hypothesis is rejected IIsing Y' it will
he rejected for any value of y", This testing approach can provide a \I~cflll
check be~ause the usual asymptotic likelihood ratio test in (5.3.77) has been
IiHlIlel to rc:ject too often.
Finally, we consider illferenres for th(' expected I.cro-beta porlf(llio rc-
tllrn. Givcn thc maximulIl likelihood estimator or y, we reqllire its asymp-
totic \'ariance to lIIake inferellces. Using the Fisher infurlllation lIIatrix, the
asrlllptotic vari,lllcc of tilc maximum likelihood of y is
5.4. Siu (if·/i'.III ,

This estimator can be evaluated at the maximllm likelihood estimates. and

then inferences concerning the vallie of yare possihle giwn the asymptotic
normality of y'.

5.4 Size of Tests

In some econometric models there arc no analytical re.~uIL~ on the finite-

sample properties of estimators. III sllch rases. it is UJlllmOn to rely on Iaq!;e-
sample statistics to draw inferences. This reliance opens lip the possibility
that the size of the test will be incorrect if the sample sile is not large enough
for the asymptotic resulLS to provide a good apPlOximalioll. Because there
is no stalldard sample size for which large-sample Iheory can he applied. it
is good practice to investigate the appropriateness of the theory.
The lIlultivariate F-test we have developed provides all ideal framework
fiJI' illustrating the problems that GUI arise if' OIl(' rdies ou as)'mptotic distri-
L'llion theory for inference. Using the known finite-sample distrihution of
tht: F-test statistic }I. we can calclliate the !illite-sample sile for the variolls
aSyll1 ptotic tests. Such calculatiolls arc possihk h(,CllISC the ,\syllljltotic test
statistics arc monotonic transformations of '/1,
We draw on the relations orfl to the 1.lIg('-sanql\c I('sl statistics. COIlI-
p;'ring equalions (:).:t22) and (:).:1.2:1) 101 ./" WI' II.'v('
('I' - N .- I)
./1 = - NT ./".

and for }:l from (5.'1.2) and ([1.:1.4 J).

.
/1 = U-N-Il
N
(exp[~] t/-,···~I.
-I). (5.13)

Under the llltil hypothesis. }o. }~. alld ./1 arc all asymptotically distributed
chi-square with N degrees of frecdolll. The exact nuH distrihution of }I
is celltral F with N degrees of freedom in til(' numerator and T - N - I
degrees of freedom ill the denominator.
We caIeulate the exact si/.e ofa test hased on a giv(,11 large-sample statistic
and its asymptotic 5% critical value. For example. cOllsider a test usillg }II
with 10 portfolios and liO months of dat,\. III this rase, under the lIull
hypothesis }II is asymptotically distrihllted as a chi-square randolJl variate
with 10 degrees of freedom, Given this distrihutioll. the cdtkal value for a
test with all asymptotic sil.C of 5% is I H.31. From (:>.'1.1) this value of 18.31
~1I'1

li,r ,A, COITl'SPOII/Is to a nitical \'ahll' of I A~l:, lill' '/1, Cin'1I that the (');an
111111 (Iislrihlliioll 01'./1 is /: wilh 10 dt'grecs offrecdolll illlht' Illlilleralor alld
·I~l degrees olll("nloill ill til(' d("lIollliliator, a lest IIsilig Ihi~ niticd \'ahlt' for
./1 has;1 sil(' of 17.0')!,. Thlls, 1111' aSYIliplotic !,'y" lest has a sil(' of 17.0';' ill
a salllpk 01'(;0 11I(llllh~: il reilTls Ihe 111111 hypolhl'sis ilion' Ih;lIlll1r('e lillll'S
looofleli.
'Elhle :,.1 PII'S('IIIO; Ihis Cliclll;tliOlilill' .A" J~, alld./I IIsillg Ill, ~Il, ;llId·1O
Ii II' valll(,s of ,v all(1 IIsill)!; (iO, 1~(), 1HO, ~40. alld :~(iO f(lr \';II\I('s of r. It is
appan'lIl 111;11 Ill(' lillile-s;lIl1ple sil(' of Ihe lesls is largn Ihall Ihe aSYlIlplolic
silt, or r,I;;,. Thus Ihe large-s;lIl1plc lesls will n:il'rl Ih(' IHlli h),polhl'sis 100
oft(,lI. This prohll'lll is sn'nl' li,r Ihl' aSYlllplolic lesls hased 011 ./t, alld ,h.
Whell N = 10 Ihl' prohl('1Il is 11I0sily il1lpOl'lalil lill' Ihl' low valll(,s of r.
For I'xalllpk, Ihl' lillih'-~;II11pk ~i/l' or a test with <Ill as}'Illptotir sill' of :)'};,
is 17.0')!, alld (l.(i'Y" lill'./t, alld.h. n'spI'clivdy. As N illnl'ases Ihl' sl'\'('rilv of
Ihe prohkl1l illcu'ases, Whl'lI N = <Ill alld T = (iO the /illile-salllple silt' of
all aSYlllptolic :,';;, It'sl is \1H.:,';;, Ii II' .1<, all<l H05% (ill' ,h. III Ihese C;ISI'S, Iltl'
111111 hypolhesis will hI' rejl'cted 1Il0si or III(' tillle evell whl'lI il is IrIiC. \\,ilh

N = '\0, Ihl' si/(' of a r,I:{, aSl'IIlJllolic Il'si is slill oVl'rslalerl cOllsic\t-rahly 1'\'1'11
wh(,11 T = :\(iO.
Thl' aSYIlIJlIOI;" I(',sl \\'ilh a lillill'-salllJlk adjllstllH'1I1 hasl'd 011 ./1 pn-
forms 111111'11 IWIII'r ill lillih' s;llIIpks thall docs its 1I1l;llljllsted cOllntcrparl.
Oilly ill the CISI' of N = ,Ill and 'J' = (iO is thl' exact sizl' sigllilicalilly on'r-
stall'eI. This shows Ihat lillill'-salllJlII' adjllslllll'lIts ofasYlllplotic tl'sl statistics
(';111 play all iIiIPOr(;1I11 rok.

5.5 Power of Test'>

\\'111'11 drawing illli-n'lHTs nsillg a gin'lI It'si slalistic II IS 11111)(11 Ian I 10 COII-
sidn ils IH,\\,l'r. The pown is lite prohahililY Iltal lite 111111 hypolhesis will
Ill' n:jl'cl('d gin'lI Ihal all aitnllaliw hypolhl'sis is 11'111'. Low pown agaillsl
all ililen'slillg aiterllalin' slIggl'SIS Ihal Ihe It'sl is 1101 IIsl'fliliO disnil1lillall'
11I'1\\'l'I'1i Ill(' ait('III;lIiv(' alld Ihl' 111111 hypolhesis. Oil Ihl' othn halld, ir Ihl'
1'01\'('1' is high. Ihl'lI till' Il'si elll he very illlill'llIalivl' hili il lIIay also rl'jl'l'I
IIII' 111111 hvpollll'sis ;Igaillst all(,)lIali\'('s Ihal an' dose 10 Ihl' 111111 ill ('1'0-
lIolllie "'I IllS. III Ihis case ;1 rl'j"('lioll llIav hI' dill' to slllall. "COllolllicdh-
IIl1illlportalll d('li<lliolls 1'1'0111 Ihl' 111111.
To t\Ot'llllwllt III\' powcr oLllt'st, it is IWITssar)' 10 spl'('il~' thl' alll'rllali\'('
data-gl'IIIT<llillg I"'l('~s alld IIIl' sil(' of Ihl' lest. Thl' (l0I\'('I' li,l' a givl'lI sizl'
ofll'sl is Ihl'l"olo;lloilill'lhallhl' t,',1 sl<ltislic is greater thalllhl' crilical I;dlle
IIl1d('l' Ihe 111111 h\'pOIIIl',is, gin'lI Ihat 11)(' aiteruali\'c hypol Itesis is IllIe.
'Ii, iIlIlSII;II,· Ihe pOller or I('sls or Ih,' <:AI'M. W(' \\'ill foclls oil 1111' Inl or
Ihl' Shal'fll'-I.illllll'r \'('I'sioll IIsillg ,/I rrolll (:,.:\.~:\). Thl' (lO\\'('I' or this Il'si
5.5. /'0/(1" of Tests 205

Table 5.1 . Finilf'-5f1111/'iP liu oj 1,.. 15 of IIIf Sllflrp,..Ulllwr r.APM wing lnrgt-1am4u. Itsl
.llllli,llir,I,

N T j" }l j,
I
\0 60 0.170 0.096 0.051 :
120 0.099 0.070 0.050 \
180 0.080 0.062 0.050 I
240 0.072 0.059 0.050 '
360 0.064 0.056 0.050 i
I
20 60 0.462 0.211 0.057 ,
120 0.200 O.IO~} 0.051 I

180 0.136 0.082 0.051

I
240 0.109 0.073 0.050 :
360 0.086 0.064 0.050.

40 60 0.985 0.805 0.141

120 0.610 0.275 0.059
·180 0.368 0.164 0.053
240 0.257 0.124 0.052
360 0.165 0.092 0.051

The exaCt finite-sample size is presented for teslS with a size of 5% asymptotically, The finite-
sample sire uses Ihe dislribution of J\ and Ihe relation between JI and Ihe large-sample 101
stalislies. jl. fl. and j,. N is Ihe number of dependent portfolio!. and Tis Ihe number of
tilllt"-~("rit"s observations.

should be representative, and it is convenient to document since the exact

finite-sample distribution of J) is known under both the null and alternative
hypotheses. Conditional on the excess return of the market portfolio, for
the distribution of Jt as defined in (5.3.23). we have

(5.5.1)

where 8 is the noncentrality parameter of the F distribution and

(5.5.2)

'Ii) specify the distribution ofJ) under both tbe null and the alternative
hypotheses. w.e need to specify 8. N. and T.
2qli 5. Thr Ca/Jila/ t\.l.Irl/'ririllg A1(}(h'/
i
I Under thc null hypothesis a is zero, so in this case 8 is lero and we have
Ihe prcvious rcsuh thaI Ihc dislrihution is central F with Nand T - N - I
dcigrces offrccdom in the IHllller,ltor and denominator, respectively. Under
Ih~ allcrnalivc hypothcsis, 10 specify 8 we need to condition Oil a value of
t!~/cr; and spccify thc vaillc of a':E-la. For the value of [1.;''/;';" ~iven a
m1>nthly obscrvalion intcrval, wc choosc 0.013 which corresponds to an rx
/10.[' annualizcd mcan cxcess return 01'8% and a sample annualized siandard
dC[iation of20%.
For the quadratic term a':E- 1a, rather than separately spedfyin~ a .lIIel
:E, we can usc thc following result of Gihbons, Ross, and Shanken (I !IH!l).1
Rc ailing thaI q is thc tangcncy portfolio and thaI 111 is the market portfolio,
wc\havc
\
I

: 'I
0-
'I
am~

USing this relation, we need only specify the difference in the squared
Sharpe ratio for thc tangency portfolio and the market portfolio. The tan-
gency portfolio is for the universe composcd of the N induded portfolios
and thc market portfolio. We consider fOllr sets of valucs lor the tangency
portfolio paramcters. For all cases Ihc annualil.ed sland,lnl deviatiol\ of the
langcney portfolio is set to lli%. Thc anllllalil.ed expectcd excess return
thcn takcs on four valucs, 8.5%, 10.2%. 11.6%, and 13.0%. Using an all-
nllalized expected excess return of 8% for the market and an allll\lali/.ed
standard deviation of 20% for the market's excess return. these four values
corrcspond to values of 0.0 1,0.02,0.03, and 0.04 for 8/ T.
We consider fIve values for N: I, 5, 10, 20, and 40. For T we consider
four values-60, t20, 240, and 360-which arc chosen to correspond to !i,
to, 20, and 30 years of monthly data. The power is tabulated for a test with
a size of 5%. The results arc presented in Table 5.2.
Substantial variation in the power of the test for different experimental
designs and alternatives is apparent in T,lble 5.2. For a fixed vallie of N,
considerable increases in power arc possible with larger values of r. For
.example, under alternative 2 for N equal to 10, the power increases frolll
0.082 to 0.380 as T increases from 60 to 31iO.
The power gaill is Slibstalllial when N is reduced for a fixed alternalive.
For example, under alternative 3, /01' T equal to 120, the power illtTC'ases
from 0.093l0 0.47f) as N decreases from 40 to I. llowcver. such gaillS would
not he fea~ible in practice. A~ N is reduced, the Sharpe ratio of the tangency
portfolio (and Ihe noncentralily parameler of Ihe F dislriblltion) will declille
unlcss Ihe portfolios are comhined in proportion to thcir weightings in th,ll
portfolio. The choice of N which maximizes the power will depend Oil the
5.5. /'/)I/I/·/"/I/"'/i·.I/.1 207

Tab/I! 5.2. /'111/'1''' '1 F·/~.l1 II} SI/lII/It··I.inlll"'- (:~/'t\I /llilll: I/,//il/i, ./J.

/Ii = I

'J" 0= IiI) IU17 n.07~, 1).0Ii', Il.O:,~) IU),,?>

r == I~I) 0.1 !1I O.IOli O.OHh o.on 0.O1l2
'J" == 2·10 O.:HI 0.17H 0.1:\,1 0.10:\ 0.OH2
"f'= :11;0 OAHO 0.2;,!) 0.1!1I1 0.1:\!) 0.10:,

Alternative 2: Il'l == 10.2% (1'1 = II;')(,

-r = 1;0 O.IH!) 0.111:1 0.OH2 0.(11;1< 0.0:,7
'J" = 120 O.:t~!1 0.17'1 0.1:\0 II.O'lH 0.077
'f' =: 2,10 05!17 (1.:1,10 (1.2·17 0.17·1 11.12,1
-r = :11;0 11.770 n.r,OH IUHO 0.21;7 IUKI

Alternative :~: Il'l "" 11.li% (1'1 = lIi%

"f' == (iO (1.262 0.1:\,1 0,101 0,07H 0.\)(,1
'1'= I:.!O 0.47:, O.2~>i I).IHO 0,12H O.O9?>
"f' = 240 O.71l9 O.!,01 0,:17-1 n.2lil 0.17:,
'f'= :1(;0 O.'lOH 0.711 (J,r,70 O,'I\(i 0.2HO

Alternative 4: Il" == 1:1.0% (1'1 = lIi%

'J" = IiI) 0,:1:1-1 O.lli7 D.121 O.OHI) O.(Hi:,
"f'= 120 O.:,!I:1 0.:1:12 o.:!:17 O.IIi:1 0.1 III
'f' = 2,10 O.H7:1 o.(iD 0.:,02 o.:\!,,(j 0.2:\1
'f'= :\liO 0.%:, O.H,I:, O,nl; 0.:,(;:1 O.:IH!l
----
Th" ;llIcllI.tlivc h)'I)('lh('~is i~ rli;u'aru'li/C'cI h)' lht' \'.1111(' of llit' ("xllI'(l('d ('X("('!'oS 1«'1111"11 and
Iht' \'alm' of 11i(' ~I.llld.lni <It.'vi.llioll of tilt" ,.lIIgt'll( r pOI Iloilo. The l:lngc'lu y pOIlfi,lio i.~ wilh
rl'spt'('t 10 til(' N illclllded portfolios and tht· lIlal kct pOilloliC). 11.1/ i~ [i1(' c.'xP'·( It'd ("xn'~'" rcWrn
of Ih(' t~m~(,'l\ry p~JI Ifolio, ;\nd Oil is til(" iU1UU"lil.l'd !>.t.uHLu·({ d{'\i.,.ion oi tht.' l'x(T~S l"C.'t\lrn oi
the 1.tngnH·y ptH ltolio. The lHarkcl portfolio is .\\.'';'UIIH'(} to h.nT .m l'Xpt't In} ("x( t's..11 return of
H.O'i; . .111<1 .1 .'it.\Il(LII(} dt'\·i.uioJl or 2U%, UI1(i<'I" th(' 111111 h)'pOlh(,!'ii~ (}at' 11I.\rkt't pOI .folio is 1ht."
lallgt'II(\' portlolio, N i!'i the IItluli)('r of portfoli()~ infillti('d ill tile 1('.<.;1 ,Ind r i, lilt, IIIlmh("r 01
IJ}Oll1h., I)f d;\I" illrill<icd.

rate at which the Sharpe ratio of the tallgency portfolio dl'riillcs as assets
arc ~rourcd tOJ,\e!hcr.
While we do JlUl have gellcdl results ,Ibollt the optilllal design of a lIIul-
tivariate test, we c<In draw somc insights ('romtllis pOWCI' all,dysis. Increasing
the lellgth ofthe time series can kad to a signilic<lnt payolfill terms of power.
Further, Ihl' power is very sellsitive to the vallie or N. The allalysis suggests
Ih;lI Ihe v<lIIll' of N shollid he kepI SIll<l11. I'l'l'h;l)s 110 largn than abollt ten.
 5.6 Nonnormal and Non-liD Returns

III this Sl'l'liOIl \\'t' ~\rt' l"IlIll"l'IIH'd wilh illrcn'llct~s when 1ht,I'(' are dcviations
/i'Ofll IIII' asslllllplioll 111011 rellll'llS an'.iointly norfllal and liD throll!!;11 tiflle,
We cOllsidn tcst~ whirll al'l'Ollllllolbtc non-norlllality, lll'tl'l'Oskl'dasticity,
antitelllporal dependellcc of' rellll"llS. Slich tests are ofilltel't'st fill' two rea-
SOliS. Firsl, while Ihl' lloJ'lllality asslllll)ltioll is sufficil'llt, it is llotlll'CCSsal'Y to
derive the CAI'M as OJ theol't'til'allliodd. Rather, the Ilonllality aSSlIlllptioll
is adopled fill' stalislical purposes. Williont this aSSIIIllI>lioll, fillile-Salllpll'
)ll'Opt'J'lil's oLlssel pricillJ,!; Illodel IcslS arc dirticult to derive. Sl'colld, depar-
tun's of' IlHllllhly scrllrilY ITIlll'llS \'rOIlI Ilormality have heen dOl'llllll:llIed.:1
There is also ahllndalll Cl'idell(,(' of ht'lel'Oskedasticity and telllporal dqJl'n-
dl'lKC ill stock rl'lllllls.1 Evcn though temporal depl'ndellce Ill"kl's tht'
CAI'M ulllikely 10 hold as all cxan IheOJ'etiralllloclcl, il is still of illll'rl'st to
exalllille Ihl' ('llIpiril'al )ll'l'fill'lllalll'l' of the lllodei. It is Ihl'l'di)l'e desirahk
to ronsidcr tIll' dfl'rts of' rclaxing these statistic,,1 assumplions.
Rohllsl IcslS of' IIIl' <:1\»1\-1 rail IIc constructed using a Cl'lleralizeti
Method 01' 1\!OIllI'IlIS «;MM) I'rallwwOI·k. We focus 011 tests of Ihe Sharpl'-
1.'IlllIll'l'\·crsioll: IIm\,('\'('I', rohllsi I('sl s or II II' B1ark vcrsion (';1/ I I)l' rOllsl I'll ned
illlhe salllc 111;111111'1'. \\'itllill til<' (;1\11\1 f'rallll'wol'k,llIedislrilllllioll of'relllrllS
('olldilioll;\1 011 IlIl' IlIark('1 rellll'lI CII\ 1)(' bOlh serially <Iepl'\lIklll and ('on-
ditiollall), IlI'tl'l'Os\..l'daslil'. \\'c IIl'ed ollly assullle that CXCl'SS assel retllrns
arc Slaliollarl' and ngodi( wilh lillill' filllrlh nlllllll'IIlS. The suhsequcnt
analysis draws 011 SI'(liol\ i\.~ of Ihl' Appendix whit'h contains a W'llt'ral
dl'\'doplllclll of Ihl' Cl\1M IIIC·lhodolo).,'Y. We contilllle with a salllple of 'f'
lillie-series oi>sl'l'valions atld N assl'ls. Following the Appendix, we necd 10
setup the vl'ctor of 1l101liellt cOlldil ions with zero expectalion. The reqllired
1II0lllellt l'OluliliollS ",lIo\\' 1'1'0111 1IIl' ('X(·('SS-relllrnlllarkellllOdd. The resid-
ual vector provides N III0llll'lII ('ollditions, ant! the product of the ('X(,css
I'l'tU/'ll of lite llIarkl'l ;11111 Ihe rl'sidual vector provicles allother N 11IOl1lCnt
cOllditiolls. Usillg Ihl' Ilolalioll of' Ihe Appendix, fill' f(O) we have

(:,.1;.1 )

where h; = (I /."" (, (", = Z, - n - (J /."''' alld 0' = (0' ,13'].

The spl'cilicali,," or IIII' C'x('('ss-retllJ'n market 1l1l)(ld illlplies Ihl' 1110-
1111'111 cOlldilioll 1':1 f,(OIl) I =- 0, \\'111'('(' 011 is the Ii'll<' par;UIlI'I('I' vector. This
IlIOllll'nt cOlldition lorllls Ihe hasis lill'l'stilllalion and lesting using a C~'IM
approarh. (;Mt-.I chooses till' l'stililalor so that linear cOIlIi>inatiolls or Ihe
salllple avc'ragl' oflhis 1lI0llll'IlI (,(llldition arc zero. For thl' salllpl(' avcragl"

"SI'I' F.""., (I'll;',. 1!17Iil. 111.,"111"1-: ,,,,,ICCI'lC'ell" (1"17·1), l\lfI(·.. ~·t:r.I\I·' a",1 ~kIlClII."eI
(I"III~I),a,"1 '\:,hl" 1.1 ill (:10,,1"'" I.
'StT (:h"IHC.'I"" '.! .uul I'.!. ,HHI ,IH' I ('klc',u C'!'. 14ln'u in 11\0'\' ("h~'ptt·,~.
).6. Nonnonllai a1ld Non-JlV Helurns

we have
1 T
gT(8) = T L f (9). l
1=1

Thc GMM estimator iJ is chosen to minimize the quadratic form

(5.6.3)

whcrc W is a positive definite (2Nx2N) weighting matrix. Since in this case

we have '2N moment condition equations and 2N unknown parameters, the
systcm is exactly identified and iJ can be chosen to set the average of the
sample moments gT(O) cquallO zero. The GMM estimator will not depend
011 W since QT(O) will attain its minimum o[zero for any weighting matrix.
The estimators from this GMM procedure are equivalent to the maximum
likelihood estimators in (5.3.13) and (5.3.14). The estimators are

jL - j3j;.m (5.6.4)

L;~I(ZI - [J,)(Zml - ft.m)

(5.6.5)
,\,T Z • ~
L...I=I ( -ml - 11m)
Thc importance of the GMM approach for this application is that a
robust covariance matrix of the estimators can be formed. The variances
a.
of and j3 will differ from the variances in the maximum likelihood ap-
proach. The covariance matrix of the GMM estimator iJ follows from equa-
tion (A.2.R) in the Appendix. It is

(5.6~6)

where
D = E[OgT(8)}
o ao t

and
+00
So = L E[f l (l;l)f l _I(9)'].
1=-00

The asymptotic distrihution of iJ is normal. Thus we have

Tlw application of the distributional result in (5.6.9) requires consistent

csrilllarors of Do and So since they are unknown. In this case, for Do we ha~e
~
Dn = -[ )l",
I (2fJ..m
u",+J1 m
2)J0IN' (5,6.\0)
210

A consistent estimator OT can easily be constructed using the maximum likt·-

lihood estimators of Ii", and a;;'. To compute a consistent estimator ors". ;UI
assumption is necessary to reduce the summation in (5.6.8) to a Ii nile 1111111'
her of terms. Section A.3 in the Appendix discusses possible assumptioll".
Defining Sr as a consistent estimator of So. (1/ '1') [O'1'S;-,1 Or J- 1 is a consis-
ten t estimator of the covariance matrix of O. Noting that 0. = RO where
R = (I 0) ® IN. a robust estimator of VarIa) is (l/1)R[O'TS;-,'Orl-'R'.
Using this we can construct a chi-square test of the Sharpe-Lintner modd
as in (5.3.22). The test statistic is

(5.1i.11)

Under the null hypothesis a = O.

(:>.Ii.I~)

YMacKinlay and Richardson (1991) illustrate Ihe bias in standard CAl'M

tes~ statistics that can result from violations of the standard distributional
ass~mptions. Specifically. they consider the case of contemporaneous condi-
tiOllal heteroskedasticity. With contemporaneous conditional heteroskedas-
ticiiy. the variance of the market-modd residuals of equation (r).3.:~) de-
pel~ds on the contemporaneous market return. In their example. the as-
5111 ption that excess returns are 110 aruljointly lIlultivariate Student Ile;\(ls
to onditional heteroskedasticity. The lIlultivariate Student 1 assumption
for xcess returns can be motivated both empirically and theoretically. One
em· irical stylized fact from the distribution of returns literature is that IT-
tun s have fatter tails and arc more peaked than one would expect from a
nor a1 distribution. This is consistent with returns coming from a multi-
vari Ite Stude III I. Further. the multivariate Studellll is a rethrn distribution
for vhich mean-variance analysis is consistent with expected utility maxi-
miz tion. making the choice theoretically appealil1g.~·
he bias in the size of the standard CAI'M test for the Student I case
'depbnds on the Sharpe ratio of the market portfolio and the degrees of
freehom of the Student I. MaeKinlay and Richardson (1991) present sOllie
estil~lates of the potential hias for various Sharpe ratios and for Student I
degrees of freedom equal to 5 and 10. They find that in general the hias is
small. uut if the Sharpe ratio is high and the degrees of freedom slllali. the
hias can be suhstantial and lead to incorrect iniCrences. Calculation of the
lest statistic 17 based on the CMM fral\lework provides a simple check for the
possibility that the rejection of the modd is the result of heteroskedastirity
in the data.
5.7. ImIJ/i'IIII'lIla/ioll o/Tr.ll.l :lll

5.7 Implementation of TcsL'i

IIIthi~ SI"I lion we considcr issues rd.lling III (~Illpiri("al illlplnllcnt<ltioll of

the test mcthodology. A summary of cmpirical rcsuIL~. all illustrative imple-
menlatioll. and discllssion o\" thc ohservahility of the market ponfolio arc
included.

5.7.1 SllInmmy oj Eml,iri((l/ ElIitlrnrr

An enormolls amolillt of literatllre presenting elllpirical evidence 011 the
CAI'M has cvolved since the development of the model in the 1960s. The
early cvidence was largely positive. with B1ark •.IellSen. and Scholes (HI72).
Fama and MacBeth (1973), and B1l1me and Friend (1973) all reponing evi-
dence cOlISistellt with the lIIean-v"ri"nce efficient·y of the markel portfolio.
There was some evidence against the Sharpe-Lintner version of lhe aPM
as Ihe esti!nated mean return onlhe zero-heta port[(llio was Iligher than the
ri~Hree return. hut this could he accoullted for by the Black version of the
l\I(,del.
In the late I ~170s less favorable evidence for the CAI'M began to appear
inlhe s(}-callcd ,lIIomalies literature. III the contexi orthe tests discllssed in
this chaplCf. the ,Illolllalies call he thonght o\" as lirm charallerislics which
can be nsed to group asselS together so that the tangency portfulio of the
included portfolios has a high I'X 110,11 Sharpe ratio relative to Ihe Sharpe ratio
of Ilw market proxy. Alternalively. COlllra!), 10 Ihe preC\inioll of Ihe CAPM.
Ihe [inn charaueristics provide explallatory power for lire noss seclion of
~alllple mean returns beyond the heta of lire CAP!'.-!.
Early anomalies included Ihe price-earnings-ratio cllect and Ihe si7.e
circe\. l\asu (1977) first reported Ihe price-cHrnings-r.ttio elTeu. BaSll's
Ii nding is Ihatthe market portfolio appears nol to he l\Iean-variance emdent
rel.ttive to portfolios forllled on Ihe hasis of the price-earnings ratios of
linns. Firms wilh low price-carnings ralios howe higher sample retllrns, and
linlls with high price-earnings ralios have lower lIIean returns Ihall wOllld
he Ihe case if the market portli)lio was lIIean-v.u-iallce efficient. The sil.e
clfert. which was [irsl doculllented by Bani, '( I ~}H I). is the resllit that low
lII,trkct rapilali/,alioll linns have higher sample lIIean returns Ih<ln would
be experlcd if Ihe market port((llio was meall-Vari<lIlCe dIirient. These two
anonlalies arc <II least parti<llly related, as the low prire-e'!lIIings-ralio lirms
IClld 10 he slllal!.
A Illllnber oj' other OlllUm<llies have 1)('('11 dis('()\'cred 11101 e recelllly.
Failla alHI French (I~}~}:l. 1~1!I:~) lind Ih,ll bela call1lot explain the dillcr-
('II Ct· ill relllrll helween portfolios lill'lIH'd 011 rll(' basis ol'lhe ralio of hook

vallie or equity to market value of equily. Firllls Willi high book-market ra-
lios have higher average relllrns lhall is pr('diclcrl hy rll(' CAI'M. Similarly,
 J, Jill' (,11/1/(111 .. 1,.\t'( I'm'jllg ,1/,,"'"
IkBolld l alld Th;dn (1~1H:1) alld ,'q~adeesh alld Titlllall
(I~}~}:,) filld lil;11
a porlli,li o lilllll«'d III bllrill)!; slocks whose \'allll' has dt'c1illl'
d ill Iht' 1);1,1
(/11.\/'/'\) ;lIul sellillg slo('k, lI'ilo,,1' \'allll' has risell ill Ihe pasl
(lI';lIlIl'n ) h;IS a
hi)!;hl'l' an'r;lg(' .1'111111 Ilwl III(' C:/\1'~1 prl'dicls , Failla (1~}~1I)
pro\'idl' s ;.
good discllssi oll ollhl'sl ' alld 01111'1' ;lIuH.lal il's,
Alt hOllgh I Ill" reslllt,\ ill till' a •• 01l.;t1i,'s lill'rat 111'1' Il.a\, si)!;lIal
('rollolll ir;dl\'
ill.porla lll d('\i;lIio lls IHIIII till" (:AI'~I, t11('J'(' is lillie IIll'oreli
('al IIIOli\'al ioll
li,r Ihl' linll (hara('( '. iSlics "llIdil'd ill Ihis lileralllr e, This
opells lip Ih('
possibilil~' Ih"l Ihe ('\'id('IIt' (, a)!;;lil.sl Ihl' CAI'M is
O\'l'rslat t'd Iw('allsl ' 01 d;lIa-
siloopill) !; alld salllpll' sd('('lio ll bia,('s, WI' hridly disCllss Ihl'SI'
possibili Li""
I lala-sllo opillg biaSI'S rdi'r 10 Ih(' biasI'S ill slatislic al ill li-rl'II
('(' Ihal r('slIll
11'0.11 IIsill)!; illlillllla Lioll 11'0111 dal;1 10 )!;lIid(' Sll bS('1) 1)('11 I
rl'search wiLh Lhl'
sallll' or relal('(1 Ibl;1. Thl'''' hi;ISt's an' allllosl illlpossi hll'
10 ,,\,oid dill' 10
Ihl' 1101I('xp ('rillll'lIl al 11,,1111'1' of 1'('OIlOIl.i('s, \Ne do .UII han'
Ihl' It.XIIJ'\' of
rllllllillg "lIolht'l ' I'xpl'rilll('111 10 (,),I'al(' a III'W dala S('I. 1.0
alld Mad\'ill lal'
( I ~}~}Oh) illllSI raIl' III(' pOlnll i;d 1I.;lglI illule ofdala-sI IOOpill) !;
hias('s ill a I('SI of
I h(' Sharpe-I .i.II.It'l' \'t'I'sioll 011 hI' ( :AI'M, They cOllsili n Iht'
('ase II'h('l'(' 11ll'
d.ara('( nisl ic lI",d 10 )!;I'OII P slocks illlo porI folios (t' ,)!;, sill'
or pric(,-I'a rllill)!;s
r;lIio) is sd"t'l(,t! 1101 11'0111 Ih('orl' bill 1'1'0111 pre\'ioll s obs('rl'"
liolls 01 III ('a II
\Itu'k 1'('1 II I'IIs IJsillg ''('/;'.1'<1 <1;11,1. (:"lIIpar isolls "flhl' 111111 dislriblJ
lioll 01'1111'
Il'sl SI;llislic \\'iLh ;11 It I \\'ilholll d;\I"-Sll oopillg SII)!;g('SIS Ihallhl'
IIl"gllill ld(' of
Iht' hias('s ('all 1)(' illllllt'lIS t', Ilm\'(,\,('I', ill praclic( ', il is dilli(,1I1t
10 spl'rih' 11t(,
adjllslllu 'lIllh;1l shollid Ill' .1I"d(,li, rdala-sIl OOpill)! ;, Thus,lh
(' lIIailllll l'ssagt'
is a \\';.l'IIillg Ih;11 Ihl' hi;lst's sl,olllt! ;11 leas I b(' cOllsidt' l'l'd
;IS a pol('IILi;t1
t'xplalla lioll for II10dd dl'l'ialio lls,
Salllpll' s('Il'('lio ll hi",,'s ('all arisl' II'h('1I daLa a\'ailabi lily leads
10 t't rl;lill
Sllhst'ls of slo('k, beillg ('xl'illd( 'd 1'1'0111 Ihl' allalysis , For ('xa.llpl
e, KOlh,'ri ,
Shallkl'l I, alld Sloall ( I ~l~l:,) argllt' I hal dala r('qllin'I IIt'lllS for
sliltlit's look i II)!;
al hook-lII arkl'l ralios Il'ad Lo bilillg sLo(,ks Iwill)!; ('xcitul( 'd
;lIld a rt'sllitill g
slIJ'\'il'o rship hias, Sillt'(, IIII' 1;lilill)!; slorks wOlild he ('xP('('ll
'd 10 han' lo\\'
It'IIII'IIS alld high ilook-Ill arkt'l ralios, Ihl' al'erage n'tlll'll ofth(,
illcllld(' d high
hook-lII arkl'l-ra lio SIOI ks 1I'01iid hal'l' allllpwa rd hias, KOlhari
, Shallkl'l I, alld
SIO;III ( I ~}~I.',) a rg 11(' I hal !I,i, hi a, is 1;lrgd), J'('spolIs ibl('IIII' lhc
previolls ly ci 1('(1
rl'sllit of Falll;1 alld FII'IIl'l, (I~I~}:!, 1~I~n), I I ow('\,e 1', tht' iJllporta
llre of II,is
pal'li(,lI larslll'\'i n ,rship hia\ is 1101 I II II\' lI'sol\'t'd as Failla ;lIld
FrclIl'l1 (I ~}~}(ib)
displIl(' Ihl' ('tlllllll\ ioIlS 01 Kolh;lIi, Sh;llIk('I I, alld Sioall,
III aliI' I'\'('IIL. il is
d .. ;II' 11,;\1 1!',\t';lrt"llt'l'.s sl,ollld 1)(' ;111';11 (' of Ihl' pOI(,lItia l prtlhll'll
I\ Ihat ('all
arisl' 1'1'011. s;lIl1pll' sl'i('t'lio ll hi;,,(",

'i, 7,2 "III"lIllh -/' 111/1",'"1/'1/1111;01/

WI' pn'St'II1 l('slS 01 II I<' Sh;1I1 11'-1 ,i II L111'1' 1I1t)( 11'1 10 i II11s1 1';11 (' II
It' It'sl i IIg II 1<'1 I lOtI-
olog\', Wt' l'tlllsid n li,IIII('SI slalisLics: ,It frolll (:,.:I,~:I), ,h
1'1'0111 U',,:I,:!:! )../I
5.7. /1Il/,ll'1l1l'1llalioll o/TrIls . 213·

from (53.41), and J7 from (5.6.11). The tests are conducted using a thirty-
year sample of monthly returns on ten portfolios. Stocks listed on theiNew
York Stock Exchange and on the American Stock Exchange are allocated to
the portf(}lios based on the market value of equity and are value-wei~ted
within the portfolios. The CRSP value-weighted index is used as a proxy
fi}r the market portfolio, and the one-month US Treasury bill return is used
for the riskfree return. The sample extends from January 1965 through
December 1994.
T(:sts are conducted for Ihe overall period, three ten-year subperiods,
and six five-year subperiods. The subperiods are also used to form overall
aggregale test statistics by assuming that the subperiod statistics are indepen-
dent. The aggregate statistics for J2, }l, and J7 are the sum of the individual
statistics. The distribution of the sum under the null hypothesis will be chi-
square with degrees of freedom equal to the number of subperiods times
the degrees of freedom for each subperiod. The aggregate statistic for JI
is calculated by. scaling and summing the F statistics. The scale factor is
calculated by approximating the F distribution with a scaled chi-square dis-
tribution. The approximation matches the first two moments. The degrees
of freedom of the null distribution of the scaled sum of the subperiod JI'S
is Ihe l1umher of snbperiods limes the degrees of freedom of the chi-square
approximation.
The empirical results are reponed in Table 5.3. The results present
evidence against the Sharpe-Lintner CAPM. Using JI' the jrvalue for the
overall thirty-year period is 0.020, indicating that the null hypothesis is re-
jected at the 5% significance level. The five- and ten-year subperiod results
suggest that the strongest evidence against the restrictions imposed by the
model is in the first ten years of the sample from January 1965 to December
1974.
C.omparisons of the resulL~ across test statistics reveal that in finite sam-
ples inferences can difTer. A comparison of the results for JI versus }l
illustrates the previously discussed fact that the asymptotic likelihood ratio
lest lends to reject too often. The finite-sample adjustment to }l works well
as inferences with}l are almost identicalLO those with JI.

5.7.3 UTlObsmlabilily o/the Markel Portfolio

III Ihe preceding analysis, we have not addressed the problem that the rJturn
Oil Ihe market portfolio is unobserved and a proxy is used in the tests. Most
(eSlS use a value- or equal-weighted basket of NYSE and AMEX stocks '¥' the
market proxy, whereas theoretically the market portfolio contains all assets.
Roll (1977) emphasizes that tesL~ of the CAPM really only reject the mean-
variance efficiency of the proxy and that the model might not be'rejec\ed if
(he relurn on the true market portfolio were used. Several approaches rave
214 5. Tile Callilat AS.ll'll',il·;IIK Modd

Table 5.3. I:m/liriml ".w/I.! for Iroflof of Ihr Shm/lr.l,ill/llrr ,,,,,,,iOIl 11/hr eM'/II.

Time .J. !~value .h !~valll(" ./1 !~vahl(' .h !>-vahl('

Five-year subperiods
)/6~)-12/fi!) 2.0~/l 0.019 20./lli7 0.022 1/l.1~2 O.O4/l n.IU!', n.u I:.
1/70-12/74 2.1~1i O.O:~9 21.712 O.UI7 19.179 OJnH 2U~/7 n.UIH
17.47ti 0.()(i4

I
1/75-12/79 1.914 O.O(j(i 1!/.7H4 0.031 27.922 0.002
1/80-12/84 1.224 0.:\00 13.:\78 0.20:1 I1.HI8 0.297 1:I.(Hi!; 0.22U
I 1/85-12/89 1.732 O.JOO IH.164 OJ/52 1(i.()15 0.098 ](UII :. 0.07(;
I 11.200 0.:142 12.:\79 (1.2(iO
1/90-12/94 1.153 0.314 12.1i1l0 0.212
\,
Overall 77.224 0.004 1(){i58(i ** 94.151 0.003 113.78~, **
ten-year rubperiods
0.013 23.883 O.OOH 22.190 O.oJ:1 24.1i19 O.O()!;
\ I/r"-12174 2.400
1/75-12/84 2.248 0'<)20 22503 O.OI?> 2J.190 0.020 27.192 0.002
1/85-12/94 1.900 0.0,,:1 \9.281 0.037 18.157 0.052 16.373 O.OH'.I
Overall 57.690 O.()(lI 1i[J.{ifi7 ** fiJ.8:!7 0.001 (iH.215 **

irty-year period
1/65-12/94 2.1:,9 0.020 2Uil2 0.017 21.192 0.020 n.17(; O.OJol

\*Le~~ than 0.0005.

R~,ult\ are for ten value·weighted portfolios (N = HI) wilh slOe\<..\ assigned 10 III,' 1'''' I(olios
ha.\ed 00 market value of equity. The CRSP valuc-w"ighled index is "sed "'" Ill""""',· .. I'll ...
n;arkel portfolio and a one-monlh Treasury bill is used as a measure of Ihe risH...·.. fa,,·. Th"
lesL. are b.sed on mOlHhly dala frolll.lalluary 196:, 10 D"cemher 1994.

been suggested to considcr if inferences are scnsitive to the lise of a proxy

in place of the market portrolio.
One approach is advanced in Stambaugh (1982). He examilles the
sensitivity of tests to the exclusion of assets by considering a Ilumber of
broader proxies ror the market portrolio." Be shows that illkrellces al'e
similar whether one uses a stock-based proxy, a stock- and bond-based proxy,
or a stock-, bond-, and real-cstate-hased proxy. This suggesL~ that infercnces
are not sellSitive to the error in the proxy when viewed as a Illeasure of the
market portfolio and thus Roll's concern is not all empirical problem.

liRc.'lfflcd work c0I1~idc.·r5 Ih(' pos.."ihility of an:oul1ling for the n'(llrn Oil human Clpit.lI. SCt'
May"" (1972), Campllt'll (19!)(;a). ;1I111.1a~;UII"l\han and Wang (1~/!U;).
.5.8. (:IO.I.I-.\·I'r/;III/I/[ U''J.,T'/I'.i.I;1I1I.\

t\ secolld approach 10 Ihl' prohll'1ll is 11I1'SI'11I<'11 hy KouHld 011111 SlOlIll-

ball~h (19H7) and Shanken (1!IH7a). Their papers ('slim,lIl' an npper hound
Oil lite correlalion hetween Ihe lIlarkel PlOxY 1'1'1111'11 and lite lrue lIlarkel
I'l'l Ill'll necessary 10 OVl'r!urtltlte rejeclion oflhe CAI'M. Tlte hasic finding is
Ihal if the correlation between the proxy and the tnl!' markclexcccds ahoul
0.70, thell Ihe njeClioll of Ihe CAI'M wilh a Illarkel proxy would also imply
Ihe rejenioll or Ihe CAI'M wilh lhl' lIue m,lrkel ponfolio, Thus, as long as
we belie\'e there is a high correlalioll bCIW(TII lite 11'11(' 1ll,lrk('1 rdurn allel
Ihe proxies used, Ihe rc.:jeclions remaill inlact.

5.8 Cross-Sectional Regressions

So far in lhis chapler we have fOCllSc(1 Oil Ihe lllean-varialHT efficiellcy of

Ihe markct ponfolio, Another view of Ihe CAPM is Ilral il implies a lin-
ear relalion bclwecn expcclcd relUI'llS and markel helas which completely
explain tlte cross seClion of expecled reI urns. These implicalions can be
les'ed IIsin~ a cross-seClional regrl'ssioll lIIelhodoloh'Y'
Fama and Maclklh (1973) lirsl (lcve\oped Ihe cross-sct'lional I{'grcssion
"ppm.lrlL The h<lsic idea is, for each cross seClioll, \0 pn~j('(\ Ihe relurns on
Ihe 1)('las and Ihell ,I~~n:~ale Ihe l'slilllaies inllte lillll' dilll!'llsioll. ASSlllllill~
Ihal Ih(' belas arc kllown, lilc regr('s~ioll Illodd f(lr Iii!' IliI cross s(,(,(ion or
N assels is
I, = YIII L + )'1, {"J,,, + 11,.
wilere I, is Iii!' (N xl) vcclor of CX«:ss assel returlls for lillie period I, L is all
(Nx I) veClor oroncs, and fJln is the (Nx I) vcdor orCAI'M helas.
Impklllcnialion of the Fama-Maclklh approach illvol\'cs lIfO sleps.
First, ).;ivcll '{' periods of data, (!U-l. I) is estilll;lln[ lISill~ Or.'; ((1I' each t.
I = I ..... '1', ~i\'ing Ihe T eslilnates of YOt alltl YI t. Then in Ihe second
step, the lilll!: scri{~s of YOt'S and YII'S arc analyzed. Dclillill~ Yo :::= E[ YOt 1
and YI = 1:'[Ylt], Ihe implications oflhe Sharpe-Lilllller CAI'M arc Yo = 0
(zelO illlercept) alld YI > 0 (positive llIarkel risk prelllium). Because the
retllrns arc lIormally dislribuled and Icmporally lID. till' ~allllllas will also
he Ilormally dislribuled and lID. llence. ~i\'t'll tillle st:rics or Yu, alld YIt,
I = I ..... T, W(' Gill tesl l!tese implic;\liol\s using Ilw IISI"II I-Icst. Ddilling
1"(Y,) ;IS thl' t-St;\liSlir. W(' have

Y,

wltnl'

Y,
:Wi

allli

The <lisirilllllioll of w(y,) is Silldelli I wilh (,/,-1) clq~rees or frccdolll ;1I\(1

asymplolically is \I:tlldanl normal. Ci\'cll Ihc lesl slalislics, illrcJ"('lIccs rail
he iliadI' ill Ihe IIslial fashioll,
The Fama-Madklh approach is particularly useful hecause il call easil~'
1)(' lIIodili,'d III anclIlIlIHHlall' addiliollal risk IIlI'aSlIreS hcyolld Ihc (;,\1'1\1
hela. By adclill~ addiliollal risk mcaSllres, we call exalllillc Ihl' h~volhc­
sis 111011 hela cOlllplelcll' ,Iescrihcs IIII' <Toss-sectional varialion ill CXp('rlc,1
I'l'l urns. For I'xa III pll' , 1\'(' call considcr if linn sizc has cxplallalory powC\'
lill' Ihl' tToss-sel'liOIl of I'xp('('(l'd relllrns where firm sil.c is dclillcd ,IS Ihc
10~aritll1l1 01 1111' 111,11 kl'l I'allle of cqllily. Deli\lill~', as Ille (N x I) wetill'
wilh dClIlI'lIlS corrcspolldill~ 10 linll si!.(' al Ihe be~iJlllin~ of period 1,11'('
can ,lIlgllll'nl (.edt I) 10 illvl'sligall' if linn sin' has cxplanalory power 1101
C''I'llIil'd hI' Ihl' 111,11\;.1'(1)('(;1:

I, = YII/" -I- YII 0", + Y~I " + 1/"

ll,illl-: till' Y~I \ 1'1'0111 (r•. H.:.), \\'" 1'0111 II'SI till' hypolhl'sis Ihal Sill' docs lI,ll
han' alii' I'xplall,lIol'l' 11<1\1'1'1' IW\'tllld hCla, Ihal is, Y~ = 0, hy sl'lIill~ j =' '2 ill
(:.,H,'2)-(:dU ).
The F,III1,I-i\ladklh IIwilllldoloh,)', while IIseflll, do('s hal'" sCl'l'ral proh-
II'IIIS. Firsl, il CIIIIlOI hc direI'llI' applied hecallse Ihe lIIarkcl helas an,' 1101
knoll'lI. Thlls Ih,' rcgrcssiolls an' COlldllCled IIsin~ helas eSlilllalt',1 froll. the
dala, which illlro,liHTS all nrors-ill-variahles complicalioll. Thc l'I"rors-i'l-
I'ariahlt-s prohlt'lIl elll hc addrl'sscd ill IWO ways, OIlC approach, adopted
hy Fama and Macl\elh, is (0 11lillillli/e Ihe errors-in-variahles prohklll hI'
),\rol1ping Ihe slocks illlo portli)lios allel illcr('asin~ Ihe precision or Ihe
hCla ('slilllal('s. A secolld approach, devl'iopcd by l.ilzellhcr),\cr alld Ra-
IIlasw;III1Y (1!17!1) alld rdirH'd hy Shallkell (1!l!l2h), is 10 explicilly adjllsl
IIII' slalltianl ('1'rors 10 COIT('CI fill' Ihe hiases illlrodll('('d hy Ihe ('1'rors-ill-
variahles, Shallkl'lI sllgg('SIS lIIultiplyill),\ lr;, ill (!'UI.4) hy all a<\jusIJlleJlI
faClor (I + (ji", - f',,)'!/lr;;.). While Ihis approach elilllillales liIe errors-ill-
variahks hias ill IIII' '-slalistic ill (:•. !t2), il does lIoll'lilllinall' IIIl' possihilily
thai olh('\' I'ariahles IIliv,ill ('l\ler spuriollsly ill (:1.115) as a result of lhe \ll!-
ohservahilily or Ihe lrue helas,
The IIl1ohs('l'l'ahilily of Ihe lIIarkel portfolio is also a pOlelllial prohlelll
1i1l'11H' ('I'oss-seclioll,d legressioll approach, Roll and Ross (I !l~H) shill,' Ihal
if IhI' I nil' 1II;II'kel (1011 Ii .Iio is I'rticil'lI I, Ihe cross-sel'liOllal rdal iOIl hel\\'(,(,11
l':<'p('(,I('(11 ('111111\ ,lIullwl;IS call hi' "1'1)' sl'lIsilivl' 10 1'1'1'11 small devi,lliolls of
IiiI' lIIal'k('1 pOrllolio prox)' frolll till' 11'111' lIIarkel portJ(,lio, Thus el'id('II(,('
of Ihe lack of a I'I'Lliioll IWIW('('II ('xl)('('le(1 relllrn all(1 hela could he Ihe
5.~. CUllriu.lion 217

result of the fact that empirical work is forced (0 work with proxies for the
market portfolio. Kandel and Stambaugh (1995) show that this extreme
sensitivity can potentially be mitigated by using a gener.llized-least-squares
(Gl.S) estimation approach in place of ordinary least squares. However their
result depends on knowing the true covariance matrix ofretums. The gains
frolll usin~ GL<'; with an estimated covariance matrix are as yet uncertain.

5.9 Conclusion

III this chapter we have concentrated on the classical approach to testing

the unconditional CAPM. Other lines of research are also of interesl. One
important topic is the extension of the framework to test conditional versions
of the CAPM, in which the model holds conditional on state variables that
descrihe the state of the economy. This is useful because the CAPM can hold
conditionally, period hy period, and yet not hold unconditionally. Chapter 8
discusses the circumstances under which the conditional CAPM !]light hold
in a dynamic equilibrium setting, and Chapter 12 discusses econometric
methods for testing the conditional CAPM. I
Another important subject is Bayesian analysis of mean-variance ein-
ciency and the CAPM. Bayesian analysis allows the introduction of prior
illformation and addresses some of the shortcomings of the classical ap-
proach such as the stark dichotomy between acceptance and rejection of
lhe Illodel. Harvey and Zhou (1990), Kandel, McCulloch, and Stambaugh
(1995), and Shanken (1987c) arc examples of work with this perspective.
We have shown that there is some statistical evidence against the CAPM
in the past 30 years of US stock-market data. Despite this evidence, the
CAPM remains 'a widely used tool in finance. There is controversy about
how the evidence against the model should be interpreted. Some authcls
argue that the CAPM should be replaced by multifaClor models with several
sources of risk; others argue that the evidence against the CAPM is overstated
because of mismeasurement of the market portfolio, improper neglect of
conditioning information, data-snooping, or sample-selection bias; and yet
others claim that no risk-based model can explain the anomalies of stock-
market behavior. In the next chapter we explore multifactor asset pricing
models and then return to this debate in Section 6.6.

Problems-Chapter 5

5.1 Result:l states that for a Illultiple regression of the return on any asset
or portfolio Un on the return of any minimum-variance portfolio Rp (except
ror the glohal minimum-variance portfolio) and the return of its associated
218 5. 'JIu' Calli/ai A.\Jr/ /'ririllK Mllr/ri

ar~~ro-bCI.a=
/32
portfolio
/3np, /31
/~, I?" = /3n+/31/~11+~2/?p+Ei:'
=I - /311 ==
/l"i" and O. Show tillS.
the regression codlkiellts

5.\2 Show that the intercept or the excess-retllrn market model, 0, is I.ero
if;the market portfolio is the tangency portfolio.
I -
5! Using monthly returns from the \D-year period January I!IW) to De-
c \IIber 1994 for three individual stocks of your dlOice, a valul~-weighted
III rket index, and a Treasury bill with one month to maturity, perform tlw
~ lowing tests of the Sharpe-Lintner Capital Asset Pricing Model.

5.3.1 Using the entire to-year sample, regress excess retlll'llS or each
stock on the excess (value-weighted) market return, and perforlll t('sts
with a sizc of 5% that the illlercept is zero. Report the point estim.lll's,
I-statistics, and whether or not you r<:ject the CAPM. Perrorm regression
ragnostics to check yoIII' specification.
~.3.2 . For each stock, perform the saUll: test over each of the tlVO c«ui-
partitioned SUbsalllples and report the point estimates, [-statistics, and
~whether or not you reject the CAPM in each suhperiud. Also indudc the
same diagnostics as above.

5.3.3 Combine all three stocks into a single equal-weighted portfi)lio

and re-do the tests for the entire sample and fi)r each of the two snhsaIII-
pies, and report the point estimates, I·statistics, and whether or lIot YOli
reject the CAPM for the whole sample and in each subsamplc. Include
diagnostics.

5.3.4 'Jointly test that the intercepts for all three stocks are zero using the
P-test statistic JI in (5.3.23) for the whole sample and for each subsalllple.
5.4 Derive the Gibbons, Ross, and Shanken result in equation (55.3).
 6
Multifactor Pricing Models

AT '1'111' END OF CIIAI'TER [} we SUllllllaril.cd cillpirical cvidcllcc illdicatillg

that the CAI'M beta does not completely explaill the cross section of cx-
IHTtecl asset retllrllS. This evidellce suggests that (llle or morc additiollal
L("[ors lIIay be required to t:haracteril.c tire hehavior "fexpeoed returns alld
nal:lrally leads to consideration of IIIlIlliElctor pricing models. Theoretical
arglllllenL~ ;Jlso suggesl lhal more than onl" fa('(or is n·qllired, sin(l~ oilly
\llIder strollj.\ ass\llllptiollS willtlle CAI'M ~'pply period l>y pniod. Two main
thnm:lical approaches exist. The Arbitrage l'ricillj.\ Theory (APT) devel-
oped by Ross (I !J7li) is based 011 arhitrage argunlClits alld the Intenemporal
Capilal Assetl'ricillg Model (ICAI'M) developed hy Mellon (I !173a) is bascd
on equilihriulIl argumcllLs. III this chapter we will cOllsider Ihe ecollolllclric
an.t1ysis of multifaclUr models.
Thc chaplcr procceds as follows. Senioll li.1 brid Iy disc\lsses the the-
oretical background of thc multifanor approachcs. In Scction G.2 we con-
sider estimation and tcsling of the models wilh known faclOrs, whilc ill
Scction li.3 we develop estimators for risk premia and expened returns.
Since lire factors are 1I0t always provided by theory, we discuss ways to COII-
strllCt lhem ill Sectioll G.4. Scctioll G.!i presenL~ empirical rcsulLs. Becausc
of tire Jack of specificity of thc modds, dcviatiolls Gin always be cxplaillcd
by additiollal !;rcwrs. This raises all issul" of illlcrprt"lill~ model violations
whkh we discuss ill Section (i.G.

6.1 'Theoretical Background

The Arbitrage Pricing Thcory (APT) was illtrodllced hy Ross (1976) as all
alternative to the Capital A%ct Pricill):( Model. The APT can hc morc gen-
eral than the CAPM ill lhat il allows for lIIultiple risk (;rclors. Also, unlike
the CAPM, the APT does not reCfuire Ihe idelllificalioll of Ihe market pon-
folio. Ilowe\'("I", Ihis generality is 1101 wilhollt cosls. III ils mosl gelieral/<>rI1I
 6. AI 1/11 i/ill'I!)/" J'ririllg ,\Ji!lll'l.\

lh(' APT provides all 1I/'/lIlIXi/ll(/11' n'lalion for cxpeCled asst'l relurns I\'illl
:III 1I11kllOWll 11111111)('1" or IIl1idt'1I1ifit'd faclors. Al lhis It'I'cI I"ejcclioll oi" lhe
lhcory is impossihle (UlIless arhilragt' opportlllliti(~s cxist) ;Illd as ;1 (OIlSl'-
I(uell(,(' lcslabilil)' or III<' IlIodl'! depellds Oil lhe illlroduClioll of addiliollal
assulllptiolls. J
Thc AI hilral4t· l'ritilt~ Theory ;ISSltll\l'S lhat tlIarkt·ts an' COlllpt·t itivc ;\IId
i"rit'liOlllt·ss alld 111;11 IIII' r('llIrJI I4t'IJ('l"alinJ!; prOfess i"or asst'l n'llIrJlS heill)!;
n ltIsidt't't'd is

U, (/, + h; f + E, «(i.L1 )

Elf, I fl 0 «(;, I.~)

., ')

Elf;1 (T-
I
< (T- < 00, (!i,I.~)

when' H, is Iht· n·II .... 1 fill' assel i, (Ii is the illtercept of Ihe /:tetor model.
hi is a (Kx I) \'t'nor of bnor sellsitivities for asset i, f is a (Kx I) V('('\or of
COI,1I111011 /;tClor rt'ali/;llions, and f, is the distnrhance tenll. For the sysletll
of N aSS(,IS,

R (IdA)

fl o (G.I.:l)

Eiff' I fl :: E. «;. \.(i)

III the systcllt (''I"ation, R is alt (N x I) Vt'clor with R = [N I R'J ... 1'.\, J', a is
an (N x I) ,'('CIOI" I\'ilh a = II/I (/,! '" (l,v)'. B is an (N x K) Illatrix widl n :=
Ihl h~ ,., h,\' 1', ;\1\<1 f is;\I\ (Nx I) vt'ctor with € = [fl E!? , .. E,'V \', We !'ttl Ihn
ass II II II' lhal IIH' i"a("\ol"s atTOIIIII fi'l" liIe COlllillon varialioll ill ;ISSI'I rl'IItI'lIS
so that tht· disltllhalt("(' I('rlll lill' largt' wcll-diversilicd portfolios vanishes,'!
This n'qllires Ihalllle dislurhaltce I('nlls be slIfficit'lIlly IIlu'olTcialed across
asst'ts,
C:il'en Ihis slrll("\llIt', Ross (11)7(;) shows that lhl' abst'ut'(' of arhitragc it!
tngc CCollolllies iltlpli('s Ih;11

/1. ~" d'l) -I- n A", «;,\ ,7)

wll<'n' /t i, Ihl' (,\, xl) "'I",,"ll'd \1'1111"11 \','('tor, Au is lilt, 111011<'1 I.,'\'o-I)('la pa-
r;lIlIt'I,'I" alld is ('qlla\ 10 11)(' riskln't' I"elllrn if slIch all assel ('xiSlS, alld Ai:
is 0\ (K x I) ,'(Tlor III b.-lor risk preltlia. Ill'n', ;t11d Ihr()lI~h()lIl lilt, ('ilapl('\",

'Thl'''' \0,,, 111'1'11 ,11"","li .• 1 .It-h,''I' Ill' IllI' 1I'.\I"hilil)' III II ..· APT. '-;I>;lIlkt-1l (1~IH:!) "lid
Ihh\ig ,11111 H,,,, (I!U"r" 11I1I\ld(' ow' illlt'U"lillg C'xt hangl'. DhrYIIH'.\, Frielld, (;lIl!l·kili. ,1I1l1
(;IIIIt'''-ill (Ptx I) .at . . ., q"t·,IHtli II", c'lIIl'il if ;11 IC"C'\,;lIIn' 01 tlu- lIuulel.
! {\ L""f\' \\dl-di\"I', ... ili",1 p"nlulio i... ;, pu"tulluwith~, lal").~"· n"'l\ht.'ruf~"" k~\\'''h \\'t'igh\i"~s
olouk. :y.
fl, J, 'J'IU'lII't'Iim/ JJarkg7Vllntl

.,
let ~ represent a cOllfonnin~ vector of ones, The relation in (6.1.7) is
proximate as a finite lIumber of assets can be arbitrarily mispriced. Because
«(;.1.7) is only an approximation, it does not produce directly testable restric•• ;~,~:':
tiollS for ,Isset returns. To obtain restrictions we need to impose additional~,;'~··
5t l'lIctlIl'e so that the approximation hecomes exact. ~ ,::~~~,; .
Connor (1984) presenL~ a competitive equilibrium version of the APT'i,:~!:
which h,lscxact factor pricill~ as a feature. In Connor's model the additional·,~~.:.~·.!.•
reCJuirelllenL~ are that the market portfolio be well-<liversified and that the .~w.:
factors be pervasive. The market portfolio will be well-<iiversified ifno single ;'::f.;-;.
asset in the economy accounts for a significant proportion of aggregate .: ~>
wealth. The requirement that the factors be pervasive permits investors to
diversify away idiosyncratic risk without restricting their choice offactor risk
exposure.
Dybvig (1985) and Grinblatt and Titman (1985) take a different ap-
proach. They investigate the potential magnitudes of the deviations from
exact factor pricing given structure on the preferences of a representative
agent. Both papers conclude that given a reasonable specification of the
parameters of the economy, theoretical deviations from exact factor pricing
arc likely to he negligible. As a consequence empirical work based on the
exact pricin~ relation isjustified.
Exact factor pricing can also be derived in an intertemporal asset pricing
framework. The lntertemporal Capital Asset Pricing Model developed in
M(~non ( 1973a) combined with assumptions on the conditional distribution
of returns delivers a n1Ultifactor model. In this model, the market portfolio
serves as one factor and state variables serve as additional factors.! The
additional factors arise from investors' demand to hedge uncertainty'about
futllre investment opportunities. Breeden (1979), Campbell (1993a, 1996),
and Failla (1993) explore this model, and we discuss it in Chapter 8 ..
In this chapter, we will generally not differentiate the APT from the
ICAPM. We will analyze models where we have exact factor pri!=ing, t~at is,

i
IL = tAo + B>'K. (p.1.8)

There is sOllie flexibility in the specification of the factors. Most empiri-

(';\1 illlpl('IlH'nt,ltions choos(' a proxy for the market portfolio as one factor.
Ilow(',,('\', different technic]lles are available for handling the additional fac-
rors. We will consider several cases. In one case, the factors of the Apt anef
lhe state variables of the I(,APM need not he traded portfolios. In other
rases the factors arc returns on portfolios. These factor portfolios arc called
lllillli(kin~ po.rtfolios becallsejointly they are maximally correlated with tIlt'
factors. Exact factor pricing will hold with stich portfolios. Huberman,
K;llldcl, and Stambaugh (19f\7) and Breeden (1979) discuss this issue ill
the context of the APT and ICAPM, respectively.
2 2 6. Multi/actor Pdrill/!. MI}{ft./.1

6.2 Estimation and Testing

In this section we consider the estimation and testing of various forms of the
ex ICt factor pricing relation. The starting point for the econometric analysis
of the model is an assumption about the time-series behavior of retul'lls.
W will assume that returns conditional on the factor realizations arc II [)
th ough time and joilltly multivariate 1I0rmai. This is a strong assumption,
bl~t it docs allow for limited dependence in returns through the time-series
behavior of the factors. FunhernlOre, this assllmption can be relaxe(1 by
casting the estimation and testing problem in a Generalized Method or
Moments framework as outlined in the Appendix. The GMM approach for
llIultifactor models isjllst a generali7.ation of the GMM approach to testing
the CAPM presented ill Chapter 5.
As previously mentioned, the multil;lCtor models specify neither the
number of factors nor the identification of the factors. Thus to estimate and
test the model we need to detCl'minc the bctors-an issue we will address in
Section GA. In this section we will proceed by taking the JIlllnber of brtms
and their identification as given.
We consider fOllr versions of the exact factor pricing model: (I) F,tc-
tors are portfolios of traded asseL~ amI a riskfree asset exisL~: (2) Factors arc
portrolios of traded asseL~ and there is not a riskfree asset; (:{) Factors are
1I0t portfolios of traded assets; and (4) Factors arc portfolios of traded assets
and the factor portfolios span the mean-variance frontier of risky asseL~. We
lise maximum likelihood estimation to handle all fOllr cases. See Shanken
(1992h) for a treatmenl of the same fOllr cases lIsing a cross-sectional n:-
gression approach.
Given thejointllormality assumption for the retnrns condition.1! 011 the
factors, we can construct a test of any of the fOllr cases using the likelihood
ratio. Since derivation of the test statistic parallels the derivatioll of the
likelihood ratio test of the CAI'M presented in Chapter 5, we will not re)leat
it here. The likelihood ratio test statistic for all cases takes the sal\le gelll"J"al
form. DeflllingJ as the test statistic we have

(ti.2.1)

wlwre t and t" arc the lII<1xilllUllI likelihood estimators of the residual
cO\'jlriance matrix for the ullconstrained 1I10del and constrained model,
resnectivcly. T is the number of time-series observations, N is the number
of ihclll<i('d portfolios, and K is the nnmber of factors. As discussed in
Ch.~pter 5, the statistic has heen scaled hy (T - ~ - K - I) ralher than the
llSll~1 T to improve the cOllvCfgence of the flllite-sample null distrihution
0,2, 1'.:~/i/ll(l/iuli fllld 'Frs/inK

10 Ihl' lar).';l' ~;\lIIpll' distriIHltioll.: 1 The hlq.;e sample distrihutiull of} ulldl'\'
Ihl' lIull hypothesis will he chi-sqllare wilh Ihe dq.;n·(·s offrecdolll eCjllallo
Ihe 1I(11111)('r ofreslrictiolls im(lo!;('d hy Ihe 111111 h),pollH'sis.

6.2. I !'orljiJiiu,\ 11,1 I·in/o/,I wilh Il lIi,I!;}II'I' AI,II'/

We Jirst cOllsider the case where the factors are Iraded (lortJ()lios ;lIld there
exists ;\ riskfrce assel. The unconstrained Illodcl will he a /\-bclOr model
exprcssed in exccss retllrns. Define Z, as all (N x I) vcnor of excess retllrns
for N assets (01' portfolios of asscts). For excess relllrns, the /\-l'al'lor linear
III orle I is:

Z, = a + HZ!;, + £:, (li.2.2)

Elf',! () (li.2.3)

(li.2A)

EI(Z,,·, -It!;) (Z!;, -It!;)'j

Cov[ZJ\,. €;J = 0, (li.2.!i)

B i~ the (N x 1\) Illatrix ofElCLOr sensilivities, Z!;, is the (/\ x I) vector onaclor
(lol'lfolio excess returns, and a ;l\ld (', are (Nx I) I'('ctors of asset return in-
lercepls alld dislurbances, respectively. 1:: is the variancc-covariance matrix
of lile distllrbances, and n/\ is the variance-covarialHT malrix of the factor
pOI'l/"olio exccss rellll'llS, while 0 is a (/\ x N) matrix of zeroes. Exact 1,~ll'lor
pri( illg illlplics that the demcnts of the v('clor a ill «(;.2,2) will he zero.
For lhe IInconstrained model in (li.2.2) lhe maximulll likelihood esti-
malors ar(' .iIlSt the OLS estimators:

(li.2.7)

(li.2.!/)

whcre
.J.L -- -TILr Z' and It/-.,
I I
-~Z.'
rL n"
'~l '~I
 O. tIIulli/ilt"/1If I'liring t\llIdl'l.~

For Ihe (oll,nailled Illodel, wilh a cOllslrailled 10 he zero, Ihl'maximllm

likelihood ('slilllalllls all'

(G. ~. \())

r
+. Z)Z, - n'z"" )(Z, - n·z",,)'. (Ii.:!. I I )
'~I

The !I II II hypothesis a eljllals I.no CIII he Il'slt'd IIsing the likdihood ratio
slatislic j ill (Ii.~. 1). L1l1cler the lIull hYJlothesis Ihe degrees offree<iolll 01' the
null distrihutioll will he N since the 111111 hypothesis imposes N restrictions.
III Ihis cas(' WI' (;111 also COllstfll('\ all exact lIIultivariale F-It'sl of Ihe Ilull
hY(lotlH'sis. Iklillill(.!;.h as Ihe II'SI stalistic we have

(G.:!.l:?)

Ulld('1' 11\('IIUIl hypolhesis,./I is II II ('01 I! Ii liollally e1islriblltl'd cCIIll'al Fwith N

dl'gn'('s of fn'('dolll ill tl\(' 1IIIIIIel'atol' alld ('j' - N - f.:.) dq!;l'cl'S or frecdolll
ill IiiI' (kIlOlllillalol'. This tcst call he very IIseflll sillc(' it can elimillate thc
prohleJlls thai call an'onlpallY fhe usc of asymptotic distrihutioll tiICory.
Johson al\(I Korkil' (I ~1H:» »J'()\'id(' a derivation of jl.

6.2.2 I'(I/'/ji}/im (II Fur/on wi/holl/a Ri.lkJrl'l' Anl'/

III tile ahs('llce of a liskfre(' aSSl't, there is a zero-beta JlIocil'l that is a IlIl1lti-
bnor ('l)lIi\';\\('llt 01'111(' 1~Ia('k \'('l'siOIl of the CAPM,IIl a II\lIltirauor COlllext,
the z('I'o·hl'la port/t.lio i~ a port/i)lio with 110 sensitivity to any or the Eiuors,
and (,,,))('('\('<1 \'('tllI'l\S ill ('X('('SS of 1)1(' l('('o-beta retllrn ~ll'e linearly rdatl'd
to 1)11' ('01 II III liS or Ihe lIIall'i" of faClor SC'lIsitivitil's, Thl' factors an' assullled
to hI' I'on/(.)io r('tunls ill ('''('I'SS 0(' III(' 'I.t'I'o-))('la 1'('lul'Il.
I)l'Iill(, R, as all (N x I) v('clOI' or I('al returns for N ,ISS('\S (01' »ol't)'olios
ofass('ls), For Ih(' 11I1('ollstraill(,d IlIodt'!, W(' h;lv(' a K-/;J('\ol' lilll'ar lIIodd:

R, = a + n RI\, + 1':, «i.~.I·I)

1':1 f,l o «;.~.)))

nf",'l (i.:!.I(i)
6.2. f:~timation and 'Jesting • 225

E(RKI - J-LK) (RKI - J-LK)'] = OK (6.2.17)

i
COV[RKio €;] = O. (6.2.18)
"

B is the (N x K) matrix of faClor sensitivities, R K , is the (K x 1) vector of

factor portfolio real returns, and a and €I are (N xl) vectors of asset return
intercepts and disturbances, respectively. 0 is a (KxN) matrix of zeroes.
For the untonstrained model in (6.2.14) the maximum likelihood esti-
mators are
a= {L-BP.K (6.2.19)
1
Ii = [t(RI - iL)(R KI - {LK)'] [t(RKI - iLK) (R K1 - iLK),r

(6.~.20)

where
1 T I T
P. = T 2:= R, and J-LK = T 2:= R K1 .
• 1=1 1=1

In the constrained model real returns enter in excess of the expected

zero-bela portfolio return yo. For the constrained model, we have

R, = Lyo + B(RKI - tyo) + €, (6.2.22)

= (t-Bt)yo+BRK1+€t.

The constrained model estimators are:

(6.2.23)

to = T1 l)R
T
/- .'.
LYo - B (R Kt - LYo)l
•

/=1

(6.2.24)

Yo =
• (6.2.2fi)
2261 . 6. Multifactor Pricing Modl'ls

The:maximum likelihood estimates can hc ohtaincd by iterating over «(i.'L23)

to (~.2.2:). B frolll (G.2.20) and :E from (1i.2.21) can bc uscd as starling
values for Band :E in (6.2.25).
Exact maximulll likelihoud estimators can also be calculatcd without
iteration for this case. The IlIcthudulu!,'Y is a generalization of the ,lpproach
outlincd for the Black version of the CAPM in Chapter 5; it is presentcd
hy Shanken (I985a). The estimator uf Yu is the solution of a fjuadratic
equatiun. Givcn y(), the constrained maximum likelihoud estimators or B
and :E follow from (6.2.23) and (6.2.24).
The restrictions of the cunstrained lIludd in (6.2.22) Oil the uncon-
strained model in (6.2.14) arc

a = (t - Bt)yu. (ti.2.2G)

These restncltons can be tested using the likelihood ratio statistic .I in

(6.2.1). Under the null hypothesis the degree5 of freedom of the null dis-
tribution will be N -I. Therc is a reduction uf one degrec of freedom ill
comparison to the case with a riskfrec asset. A degree of freedom is used
up in estimating the zero-beta expccted return.
For use in Section 6.3, we note that the asymptotic variance of Yo evalu-
ated at the maximum likelihood estimators is

Var[y()) +- (1 + (11" - y()dn~t (jL" - YUL»)

x [(L-B·L)':E·-t(L-B·LW t . «(j.2.27)

6.2.3 Macroeconomic Variables (lJ Factors

Factors need not be traded portfolios of assets; in some cases proposcd hlc-
tors~:, leludc macroeconomic variahles such as innovations in GNP, changcs
in IJ nd yields, or unanticipated ill!lation. Wc now consider estimating and
tcstil g cxact facLOr pricing models with such factors.
• Again define R/ as all (N xl) vector of real rcturns for N assets (or
portfolios ofasscts). For thc ullcollStrained model we have a K-f;IClor linear
\Ilo<\fl:
I (G.2.2H)
I

I
! E[f,] () «(i.2.2~)

i Elf/E,'} == :E (li.2.30)

I Elf",) = E[(f...:, -,Ltd (f", -ILf ,,)'} = «(i.~.31)

,
Cov[f"/. f;1 = O. (li.2.:·m
6.2. Estimation and TesliTlg 227

B is the (N x K) matrix of factor sensitivities, f",

is the (K x I) Vl'l'\or of factor
realiJ.ations, and a and (;, arc (Nx I) Vl'('\ors of asset return intercepts and
distlll'\)'Illl'CS, respectively. 0 is a (/\ x N) lIlat rix of lero(·s.
For the unconstrained model in (I;.:!. H) thl' Ill<lxi 1111 I III likcrlliood l'sti-
lIlators arc

(ti.:!.33)

«i.2.:H)

T
= T1 '\'
L..,(R , -
1=1
• - .',
a - Bf",)(R, - a - fif"l) , (G.:!.:l5)

wlwre
T
•
It = T1 '\'
L.., R, and
'~I

The constraincd model is l1Iostl'ollv('niclltly hll'lllulatcd hy comparing

thl' unconditiollal expectation of (11.:!.:!H) wilh (1i.I.H). The IlIlConciitional
l'xpectation of ((i.:!.2H) is

/L = a + B/L/". (ti.2.:~(i)

where J.LI" == Elf",]. Equating the right hand sides or (li.I.H) and (1i.2.36)
we havl'
a = LAu + 8(>'" - J.L/,,). (G.:!.37)

Delining y" as Ihe zero-heta paramctt'l' A/I and dclinillg II as (>'" - J.L/,,)
whcre >." is Ihe (Kx I) vcclor of faclor risk premia, for Ihc constrained
Illodel, we h,l\'c
(G.2.:lS)

Thl' constrained model estimators <In:

(C).2.39)
 6. MIII/ijf/r/llr Prjr;lIg MIII"'.1

(n. ~.40)

(li.~.·11 )

whl'rt' ill (li.:!.·II) X == 11,11'1 and I == I Yo 1'1 J'.

The Illaxillllllll likelihood estilllatt's call be obtai lied hr iteratillg o\'er
(li.'139) to (li.'1..1 I), B hom «).~.:H) and t
from (li.2.:);» Gill he \lsnl as
stOlrlillg vOIlllcs fill B alld }:; ill (n.~.'II).
The rcstriniolls of (1;.2.:IH) Oil (1;.~.2H) are

Thl'sl' n'stl'll"tlllllS em he tested \Ising the likelihood ratio statisti<: .I ill

(li.2.1). lhull'!" lIlt" 111111 hypolh('sis the dcgrecs or rrcedolll of the null dis-
trihulion is N - K - l. Th('l'e arc N rcslrictiolls but one degrce orfreectOIll
i~ lost t'stilllatiu),( Yo, alld K d('),(I'!'l's of frcl'dom are used eSlimatillg the K
('h-nlt'nls of AA'.
The ;1~Yllll'tOlic \';11 i;II",(, 01 :y follows frolll Ihe lIIaxillluln likelihood
approach, The 1';1Ii;IIICe ('\';IIl1all'd OIl Ihl' JIIaXilllUIII likelihood I'stilllalOrs is

Applrillg thc partitiolled illVt'lse rule to (1i.2.4:\). fe)r the variances of t)le
compolIl'nts of:Y \\'c ha\'c cstilllators

+(I + (:y I + ill 1.;>'1i~ (:YI + P-j IJ) (B"t,-llh- 1

I

-1 (B"E,-IU')-IB"E·-\(Y.;'i·{yu))
x t'}:" Iihil,,}:·-I B·)-I,
We \Villus(' Ihl'se I'ariallcc n'sulls li)r infercnccs cOllccrnillg Ihc lilnor risk
premia ill S('nioll (i.:1.

fl, 2,,' 1,(1t lot I''''I/o/im .'i/llllllli IIg Ihl' MfilIl-l'a/'illllC/' 1-I1I1IIit·,.

\,\'hclI 1~\('lOr pOI'I«.lios span Ihe Illean-I'ariall(,(' fronlier, tIlt" inlerccpt 11'1'111
of thl' I'xact pricing rl'ialioll All is /('ro wilhonllhl' !ll'cd lill' a riskfree ass('\.
6.2. i:'sti11l(l/ion and 7fSlill/(

Thus this case retains the simplicity of the first case with the riskfree asset. In
the context of the APT, spanning occurs when two well-diversified portfolios
arc Oil the minimum-variance boundary. Chamberlain (1983a) provides
discussion of this case.
The unconstrained model will be a K-factor model expressed in real
retll\'lls. Define R, as an (Nx I) vector of real returns for N assets (or
portfolios of assets). Then for real returns we have a K-factor linear mode!',:
I
R, = a+BRJ\r+f., (6.2.4&)
I

o (6.2.47 )
1

E (6.2.4~)

(6.2.49)

(6.2.50)

n is the (N x K) matrix offactor sensitivities, RJ\, is the (Kx I) vector offactor

portfolio real returns, and a and f., are (N x \) vectors of asset return interr
cepts and disturhances, respectively. 0 is a (K x N) matrix of zeroes. The
restrictions on (6.2.46) imposed by the included factor portfolios spannin~
the mean-variance frontier are:

a = 0 and Bt = t. (6.2.5\ )

To understand the intuition behind these restrictions, we can return to

:he Black version of the CAPM from Chapter 5 and can construct a span-
ning example. The theory underlying the model differs but empirically the
restrictions are the same as those on a two-factor APT model with spanning.
The unconstrained Black model can he written as

R, = a+ f3 0mRol + f3rn Rrn, + f." (6.2.52)

where ROIl' and Ro, arc the return on the market portfolio and the associated
zcro-beta portfolio, respectively. The restrictions on the Black model are
a = 0 and f30m +f3rn = L asshown in Chapter 5. These restrictions correspond
to those in (6.2.5\).
For the unconstrained model in (6.2.46) the maximum likelihood esti-
mators are

(6.2.53)
230 6. Multifactor PricillK MrHlrLl

(li.2.:,·1)

where
T
I.L. = TL.....RI
I '" and
1=1

To estimate the constrained lIIodel, we consider the uncolJStrained

model in (6.2.46) with the matrix B partitioned into an (N xl) cO\lIlIIn vector
b l and an (Nx(K-I» matrix BI illldthe factor portfolio vector partitioned
into the first row RI! and the last (K-l) rows R K,!. With this partitioning
the constraint B ~ == ~ can be written hi + BI ~ == to For the lI11colIStrailled
model we have

Y Substitllling a == 0 and b l == L - BI L into (G.2.56) gives the constrained

jmodel,
I R, - ~RII = BI (R h ,! - ~RII) + E,. (li.2.:,7)
1
\ Using (6.2.57) the maxillllllll likelihood estimators are

«(i.25H)

b;
:to (G.2.IiO)
==
II
~rhe null hypothesis a e«uals I.em c<In he tesled lIsing rhe likelihood ralio
hatistic J in (6.2.1). Under the null hypothesis the degrees of freedolll of
the null distribution will be 2 N since a == 0 is N restrictions and B ~ == ~ is
N additional restrictions.
We can also construct an exact test of the null hypothesis given the linear-
ity of the restrictions in (i.251) and the Illuitiv<lriatc normality asslIlllption. '
6.3. }~,\lill/(/li(}1/ o/UiJ/, /'mllia ami }';x/}('(/t'li UI'IIII7I.~ 231

Defining.h as Ihc lest slatistic we haw

h =
(T -- N - h') [1i--;;--
:;'1 -I,] ((i.:2.(il)
. N I~I

U\ld("\" Ih(~ \lull hypothesis, J'l is IIIKoll(litionally disllilHltnl n~ntral F with

2N degrecs o\" frcedom ill the 1I11111crator and :2( '{-N -- K) (\egrees o\" free-
d011l ill thc dCllolllillator. lIuhcrmall alld KUHlel (1~)H7) prescnt a deriva-
tion o\" Ih is Icsl.

6.3 Estimation of Risk Premia and Expected Returns

AI! the exact/;IClor pricing models allow one to estimate the expected retllrn
on a givcII asset. Since the expecte(1 rclurn relation is It = LAu + B>' . , , olle
lIe.:ds lIl.:aSllrcs of the faclOr sellsitivily malrix B, Ihe risk\"ree rate or the
zcro-bcla expccted retllrJI Au, alld thc LInnI' risk prcmia >'1:. Ohtainillg
mcasures of B and the riskfree ratc or the expectcd I,ero-heta return is
stra;~lllforwanl. For the given case the constrained maximllm likelihood
estimator S' Gill be IIsed lor B. The observcd riskli'cc 1'.11(' is appropriate
li)r the riskl'rec asset or, ill the GIS(~S without a riskCnT asset, the maximum
likelihood estim,l\or Yo Can be IIscd for the cxpertctl L('w-lJeta r('tllm.
Furthcr estimation is lIeccssary to form ('~Iimalcs of the Linor risk pre-
mia. Thc appropri,lIe procedure varics across the [(Jill' cascs of cxact htctor
pririllg. [II the case where the fa<:lors an~ thc exn~ss retllrllS Oil traded port-
folios, til,· risk prl'mia (',111 he estim;l\l'd directly frolll Ihe salllple mealls or
the exccss rctllrns Oil the pOrllillios. For this (".I.'C we ha\'c

(li.:t \)

An estilllator o\" th(' variance of ).1: is

(\).:\.2)

[Il tile rasc whlTe j>orLfo[ios are /;\('101" I)\n tlln(' is no riskfree asset,
the EIClOr risk prelllia (all be estimatcd IIsing Ihe !lith-rCl\cc bctween thc
Slll1lplc IIIcall of the factor portl(Jlios and thc estilllalcd {(To-beta rctllrn:

(i.:D)

III this casc, an estilllator of the v;lriall(T or >.1; IS

(li.:\.1)
 (). ill 11//1/1111111 "ril"illg .\lII/It'll

II'hnl' \-;;;-rl)'ul i\ InJlII «(;.:.!.~7). Till' tic! Ihal ii."

alld Yu are indl'pI'llIll'nl
lias 1)('1'11 Jllili/l'd 10 WI IIII' covariancl' Il'rlll ill (Ii.:!.'!) 10/('('0.
In Ihl' C\SI' I\'hert· Ihl' btlors an' 11111 Iradl'd portfolios, an eSlilllator Ill'
till' Vl'nor 01 bClo .. ri~k prl'lIIia AA' is Ihl' S\lIn of Ihl' I'sliJllalor of Ihe lIIeall
oflhe 1;1('(01' n';tli/;lliolls alld Ihl' I'slimator of' YI,

I
I
I
All I'slilnalor of II\(' ";lriaJl(,(' of >-i-: is
I - . 1.-
\'arIAi-:1 = -:rn,,+Varl-rd, (Ii. :l.Ii)

when' \-;;;'[1'11 i~ lrolll (li.~.'I!i). I\l'callse ilfi-: and 1'1 an' illdl'(lI'llIicllt Ihl'
lovarianfl' Il'nll ill «;.:U;) is 'l'fIl.
Thl' 1IIIIIIh casl', whert' Ihl' faclor portfolios span Ihl' nll'an-variancl'
fr(Jnlin, is IIll' sanll' as 1111: firsl casl' exn'pllhal rcal rl'llIJ'llS are SlIilSlilllll'd
\ lill' exn'ss n'llIrtls. 111'1'1' Ai-: is 1111' I'l'l'Ior of !'aclor pOrlldio sampll' 1Ill',\lIS
;\lHI All is 1.1'1'0.
For any assel Ihl' t'X(lI't'lI'c\ reillm call bl' ('slimaled by suilsliluliJlg Ihe
('slilllall's 01 R, Au, alld Ai-: illio (li.I.H). Sinn' «(i.I.H) is nOJllillear ill Ihl' pa-
\ \
r;III1I'ttTS, calculating;\ stalldard ,.\ 1'01' \'<"Iuirl's \lsill)!; a lilll',lr approximatioll
alld ,'slinlaH's or Ihl' '1II',lriaIH'!'s of II\(' paraml'ler ('slilllall's.
I II is also 01 illll'n'sl 10 ask ir Ihl' tll'lOrs ar(' joilllly prin'd. Cil'l'1I Ihl'
,'('\'lor of risk premia I'slilllall'S ;tllIl ils coval'i;IIICt' lIIalrix, II'SIS of Ihl' lIull
hl'polhl'sis Ihal II\(' bClors an' .ioillliv 1101 prin'd rail hI' cOII<lU('(C<\ usill)!;
II\{' filliowill)!; I,'SI stalislie:
cr - /\) .. _. I'
./1 "" '~AA VarIA ... -r- Ai-:. (1;,:1,7)

Asymptolical"', IllId\'l the lIulI h\'(lollH'sis Ihal Ai-: == 0,./1 hots ,Ill f dislribu-
lioll wilh 1\ alld '/'-/\ d"glTt,S or frlTtlolll. This dislribuliollal reslllt is all
applicalioll of lit!' Iloll'llillg 'r~ stalislic alld will he exaCI ill fillill' salllpil's
ror 111\' (';lSI'S whcrt· Iltl' I'slilllalOr or Ai-: is hased ollly 011 IIt I' sa III pll' IIwallS of
Ihl' Iit\'lors. \\'(' (;111 also II'SI Ihl' ,igllilicaIH'e or any indi"idllall;\{'lor IIsill)!;

A/A
«(i.:I,H)
..[i';,

whl'll' ~'i-: is Ill(' lilt 1'1('111('111 or>-i-: :tlld "II is Ihl' (j. jllh dl'lIH'llI 01'\Tt;'1>-i-: I·
T('still~ irindi\,idll;tI Lln"rs ;\1'\' prin'd is sl'nsihll' lill' (,<IS,'S \\'hl'l'l' Ihl' bnors
halT hl'l'll IIlI'IIIt,til;tll\' spl'lili,'d, Wilh I'llIpiri(ally deril'l'd faClors, stlclt
\l'sls an' 11011,,1'1111111'(';111\,',;1\ WI' "'plaill ill Se(lioll li,'l.l, 1;IClor,~ al\' id .. l1-
lilil'd Oil'" lip 10 ;111 ()1111<1~OII;t1lr;IIISIiIl't1lalioll; II\'II\'!' illdi"idllall;lI'lor, do
1101 Ita,',' dl'al,nll '''-''IIOlllit' illll'rpn'I;lIiolls,
6. -I. Sdrcliull UJ Faclors

Shanken (I 992b ) shows that factor risk premia can also be estimated
usin~ a two-pass cross-sectional regression approach. In the firsl pass ,he
f;ICtor sensitivities are estimated asset-by-asset using OLS. These estimators
represent a measure of the factor loading matrix B which we denote B. This
estimator of B will be identical to the uIlconstrained maximum likelihood
estimators previously presented for jointly normal and lID residuals.
Using this estimator ofB and the (N xl) vector of asset returns for each
time period, the ex post factor risk premia can be estimated time- period-by-
lime-period in the second pass. The second-pass regression is

(6.3.9)

The re~ression can be consistently estimated using OLS; however, GU) can
also he used. The output of the regression is a time series of ex pOSI risk
premi,l, )..KIo I = 1, ... , T, and an ex post measure of the zero-beta portfolio
return, XOIo / = I, ... , T.
Common practice is then to conduct inferences about the risk premia
using the means and standard deviations of these ex post series. While this
approach is a reasonable approximation, Shanken (1992~) shows that the
calculated standard (lrrors of the means will understate the trut standard
errors Iwcause they do not account for the estimation error in B. Shanken
derives an adjustment which gives consistent standard errors. No adjust-
ment is needed when a maximum likelihood approach is used, because the
maximum likelihood estimators already incorporate the adjustment.

6.4 Selection of Factors

The estimation and testing results in Section 6.2 assume that the identity
of the factors is. known. In this section we address the issue of specifying
the factors. The approaches fall into two basic categories, statistical and
theoretical. The statistical approaches, largely motivated by the AYf, involve
building factors from a comprehensive set of asset returns (usually much
laqJ;er than the set of returns llsed to estimate and test the model). Sample
data on these returns are used to construct portfolios that represent factors.
The theoretical approaches involve specifying factors based on argumen,ts
that the factors capture economy-wide systematic risk~. ~

6.4. J S/a/is/iral Approaches

Ollr startillg point for the statistical construction of factors is the linear
hlclOr model. We present the analysis in terms of real returns. The samf
;In;llysis will apply to excess retnrns in cases with a riskfree asset. Recall th*
2;\4

lilr the linear llIodd we have

R, = a + B f, + (, (Id.l)

where R, is the (Nx I) vector of asset rcHlms fill' time period I, f, is Ih('
(Kx I) veclor of faclor realizaliolls fiJI' lillie period t, and lO, is Ihe (Nx I)
\'l'ctor ofmodcl dist\lrhan(l~s lor time period t. The numher of assets, N, is
1I0W very hlrge alHlllsllally mill'll \arg,:r thall the IIIlIllber of till\\, pniods, '{'.

There arc two primary slalislic~11 approaches, f~IClor analysis and prilll'ipal
COlli pone illS.

'1,'(/(/01' AI/alysis
\ ~slil11ali()n using f~IClOr analysis involves a Iwo-slep prOl:c<illl'e. First Ih('
iIClor sensilivity matrix B alld the <iistl\l'h~l\Ice covariance lIIalrix r: ar(' est i-
!\IOlled and thell these estimales arc IIsed to (,{lIIstrllctllleaSllrl'S of the f,,('lor
realizatiuns. Fur standard faClor analysis il is assnl\led Ihal Ihere is a ,I/rirl
J(/(tor structure. Wilh Ihis slruclure K factors account for alllhc cross covari-
ance of assel relurns and hence r: is diagonal. (Russ imposes Ihis slructure
in his original developmenl of the APT.)

l Given a slrict faclOr slruclure and K f;lclOrs, we can express Ihl' (N x N)

'ovariance malrix of assel returus as lhe sum of two cOlllponeuts, Ihl' varia-
jion frqnl the faclors plus the residual variation,

\ n ::: 8n" 8' + D, (liA.:\)

there n" and r: == D 10 indicate it is diagonal. With the bClors

J:'lf, r,l ==
~lIIkuown, a rotatioual iJl(\clerllliuacy exisls alld B is idclllilinl ouly up to
;\ lIollSingular transformation. This rolalional indeterlllinacy Gill he dillli-
Irated by restricling' the faclors to be orthogonal III each olher and to have
~ltJit variance. In this case we have 0/\ == I and B is uniquc lip to an 01'-
thoKonallrans/'Ol'lIIatioll. A1ltralls((JI'IIIS GG are equivalent ((II' an)' (K x K)
orlhogollallransforlllalion matrix G, i.e., GG' = I. Wilh th('se r('~lI inions
in place we Gill express the rei II I'll covariallc(' lIIalrix as

n = GB' + D. «d.·I)

With Ihe structure ill «(i.4.4) alld the asslllllpliollihal asset I'l'l II I'IIs ;11 (',ioililly
IlOrlllal alld t('mporally III>, ('slimalors of B alld D call he fill'llllllated IIsill~
lIIaxillllllll likelihood factor aualysis. Becallse the first-order cOllditiolls ({II'
lIIaxilllllllllikelihooc! ar(' highly nOlllincar ill the parameters, solvillg for lhl'
estimalors with the IIsual ilerativ(' proccdurl' ('all be slow ancl COnV('IW'IH'l'
diflicllIt. Alternative algorithms have hl'en developed by Jiiresko~ (19(i7)
and Rubin alld Thayer (I !'H~) which facililate Cluick ('ollvergl'lHT 10 Ihl'
l\IaXilll\lII1 likelihood estilllators.
 Olle illlnprd<l(ioll ol"llll' lIl;\xill\"lIllikdihood l'slilll,Hor orB giVl'llthl'
maxill\"111 likl'lihood l'stilllator or D is thaI 0- 1 lillH'S the eSlilllalor o\" B has
the eigellv('('\ors or D-"In ;\ssoci;Ill'(lwilh IIIl" I\. larg('sl eigenvalues as ils
COIIlIlIlIS, For clt-Iails o\" Ihe estilllalioll lite inle("nl('c\ ("eaeler ("all sn: Ihl'se
papns, or Morrison (I\)\)(), chapler \») ,IIHI ("e((-ITllles Ihnein,
The se("ollel slep in Ihe l'slilll<llioll procedure is to eslilllale lhl' fanors
!!;in:1l B <llld }:, Sillce lhe (~\(IOrs arc derivl"<l froll\ Ihe ("(l\'ari'II\("(' slrlll"lllre,
the 1II(',IIIS 01("(' Ilol sped lied ill (liA,I), WithlHII loss of );l"lll"l"alily, we rail
reslriu Ihl' 1;Il"IOl's to have 1,('\"1) IlH'ans alld ('xpn'ss I Ill' fanol' mockl illle("lIls
or deviations aho"t the means,

(R, - Il) =: B f, -I- <-,.

Civell ({i.-I 5), a candidale to prox), lor Ih(' 1;lclO(" re;ili/;llions lor lillie pniocl
I is Iltt.: cross-s('c'liollal ~elll:rali/,ed leas I squares «:I.S) re~rl'sSi(llleslilllal(lr.
Usillg lh(' 1l1'IXillllllll likl"lihllod ('slilllalms or B .\1\11 n we h,\\'(' ror eacll 1

(liA.{i)

I kre \1'(' are eSlilllatillg f, by ("eg("essillg (R, - il) 01110 n. The factor real-
izalioll scries, f" 1 == I, .. , , T, call hI' 1'Il1pl"yed 10 lesl IIIl" Illodl'l IIsillg II\('
app("oach ill Sl'('\ioll {i,~.:t
Sillce thl' fano(", are lilll'ar l"ol\lhill;ltioIlS or I'l'tlll'IlS WI' (";111 I"OIlSI\ 1\l"1
!)onf()lios whidl arc \lel'kl"lly t'I)\Tl'Iatl't! wilh lilt' 1;lrlo)"s, Denoling R h", as
lhe (I\. x I) Vl'rlor offartor ponfoliolTllIJ"Ils for lillie period I, w(' hav!'

R h", = AWR" ((iA,7)

11'1(('1"('

allel A is ddilll'd as a dia~ollalll\alrix Wilh 1/ II; ;\s till' JIll di;rgollal d<.'llIt'III,
wlll'l"<" 1\;
is till' .ith l'IClllt'lI1 OfWL
Thl' !;\\"Io\" portfolio weights oill;lill .. d !'" 1111' /111 1";,,1111 f.-Olll this p.-o-
r .. dlln' .11"(' "'1l1ivaklll 10 Ihe weights Ihal \\'ollid '-"S II I I I"I0lli soh'ill~ lit I'
followillg oplilllil:alioll p.-oblem alld lliell II()'-Illali/.ill~ III<" w('ighls to Slllll
to olle:
1\1iIlW'I)w, «i.,LK)
w, 1

suhjcn to

o VI! ;" J (d.!) )

VI; I ({d./O)
 (), i\l/lIIIJ(/rI()"",il'il/~ ,Ilotld{

ThaI is, 1111' bclor pOri folio II'cigllls minimize the residual variant:(' suhject
to Ihe COIlSlrailllS Ih;1I each faclor portfolio has a ullit loading Oil its own
fal'lor alld it'l'O loadillgs Oil olher bl'lors. The resuiting 1;l('tor porI folio
retuflls call he IIsed ill alllhe approaches discussed in Set'lion li,2,
If n alld n are kllOWII, Ihl'n the 1;lrtor estimators hased 011 CI.S ",ith
the populalioll I'alul's of alld n n will have the maximum correlatioll I"ilh
Ihl' populalioll l;(<'Iors, This IClllows from the miuillllllll-variance unhiased
estimalor pl"Opl'l"l)' of gellt'ralized least squares given the assumed lIormality
or the dislurhallce 1'1'1'101', But ill pral'lice the l;tcltIJ'S ill (ljA,Ii) alld (1;,4.7)
III'('d lIot hal'l' lilt' IIlaxillllllll correlalioll wilh the population common bc-
tors sinn' Ihe}' are hasl'd Oil eSlimales or Band D. I.ehmann and Modest
(I QXX) preselll all ;t1lt'1'lIalil't· 10 CI.S, III thl' presence of lIH'asu rt'lIH' II I er-
mI'. they lilld Ihi, alllTllali\'{' call pmdllct· fa('lor portfolios ",ith a hi)!;lll'r
populatioll correlatioll willi Ihe I' 0111111 Oil 1;I('IOfS, They slIggesl for lile jlh
Etl'lor 10 IIS(' w;R, II'h('l"l' I hI' (N x I) v('ctor w,
is Ihe solulion 10 Ihl' following
prohklll:
Minw'DwJ' (GA,I!)
W, I

slIhjl'('\ 10

o Vk j j (E,<1,12)

I.

This approadl lillds Ihl' pllli/olio which has Ihe llIillilllulll residual '!ari;\ll(l'
0(' ;,11 porllcllios orlhogoll;i\ 10 Ihl' olher (K-I) farlms, Ulllike Ill(' CLS
pml'l'd\ll"l', Ihis pro('('dlln' igllorl's Ihc illli)rlllalion illihe ElClor loadillgs of
Ihl' jill EII'IOI', It is )lossi"'" Ihallhis is bl'llefH'ial became ofllll' Illl'aSllrt'lIlelll
error ill 11ll' loadillgs, Illt!I'I'd, I.dllnallll alld Modest lind Ihal Ihis Illelhod
offo1'l1lillg tll'lor pllnfolills results ill fa('\ors with less extrel\le weighlings on
1111' ass,' Is allt! a resultillg highl'r ('oITe\;Jlioll wilh Ihl' IInderlying l'0ll1J1l0n
faclors,

"'-;11(,;/1(// (:0111/1111/1'11/1
FaCioI' allah'sis n'pn 'SI '1I1s 01111' 0111' sial ist icalllIel hod of fOJ'lll i Ilg 1;11'101' port-
«,Iins, /\11 ;Jilt· .... alil't· ;ll'pro;lt"h is prillcipal COIlIPOIII'lIls ;lIlalysis. Principal
COIIIIHlIlI'IIIS is;1 It·t"hlliqll'· 10 J't'dllIT Ihl' 11111111)('1' ofvariahll's heing sllld·
in(wilholll losillg 100 111111'11 illlclllllalioll ill Ihl' ('ovariall!'e lIIalrix, III lite
1'J't'S"1I1 al'plicalioll. lIlt' ohjl'nil'l' is to reduce Ihe dilllensioll frolll N assl'l
relllJ'lls 10 1\ Linors, TIlt' pi illcipal (OIll()OIl\'lIls sl'rvI' as IIII' bl'lors, Tltl'
lirsl prilltip;tI 'OIIlP"II'·1.I1 is lilt' (lIorlll;t1izec\) lilll'ar I'ollli>illalioll or asscl
relllntS lI'illl 11I,I,illllllll 1';lri;IIICt', Tltl' S"('(lIld prill!'ipal ,'OIllPOlH'11I is lilt·
(lIonllali"'d) lilll'ar, IIlllhillalioll "I' ;Issel rei II 1'1 IS wilh IIl;1Xilllll1ll \';lri;lIl1,(,
"f;l 11'·"111 hi 11;11 i, 'I" IIr! h"~"lIal I, , IIII' Ii rsl pri lI!'i pa I I'OIIlPOII,'1I1. i\ 11<1 SII 1111.
6.4. Sf/fCljolt oJ Faclors ~37;'~
I
:
~rl¥'~~'
~~4..M.sJ:l.
The first sample principal component is xi'R, where the (N x 1) veflor
xi is the solution to the following problem: I
(6.~.14)
!

subjert to
(6.~.15)

n is the sample covariance matrix of returns. The solution xi is the eigen-

vector associated with the largest eigenvalue oH1. To facilitate the portfolio
interpr(~tation of the factors we can define the first factor as w; R t where
WI is xi scaled by the reciprocal of L'xi so that its elements sum to 'ne.
The second sample principal component solves the above problem for X2
in the place of XI with the additional restriction xi'x2 = O. The solution
x 2 is the eigenvector associated with the second largest eigenvalue of n. xi
can be scaled by the reciprocal of L'X 2giving W2. and then the second factor
portfolio will be w~Rt. In general the jth factor will be wjR, where Wj is the
rescaled eigenvector associated with the jth largest eigenvalue of n. The
factor portfolios derived from the first K principal components analysis can
then be employed as factors for all the tests outlined in Section 6.2.
Another principal components approach has been developed by Con-
nor and Korajczyk (1986. 1988).4 They propose using the eigenvectors as-
sociated with the K largest eigenvalues of the (Tx n centered retu-ms cross-
product matrix rather than the standard approach which uses the principal
components of the (NxN) sample covariance matrix. They show that as the
cross section becomes large the (K x T) matrix with the rows consisting of
the K eigenvectors of the cross-product matrix will converge to the matrix
of factor realizations (up to a nonsingular linear transfonnation reflecting
the rotational indeterminancy offactor models). The potential advantages
of this approach are that it allows for time-varying factor risk premia and
that it is computationally convenient. Because it is typical to have a cross
section of assets much larger than the number of time-series observations.
analyzing a (TxT) matrix can be less burdensome than working with an
(N x N) sample covariance matrix.

File/or AI/(I~YJiJ or Princi/mi Com/lOllmls?

We have discllssed two statistical primary approaches for constructing the
model factors-factor an,llysis and principal components. Within each ap-
proach there are possible variations in the process of estimating the factors.
to. qucstion arises as 10 which technique is optimal in the sense of providing
the most precise measures of the population factors given a fixed sample of
returns. Unfortunatcly the answer in tinite samples is not clear although all
proc(,dur(,s can ht' justified in large samples. I
 238 6. MultiJlI(I()"I,,.ifil/~ Mllllrl.\

Chambcrlain and Rothschild (19H:~) show that consistent estimates of

thc factor loading matrix B can bc obtaincd from thc cigcnvectors associated
with the largcst cigcnvalues of y-I f!, where Y is any arhitrary positive
Odelinite matrix with eigcllvalues bounded away frOllllero anti inlinity. Both
istandan.l factor analysis and principal cOlllponents fit into this category, f(lr
Ifactor analysis Y =D and for principal c01llpollents Y = I. Ilowever,
Ithc finite-sample applicability of the result is unclcar since it is rcrJllired that
,hoth thc numbcr of assets N and the number of time pcriods T go to infinily.
i The Connor and Korajczyk principal components approach is also Uln-
isistcnt as N increases. It has the further potcntial advilntage that it only
requircs T ~ K and does not require T to incrcase to infillity. Ilow("vl'l",
whcthcr in tinitc samples it dominates f~\Ct()r analysis or standard prim"ip.1I
componcnts is an opcn question.

6.4.2 Numlier of F([(lors

The underlying theory of the 1IIultif~lc!Or 1IIodels docs not specify the nUIll-
ber of factors that arc requircd, that is, the value of K. While, {(U" the theory
\10 hc useful, K should be reasonably s1llall, the researcher still has signili-
cantlatitude in the choicc. In empirical work this lack of specificalion has
\bccn handlcd in scvcral ways. One approach is to repeat the eslimation .
~\IIr1tcsting of thc model for a variety of values of K and ohsern' if the tests
~\re sensitive to increasing the numher of f~IClors. For exalllple I.citlllann
and Modcst (1988) present empirical resulL~ for ftve, ten, alltl fincen rac-
'tors. Their results display minimal sensitivity when the numher of f;IClors
increa~es from ftve to ten to ftfteen. Similarly Connor and Kor'~iczyk (I ~lHH)
consider five and ten factors with lillie sensitivity to the additioll,,1 five br-
tors. These rcsults suggest that five factors are adeC"fuate.
A second approach is to test explicitly for the adequacy or K factors.
An asymptotic likelihood ratio test of the adequacy of K factors rail he COIl-
structed using -2 times the difference of the value of the log-likelihood
function of the covariance matrix evaluated at the constrained ami lIn-
constrdined estimators. Morrison (1990, p. 3li2) presents this test. The
likelihood ratio test slatistic is

J'> = - (T-I-t(2N+5)-"3 K 2) - ---

[loglf!I-logIBB'+DIJ, «(i.'l.lli)

where n is the maxim 11m likelihood estimator of f! alld Ii anrl Dare Ihe
maxinllllll likelihood estimators of B ,lIld D, respectively. The lcadill).( terlll
is an a(ljustlllent to improve the convcrgence of the finite-sample 1111\1 dis-
trihution to the large-sample distrihution. Under the null hypothesis th"t
K factors are adequate.}. will be asymptotically distributed (T -+ (0) as a
chi-sC"fuarc vari,ile with ~ I (N - K)~ - N - K I degrees or freerlom. Roll and
6.-1. Sl'il'rlioll O/foill'/IJIJ

Ross (l!lHO) lis(' this approarh alld cOllclllde tll;lt tim'" Ol'/i'llr hlnors arc
adequate.
A potelltial drawhack ofllsin),( the test rrollllll;\),illlllmlikdihool! fal"lm
<Il1aly.,is is lhat the rOllslrailleci modd aSSllllll'S a sl ri, t /aCIOI' slrunllre-
all assumptioll which is 1I0l lheorelically IH'Cl'SS:lIY. COli 1101' alld Kor:~iczyk
(l!l9:1) develop all asymplotic tesl (N -> ev) Ii,,' thl' .llil'qll.ll·y or 1\ tlrtllls
under the a~sllmptioll or all approximate raClOr ~lr1Icturl', Their test uses the
resull Ihal with an approximale bctor slrllcture Ihe "wrage noss-serliollal
variatioll explailled by the 1\ -I- I 'st brtor appro:lrIll'S {('ro as N inrleases,

0, (()A.17)

where the dependence ofbl(+\ Oil N is implirit. This implies that in a large
uo" scnion generated by a I\-far\or lIIodel, Ihl' aWl age residllal variance
in :, linl';II' raC\Or llIodel estimaled wilh 1\ + I faclors sllollld converge to the
<:\'cragc residllal variance with 1\ (;Ic\ors. This is till' illlplicatioll COllllor and
K(,r:~jczyk test. Examining returns hom storks listl'l\ Oil the New York SlOck
Exchange and Illl' American Stock Exchallge Ihl'\' conrIllde that Ihere are
lip to six pervasive (;Ictors.

(),-I,] nll'll/"I'/I((/I A/'/)/I)I/("hl'.\

l'heoretirally based approaLhes 1'01' selecting L\clors /;tli illl<> two m'lin \::It-
egories. One approaLh is to specify lIlacroenlllolllic and financial market
vari:lbks thaI arc thoughl to C<lpllln' th .. sysll'l1lalir risks of the l'l"OIlOIllY. A
second approaLh is to specify chara.-tnistics of linlls whidl are likely to ex-
plain di/ferelltial sensitivity to the systl'llI:llic risks alld IhclI rorlll I'ort/i)\ios
of stocks b:lsed 011 lhc characteristics.
Chell, Roll, and Ross (I YH(;) is a good cx:nnp,," uf the first approach.
The aUlhors aq.;ue lhat in selecting facturs we should cOllsidn forces which
will explain challges in the discount rate used to discuunt futme expected
cash /lows alld forLCS whidl in/hlelllT expecled cash flows thelllselves, n<lsed
on illtuilive an:llysis and cmpirical investiJ.:ation a live-(~Ictor llIodel is pro-
posed. The ractors includc lhe yield spre,\{! betwecn lung and slmrl intercst
rates for US governmcnt bonds (malurity premium), expeLted inflation,
uncxpected inflation, industrial production J.:rowlh, and Ihl' yield sprcad
betwcell corporate high- and luw-gr:Hk bunds (dd~ltlh prelllium). Aggre-
gate COllslllnption growth and oil prices arl' (ollnd IlOIlO have increlllental
efl<:ns heyond the (ive !;Jcwrs."

\\11 ;i1tl'III.llin' illlpkllu'lIlalioli of' tlu' fil!o.l "PI'IO,I('/I i, gi\('11 hr (:,11111'1)('11 ( I !'~Hj.l) ,lIul j,
cli.,nl.,~('d ill Ch;II'I(,1" H.
 6. MlIl lljil( /ol'l' r;r;I IR ModI'/.\

Thc scco nd ;Ipp roar h of nl'a ling

1;1("101' port folio s basc d on linll
aClc risli cs h;IS hl"cn IIwd in a 1IIII char -
IIbl'r of stllc\ies. Th(' sc char acle
lIIostly sllrf ;u'cd flllli l til(" lill" risti cs hav( '
ralli rc ofC APM viol alion s disc
1('1'r,. Clla r;lIlt "risl ics wllic h hav( ' b(,(,1 llsse d
1 fOlillel to h(' (,lIIp irica lly illip
ill Clla p-
illcl ilde IIlark('t \'ahl(" or ('qlliIV, orta lli
pric c-to -(,ar ning s ratio , ;11111 ralio
I';lIlIe of ('qllill" 10 111;1/1('1 I'all/(, of hoo k
01 eqlli ly. The g('II ('ral filld illg
lIIod els whic h ill.-ll/<I(' a hroa is Ihal bno r
d hase d Illark!'1 port folio (suc
w('i ghlc d illti( 'x) alld fano r port h ;IS all equa l-
f(lli os neal ec\l Isili g Ihes l' char
a goo d joh ill ('xpl ailli llg th(' acle risli cs do
cros s sect ioll of retll rns. I Iow
th!' ililp orta lit char acle risli cs !' \'('1", \)('CUISt'
hal'(, h('(,11 id('n lili( 'd larg( ,ly Ihro
cal allal},sis, Ihei r illip orta nc(' llgh ('mp iri-
111011' h(' ol'er slalc d h('ca
hias cs. Wc \\'ill disc llss litis issll lls(' of elala -sno opil lg
c ill S"cl ioll Ii.ti.

6.5 Empirical Results

1\bll )' I'lllp iricl l silid ics of 1I111
11ifanor nlOd ('\s ('xis!. VV(' will
Ihe silld i('s I"lIich IIiI'd )' illus lrall rCl'i('w four of
' IIII' cSlil llali on alltl I(,Slilig 1IIt'l
wc' hal'( ' disc llsst 't\' 'lim Ctlil lpr hudoloh'Y
.. hcliS il'e siud ies IIsilig stali slica
10,'l "kct tilt" Lit It'" ;11'" l,t'll IlIal l app roac hcs
lll ;11111 Mod eSI (I ~IHH) alici (:011
r;~iCl)'k (19HH). 1,!'IlIlIali 1101' alld Ko-
ll ;lIId Mod cSI( I.Mj lls(' raCloralla
alld Kor ajol 'k I ( :1\ IlIsc' ( '(' X '/') l~'sisalld COli 1101'
prill cipa l COIlIPOIlt'IIIS, Two sllId
IIH'o r('lic al app roac h 10 faCl or ies usill g t h('
ideli lific atiol l Mt' Faill a alltl Frcl
alld Che ll, Roll, alld Ross (1~'~ lch (I~'(l:~)
1;). F;lIlIa and Frt'l ich
I('ris lics 10 1(,,'111 1;11'101' port lillio (FF jlls( ' firlll char ac-
s alld ChC lI, Roll , alld Ross [CR
IlIanO('COIIOlilic l'ari; lhl('s as racto R] s!)t'cify
rs, The first thre e stud ics illcl
till' impl icali olls 01 exac i brto r ude t('s;~ or
pric illg, wltil<' Che ll, Roll , alld
Oil wh( 'lher or 1101 Ih Ross ronl s
.. faClors art' pric ed. Tht' evid
bno r pricill~ is 1I1ixed, 'J;Ihlt- ('I)(T supp orlil lg t'xac t
Ii. 1 stull lllar iz('s Ihem aillr esul
CIi., alit! FF. tsrr olll 1.1\1,
A 11111111)('1' 01 !!;elltTal poil lis
(,lII nge froJll Ihis lahlt '. The
nid( ,lIcc ' agai ml exaCI f;lrt or Slroll~esl
pric illg COIlIt'S rrom tt'sis llsill
port folio s b;Isecl Oil III;U kel I';" g dt'(l(,I)(\('lIt
lie or ('!(lIiIY alld hook -lo-l IIark
Jlllll tibC !or lIIod els h;II'(' difli ( el ratio s. EI'(,II
ull)' n:p/ ;Iill illg Ihe "siz(''' ('fre cl
1II;lIket" dl('c !. P""f olio s ",hie alld "hoo k to
h arc' lorn it'd has( 'd 011 divi dell
hast' l! Oil O\VII I'ari allt'" prov ide d yield alld
lilllt- t'\'id ('I)(T agai llsl (,X;Ict fact
The CK r(,su lts for ,\;ulual"l' alld or pric illg.
1I01l:I_IIIII;lr)' 1llOIIIhs sligg esl
(\cll ee agai llsi exac l b(lo r pric Ihal II,,' ('I'i-
ing dot's 1101 arise rroJll Iht'J allll
lisil lg Ille stali slicI ) appr oach ary erfe c!.
('s, CK alld I.M filld little S(,IIS
iIlCTt'asill~ til(' IIIII IIhn ilivily to
of bClo rs 1)('\'011(1 fivt'. Oil Iht'
SOliI I' iIIlP""I'('III1'lIt goil
olh( 'r hallc l FJ: fill(1
l~ from Iwo facto rs 10 fil-('
, illcl uded , FF lilld Ih;II with sioc ';'clo rs. III r('sll lis lIot
ks olll\ ' tlm' (' f;Iclors are II('c essa
wllt'll hOll d pori folio s ;ur illcl n' alld that
uded Ihel l five EH"lors an' II('('
dt'd. The se
 Table 6.1. Summary oj r,su//s Jor {,sis oj eX(lri Jf/r{or priring wing uro-in~t F-test.

___S_'I_u_d~y______'r_i'__ __c_h_a_rd_c_t_~_ri_st_ic____________________
lleperiod_______P_o_rd_'_o_lio N K ~______
p.vaIue
CK ti4:0I-ll3:12 markel value of equity 10 5 0.002
CK 10 10 0.002
CK/ 10 5 0.236
CK/ 10 10 0.171
CK N / 10 5 0.011
CKI'II 10 10 0.019
I.M 63:01-B2:12 market vdlue of equity 5 5 ..
I.M
I.M
5
5
10
15 ..••
I.M 20 5 0.11
LM 20 10 0.14
I.M 20 15 0.42
I.M 6:i:O 1-112: 12 dividend yield 5 5 0.17
1.M 5 10 0.18
I.M 5 15 0.17
I.M 20 5 0.94
1.1\1 20 10 0.97
I.M 20 15 0.98
I.M
---------------------------------------------------------
ti:i:()1-1I2:12 uwn va rhll u:e 5 5 0.29
I.M 5 10 0.57 I

I.M 5 15 0.55
I.M 20 5 0.83
I.M 20 10 0.97
I.M 20 15 0.98
FF 1i:l:07-91:12 stocks and bonds 32 2 0.010
FF 32 3 0.039
FF 32 5 0.025

·'I.e" IhJn 0.001.

CK rd"rs 10 Connor and Korajczyk (I!lBHl. LM refers to Lehmann and Modest (1988), a~d
FF rd"r, 10 Fa,na and French (1993). The CK faClors are derived using ('fxn principal
componenl', Ihe LM factors are deriv~d using maximum likelihood factor anal)'5is, and the FF
factors are prespecitied factor portfolios. For the FF two-factor case the factors are the return on
a portfolio of low market value of equity finn. minus a portfolio of high market value of equity
firms and Ihe relurn on a portfolio of high book-to-market value finns minw a portfolio oflqw
book·to-market value finns. For the Ihree-faclor case the factors are those in the two-factor c~
pillS II", relllrn on Ihe CRSP value-weigh ,ed slOck index. For Ihe five-faclor case Ihe returns
on a IeI'm structure faclor and a default risk faclOr are added. CK include teslS separali'K
Ihe in"'rcel" fill' January from Ihe illl~rcepi for other months. CKJ are resullS of leslS of Ihe
hypolhesis IhallheJanuary illlercepi is 1.ero and CKNI are re.ults of Ie SIS oflhe hypolhesislhal
Ih .. 'lOn:/anllary inlercept is lero. CK and FF work wilh a monthly umpling inlernl. LM use
a daily illlerval 10 estimale Ihe faclors and a weekly illlervdl for lesting. The lesl resulu from
CK and I.M are hased on leSl' from four five·year periods aggregaled logelher. The porlfolio
charact .. ri"i. n·pres,,"I., Ihe finn d,ar~Clerislic "s~d 10 a!iocollt' Slocks inlo Ihe dependent
I'Drlh)liu... FF I"e 2:) sUlek ponli)lios alld 7 bOlld portfolios. The stock portfolios are crealed
",ill~ " 11'0 ''''y ,on hast,,1 "" mark"1 value of "'I',ity "lid hook-v~lue·,o-markel-voIlue rollio•.
Tht' h,,"d p"nt')lios inrludr five US gOY('rttme"t bond portfi)lios and two corpora Ie bond
port'i)li"s. The gowntlllenl hund portfolins art' created hast'tI on mattrrity and Ihe corpordlt'
h,,"d p"rt'i,'ios an' ....ealed h«'t'd "" Ih" ll'wl or tI"bult risk. N is Ihe number of depenclenl
I'"rt fi,li", alld 1\ i, Ih,' JllIIlIher of!',f1ors. Th,' I~\'"hlt·, an" t'l'tlrtt'tI for the ler<~illlerrel" f~l ..sl.
f42 6. Multi/(Ir/or I'ririll}; Mor/I'L{

I
~esults are generally consistent with direct tests for the IlIlmber of fartors

~
iSCUSSCd in Section 6.4.2.
The LM results display considerable sensitivity to the IItllnher of depen-
ent portfolios included. The Irvalues arc considerably lower with fewer
portfolios. This is most likely all issue of the power of the test. For these
lcsts with an unspecified alternative hypothesis, reducing the 1I11111ber of
>ortfolios without eliminating the deviations fro III the null hypothesis can
ead to substalltial increases in power, because fewer restrictions nlll.\t be
ested.
The eRR paper focuses all the pricill~ of the factors. They usc a cross-
ectional regressionlllethodo\uh'Y which is similar to the approach presellted
II Section 6.3. As previously noted they lind evidence of live priced factors.
~'he factors include the yield spread between long and short interest rates
for us government bonds (maturity premium). expected inflation, unex-
pected inflation, industrial production growth. and the yield ~pread between
corporate high- and low-grade bonds (default premium).

6.6 Interpreting Deviations from Exact Factor Pricing

We have just reviewed empirical evidence which suggests that, while lIIulti-
faclOr models do a reasonable job of describing the cross section of retunts,
deviations frolll the models do exist. Civen this. it is important \0 ('onsiller
the possible sources of deviatiolls frolll exact factor pricing. This iss lie is
importallt because in a given finite sample it is always possible to lilld all ad-
ditional factor that will make the deviations vanish. However the procedure
of adding an extra factor implicitly assumes that the source of the deviatiolls
is a missing risk factor and docs not consider other possible explanatiollS.
In this section we allalY/.e the deviations frolll exact factor pricing for
a given model with the ol~iective of exploring the source of the deviations.
For the analysis the potential sources of deviations are categoriled into
two groups-risk-based and non risk-based. The objective is to evaluate the·
plausibility of the argument that the deviations from the given factor model
call be explained by additional risk factors.
The analysis relies on all important distinction between the two cate-
gories. namely. a difference in the behavior of the maximum squared Sharpe
ratio as the cross sectioll of securities is increased. (Recall that the Sharpe
ratio is the ratio of the Jlle,1I\ excess return to the standard deviatioll of
the excess relllrn.) For the risk-based alternatives the maximuIII sq\lared
Sharpe ratio is bounded and for the nOli risk-based alternatives the lIIaxi-
JlItJIII squared Sharpe ratio is a less usefid construct and can, in principle,
Ire unbounded.
6.6. Inll'llmlillg /)l'lIia[ioll.l frollll:xf/d l'ill'lor 1'>i";lIg 243

6.6. J I:'x(lr[ Far[or l'ririllg Modf'll, M"Ill/-\'arim,,"(' Alla/v.liI,

fllld tltp O/llilllll/ Orllwgowi/ I'orlfo/;o

For lhe illitial analysis we drop hack to the level of the primary assets ill the
economy. Let N be the number of primary assets. ASSIlIll(' that a riskfree
asset exists. l.et Z, represent the (N x I) ve(lor of excess ret mIlS for period
[. Assullle Z, is stationary alld ergodic Wilh meall IL alld covariance malrix
n that is full r;\Ilk. We also take as giVl'1I ;1 set of 1\ fiKtor I'ollf()lios ;llld
allalyze the deviatiolls from exact /it("(or pricillg. For til(" (ilctor model,;ls ill
(G.:.!.:n, we have
Z, = a + BZ At -I- f" (li.Ii.I)
Here B is the (N x I\) 111',11 rix of f~l("\or \o,ld'lllgs, Z/:t 'IS the (l\ x I) vector of
lime-llilClor portf()lio excess returns, alld a ,lilt! { t are (N x \ ) venors of asset
retum illterccpt.\ ;IIHI dislllrballces, respectivcl)'. The variallce-covariance
matrix of the disturballccs is E ;IIHI the variallce-covariallce m<ltrix of the
faClors is n/:, as ill (li.2.3)-(6.2.li). The vallies of a, B, <llId E will depclld
0;1 the f;l("(or portfolios, but this dejlrluknce is suppressed for Ilotatiollal

cOllvelliellce.
lfwe have exact faoor pricillg relative to the 1\ (ilctors, all the clemellts
of the vector a will be zero; equivalelltly, a lillear combillatioll of the f,letor
portfolios forms the tallgellcy pOl"t()lio (the 1I1('all-\',lrialH"e efficiellt portfi)-
lio of risky assets given the presence ora risklrce asset). Lct /'1 1 he the excess
relllrll of lhe (ex linle) langency portfolio anc! kl w'l he the (N x I) V('r!or or
(Jortl()\io weights. Frolll lIIean-variallce analysis (sec (:lI;lpter [»,
w'l = l~'n IlL) I! I IlL. lli.li.'2)
In the cOlltex.t of the I\-/";Jctor lIIodel in (li.<i.l), w{' haV\' Cl';trt ha:tor pric-
ing when the tallgency portfolio in (li.Ii.:.!) call he (lI"IlIl"<1 frolll a liut'ar
combination of the 1\ /";JClOr portfolios.
l'\ow cOllsider the case where we do not have {'xact (ilclOr pricing, so the
tangellcy portfolio cannot be formed from a linear combination of the faClOr
portfolios. Om interest is ill developing tite relation betwl'enthe deviations
from the asset pricing lIIodel, a, and the residual ('ovariallf{' matrix, E. To
facilitate lhis, we define the II/)[illwlllrlilllgollf/l/}()rljil/io,'; which is the uniqlle
(Jonfolio that can he cOlllbined with tite 1\ factor portfolios to forlll the
tangl'ncy portfolio and is orthogonal to thl' faclor portfolios.
Definiliun (optimal orthogunal portfoliu), '/ilil/' fI.1 giwl! 1\ jll(lor /)()rtjo/ill.l !tlhirh
fall 1101 /1(' mmbil/f'tl 10 form the Iflllgrl/Cy /){)d/iliio Ilr /III' gill/)(J/ lIlillillllllll-!ltIIlallrp

/lOrlfolio. A /)(ntjiJlio It will be defllll'd fl.1 IIIf' 0/' (i 11111 1orlhogollill /unl/iJii" Il'ilh re.I/IPr/
[u Ilu'sf 1\ jf/rlor f'O!lfo/im if

(ti.ld)

11.")('(. Roll (I ~IH{J) fllr g<'lH'r.d 1'1 ()p('lli("~ of flllliogolI.1I p!llllo/l( .....
-,,
(/1/11

(G.(iA)

jor (/ ( 1\ x I) II/'t//II W lI,h/'/I' WI' i., I hI' (N x 1\) ml//rix 0/ IIHd I{lfi~ht.\ jor Ihf filtlor
porljolim. W J, i.1 Ilu' (N x I) 11/'(/11/ ofal\l'Il{lfi~ht.\ jor Iltf o/Jlil/lid orllwgol/II/ Imrtji>iio.
111/(1 w,' i.\ Iltt'( N x 111'/'(/111' oland II'figh/l./iu·lltf IIII/gnlf) l)/IrljiJli/). I[,JIII' (tjll.\iril'r.l
1/ /111/cM wilhlllli 111')'1"(/01' IUJlIIOlio\ (1\ = (\)
111m 1"1' nl)li/llll/orllwgol/flllwrlji,lin
lI'ill bf lite' lallgnl"'I}()rlj',Ii().

TIll' \\,I'ighh of porll •• lio Ii (";1/1 1)(' expressl'd ill lenllS of Ihe parallH'Il'fS
of Ihe I\-fa((or llIodel. The vc"("lor of weigh Is is

WJ, (t:n-1a)-ln-1a

(/.'Eta)-IEta.

wh('l"l' 1111'/ SlIpI'lsnipl illdicales Ihe J,!;I'IH'ralil.ed illvt'rst'. TIl(' lIsd"tllll('SS of

Ihis ponfi.lio ("OIlIl'S fmlll IIII' (;1("( Ihal whl'1I aclcleclto (lUi. I ) til(' illtlT("Cpt
wi II. \'a II isil alld II It' (;uII.r loaelill),!; lIIatrix n willnotlw all('l"('d, The optimality
reslriclion ill (1;,li,:I) le;lCls 10 Ihe inl('("("epl v<lllishinJ,!;. alld III\' orthogonalilY
nlllllilion ill (li.li.·I) iI';u/s 10 B Ill'inl!; llll\"hallgcd, Addillg ill 1",:

(Ii.li.li)

o (li,li.7)

E III/u; I

(Idi.!)

(:o\"1 ZAr, 11/ I () (li.h.W)

Covl1/,(, \1/ I == n, (1"•. 1"•. 11 )

v.',' ("all rciall' Ihe oplilllal orlllC'J,!;ollal portfolio par;lIl1(,\('I"S to Ihl' fal"lor
IllOdcl devialions hy "'lJllparillg (/i.li.l) alld ({i,li,li), 'Hlkillg Ih(' 1l11("0lHli-
liollal ('Xpt'("\;llioIlS 01 hOlh siell's,

((i.(i.I~)

;lIId Ill' 1'C)1I;lIillg IIie \';11 i;lIltT 01 f I wilh IIIl' variallce or f3,,1,,/ + u/.
'J

~'
_, '=
4'"
/J,fJJ,r1i, /.,) C1;;
I == aa ' -;; + ....
'i'. ((i.li.I:I)
IIi,

Thl' kl'Y lillk 111'111'('('11 Ihl' Illodd ckl'i;lliolls and IIII' n'sidllal variallfl's ;IIHI
("OI'arialin's l'lIh'lgl'S tnllll ((i,li.I:I). The illlllilioll I'm 11ll' lillk is ~Ir;lighl­
((,("wanl. Ik\'iali<llls fnllll IIIl' lIIodei IIIllsl il(' ,\("("olllpallil'l1 Ill' a ("lllllllHlll
6.6. lllll'rprrlilli{ Droialion.! fmm /:'xllcl F(/clol' Prici1lg •245.~.~~~·1
," .',

cOlllponent in the residual variance to prevent the formation of a portfolio

with a positive deviation and a residual variance that decreases to zero as the
number of securities in the portfolio grows. that is. an asymptotic arbitrage
opportunity.

6.6.2 Squared Sharpe /lalios

The sCJuared Sharpe ratio is a useful construct for interpreting much of

the cnsuing analysis. The tangency portfolio q has the maximum squared
Sharpe measure of all portfolios. The sCJuared Sharpe ratio of q. is s;.
(6.6.14)

Givell lhat the K factor portfolios and the optimal orthogonal portfolio h
can be combined to form the tangency portfolio. the maximum squared
Sharpe ratio of these K + I portfolios will be ~. Since h is orthogonal to the
portfolios K. MacKinlay (19%) shows that one can express s: as the sum
of the squared Sharpe ratio of the orthogonal portfolio and the squared
maxilllllill Sharpe ratio of the factor portfolios.

(6.6.15)

where s;, = Jli/a~ and si

= l1-~nKI 11-1\.7
Empirical tests of multifaclor models employ subsets of the N assets.
The factor portfolios need not be linear combinations of the subset ofasscts.
Results similar to those above will hold within a subset of N assets. For
subset analysis when considering the tangency portfolio (of the subset), the
maximulll squared Sharpe ratio of the assets and factor portfolios, and the
optimal orthogonal portfolio for the subset, it is necessary to augment the
N assets with the factor portfolios K. Defining Z;, as the (N+Kxl) vector
[Z; Z~/l' with mean 11-:' and covariance matrix n;,
for the tangency portfolio
ofthl'se N+K asseL~ we have
I
s;. = 11-;'n:- II1-;. (6.6.\6)
i
The subscript s indicates that a subset of the assets is being considered.' If
allY of the J;Jctor portfolios is a linear combination of the N assets, it wil\'be
11l'('('ssary to use the generalized inverse in (6.6.16).

~Thi, \'('sul! is r"\OII"d 10 Iht· work of Cihho"s. Ross, OIl1d Shankt'O (I9R9). i
I
~
 .
I
46 . 6. Multi/artor PlirillK MII/"",~

The analysis (with a subset of assets) involves the Cjuaclratie a':E- 1a com-
)lIted using the parameters for the N assets. Gibbons, Ross, and Shankcn
~ 1989) and Lehmann (19H7, 1992) provide illterpretations of this quadratir
terril using Sharpe ratios. A~stlJlling :E is of full rank, the), show
i
(li.li.17)

Consistent with (6.6.15), ror the subset orassets a':E-la is the squared Sharpe
ratio orthe subset's optimal onhogonal portrolio h•. TherclillT, fill' a given
subset of assel~:
~
',1", a'.:E~la. (G.G.IH)

and
2 ~
.5;," S", + J~, (li.fi.I!J)

Note that the sqmlred Sharpe ratio or the suhset's optimal onhogonal pon-
folio is less than or equal to that or the population optimal orthogonal
portfolio, that is,
«i,G,20)

Next we use the optimal orthogonal portfolio and the Sharpe ratios
results together with the modd deviation residual variance link to develop
implications for distinguishing among asset pricing models. llerealkr the
.I subscript is suppressed. No ambiguity will result since, in the suhsequent

analysis, we will be working only with subsets or the assets.

6.6.3 InlJllimtions Jor SrJiUmtillg Altematiue Theon'fS

Ira given factor model is rejected a COllllllon interpretation is thatlllore (or

dilTerent) risk factors are reCjuired to explain the risk-return relation. This
interpretation suggests that one should include additional factors so that the
Ilull hypothesis will be accepted. A shortcOllling or this popular approac!1
is that there arc multiple potential interpretations of why the hypothesis
is accepted. One view is that genuine progress in terms or identifying the
wJight" asset pricing model has been lIIade. nllt it could also be the else that
t; Ie apparellt success in identifying a heller model has COllie from linding
, good within-sample lit thro\lgh data-snooping. The likelihood of this
Ijossibility is increased by the fact th"t the ;ulditional factors lark thet>retical
'~lOtivatioll.
i This section alll'lllpts to discrilllinate belweell the t\VO interpretatiolls.
'I~) do this, we compare the distribution of the test statistic under Ihe null
h[/'pothesis with the distribution ullcler each or the alternatives.
We reconsider the 1.t'ro-intt·IT(·PI F-tl'st of Ihe l1ull hypothesis Ihal tht'
i'l tefcept vector a frolll (li,li.l) is O. I.et lin he .the 111111 hypothesis and 11.1
 247

he the allcrualivc:

Ilu: a ()
11. 1: a f- n.
I III (,lll be tested using the test statistic Ji hom «i.~. I :2):

«;.().:21)

where 'j' is the illJlllberoftirlle-scries obsCl'vatiolls, N is the rllllllhlTofassets

or portfolios ofassets included. antl/\ is the nlllnbn of 1;lctor portfolios. The
hat sliperscripL\ indicate thc maxilllll"r likelihood estimators. U"der the
lIuli hypothesis • ./1 is ullcondiliollally distributed Cl'IHr,,1 F with N degrecs
of freedom in lhl' III1I11CI'.IIOI· alld ('/' - N - /\) dl'gnTs of fn'cliolll ill thc
dell Oil Ii lIat or,
To illterpret dcviations frolll the IIull hypothl'sis. wc rClluire a general
rej)l'esellt'llion for lhe distributioll of}" COllditiollal Oil rill' buor portfolio
rct!p'ns the distribution of Ji is

JI ~ /.:'1.1. N-~('\)'

o= '/'[1 +iL~il~'iLf..J-Ia'1: la,

Whl'IC a is the noncl'lItrality paraml'ter of the F distrihlltioll. If 1\ = () thl'll

, ... -1
the (crill 11 + iL/o..n,,: f.r.d- t willllot appear ill (t;.Ii.:21) or ill (ti.li.:2:~). alld
Ji I,'ill he IIIl(olHlitionally distrihuted 1I0lHTIltral F.
We cOllsidl'l' the distribution of./I unell'\' t\\'o different "ltlTllatiVl's.
which are separated by their implications for the Illaxillllllll valllc or the
squared Sharpc 1·;ltio. With the risk-bascd IIlllltif;ll'tor altl'rnativc thlTl" will
he an upper bound on the squared Sharpe ratio, whcl'l';ls with the non risk-
based alternarives the maximum squarcd Sharpe ratio i~ IInhollll<lcd as the
llumiJer of assel.~ illcreases.
Firs! consider the distribution of )1 IInder 11ll' alternative hypothcsis
that deviations ;Ire dill' 10 'llissing hetors. Drawing' on the resliits for the
sqllarcd Sharpe ratios, the Ilollcentrality parameter or (he F distribution is

«i.(i.:24)

Frolll (i.(i.:!O) .the third tcrlll in (i.(i.:2'1) is hounded ~Iho\'l' hy .17, ~lIld positive.
The .,('Co/Hlterlll is hounded hetwlTIi Il"ro and olle. Tlin.s tIlCrc is all upper
hound f()r S,
,) < '/'.If, :" rl~. (ti.ti.:2:»
The Sl'('Olld inl"Jll<llity follows frolll the f~lrt 11i~lt th" l~lIlg"I\( Y portfolio 'I
has Ihe IlIaxiJIIlI1II Sharpc ratio or all)' as.'('t or portfolio.
..:. Ji) 6. Mull/jl/dlll hieillg '\/lIlld,

C;il"en a lIIaxinllllll I"ahl<" 1,.1' til(" sqllared Sharpe ralio, Ihe IIpper houlld
011 Ihe lIon("('lllralill" p;II'aIlWI('I" (";111 he illlportanl. Wilh Ihis hOlilld, in-
d'"!wlld('1I1 01 hOI\" Oil(" ;1I"I;lIlges Ihe assels 10 he included as dq)('ndclII
I"ariables ill Ilw pricillg lIlodd regrcssion alld lill' any I"alue or N,lI tll('l"(' i., a
lilllit Oil the dislallce I)("tll'('('n the lIull distributioll anel tht' distrihution or
the lest st;lliSlic 1111111'1 IllI' Illissillg-Llctnr ;lht'l"IIaliVl'. All Ihe assels call he
IlIispric('(1 and I·('t th(' holtlld will slill apply.
III cOlltrasl, II'h(,1I Ihe altel"llatil"c Ollt' has in lIIilld is that the sOllrce
of del"ialiolls is lIollrisk-has('d, SlIch as dala snooping, lIlark('1 frictiolls, or
lIlarkCI irraliollalilies, th(' lIotioll of a lIIaximllm sfJllareci Sharp(, ralio is
1101 liseI'll\. Th(' sqllarl'd Sharp(, ralio (all(1 Ihe lIollcelllralil), paralll('ter)
arc ill principlt- IltlhOlll\(l('d h('("alls(' II\(' Ih('ory linking Ih(' (\t-I"ialiolls alld
Ih(' r('sidllal varian("('s and ("ovariallc('s does nOI apply. Wh('n comparill!!;
alterllalil"es wilh Ih(' illlcrc('pis of ahoul Ihe sallie lIIagllilude, ill gt'nt'ral,
011(' wOllld ('xp('n 10 se(' larg('r lest slalislics ill Ihis lIonrisk-iJaseci case.
We exallline Ih(' inforlllalil'l'Ill'ss of the above arJ;llysis hy considering
a\ll'l"lI;\liws wilh realislic parallll'll'r vailles. We consider the dislrihulioll of
Ih(' I('sl stalislic 1(11 1111('(' casl's: Ihl' 111111 hypOlh('sis, IlIl' lIIissing risk EI("(ors
altl'l"nalil"(" alld Ih(' 1I0llrisk-hased alt('malil'c. For Iht' risk-has('d alt('rnative,
Ih(' fralllel\"ork is Ilt-sigll('d 10 hI' silllilar 10 Ihal ill Failla alld Fr(,lIch (19!}:1).
For Ihe lIolllisk-has('d alt('l"lIalil"(, 11'(' ltS(' a s('IUp Ihal is cOlISisll'lI1 Ivilh liIl'
all;llvsis of 1.0 ;11111 tlhd,illl;II' ( 1!'I}Oh) alld the work of I.akollishok, Shkikr,
alld Vishll), (I !I~H).
COllsid('r a Olw-bclor ass('1 pricillg model ltsill!!; a lilll(, sni('s of the
('X("('SS r('llll"lls I'll" :I~ ponl,.lios as Iht' dqH'lIdelll v;lI·iahlc. The 011(' 1;\\'lor
(illdqlt'lldeill I'ariahit') is IIII' ('X("(,SS 1'('1111'11 of Ihe lIIarkel so Ihal Iht' l.l'l 11-
illt('l"("q>t IIl1l1 hypol\\('sis is Ihl' (:Al'tll. Th(' lellgth of the tilll(' s(,ri(,s is :q~
11I011lhs. This SI'llIl' ("OIT(,SPOllds 1o Ihal (Jf Failla all(1 Frellch (\ !I~I:{, Tabk
~I, \('gn'ssioll (ii». Th(' lIulI dislribulioll oflh(' I('sl slalislic./I IS

({i.{i.:!{;)

'\i. ddill(' IIIl' disll ihlliioll .. 1'./1 lIlHkr Ihe altl'rll;lIil"l's of illl('l"('si Ol\('
IH'('d~ 10 spl'dl'" Ih(' 1':lIall\('\('IS IH'(TSsary 10 t'alclliall' Ihl' lIoIH'('lIlralily I'a-
r:IIIH'IIT. For Ihl' risk·hased alterllalil"t', giv(,11 a Valll(, for Ihl' squared Sharpl'
ralio .. I' Ihe "l'lilll;1\ ." tilOgoll;1\ l'0nl,.lio, Ihe dislrihulioll ("orr('spolldillg
1o Ih(' "1'1'(,1' hOlllld .. I" III(' lIolHTlilralil), parallll'ler frolll ((;.I;.~:.) (";111 h('
Ulllsid('11'11. Th(' Sharp(' ratio of Ih(' oplillial orthogollal portfolio call Ill'
ohiailll'd IIsillg (li.I;.1 :.) gin'lI Iht' squarl'd Sharpe ralios of Ih(' lallg('IIl"\'
ponfolio ;1111101111(' ill<iud('d 1;11"101' porllolio.

~In pl.II lic t' \du'll U"'lll).!. lilt" r .!t',{ II \\,1111,(, tH't C:'\.H Y fur S to lu.' t.:~, lku\ F- ~: M' th.lt ~
willi ... "I 11111 1,'lIk.
6.6. 11i/1'/llrftilig Deuiations from f:xac/ Fac/or Pricing

MacKinhlY (1995) argues that in a perfect capital markets setting, a'

reasonahle value for the Sharpe ratio sfluared of the tangency portfolio
for an ohservation interval of one month is 0.031 (or approximately 0.6i -;,
for the Sharpe ratio on an annualized hasis). This value, for example,l
corresponds to a portfolio with an annual expected excess return of 10%:
and a standard deviation of 16%. If the maximum sfluared Sharpe ratio of
the included factor portfolios is the ex post sfluared Sharpe ratio of the CRSP
value-wciRhted index, the implied maximum squared Sharpe ratio for the
optimal orthogonal portfolio is 0.021. This monthly value of 0.021 would I
he consistent with a portfolio which has an annualized mean excess return :
of R% and annualized standard deviation of Hi%. We work through the
analysis lIsing this value. !
UsinR this squared Sharpe ratio for the optimal orthogonal portfolio to l
calculate 8, the distribution of 11 from equation (6.2.1) is ~

(6.6.27)

This dislribution will be used to characterize the risk-based alternative.

One can specify the distrihution for two non risk-based alternatives by
specifying values of a, ~,and jJ.~n; 1 jJ.K' and then calculating8 from (6.6.23).
To specify the intercepts we assume that the elements of a are normally dis-
trilmted with a mean of zero. We consider two values for the standard devia-
tion, 0.0007 and 0.001. When the standard deviation of the elements ofa is
0.00 I ahollt 95% of deviations will lie between -0.002 and +0.002, an annual-
ized spread of about 4.8%. A standard deviation of 0.0007 for the deviations
would correspond to an annual spread of about 3.4%. These spreads are
consistent with spreads that could arise from data-snooping. 9 They are plau-
sible and even somewhat conservative given the contrarian strategy returns
presented in papers such as Lakonishok, Shleifer, and Vishny (1993). For E
we use a sample estimate based on portfolios sorted hy market capitalization
• for the Fama and French (1993) sample period 1963 to 1991. The effect of
• -I
jJ.~f1.K iLK on 8 will typically be small, so it is set to zero. To get an idea ofa
reasonahle value for the noncentrality parameter given this alternative, the
expened value of 8 given the distributional assumption for the elements
or a conditional upon E == t is considered. The expected value of the
llollCt'lltrality paralileter is 3!l.4 for a standard deviation of 0.0007 and 80.3
for a stalHlard deviation of 0.001. Using these values for the noncentrality
par;illll:ler, the distribution of JI is

(6.6.28)

"Willi d.""'''lClC'pinl: II ... dislI'ihlllion .. r}1 i., 1101 <",,,clly,, n,,"c~nlrdl F (se~ I.o and MacKin-
LIY Il~I(IOhl)· I ("WI'WI", fur Ihe purl'",es "r Ihis allaly,is, Ihe lIuncelllfdl F will be a good
al)I,nlxill1;(ti t HI.
~50 6. Multifactor I'ricillK Mot/rls

Null
(fi.Ii.:!fi)

AII"rIlatiw I (G.G.'.!7)

..... / Allernalive '.! (G.li.211)

1 Ii
F 'lali.'lic

Figure 6.1. /)iJtributiom for Ihp CAI'AI 1.I'lTrllltfrrr/Jt Tr.11 Sta/i.ltic for f'(mr 11)lm/hrJ'.!

whcn a. = 0.0007 and

«(;.6.29)

whcn a. 0.001. =
A plot of the four distributions frolll (6.6.26), (6.6.27), (6.6.28). and
(~.6.29) is in Figurc 6.1. Thc vertical bar on thc plot rcprcsents thc value
1\91 which Fama and Frcnch calculate [or the tcst statistic. From this figure.
Ilt)ticc that thc distributions ullder the null hypothcsis and the risk-based
a tcrnativc hypothcsis arc <]uitc closc together. III This reflects thc impact of
tl~e uppcr bound on the Ilollcentrality parametcr. In contrast, the lIomisk-
hhscd alternativcs' distributions arc far to the right of thc other two distri-
hiltions, consistent with the IInbollndedness urtbe 110nccntrality parameter
f(~r thcsc altcrnativcs.
I Givcn that Fama and French liJld a test statistic of 1.91, these reslllts
5Vggcst that the missing-risk-factors argulllelll is not the whole story. From
Flgurc 6.1 one can scc that 1.!11 is slill ill the upper tail whcn the distrihution
Of JI in thc prescncc of missing risk factors is tabulatcd. Thc /rvallll' IIsing
tl is distrihution is 0.03 ()r the mOllthly d'lla. Hence it secms ulllikely that
Il issing bctors completely explaill thl' deviatiolls.
I Thc data oncr SOllie support for the Ilonrisk-based alternali\'(' views.
TIIC test stalistic falls almost in the middle of the Ilonrisk-hascd ,,\tl'ma-
I\
IIIIS('(' MacKilllOlY (1!11I7) for (kl"il("d ,,"al)",is of lil(' I i,k·has('d OIll("rtlOIli,"(".
 6.7. (;ollr ill.lio ll

ti,'c "illl tllc lowe r st'IIH lan\ dcvi

aliol l of the deil leill s or a. Seve
the lIollrisk-l><lsn\ aher nali ves ral or
("ould e<[II.lIly well expLlill lhe
krcl it lIolirisk-l>asee! views call I ("Suits. Dif~
I{iv!' lhe salll(' lIoll (clIl r.dil y para
(('\t- slali slic distr ihwi oll. The resu melC l' alld
lts are cOlisisl!'111 wilh lhe e!al.l-sno
alter naliv e of 1.0 aile! Mac Kinl ay opinl{
(1\1\101», wilh lhe rt'i<lle<i S<llIlple
hi'lse" disc llsse d hy fin:e ll alld Kor. scle niol l
!jezyk (I !I!I:~) alld Koth ari, Shal
Sioa ll (IH! I:), alld wilh the pres lk('I l, alld
elHT orill arke l ilidf icicl icics ,

6.7 Con clus ion

III Ihis chap ler we have devc lope
clth e ('col lolll etric s for ('slillialil
illg- Illlll tibC lor pric ing mod els, ll{ alld test-
The se mod els prol 'ide' lIl allra ctive
lin' to the sillg lc-fa clOr CAI 'M. ahem a-
bllt lIsers of slich IIlod ds shol iid
two serio lls dalll {ers that arise he awar e of
whe ll brlo rs are chos ell 10 lit
wi Ihol ll rega rd to ecol lom ic lheo existinl{ data
ry. First, the IllOdcls Iliay over fit
lJeGlllse of data -sllo opin g bias ; the data
in this case Ihey will Ilot hc ahle
as\': t retu rns ill the futu re. Seco to pred ict
nd, the IIlod eis lIlay capt ure emp
ular ities that arc dlle to mar ket irica l reg-
illef licic llcy or illve stor irral iolla
case they iliaI' cont inue to !it the lity; in this
data hili they will i'llpl y Sha rpe
facto r port folio s that arc 100 high ralio s for
to be cOll siste nt with .1 reas onab
lying 1l1Odd of mar ket equi libri le unde r-
um, Both thes e pwh lem s call
if olle deriv es a facto r stru ctur e he miti gate d
from an equi lihri lllll mod el, alon
disc llsse d in Chapter~. In the l{ Ihe lines
elld . how ever , Ihe usef ulne ss of
1110dels will 1101 bc fully kllow li 11111ltifaClor
ullti l slIIIicieli1 IICW dat'l I)(,COIIiC
prov ide a true oIlH)I~sal11ple chec avai lable 10
k Oil tllci r perf orm ancc .

Pro blem s-C/ lUjJ ter 6

6. I COl lside r a lIIul tiple regr essio ll

of tire rctu nt Oil any assc t or port
flu I)n the retu rns of <lily sct of poni folio
c)lio s frol11 whic h tlie clili re lIIilli
\"Iri allce bOli lidar y call he g-ell erate llllll11-
d, Sho w thal lhe illte rccp t of Iii
sioll willl>e zero and that the facl is ,'egr es-
or ITl{ressioli (odI ici(' IlI.' for allY
SlIIll 10 llilily, asse t will

6.2 COl lside r two ccol loll1 ies,

ecollolllY 1\ and ccol lom y II.
('XCl'ss-rcturIi \'('cl or and the cova TIr(' mca ll
ri'III (T Illat rix is spn ilicd I)('\o
of the ecol lom ics, Assu mc ther w Ii)!' ('ach
e exist a riskl n't' 'Isset, N risky
IIIcali cxcc ss retu r" f.L alld non ass('ls with
sing ular ('()\'ariall(,(' Illat rix n,
\'act or port folio with IIIcali ex(e
port folio is lIot a lille ar com billa
ss ITIIII'Ii II" alld I'aria llcc
tion of the N 'Isscls, (Thi s nite
orand a risky
The faclo r
riol l Gin he
IIl{,thy clim inati n),( one oflh e asse
ts whic h is illdl ldcd illlh (' 1;lclor
ponf c)lio
 O. Muftil'll·tor/),.iri,,/!. ,Hot!l'/.~

if III'fl·ss"ry.) Fill" hllill ('CIIIIO\uil's r\ alld II:

It = a + {-JIJI' ((;.7.1)

n = tWa;; + liIi'al~ + /a/.

C:i\'l'lI the OII1 .. \,e IIll"all alld c .. \'ariaIIlT lIlatrix and thl' asslllnplioll Ihal Ihl'
brtor pllrlhllio /1 is a traded asset. what is the maximulII sCjuared Sharpe
ralio 1'01' Ihe gi\'('11 (·C .. II .. llIil's>
6.:1 Relllrllillg 10 11\l" all .. \,l' proillelll. Ihe I'COIHllllics an' rllrther spl'cili('(1.
ASSlIlI1l'II\(" ("Ie II It'll IS or a 011'(" .... oss-s("((i .. llalJr illdl"()('llIklll alld idl'lllically
distli 1111\('''.
i = I ..... N.
The sp"(ilicali"l1 or IIIl' disirilllllioll or Ih,' delllents of {j cOllditional Oil a
differelltiates 1','Olllllllil's :\ alld II. For econolllY 11.:

i = I. .... N. ((i.7.4)

;\11111'01' I"l'OlltIlIlY Ii:

i = I ..... N.

1IIH'Olldiliollal\" III<" noss-s,"llioll;t\ dislrihlltion or tl\(" delll("lIts or {j \ViII

Ill' lIlt' salllt" lill' 1I.. lh ecollolllies. hilt lill' CCOIIOIII), A conditiollal on a. f5 is
lixed. Wh;1I is Ihl' Illaxillllllll sqllarl'd Sharp'- ratio for each ecollolII)'? W:I<l1
is the maximulI\ s((Ilan-d Sharpe ratio lill'cach ('CO\\OIllY as tlte N infll'ast"s
10 illlillil)'?
 7
Present-Value Relations

TilE FIRST PART of this book has examined the behavior of stock returns;
in some detail. The exclusive focus on returns is traditional in empirical!
research on asset pricing; yet it belies the name of the field to study only
relurns and not to say anything about asset prices themselves. Many of the i
most important applications of financial economics involve valuing assets, ':
and for these applications it is essential to be able to calculate the prices I
that are implied by models of returns. In this chapter we discuss recent'
research that tries to bring attention back to price behavior. We deal with 'I
com ilion stock prices throughout, hut of course the concepts developed in
this chapter are applicable to other assets as well.
The basic framework for our analysis is the discoiinted-cashjlow or present-
valliI' model. This model relates the price of a stock to its expected future
cash flows-its dividends-discounted to the present using a cons.tanl or
time-varying discount rate. Since dividends in all future periods enter the i
present-value formula, the dividend in anyone period is only a small com-
ponent of the price. Therefore long-lasting or persistent movements in div-
idends have much larger effects on prices than temporary movements do. )
A similar insight applies to variation in discount rates. The discount rate
between anyone period and the next is only a smaIl component of the
long-horizon discount rate applied to a distant future cash flow; therefore
persistent movements in discount rates have much larger effects on prices
than temporary movemenL~ do. For this reason the study of asset prices is
intimately related to the study of long-horizon asset returns. Section 7.1
uses the present-value model to discuss these links between movements in
prices, dividends, and returns.
We men tioned at the end of Chapter 2 that there is some evidence for
pr('(linability of stock returns at long horizons. This evidence is statisticaIly
weak whell only past returns arc used to forecast future returns, as in Chap-
. tt'!' 2, hut it hecomes considerably stronger when other variables, such as
the dividelld-price ratio or the level of interest rates, arc brought into the
254 7. Prl'.If11I- Va/III' Urialililu

analysis. In Scctioll 7.2, we lise thc fill'lnllias of Section 7.1 10 help inter-
prct thesc findings. Wc show how variolls tcst statistics will hchavc. hoth
unclcr thc null hypothesis and undcr thc simple altcrnativc hypoth(,sis that
the expected stock return is tilllc-varyill~ and follows a jlnsis\('1\1 lirsl-onkr
autorcgressivc (AR( I» proccss. A Ill;!ior Iheme of thc scction i.~ that reccnt
empirical findings using longcr-horizon dat;1 arc roughly consistcnt wilh this
persistent AR( I) alternativc Illodel. We also dcvelop thc implications or the
AR( 1) model for pl'ice behavior. Persistcnt movclllcnts in cxpectcd returns
have dramatic effects on stock prices, Illakin~ them much morc volatile than
they would he if expectcd returns were constant.
Thc source of this persistent variation in expectcd stock rctlll'llS is an
important unresolvcd issllc. Onc view is thatthc timc-variation in expcctcd
returns and the associated volatility of stock prices arc evidcncc against the
Efficicnt Markcts llypothesis (EMil). Bllt as we arguc<t in Chaptcr 1, the
EMil can only be tested in cOIUllnClion with a model ofcquilihriulIl retul'Ils.
This dJapter describes evidcnce againsl lhe joint hypothesis lhal Ihe EMil
holds and that equilibriulll stock retu\'IlS are constant, but itlcaves "pen the
I¥,ssihility that a model with time-varying equilibrium stock rctu\'lls can he
c~>nstructed to fit the data. We cxplore this possibility further in Chapter H.
I
I
7.1 The Relation between Prices, Dividends, and Returns

Itt this 6ection we discuss thc prescnt-valuc model of stock priccs. Using
tl e identity that relates stock prices, dividends, and returns, Section 7.1.1
P esents the expected-prcselll-valuc forllluia for a stock with constant cx-
Pfcted returns. Section 7.1.1 aSSUJl\es away the possibility that therc arc
s(kalkd rational bubbles in stock priccs. but this possibility is considered in
Srction 7.1.2. Section 7.1.:~ studies thc gencral casc whcrc cxpccted stock
r1111flls vary through time. Thc exact prescnt-value forllluia is Ilonlillear in
tltis case, but a loglinear approximatioll yields somc useful insighL~. Scc-
tion 7.1.4 develops a simple example in which thc expected stock retllrn is
tilne-varying and follows an AR( I) process.
i We. first recall the definition of the return Oil a stock given ill Chapter
I.,The net simple rCllIfII is

(7.1.1)

This dclinition is straightli.Hwanl, but it docs me two notational conwntions

that deserve emphasis. First, NI + t dellotes the relUrn on the stock held from
time I to tillle I + I. The sub~cripl I + I is used because thc return only
hccollles knowll at tillle 1 + I. Second, PI denotes the price of' a share of
stock measured at the nul of periocl I. or equivalently an cx-dividend price:
Plirchase of Ihe slock al prke f', lod;I)' givn 0111' a cbilll 10 Ill'xl P('l iod's
di\'idelld pn share /),+ I bllt nol to Ihis period's dividend /),,1
All ;llternali\,e llleaslireofrCllI1'Il is Ihe log orcoliliIiIlOIlSI),cOlllp(lIll1ded
rei 11m, defilled ill Chapter 1 as

/i+ I == Jog( I -1- 1\". I)· (7.1.~)

Here, ;IS Ihrollghollt this chapler. we lise JOW('I'(,<IS(' 1c1l('I'S 10 <ll'lIot(' JO)!;
vari.lhles,

7,1.1 'fYl,'f.ill/'lI/' f'w,II'lIt-VlIlul' Iidlliioll wilh L't1l/,'lrlllll::\jil'l1l'd fMum"

III Ihis senioll we explore the cOllse(l'l<'llces of Ihe asslllilplioll Ihat Ihe
expecled slock relllrn is eqllal \0 a (,(Hlslalll R:

E,l/(H I I = Ii, (7.1.:\)

Tak:l1g expectatiolls of the idelltity (7.1.1), illlposi IIg (7.1.:1). and rearrang-
ing, we obtain all equation relating th(' (tl1n'nl slock price 10 Ihe Ilexl
period's expe('icd stock price alld dividelld:

,- .I',
1( -
. [/',+1
-- + /}(II]
1-
+-/I - . (7.1.1)

This expectatiollal differcnce cqllation can he solved fi)l'ward hy repcatcdly

substituting Ullt flltllrc priccs and using the l.aw of Ileraled l':xpectations-
the rcsultthat E, [E,+t [Xll =
E,[X], disuissed ill Chapter I-tu eliminate
future-dated expectations. Aftcr solving furward 1\ periods we have

I', = E, [ L,=1~ (-) I

I -I- U
;
D,+.
]
+ 1':, [
(-)
I
I + Ii
K
I"+K
]
. (7.15)

The second term Oil the right-hand side of (7.1.:;) is tlte expeued discoulItcd
vallie of the stock price K periuds frolll tll(~ prcscl1t. For 1l0W, we asslImc
thai this tcrm shrinks to zero as the horizon 1\ in(Tcases:

lim
K~",
E, [(_I
I+
)K /',~ /-. ] O.
f{
= ('i.I.G)

I These..' limillg a:-'slIlIIpliollS arl' .,I;,IIHl.ud ill tht' lill;tlHT liter.lIllft", 110\\"('\'('" .'onlt.' (Jf,he Ii,·
<,,,II lin: 0/1 \'olalilil)' \('>\.', fort'''" II pi .. Shill<-r (I!IIII) .111<1 (:,"111'1,..11 ,,,I<I ~llIlI('r (PI!!? I!IHHa,h),
Wit'" Iht' ait('rl1;1lin' timillg COllvelltion Ihal tilt, :o.lol"k pi i( l' i., IIH';I~III(,d.tI 111«.' IU.'KillninK (II tilt'
period 01" traded (1II11-divi<iC:11l1. Dilll'n'lHTs 1,('1\\,('(,11 tile IOIlIlIlI.I~ gi\C'11 ill rlli;.; (h;'pICr and
Iho,(' ill lile oliKin;d \'obtBilY p;'pt'rs ;\1(' (hI(' 10 tlll .... llilkn·llcc· illlllllillg« OIl\ClllioIiS.
 I. /'11'.1/'/11-\'111,1/' /("illll(l//J

ASSlIlIlplioll (7.1.li) \\'ill II(' salis/ied IIl1less IIII' slock pri(T is expecled 10
grow I(lr\,\,1'I" al 1';\1(' U or b~ln. III S('clioll 7.1.~ Iwlow, WI' discllss IIHHkls
of ",Iillllal "IIM/I'I 111;\1 rclax Ihis ;ISSlllliplioll.
1.l'lIillg I\. illl'll'asl' ill (7.1.:.) alltl assul\lillg (7.1.(;), we ohlaill a formula
expressillg Ih(' ShIck Illin' as Ihl' expeCled presl'lll value offulure dividcllds
011110 Ihe illfillile 1'111111'1', discollllll'd al a ('ollslalll 1',1\('. For fUIUIT (OIIH'-
llit'lllT we wril(' Ihis ('xpecled prCSt'll1 \'allll' as 1'0':

/'/ =: 1'," - F/ [t (_I

1+ U
)/ f)/+/].
/~I
<7.1.7)

An 1I111"t';i1islic spt'ci;i1 CISt· Iii'll IU'l'crlhdl'sS provides SOIlU' II SI' I'll I ill-
Iuilioll occlirs \\'lIell dil'idcllds art' ('xpt'('Ied 10 grow al a ('ollsl;ml rail' (;
(\\'hkh IIlllsl hI' ,slII;i1ln Ihall /( 10 keep Ihe slo('k price flllile):

(7.I.H)

SUhSlillilillg (7.I.H) illlll (7.1.7), Wt' IIhlailllhe well-kllowlI "Conloll growtll

Illodd" (;oHIIIII II!Hi~ I) fill' till' priCI' 01';1 Slock wilh a COllslallt discoullt
ratl' U alld di\,idt'lId groll'lh ratl' (;,11'11('1'1' (; < /(:

E,I Il" II (I -I- (;)/),

(7.1.'1)
1'/
U -- (; u-(;
The (:01'l101l gnm'th Illodcl shIm'S Ihatlh(' stock price is ('xln'lud), semiti\'('
to a pI'I'lIIall('lli (hallg(' ill thl' clist'otllli ratl' /( wh(,11 /( is dose to C, sill('e Ihe
elasticit), or thl' price Idlh n'spl'('\ to thl' discoullt ratt' is «(II'/tlU)(U/ I') .-::
-/(/(/l - c).
It is illll'Ol'lali1 til avoid 111'0 ('0111111011 t'frol'S ill illterpretillg Ih('se formu-
las. First, lIott' Ih;\I \\'t' hal'l' IliadI' lit. assllmptions ahout (,lJuity l'epllrchaM's
hv finllS, Equily repurchasl's arrcrt Ihe tillll' pattern of I'xpl'ctcd fUlure di\'i-
dellds 1'1'1' sharI' ill (7,1. 7), hllt 1111'\' do lIot alfeet the validity of t ht' lill'lllllb
itst'lL Prohlem 7,1 l'xplnres Ihis pOill1 ill 1II0f(, detail.
Se('olld, Ihe hypothesis Ihal lilt' expl'cted stoek n'lurll is COllstallt
t h mllg II t ililt' i~ SlIllll't iIIit's kllOWIl a, tI H' 1/11/1/ ill~fllr /llOi/p/ofstock pricC's, ~ Bill
a COllstall1 ('xl)(,(,11'1I Slol'k 1t'llIl'Il does not illiply a martingale Ii II" tht, stock
pritT itst'lL Rccall that a llIarling-alt, 1<11' thl' priet, rt'(I"in's Ed 1'(+11 = i'/,
wllt'n'as (7.1,") illlJllil's Ihal

(I t m I', - Ed /),., I, (7,1.10)

:!Sl't' (:I"'lIh'l" ~ lot .1 C\I('lul di'nl ...,j'll\ HI II", IU.n li,,~~,lt· hypn'ht.. :..i~. l.t'ltny ( I~)X~}) 'urn'\',
tht' '\\~\I'i,,~~,I\' h,,'I".'\U"· hOUl S;UU\U+.. IlU ('~H{) on. Mort, 14t'II(· .. ,,1 lH.tnillg.ll .. It',nlrs Iflr
Il''-.-lW\llIaH,,',1 pi" (' pilI! t'~'t" .Ht' ,h."'lll,'c',1 ill (:h"plt" ~).
7. I. nil' IVialio/l bl'lwl'l'1I Prius, /)iui(/l'Ilds, alld Helums

i
The expected stock price next period docs 110t equal the stock price today ¥
would be required if the stock price were a martingale; rather, the expected
lilture stork price equals one plus the constant required return, (l + m,
timcs the current stock price, less an adjustment for dividend payments. 3
To obtain a martingale, we must construct a portfolio for which all dividend
payments are reinvested in the stock. At timc I, this portfolio will have N,
shares of thc stock, where

N,+ I = N, ( I D,+I) .
+ -,- (7.1.11)
1,+1
The value of this portfolio at time I, discounted to time 0 at rate R, is
N,P,
M, -- (\ + R)' (7.1.12)

It is straightforward to show that M, is a martingale.

Even though the stock price P, is not generally a martingale, it will follow
a linear process with a unit root if the dividend D, follows a linear process
with a ul1it root. 4 In this case the expected present-value formula (7.1.7)
relates two unit-root processes for Pr and Dr. It can be transformed to a
relation between stationary variables, however, by subtracting a multiple of
the dividend from both sides of the equation. We get

1',- -
/),
U
: : : (.!.') E, [f (_I
R ,~O
1+
) 6Dr+l+i] .
R
i (7.1.13)

F.qualion (7.1.13) relates the diITerence between the stock price and l/R
tillles the dividend to the expectation of the discounted value of future
changes in dividends. which is stationary if changes in dividends are station-
ary. In this case, even though the dividend process is nonstationary and the
price process is nonstationary, there is a stationary linear combination of
prices and dividends, so that prices and dividends are coinlegraled. 5

:IIIIIIIe special case where dividellds are expected 10 grow at a constant rate G,lhis5implifies ;
10 E,I'HI = (I + (nl',. The stock price is expected to !(row at the same rdle as the dividend, ,
h~r;l\lw lilt" dividt"nd'price ralio is conslant ill Ihis case. I
·1~)"'t"ly, 01 Variable follows a Mationary lime-series process if shocks to th~ variabI~ have,
It"lliporary hilt 1101 permanent elTeCl5. A vdriahle follows a process with a unit root, also known \
as all ill"lf'tl/ft/ process, if shocks have permanent e!Tects on the level of the variable, but not
oll·lht".change in the vdriable. In this case the first di!Terence of the variable is stationary, bUI
Iht" ".\"t" I i., nol. A marlingale is a unit·root process where the immediate e/Tect of a shock is
lilt" S:1I11t" a.' Ih,' pt"f1nanent e/Tecl. See Chapter 2 nr a textbnok in time.. eries analysis such as
I i;lInillon (I ~)~H) f()r precise definitions of these concepts. .
r'Two variahles with unit roots are COillle!(rated if some linear combination of the variables
is SI"tion"ry. St"e Engle and Gmnger (\!IR7) or Hamilton (1994) for general discussion, or
(:"mpl"'11 ,\1111 Shiller (1 !IR7) for this application of the concept. Note thaI here Ihe >lationary
lillt'"r fllIllhinOllioll of Ihe variahles involves Ihe COIlSt;lIlt discount rate R, which gener..lIy is
1101 ~n{lwll a /Jrimi.
258 7. PreJellt- Vtllue /lelatiuns

Although this formulation of the expected present-value 1Il0dd has

been explored empirically by Call1pbell and Shiller (1987). West (19HHI».
and others. stock prices and dividcnds arc like many other macroeconomic
lime series in that they appear to grow exponentially over time rather than
linearly. This means that a linear Illodel. even one that allows I<lr a unit root.
is less appropriate than a loglinear model. Below we develop a present-value
framework that is appropriate when dividends follow a loglinear prot:ess.

o 7.1.2 NIl/iOlwl /Jubbll'.I

In\ the previous section we obtained an expeuational difference cqllation.
(7,1.4). and solved it forwal'd to show that the stock price llIust c'luall'/JI.
thi:: expected present value of future dividends. The argument relicd on
the assumption (7.15) that the cxpected discounted stock price. 1\ periuds
in\the future. converges to zero as the hori7.ol1 1\ increases. In Ihis sectioil
WI1 discuss models thai relax this assumption.
I The convergence assumption (7.1.5) is essenlial for obtaining a unique
solution PD, to (7.1.4). Once we drop the assullIptiun. there is all in/inite
Ill\mber of solutions to (7.1.4). Any solution can be written in the form

"'~~!
1', = 1'/), + /I" (7.1.14)

,
1J, = I'.,• [ 11J++ IU ] . (7.1.15)
I
Th1e additional terlll B, in (7.1.14) appears in the price only becausc it is
eXI)ected to be prescnt next period. with an expected vallie (I + U) times
its Clirrent value.
The term Pili is sOllie times called fUlldamental value. and the tcrm B,
is often called a rational bubble. The word "bubble" recalls sOllie of the
famous episodes in financial histolY in which asset prices rose 1~lr higher
than could easily be explained by fllnciamentals. ami in which investors
appeared to be betting that other investors would drive prices even higher
in the future. 6 The a(ljective "rational" is used because the presence of
lJ, in (7:1.14) is elltirely consistent with rational expectations and constant
expected returns.

fiMCIckay (lH5:l) is a riassif .. clt'n'un' 011 t.·ady t'pi~odt's MICh as tile Dwch tllliplII;lIIia
ill Ihe 171h Century ~"t1 Ihe I <I"dou Soulh Sea I\"hhl" aud I'.ri, Mi"jssiPl'i lI"hhle in Ihe
IKlh Cenlury. Kintllcber)\rr (19Wl) <le,erih.·, 11",s<' ',lIId olher \lime rercIII <,\,iM,<l,·,. while
l;arht.'r (ltjK~) arglu':\ that l)u\« h lulip prift'~ \\It'n' mOle .. h)Sl:ly 1t"lattt{ tn tunt\;nnt'nt~":;' than
is unnlllolily realilC'd.
7.1. Thr Up/alioll /JrtwrPn Pri(r.l, DillidPlld.I, tll/I/ Up/llnll 259

It is easiest to illustrate the idea of a ratiollal huhhle wilh an example.

Blanchard alld Watsoll (I 9H2) S\l~~('st a huhhle of Ihl' ('!'Itl

with prohahility IT:

(7.1. Hi)
with prob;\bility I -- IT •

This oheys the restnC11011 (7.1.15). provided thaI Ihe shod:. (al satislies
E'(H I == O. The Blallchard alld Walsoll huhble has a COllstant prohability,
I - 7f, o( hurstin~ ill allY period. If it docs not hursl, it ~rolVs at a rate
I ~II _ I, faslcr than H, in ordcr to cOlllpellSate for the prohability ofhursting.
Many other bubhle examples can be construCled; Problelll 7.'2 explores an
example s\\~~estcd by Froot and Ohstfdd (I ~)~ll), ill which the huhhle is a
nonlinear function of the stock's dividend.
Altho\\~h rational bubbles have altractl'd cOllsiderahle alt(,lltioll, then~
arc hoth Ihcor(·tical alld nllpirkal argllllH'lllS Ihal CIII b" IIsed to rule out
huhhle solutiolls to the dilkrcilce equation (7. J A). Theorelical arglllllcills
may be divided illto partial-equilibriulIl argulllellls alld ~clleral-('quilihriulll
argulIle .1lS.
[11 pMti,,! equi!ihriulII,thc first poilltto lIotl' is tlr,1l tllt're elll IH'wr he;1
Ilcg;lliv(' huhhle Oil all asset wilh limited li;lhility. If a lI('gative huhhle W!'\'('
to ('xist, it would illlply a lIe~ative expecte!l asscI price at sOllie date ill the
futllre, ami this wOllld be inconsistenl with lilllite(\ liahility. /\ second illl-
p0rtant point ()lIows fmlll this: /\ hllhhle Oil <I lillliled-liahilil), asset callnot
slart wilhin all asst'l pricing modcl. II 1\l1l~1 hav(' "xisH'" sill ... · assel Irading-
begall if it exists loclay. The reason is Ihal if the bllhhle ('V('I' has a fCI'O vallie,
its cxpected fUlure value is also zero by ulndilion (7.1.1!.). IIl1t since Ih('
bubble Gin never he lIegative, it call only hav!·.1 zero ('x)lect;t[ioll if it is Z('rO
ill th(' fUIIIl'(' wilh probability one (Diha and (;msslllall (I ~)HH»).
Third, a bllbble canllot exist if there is all)' IIpper lilllil on th(' price of
an aSM~1. Thus a ('ollllllodity-price buhble is ruled 0111 h)' the ('xistellce of
sOllie high-priced sllhstitUlc in infinitely clastic slIpply (for example, solar
ellcrgy in the case of oil). Stock-price bubbles ilia), 1)(' ruled Ollt if firms
imposc all upper limit on stock prices hy iSSllill/-i stock ill rcspollse to price
increases. Finally, buhhles cannot exist Oil aSS(,lS sllch as hOllds which have
a lixed value on a tcrminal dale.
CCller;ll-eqllilibrilllll consideratiolls also limillhe possihiliti('s for ratio-
Ilal buhbles. Tirole (J!)H2) has shown that bllbhles ('all 1101 exist ill a model
with ;\ (illite Ill\lI\hcr or illlinite-lived raliollal agellts. 'I'll(' arglllllellt is (';\si-
est to sec ",hell short sales arc allowed, although it docs 1101 ill (;\('I depend
on the possibility of shan sales. 11';\ posiliVl' bllbl>\(o ('xisled ill all ass!'t
infinite-lived ag('nlS could selllhe assel short, inv(,st \01\1(' or IIIC IlJ()(,(Tds
to pay the divide lid strealll, alld have positi\'(' wealth lerl OWl. This "r"ilr;\gc
opportunity rilles Ollt bllbbles.
 7. /'rl'vl//-\'lI/ul' IMII I illl/.!

Tirok (I "H:,) has slllllied 1111" possihility ol"hllhhlt's withill the Dialllolld
(I!Hi:,) ovnlappillg-gl'III'Lltions lIIolld. In this IIIOtil'! there is an infinite
II til III 11'1' of lillitl'-lived agl'lIts, hilt TirolI' shows that evell hne a hllhhle
call1lot ;Irisl' \\'hl'll the illtl'll'st \;Itt' excecds the growth raIl' of tht, t'COIlOlllY,
hecallsl' the bllhhle I\'ollid I'vl'lltllally hecolIIl' illlillitcly large rdative to the
we;t1th of the 1'1'0110111\'. This wOllld violate SOIlW agl'lIt's hlldget cOllstrailll.
Thlls hllhhks CIII (111)' exist ill t1.\'I/{/lIIi({//~\' illl,/Jiril'lll overlapping-gl'n!'!'at it illS
t'conOlllil's th,lI h,l\'I' O\'nalTlIllllilatl'd private capital, drivin~ till' intl'l cst
1',111' dowlI Iwln\\' Iht, gn)wlh 1',111' of Ihl' I'COlltllllY, Mall), t't'olltllllislS kel
Ih,tI lIyn'"llic ill""licil'n<'\' is IIlllikdy 10 01'1'111' ill practice, allel Ahd, Mallkiw,
Slllllllll'rs, and /.l'ckklllScr (I !)H!)) Plt'Sl'lIt I'lllpirical ('vi(II'IKe that it does
not dl'scrilw tilt' liS I'COIlOIIl\'.
Thnc are ,d~o Stlille I'lllpirical ,IIW"lIt'llIS agaillst th(' existcllt't, of hllh-
hies, The IIlost illlport,lIlt )Ioillt is that bllhhles illlply explosive hehavior of
variolls sl'ries, In tilt' ahSl'nt't' of hllhhll's, if Iht, dividend /)( filllows a lillear
PI'III'l'SS with a IInit mot then tilt' stork price 1'( has a IInit rool whik the
challge in the price Dol', alld the spread hetween prilT and a IlIl1ltiple of
divitlclHls 1'( -- n,l/( an' statiollary, With hllhhks, thest' variahks all have an
I'xplosivl' cOllditionall'XIII'ctatio'lI: lilll"_,,,,(1/( I + m")I':" XI-/" J l' 0 ror
.\, == I',. /\1'" .. , 1',- /J,j I:. Elllpiricallv, thl'rl' is little Cl'i"I'IIIT of I'xplnsin'
Iwhavior ill lhl'sl' sl'ries. :\ can'at is that StOt'\lOlstit' huhhles are nOlllilll'ar,
so stallclardlinl'ar IIl1"thods Illa\' Elil to tll'tl'd Ihl' I'xplosil'l' hl'havior or the
conditional l'x!,I'I'lalinn ill Ihl'sl' Illl)dds.
Fillallr, \\'1' 1I0tl' IhOlt ratioll;11 hllhhll's call1lot I'xplaill thl' ohsl'\'\'t'd pre-
tlinahility 01" stock retllrns. Bllbhll's ITl'atl' volatility ill prices wilhou: cre-
ating prl'dinahilit)' ill rl'turns. To Ihl' cxtent that price volalility C'1ll he
I'xplaillctl hy I'l'tUI'll prl'dictahilit}', lhl' huhhlt, hypothesis is superfluous,
Altho\l~h raliollal huhhles ilia), 1)(' illlplausible. thnl' is nllKh to he
It'anll'(1 frolll sludyillg thl'lII. All illlportallt thl'lIIl' of this chapter is thaI
slllalllllovCIll('IlIS ill expcrtl'd lI·turns call have Iargl' dICcts 011 prices irthey
arc Ilt'rsislt'llt. COllversd)'. Iargl' persistl'nt swings in prin's call hal'e slllall
cfJ(-cts on ('xpl't'ted rl'lul'lls ill all)' 0111' period. A ratiollal huhhle CIII Ill'
sl'l'n as thl' I'xtn'nll' casl' whl'\'(' pril'l' IllIlVI'llH'lltS an' so persistent-indl'l'd,
explosive-that tlln' lIa\'1' 110 "'fl'l'\s Oil I'x(ll'l'\l'd retllrllS at all.

7.1 . ., ,III ,1/'IlItI\'jllllllt'/'/I'\I'III-ljdllt' Udillitlll l(1ilh Tillll'-\'tll)'ill~ J::\,/lI'rtl'lllll'llllll.l'

So 1;11' WI' hal'\' a~slllllt'd thOlt ('x I'I'CI 1'(1 stock retnrns arc cOllslall!. This
as,,"nplitlll is ,lIlalytilalh ctlll\'l'nil·lll. hilt it ctllltraelicts Ihl' 1'\'iell'IIlT ill
(:hap"'r ~ alltl ill S('(liOIl 7,'2 th,ll stotk rl'tllrns an' predictahll'.
It is n1\\('h Ilion' dirlinllt to wllrk wilh pres('nt-vahl<' rl'latiolls \~hl'n ('X-
p('l'Icd stot'k r('tlll'll~ ar(' t i1111'-\';1 r\'i Ilg, lill' Ihl'll the relatioll hl'tWl'l'1I (lrilTs
alit! returlls hl'COIIII'S lI11nIiIH';t1'. (hll' ;tpproach is \0 use a loglilll';tr ap-
7.1. Tilr Ul'laliorl bl'lllll'l'II ['rias, /hvidl'rld.l, 111111 Uflums 261

proximation, as suggested by Campbell and Shiller (1988a,b). The loglin-

ear relation between prices, dividends, and returns provides an accounting
framcwork: High prices must eventually be followed by high future divi-
dends, low future returns, or some combination of the two, and investors!'
expectations must be consistent with this, so high prices must be associated
with hiV;h expected future dividends, low expected future returns, or some
combination of the two. Similarly, high returns must be associated with up-
ward revisions in expected future dividends. downward revisions in expected
future relllrns, or some cornbination of the two (Campbell [1991]). 1
Thus the loglinear framework enables us 10 calculate asset price behav,
ior under any model of expected returns. rather than just the model with
constant expected returns. The loglinear framework has the additional ad~
v<lntav;e that it is tractable under the empirically plausible assumption that
dividends and returns follow loglinear driving processes. Later in this chap-',
ter we lise the loglinear framework to interpret the large empirical literature:
011 pn'dictahility in long-horizon stock returns. '
The loglinear approximation starts with the definition of the log stock'
return f,+I. Using (7.1.1), (7.1.2), and the convention that logs of variables'
are denoted by lowercase letters, we have

= P,+I - P, + 10g(1 + exp(d + 1 -

PHd}. (7.1.17)
'
The laS[ term on the right-hand side of (7.1.17) is a nonlinear function of the
log dividend-price rj\tio, !(dHI - PHI). Like any nonlinear function !(Xl+l),
it can he approximated around the mean of XH[, X, using a first-orderTaylor
expansion:
!(XI+t> ~ lex) + !'(X)(XI+I - x). (7.1.18)
Substitllting this approximation into (7.1.17), we obtain

Y,+I ~ k + P PHI + (l - p)d + 1 - Ph (7.1.19)

'
where p and k are parameters of linearization defined by p == I/(l +
exp(cI- jJl), where (d - p) is the average log dividend-price ratio, and k ==
- log(p) - (I - p) logO I p - I). When the dividend-price ratio is constant,
[hclI p = I I( I + D/ P), the reciprocal of one plus the dividend-price ratio.
Empirically, in US data over the period 1926 to 1994 the average dividend-
price ralio lias been about 4% annually. implying that p should be aboutO.96
ill al1l1l1al data, or ahout 0.997 in monthly data. The Taylor approximation
(7.1.1 H) replaces tile log of the slIln of the slock price and the dividend in
(7.1.17) with a weighted averar;c of the log stock price and the log dividend
in (7.1.19). The log stock price gets a weighl p close to one, while the log
dividend v;cts a wcight 1- p close to zero because the dividend is on average
 262 7. Prt'st'lli- V(/lut' [{rlatiolls

~lUch smaller than the stock price. so a ~iven proport ional chan~c in the div-
Idend has a much smaller effect Oll the return than the sallie proport
ional
~:hangein the price.
I
I
ANn"Oximation Accurm),
the approxi mation (7.1.19) holds exactly when the lo~ dividend
-price ratio
~~ constan t, for then dl+l and /'t+! move togethe r onc-for- one and equatio n
~7.1.19) is equival enlto eqllatio n (7.1.17) . Like any
other Taylor expansi on.

~
he approxi mation (7.1.19) will bc accuratc provide
d that the variatio n in
he log dividend -price ratio is not too great. One can get a sellse
for the
,ccuracy of the approxi mation by compar ing the exact return (7.1.17)
with
tl~le approxi mate return (7.1.19) in actual data. Using monthly nominal
( ividends and prices on the CRSP value-w eighted stock index over
the pe-
iod 1926: 1 to 1994: 12. for example . the exact and approxi mate
relllrns
1 ave means of 0.78% and 0.72% per month. standar d deviatio
ns of 5.55%
'lne! !J56% pcr month. and a correlat ion of 0.!)!)99I. The approxi
mation
<1rror-t he dilTeren ce betwecn the approxi mate and the exact return-
has
"mean of -0.06% , a standar d deviatio n of 0.08%. and a correlat
ion of 0.08
\~ith the exact return. Usin~ allnllal nominal dividen ds and
prices on the
CRSP value-w eighted stock index over the period 1926 to 19~11.
the exact
and approxi mate returns have means of9.20% and 9.03% per year.
standard
deviatio ns of 19.29% and 19.42% per year. and a correlat ion 01"0.999
93. The
approxi mation error has a mean of -0.17% . a standar d deviatio
n oI"0.2G%,
and a correlat ion of 0.51 with the exact return. Thus the approxi
mation
misstate s the average stock return but capturc s the dynamic s of stock
returlls
well. especial ly when it is applied to monthly data. 7

Implications for Prices

Equatio n (7.1.19) is a linear difTeren ce equatiol l for the log stork
price.
analogo us to the linear differen ce equatio n for the level of the
stock price
that we obtaine d in (7.1.4) under the assulllp tion of cOlIStan
t expecte d
returns. Solving forward and imposin g the conditio n that

(7.1.20)

we obtain
k co •
III =- - + L..
I-p
"fJ'I (I- fJ)dlllf ) - li+l+jJ. (7.1.21)
J~"

7011(' ran also (OlUlldrC l'XiICI ~lIId approxiru alt' re,.d

U'UIrI1S. The nnn'fliol l fur iullalic,..
ha. no important clT~<I' on II ... fOlIIl'al"iwn. S,·,· (;:lIlIl'h.-l1 ant!
Shill,'r (1!IHHa) Inl" a 111"1""
dc-tail('d c\'aillatinn (,f _'ppnlximOllion it(Tur;u'y .tl slu,rt illull(Ulg IH)J'ilcm~.
 7.1. Till' IMII /io/l lip/wPI'1l Prirr-s, lJiliit/nuLI, 111111 UP/lIm.l
2(i3
EfllI ation (7.1 .21) is a dynami("
a(collntin~ idcll Iity; it has
mer ely by approximatin~ an iden heen obta incd
tity and solv ing forwal d slIhj('ct
nal cond itiol l. The term illal cond to a tenn i-
itiol l (7.1 .20) rull' s Ollt ratio llal
that wOlrld calis e the log stoc k pric hllh hles
e to grow ('xJ>ollclltiall~' «,re ver at
or fa.)tcr. Eqll ation (7.1. 21) show rate 1/ p
s that if the stoc k pric c is hi~h toda
ther e IlllISt he SOIll C ('om hilla tion y, thell
of high divid cllds alld I"w stoc
in the ftllllre. H k retul 'lls
EfllI.lIioll (7.1 .21) hold s ex Im.I/,
hut it also hold s PX 1111/1'. Tak ing
tatio ns of (7.1 .21) , and noti ng expe c-
that /'t = E,l/I,I heCIIIS(' fit is kllow
I, we obta ill n at tillle

Ii EI L.., p'[(
/'1 = ~+ [~.
l-P )d,f .t+, -r,f .lf) ] . (7.1. 22)
p ,=(J
This ,1101I1d be thol lght of as a cOll
sistellcy cond ition f(lr expe ctati ons,
ogol ls to the state mcn t that the anal -
expe ctati olls of rand olll varia hles
shol l!d add lip to the expe ctati on X and Y
of the sum X + Y. If the stoc k pric
today, thcn inve stors IIlUSt be expc e is high
ctin g sOllle com hin, llion of high
divi dend s and low futu re retu rns. futu re
Equ atio n (7.1 .22) is a dyna mic gene
tion ofth c Gor don form ula for raliz a-
a stor k pric e with cons tant requ
alld divi delld grow th. Cam pbel ircd retll1'll5
l and Shil ler (I9HHa,h) call (7.1
(7.1 .24) belo w-th e dynamic Gurd .22) -all d
un gmw lil /IIotlrl or the tlillit lrnd
I.ikl' the orig inal Gor don grow -mlio mud d
th mod el, the dyna mic Cor don
mod el says that stoc k pric es arc grow th
high whe n divi dend s ,liT expc <·ted
rapi dly or whe n divi delld s arc to gnlw
disc oun ted at a I(lw rat(~; hilt Ihe
the sioc k pric c of a high divi dend elkc t Oil
grow th rate (or a low disc oull t
depc nds on how long the divi dend rate) IIOW
grow th ratc is expe cted to he high
how IOllg the disc oull t rate is expe (or
cted to be low) , whe reas in thc
mod el thes e rates are assu med orig inal
to be cons tallt at thei r initial level
One can lise the ddin ition s of s forcver.
p and " to show that the dyna
grow th Illod d redu ces to the orig mic Gor don
inal Cor don grow lh 1I10dei whr
grow th rail'S alld disc oull t rate s n divi dcnd
arc (Oll stan t.
For futu re conv cnie nce, we can
simp lify tile Ilota tioll in (7.1.~~),
illg it as rewrit-

(7.1. 23)
whe re /',/1 is the expe cted disc otlll
ied v.lllle of (I - p) tinH's !'ruu re
idcn ds in (7.1. 22) and 11" is thc log div-
expe cted dis('oUIIl!'d \'ailic of
stoc k retu rlls. This para llels the futu re log
nota tion WI' IIsed f(lI' tl}(' cOll stant
retu rn case in Sect ion 7.1.1 . -{'xp e!'tc d-

"C;"" pl>cl i OI'HI Shill "r (I!IHHOI)

"I',.I" au' III<' ,n I """ I' III III" 011'1"
",i"1 0'I,"" ill (7.1.'11).
 Equatioll (7. I.:!:!) C;III hl' l'('IITilleli ill terllls of thc log dividclld-prit'(,
ratio rathn Ihall Ihe log Slock prin':

tI, - I', =0 - Ii
--
1- fI L
/ __ 11
1
"\. P 'I - /\ tI'-I It) + /", t-I + ,I .
+ 1-'., [ '\' (7. I.:!'!)

Thc log dividelld-price ralio is high whell diviciellds are exp('Cl('d 10 grow
ollly slowly, or whclI slock n'llIl'lis art' ('XI}('('lcd 10 h(' high. This cqllalioll
is II s('fll I II'hell 111(- dil'idt'llcl folloll's a loglillt'ar IIlIit-root proccss, so Ihat
log ciivid('lIds alld log I'rin-s an' IUHlstatio\lary. hI this cas(' change, ill
log divi(ic'nds ar(' stational'\', so 1'1'0111 (7.1.~4) till' log- dividend-prict' ratio
is stational')' prOl'iclc-d that tht' ('xp('Cl('d stock rellll'll is statiollary. TillIS
log- stock prin-s and dividends an' cointegrateci, and thl' stalionarr lillt'ar
cOllliJill;Ilil/n or IIII'S(, variahles ilivolVl's IIIl unknown paraml'ters since il is
jllst tht' log ratio. This simple strtlt'lllrc makt's the log-linear mociel ('asier to
IIS(' in elllpirical work thantht' lint'ar coilllegraled model (7.1.13),
So rar W(' hav(' w)"illclI asst't pric('s as linear combinations of t'xpeClt'ci
1'111111'(: divici(,lIds alld )"('IIII'IIS. 'VI' can lise Ihe sallie approach to wrile asst't
r('1II I'IIS as lilH'ar cOlllhillaliolls of n'visiolls in t'xpt'('\t'd 1'111 lire divid('ncis and
)"elIll'IIS (:alllpl)('llll!)!lI J). SlIhslilillillg (7.1.22) into (7.1.1!), 11'(' OI>I;lill

'iI I -- E,lli III

-. (1-'.'1 I [to fl' rill f/] -

r' I
E, [f
J~I
p ir,-I 1+/]) . (7.1.~:)
This ('qll;llioll SItIlWS Ikll Illlt'XI'(TI"d Slock ('('lllnlS IllIlSl 1)(' asso('ial('d \"illl
challgl's ill l'x),,'n;l1iolls of 1'111111 (' divid(,lIds or ('('al relll)"IIS. All illcrl'asl' ill
I'XIll'Cll'd 1111111'(' dil'idl'lIds is associall'd wilh " capilal gaill loday. whill' all
illn(';IS(' ill ('XI\tTll'd 1'111 lire \'('\llrIIS is associated wilh a capilal loss \(Hlay,
Thl' reasoll is Ihal wilh a gil'l'lI dil'icil'lId slrl'alll, high('r flltllre r('llIl'IIs call
ollly h(' W·lu'r;l\(·t! ll\' 111111\1' pritT ;lpl'\'('cialioll frolll a lowl'r ('111'1'('1\1 pl'i('t',
For COIII'('lIil'lI(,(', WI' CIII silllplifl' Ihl' lIolalioll of (7.1.~:.) 10
(I.I.:!(;)

w!tnl' '/11 1 i, III<' (1IIt'XI,,'cI('(1 .,Iod.. 1'('1111'11,1/01./+1 is Ih(' ('hall1-:(' ill t'xlw(la-
liollS ofhl\IIIT di\'itl('lItis ill (7. I.:!!'.), ;llIdl/di I is the changl' in I'xpectatiolls
01'1111111'1' I'l'tllntS.

'I'll<' forlllllbs ,It-n'lol'l'd ill III<' )'n'l'i,,"~ s('c'lioll Illay hI' ('asil')" 10 lIIull-rsl:tllci
ill Ihl' I'OIII('XI of a ,illll'll' (·x:III1),I(·. LlltT W(' will arglll' that tht, I'xalllple
7. J. Thp UelatioT! be/wpm Prial. /)ivitimtis. (lnd &turns 265

is not ollly simple. but also empirically relevant. Suppose that the expected
log stock return is a constant r plus all observable zero-mean variable X,:

(7.1.27) ··'f:

We further assume that X, follows the first-order autoregressive (AR( 1))

process
-I < I/> < I. (7.1.28)
Whell the AR coemcient I/> is close to one. we will say that the X, process
is highly Ilmistent. Equation (7.1.28) implies that the variance of X, and
iL~ innovation ~/. which we write as a; and a{ respectively. are related by
2 2 2
a,==(I-¢)a,.
Under these assumptions. it is straightforward to show that

[
Ilrl == E, "\"'
i...J
,=0
,
"" p'r,+I+j ]= - - T

1- p
~
+ ---.
1 - pI/>
(7.1.29)

Equation (7.1.29) gives the effect on the stock price of variation through
time in the expected stock return. The equation shows that a change in the':
expected return has a greater effect on the stock price when the expected:
return is persistent: Sinc, p is close to one, a 1% increase in the expectedl
return today reduces the stock price by about 2% if ¢ = 0.5, by about 4% ir'
rp = 0.75, and hy about 10% if ¢ = 0.9.
This example illustrates an important point. The variability of expected
stock returns is measured by the standard deviation of X,. If this standard
deviation is small, it is tempting to conclude that changing expected returns
have lillie influence on stock prices. in other words. that variability in prl '
is sm'lll. Equation (7.1.29) shows that this conclusion is too hasty: The.
standard deviation of prl is the standard deviation of X, divided by (l - pI/» , I,
so if expected returns vary in a persistent fashion, p,/ can be very variable "
even when X, itself is not. This point was stated by Summers (1986), and i
particularly forcefully by Shiller (1984):
Returns on speculative assets are nearly unforecastable; this fact is the.
basis of the most important argument in the oral tradition against a role,
for lIlass psychology in speculative markets. One form of this argument
claims that because real returns are nearly unforecastable, the real price
of stocks is close to the intrinsic value. that is, the present value with
cOlIStant discount rate of optimally forecasted future real dividends.
This argument ... is one of the most remarkahle errors in the history
of ecollomic thought.
In ollr example the stock price can he written as the sum of two terms.
The first «'nn is the expected discounted value offuture dividends, Pdl; this
,
i266 7. Presml- Vttlue UelllliUTlS

\ is not quite a random walk for lhe reasons given in Section 7.1.1 abow. but
Iit is close to a random walk when the dividend stream is 1I0t too hU'ge or
I variable. The second term is a stationary AR(I) process. -/1,/. This lwo-
compollellt description of stock prices is often found in the lilerature (sct:
Summers [ 19861. Fama and French [I !l8Hb 1. I'oterba and SUllllllers [ I !lH!{ J.
andJegadeesh [19911).
The AR( I) example also yields a particularly simple formula lilr the
one-pe;iod stock return r/+I. The general stock-return equation (7.1.25)
Isimplifies because the innovation in expected future stock returns. 1/,./+1. is
,given by P~,+';(l - p</». Thus we have

P~'+I
r,+1 := T+ X, + '/<1.'+1 - ---. (7.1.30)
1 - P</>
To understand the implications of this expression. assume for simplicity
that news abolll dividends and about future returns. 1/d.I+1 and ';'+1. are
uncorrelatedY Then using the Ilotation Var[lld.I+ll = O'j (so oj rqll'csellL~
the variance of news about all future dividends. not the variance of the
clITrentdividend). and using the fact that 0(2 := (1-</>2)0';. we call calculate
the variance of T,+I as

(7.1.31)

where the approximate equality holds when </> « p and p is close to one.
Persistence in the expected return process increases the variability of re<ll-
ized returns. for small but persistent changes in expectcd returns have large
efTects on prices and thus on realized returns.
Equations (7.1.28) and (7.1.30) can also be \\Sed to show that realized
stock returns follow an ARMA( 1.1) process and to calculate the autocorre-
lations of this process. There arc offsetting eflects: The positive 'lIItocorre-
lations of expected retuTIIs in (7.1.28) appear in realized returns as well. but
a positive innovation to future expectt:d returns causes a contemporaneous
capital loss, and this introduces IIq~ative autocorrelation illt<> realized re-
turns. In the ARMA(l,I) representation the AR coefficient is the positive
persistence parameter l/J. hut the MA coellicient is negative. Problem 7.3
cxplores these effects in detail, showing that the latter effect domin<ltes pro-
vided that l/J < p. Thus there is some presllmption that changing expected
returns create negative alltocorrel<ltions in reali1.ed returns.
Problcm 7.3 also gcneraliJ.es the example to allow for a nonzero covari-
;lIlce hetwecn dividcnd news .11111 expected-return news. Stock relnrns ran

I "TIIi., lIliglll I", Ihe ('''e. f(>r exalllpk. if expcn,·<1 '-Cll,ms arc d"I,'nnin!'<I hy Ih,' vol,lIilily
pf Ihe di,·idcn<l growlh prorcs.. alld divid"lHl volalility i< <I.-iV<' II hya {;ARClllIlo<l'" of II ... Iypc
,Ii~("ll.\.'\ed in Chapter 12 ~o Ih'll ~hn("ks (0 \'olatility an' IIl1c'oneiawd wilh ~hOfk.'\ In Ihc' )('\'e! of
,Iividen" •.
 7.2. I>rl'.mll- Valli I' R,la lioll. l fllld
liS S/O(/( 1>/1((' IMlIl lIior
2(;7

he posilively aUIOCOlTeialed ifdivi

d('11<1 11('\ " alld ('xl)('( led-r ellln
a slIfficiellll), I<lr),(c posi live l'ova llll'W S have
riall(,(,. The ('(lv;lriaIIlT IWlwtTII
nC\~s alld ('xp( '('(ed -rell divi dend
lrn news (';111 also hI' c1los('11 10
seriall), 11I1('oITl·lal('d. This case lIlake slOt'k relllrllS
, ill wlli dl .,Iock r('tll nlS follo w
ullco rrcla lCd whil e Ilois e pr()(:ess a seria lly
whil t' ('xl)('('(ed slOck n:lll nlS Illllo
SiSI('1l1 AR( I) proc css, illlls lralc w a pn-
s Ihe possibililY thaI all assel 1Il;II
wcak-Illl"lll effic ient (rell lrns arc ,kel llIay he
IIIlf(ll'ccasl.lhlc fron l Ihe hislo ry
Ihel llscl ws) hilt Ilot semi sll'O ng-f of retu rlls
onll dlir iellt (reI urns arc fOl('(,<ls
the info rma tion vari able XI)' lahle frolll
This possibililY seem s 10 be enlp
irica lly re\ev allt for the US stoc k
The stati stica lly insig nific ant long mark et.
-hor iwn <llll o(ol Tela lions repo
elld of Cha pter 2 impl y that ther rted al the
e is ollly weak evid ellce /(1" pred
IOIl!!;-horil.oll stoc k retu rns give ictab ility of
n past sloc k relll rns; hllt ill Ihc
we show that ther e is stro nger nexl sect ion
evi<iem:e for pred il'lah ility of long
retll rns givell olhe r info rma tioll -hor izon
varia hles .

7.2 Pres ent- Val ue Rela tion s

and US Stoc k Pric e Beh avio r
We IlO\\' use the iden titie s disc
llsse d ill tlte prev iolls s('('(ion
recc nt emp irica l find ings on Ihe 10 inte rpre t
limc -sni es I>cll'lvior of US sloc
Sect ion 7.2.1 disc usse s emp irica k prke s.
l work Ihat pred ins sl()(,k reI urns
hori zons , lIsin g I()re cast ing varia over long
bles othe r Ihall pasl relll rns Ihem
pres elll illus trali ve emp irica l resu selv es. We
lts whe n divi delld -pric e ralio s and
rate v;tri;tbles are IIsed to fore casl inte rest
sloc k reI urns . S('cl ioll 7,'2.'2 relat
horil.OIl relu rn beha vior 10 pric es long -
e beha vior , in parl icul ar sloc k pric
Secl ion 7.'2.:~ show s how time -seri e volalililY.
es Illod els can he used 10 calc ulale
hori zon illlp lical ions of shor t-ho Ihe long -
ril,o ll asset mar kel I)('havior.

7.2,1 LOllg-IIOlizoll Ul'h7C,I.lio/I,\

Recc lllly thcr e has heen Illllch
inle resl ill regr essio ns of retu rns,
over vario us hori zons , Ollto forec mea sure d
aslill),( v;tri abks . Popl liar filre casl
abit' s incl ude ratio s of pric e to ing vari-
divi delld s or earn ings (sec Cam
Shil ler [1~)HHa,bl. Fam a and Fren pbel l and
ch [1!)HHa], Ilod rick [1!)!J'21. and
[I !JH·I]) , and vario us illle rest Shil ler
.. ate llleaS\ll('S such as Ih(' yield
Iwecn long - and shor t-ter m raIl'S spre ad be-
, the qual ily yield sprc ad h('tw cell
higll-gr;l<le corp orat e bon ds or low- alld
COllllll('rci.ti p.lj> n, alld IUC;15(11'e
chan gcs in lite /('vel of shor t rates S of rccc lll
(sec Call1pbt~1I [I !JH71. Faill a alld
(19K!)!. J-iod rick (I!N 2J. anc! Keill Fren ch
l ;lIId Slal llbau gh (I!JHlij).
lIer e we COl lccn lrate on the divi
dcnd -prit T ralio . whic h in US dala
1Il().~1 sllcc essfu l fore casl ingv is Ihe
aria ble fi>l' long -hor izon relu rns,
terlll nOlllillal inln ('sl- ralc varia and (Ill a shor t-
ble. Wc sl;11"I wilh pri(l 's .lIld divi
dcnd s 011
the vallie-weighted (:RSI' illdl'x of stocks Iraded olllhe NYSE, the AMEX, anel
Ihe NASDAQ. Till' dividl'lId-price ralio is measured as Ihe Slllll of divide lids
paid on Ihl' illdl'x over Ihl' prl'vious Yl'ar, e1ivided hy lilt' clIITelllll'vcl of the
indl'x; sUlllluillg dil'idcllds oVl'r a full year rellloves allY seasonal pallerns ill
dividt'lld j>aynwllls, hut Ille nll"l"t'lIl siock illcl<'x is lISt'cilo incorporale Ihe
ItlOSt n'n'lIt ill(illlll;tliOIl ill sluck prin·s. 11l
The illleresi-rall' variahlc is a Irallsformalioll of Ihe Olle-IIIOIlI h nOIll i lIal
US Treasury hill rail' lIlolivatl'd hy thl' bCI that unit-rool tests often (;\il
to rcjecl Ihe hypothesis thaI Ill<' bill I'ale has a IIllit roo\. We sllhn',l('\ a
hackward 0111'-1'1'''1' lllOvillg avcl'agl' of past hill rates fro III the I'lIlTI'nt hill rate
10 get a ,lllIl'illlIlimllv "fir/'lll/rtl illtl'l'est rate that is eqllivalent to a triangularly
1\,l'ightecl Illoving aVI'rage of past changes in bill ratl'S, wherl' the weights
dl'clinl' as 0111' IllOves hack in lilliI', Acconlingly Ihe dl,trended interest rate
is stationary if changes in hill ratl's arl' stationary. This slochaslic clel rellding
1I11'Ihod has hl'(,11 IIsl'd hy Camphl'll (1!J!lI) andllodrick (1992).
'E\hlc 7.1 shows a I\'pical Sl't of rl'snits whell the dividl'nd-price ratio
is lIsl'd 10 (ill'l'casl rl'lllrtls. Thl' lahll' rl'(lorls monlhly regressiolls of log
\'l'al stork retllnlS Ollto till' log of Ihe dividend-price ratio at lhe start of lhe
holding (lniod. RI'I II rtlS are Illl'asurl'd over a holding pI'riod of K nlOlllhs,
which rallgl's frolll 0111' Illollih 10 'IK 1I10111hs (1'0111' YI'ars); Whl'lll'Vl'r l\ > I,
Ihl' I'l'grl'ssiolls IlSI' OI'I'Ibppillg llIolllhly clala. Results are J'('porlcd fur the
period 1927 to I !}~).( alld also IClI' suhsalllpks 192710 l!l!i I alld 19:1210 1!I~14.
For I'ach regressioll Tallie 7.1 rl'ports lill' Il~ stalislic and Ihl' I-slatislic for
Ihl' hypolhesis Ihal III<' ('(wHicil'lIl 011 Ihe log dividend-price ralio is z('ro,
The I-siatislic is cOITl'ctl'l1 for hl'l('\'oskl'dasliciIY and serial correlali-J1l in
Ihe eqllalioll elTor IIsing Ihl' asymplolic Iheory discllssed in Ihe Appell'lix.
Tahk 7.1 ((,lIows Failla alltl Frellch (l~}KKa) t'xcl'plthatlhe rl'j.~r('ssor is Ille
log dividl'nd-pril'(' ralio ralhn Ihan Ihl' ieI'd of Ihe dividend-prict' r,llio
(a challg\' which Jllak('s \'l'I'y lillie dilkrellce 10 thl' results), overlappillg
Illolllhly dal;\ an' IIsl'd fc II' allllOrilOns, andlhc sample pniods an' IIpdalcd.
Although Ihl' rl'SlIlts ill Ihe lahll' arl' (i,l' I'l'al stork n~tllrus, allllosl idelltical
rl'sults ;11(' ohl ;lilll'd fill' I'X('I'SS relllrns 01'1'1' IhI' ont'-Illonth Treasllry hi II 1'01 Ie,
AI .1 hori/oll 01'0111' IIIOlllh, Ihl' r~'gression results ill '):Ihlc 7.1 are ralher
IlIlilllpn'ssin': TIlt' H~ slalislics 111'\'1'1' I'xn'l'd 2(}{J. alldlhe I-stalislics eXCI'cd
2 clIll)' ill Ih(' l'0sl-Wulld War \I slIhsaJllplc. The slriking LI('[ ;lhoUI Ihe I"hlt'
is how Illlich slHlllg,'r IllI' n'slliis hl'colI\\' whl'1I on\' ill('J'e;JSI's IIII' IlDri/oll
1\. AI a Iwo-year !Juri/Oil IIII' N~ slalislic is 14% ((II' Ihl' filII salllpll', 22'X, fClr
thl' prewar slIhs;lIllpk, alld :\2'1., ICll Ihe poslwar slI\)salllplI'; OIl a fO\lr-~'l';\l'
hori/oll IIII' U~ sialislic- is 2ti% for Ihl' 1'1111 sample alld 42% for earh of Ihe
sllhsallll'lcs. III Ihl' 1'1111 sallll'll' and Ihl' pl'l'wal' sllhsalllplc Ihe regressioll 1-

IIITIII' \\',1\' UIIlIt".I'lIIl1lg lilt' di\'iclnul-p' i, C' I.llill j, ,1;uIII;lId indl(' ;u';uklllic' lilt'I;IIII1t'. ,11)(1
II j ... al . . ., 101111110111\· ""'.( ilillu- hu.lllcial iutlu ... llv.
7.2. /'fl'.ll'l/l· V(dll~ UI'/(/I;fI//.Illl/r! us Siork !',i((' !MullIior 269
!
Table 7.1. I AII'K'/lIIriwl/ I"I'K'l'lIio/l.1 of 10K .l/ork 11'1/lI'II\ 01/ IIIf loJ!. dil,idnlll-prirl' ratio.

'i+1 + ... + 'iH = fJ(l\)(d, - /I.) + 'II+A".I'

FOfl.'cast lIoriwlI (1\)
:{ I:! 24 36 41\

1!)27 10 19!H
fo(l\) 0.01:1 0.(144 0.1 !}I O.:Hl:{ 052!! O.fi!>4
H"(/o:) 0.004 0.0 I:> O.lHiH 0.144 0.209 0.267
I(~( /0:1) U!21 1..100 2.07'l 4.113 ,t.t;:~1 3.943
1\)2710 1!):>1
jJ(l\)
II~{I\)

I(jJ(I\)
0.01:)
().()(l:~

0.660
(l.W>!)
0.014
0.1\44
0.27'1
0.074
1.677
0.629
11.207
4.!i'21
O.HHO
1I.:m!
'2.967
I.O!iO
0.4'24
3.7H3
•
1%2to 1\1\14
fo(l\) n.n24 n.07!) O.:W!) 0.601 0.776 0.H63
!t(K) 0.01:> 0.047 O.I!JO 0.344 O,12H 0.432
IIjJ(/o:» '2.73:~ 3.0:':> 3.22f\ 3.'2'25 3.315 3561

or
r is II ... 10); ... ·,,1 r~lurn on a valu,,·weighl~d index NYSE, AMEX, and NASDAQ.locks. (d- PI
is lilt' log ralio of divideuds o\'er the last year to lhe current price, Regressions are estimated
by 01.';, wilh I 1"list· n alld Hodrirk (I!JHO) siandard errors, calculaled rrom equalion (A.3.3)
ill Iii,' APP","lix s<·ttill~ au!Ocovariauccs heyond lall K - I to zem. Newey and Wesl (19K7)
= =
,larul" ... I,·rrms I.ilh 'I K - I or q ';I(K - I) are very ~il\lilar and typically are slightly smaller
Ihan Ihm,· r<,ported ill Ihl" labll".

stalistics also increase dramalically with the forecast horizon, although they
are fairly stable within the range 3.0 to 3.5 in the postwar suosample.
It is interesting to compare Ihe results in Table 7.1 with those obtained
when stock relUrns are regressed onto Ihe stochastically delrended short-
terlll inlereSI rate in Table 7.2. The regressions reported in Table ·7.2 are
run in just the sallle way as those ill Table 7.1. Once again almost identical
results are obtained if real retllrllS are replaced by excess returns over the
one·lIlonth Treasury bill rate.
Tahk 7.'2 shows that, like the dividend-price ratio, the stochastically
detrcndcd short rate has some abilily 10 forecast stock relllrns. However this
forl'casling power is very different in IWO respects. Firsl, it is concentrated in
Ihe postwar suhsalllple; Ihis is not slIrprising since short-term interest rales
were pq~ge(l hy the Federal Reserv(' during I11l1ch of the 1930s and 1940s,
and so thl' dl·trl'IHlcd short nile hardly v'lriL's ill these years. Second, the
fi>nTasting power of Ihe short rate is at Illllch shorter horizons Ihan Ihe
270 7. PreJp.III- VallII' UdaiiOlIS

Table 7.2. l.ol/g.!wtil.ll11 IfJ.."I'.I.lilll/.l IIJ log .1/{)(}{,l'Illrll.l (11/ /Iz, .1/(I(},flS/i((/I~V <l1'I1I'11I11'I1.1},1II/·
IPrIll iI/Inn/ mfr.

'HI + ... + 'i,~ = fJ(K)(YI.I - L:~II)'I.I_I/1~) + 'Il!u;

Fore .. ;"1 I lori/oil (1\)
-----_._------ ._--------_.
:1 I:! :!4 :lli ·IX

1927 to 1994
ft{K) -5AG!'! -17.IHI -·II.fifi~ -4.49~ -:!fi.I·lx -:20.1:2\1
!elK) 0.00:. O.Olfi fU):2:1 0.000 0.004 0.00:2
I{~(K» -:2.:29:2 -:25H~ -1.:.fi4 -0.lli4 -1.:1-11' -OXI!'!'

119:2~ \0 1951
Jl(K) 3.144 -fi.! H~ 7:1.71~ IfIH.9H\) -67.f.0:. -f)O.!IOO
le{K) 0.000 0.000 0.111 :2 0.031 0.00:) 0.00:2
: I{~(K)) 0.:2~~ -0. Hi:. O.f):20 I.fi!i:! -O.li:17' -05XO'
!
195~ to 1994
~(K) -6547 -IH.ti21 -:)(;.401i -26.115 -2(i.:)7:\ -~r).X\H
112 (K) O.(1l9 0.047 O.IO~ O.OI~ 0.010 O.OOH
[(folK)) -3.263 -3.206 -2.741 -1.354 -1.092'

I
1 i. the log real return 011 a value.weillhteu index "I' NYSl'.. AMl'.X, and NASDAQ stO! ks. YI.I
i. the I·month nominal Treasury bill rate. Rellre"i"tl, are eSlimaleu by OIS, with 11 .. ",etl
",.. d Hodrick (1!l80) Slandanl errors, calculated from e'luation (A.:!.:!) in tht· Appendi" setting
llocoV'driances beyond lagK-I lo,ero. Newey and West (19117) Mandanl cr)'Ors, willi '[ =

:f
( • - I), are used when the lIan5cn and 1I0drick (19HO) covariance matrix .. Sli,nalOr is nol
1 "itivc definite. The cases where Ihis OCfurs ar .. marked '.

~'''''"ng pow« of"" di,idcnd-p"« ,""0. Th, I'""W" 1<' " .. ,i"i" .. "
oomparable to those in Table 7.1 at horizons of one or three JlIonths, but
tlley peak at 0.10 at a horizon of one year and then rapidly decline. The
regression I·statistics arc likewise insignificant beyond a one-ye,lr horizon.
How can we understand the hUlIlp-shaped pattern of R~ statistics and
I·statistics in Table 7.2 and the stl'Ongly increasing pallcrn in Table 7.1? At
one level, the resulL~ in Table 7.1 Gill be understood by recalling the f<>nuula
relating the log dividend-price ratio to expectations of future returns and
dividend growth rales, givcn above as (7.1.24):

This expression shows that thc log dividcnd-price ratio will be a good proxy
for market expectations of future stock rCllIrns, provided that expectations
of future dividend growth rates arc not too variable. Moreovl'l', in gl~ncral
7.2. !'rp.lml-Vtdlll' !lRlalioll.1 allli US SllIrh !'Iia !Mulliiol' ~71

the log dividend-price ratio will be a h('ul'l' prox), 1m cxpectaliolls of IOllg-

horizoll rellll'lls thall fiJI' expectatiolls of shon-lioril.OlI retlll'llS, becanse
Ihe expectatiolls Oil Ihe righi-hand side of (7.1.~'1) are of a discounled
vallie of ;\11 retlll'llS illio tile infillill' ('111111"('. This Illay help to explain the
improvenH:llt ill forecast power as tilt: hori'l'on incre:ls\'s ill '!;\hte 7. t.
[<:\'\'11 ill the ahsellcl' or this dkn, howev('r, i I is I'",,,illl(' 10 "hlaill results
like those ill 'I;,hk, 7.1 and 7.'2. 'Ii, sec Ihis we lH>W 1'l'llII'n to our AR( t)
example in which the variable X" a pnkc( pmx>' ({,,' Ihe expected sturk
retllrn at allY horizon, is observable and (';\11 he Ilsnl as a rq~ressor hy Ihe
eCOIIOllletririan. Prohlem 7.4 develops ,I strlll'tllr;Il lIIodl'l of SIlKk priccs
a!H1 dividends ill which a mllitiple of the log dividend-price ratio has till'
pruperties of the variabk X, ill the AR( I) exampk.
W" lise the AR( I) example to show that whcll .\'/ is persistellt, the If
01';\ return rcgression on X/ is very small at a short horil.oll; as the horizon
increases, the /{~ (irst increases and thcn eventually d\'tTCases. We also
discllss (inite-sample difli('uIties with statistil'al inkl'elHT ill long-hot il()n
regrcs.'iions.

n~ S,(J/i.,/in
First cOllSidn regressing the one-period I'ctlll'll 'i+t on the variahle x"~ For
simplicity, we will ignore conslant lel'lllS sincc lilese arc lIot tilt, oi>jccts of
interest; constan(s l:(l\Ild be included in Ihe regression, or we could simply
work with demeaned data. In population, fi(l) = I, so Ihe filled value
is jllst x, itself, with variancc a;,
while the vari,lIlce or the letlll'll is givcn
by e<]lIation (7.1.:'>1) ahove. It follows thai lhe one-period regl'essioll R~
statistic, which we wrile as /(~(I), is

(7.'2.1)

WhCIT fill' simplicity we are using Ihe approximate version of (7.1.31) that
holds when c/! « p and p is close to one. U~( I) n',Klles an upper hound of
(I - c/!)/'2 wlwn the variability of divi(ll:nd IlCWS, a,i,
is zero. Thus evell when
it stock is clTenivc!y a real consolhon<i with knowll real dividends, so that
all v,ll'iation in its price is due to changing expectcd relll1'll5, the one-periud
!f s(ati,(ic will be small when <p is larl4e. The reason is tl101t innovations to
expected returns (allse large ullfon'('astabk changes in stock prices whcn
expected returns are persistent.
The behavior of tlIC If stalislic ill a IOIlI4-\toril.Oll Il'l-\l'('ssion is sOlllcwhal
more complicated. A rq,;-ressioll with horiLOIl I\. takes the form

'/1,1 + ... + r'H' == /I(I\.).\'( -I- 'I/fAA· (7.:1.2)

In the AR,( I) example, the ileslliJrccasl of till' otlc-pniot\ n:tllrn j pniocis

ahead i, al",;,),s hl,\'( f /_ f I = tjI,-I,\'/. 'I'll<' bcSI fim''';lsl of Ill<' ""l1lllali\'('
 I. • Ir.\t'lI/- V(II/It' /(l'Iall<J//.1

/"('111111 OV"I 1\ IIIOlllh~ is IIHllld lIy sllllllnin~ Ihe f(ln'('asls one-period or

relll""slIplohorilOlIl\,so/l(K) = (J+I/J+",+I/JIi-I) == (1-1/J1i)/(J-I/J).
The J(~ sl;lIisli(' IiII' IIII' I\-pniod legressioll is givcn by

Val' I/'.~II" II -+- ... + EI [l'lt ...·11 (i.~.:\)

\'all 1'" I -I- ... + I'H Ii I

Dividillg hy Ihl' oll"-pniod U~ slalislic alld n'arranging, w,' ohlain

U~(f~) Val 1/':11 I'll I l-+-' .. + \0: 1 [ fIt ",11 )

W(\) ( Val' i /,.t! li+ I II
"ar! 'itl I ) 0.2.·1)
x ( Vad 1'" I + ... + r".J\ I .

Th(' lirsl ralio 011 Ihl' righl-halld side of (i.2.4) is ,illSI the sqllare or
IiiI' I\-pcriod rl'gn'ssillll cOl'flici"111 divided by thl' sqllare of Ihl' OIlI'-pl'l'iod
re)!;rl'ssioll ('(wl'lici"1I1. IlIlh,' AR( I) I'xampk Ihis is (I -I/J"')~ I( I -I/J)~, which
is "PPIOXilll;lIdr (''1,,;11 I.. ,,".' lill tll'g(' <II alld small K. TIll' SI'('olld lalio Oil
Ihe ri)!;hl-halld sid,' Dr (7 '~"I) is rlosdy Idall'd 10 till' variallcl' ratio discllssed
in Chapln~. III bCI, it Clll hI' rl'wril\l'll as J/(KV(K». \.. hne V(I\) is the K-
peliod valiallCI' 1;lIio lill s\fIck n·IIIIIIS. III 1/11' AR( I) exalllpit', Prohlem 7.:~
shows Ihal Ihe alliocOITI'1a1iolls of S\fI,'k rellll"llS al'e all lIeg-alive. II follows
thai V(K) < I,so 1/(1\1'(1\» > 1/1\.
Pllllill~ Ihe 1wo Il'n11S Oil Ihe right-halld side of (7.2.'1) toget Iwl', w,' find
Ihal ifex(>"('(l'd slock I'l'l 111'1 IS all' n'l,\, pnsisl"III, Ihe 1lI11ltipl'riod It stalistic
grows at lirst approxilllatdv ill plOpor\ioll to Ihe horizo/l 1\. This bl'havior
is w('11 illllstrated hy thl' lI'slilts ill '1:1),1" i.l. Illtuitively, it OCClII'S hel'ausl'
Ii >recasts or "x pITh'" Il'tlll"llS sl'vl'ral pniods ahead are ollly slightly less
variahk thall th,' !I.n·cast of the 11I'xi period's ,~xpl'l'Ied retlll'll, alld they
arl' pl'rfenly (,OlTd;ltl''' with it. SIICCl'ssivl' realized retllrllS, Oil Ihe other
halld, are slightly /lc)!;ali\'C/y ('orrl'lall'd wilh 011(' allothl'r. Thlls 011 IIrst IIIl'
varianI'(' ofthl' IlIl1ltipl'riod liltnl vallie grows more rapidly thall the vari;IIICl'
of thc IIIl1ltipniod rl';dilcd rl'tlll'll, illcrl'asillg Ihl' Illllltip('rio<l It stalislic.
E\'l'lIllIally, of (,OllrSl', forccasts of rl'tllills ill Ihe distallt 1'111111'1' die Ollt so thl'
lirst ratio 011 III<' righl-h;IIHI sidl' of (7.~ .. 1) COIIVlTgl'S to a fixed lilllit; bllt
the variahility of ,,'ali/I'd Illldtipl'lilld rl'turns ('ontillll('S to illlTl'aS(', so the
sl'(,OII1I ralio 011 thl' right-halld sid,' of (7.~.'1) hl'('olll"s proportioll;t1lo 11K.
Thlls ('\,('11111;111)' 1lIllltipl'riod It st;llislics go to z('ro as Ihl' horizoll illcr('ases.
It lIIay 1)(' helpflll to giw all (,VI'II 1I10\'(' explicit fonllllb for the AR( I )
I'xalllpl(' ill th,' case \\'h I' II' I he lOll)!; hOl·i/.OIl is jllst two pl'riods. that is
wll<'l'I'l\ = ~. III this ,'as,' tl'dious hut straightforward C<llclllatiolls alld the
7.2. PI'f5t'1lt-Value Relations and US Slock Price Behavior 273

simplifying approximation that holds when </I « p and p is close to one

yield

U~(2) ~[2+(1-</I)(a;/a;)]
U~(1) "'" (1+</1) 2(l+</I)+2(l.-~)(a;/a.?> . (7.2.5\

The ratio in (7.2.5) approaches (I + </I) as a,7/a; approaches zero, so a two-

period regression may have an R~ slatistic almost twice that of a one-period
regression if expected returns are persistent and highly variable. On lh~
other hand the ratio approaches (1 + </1)2/2 as a; fa;
approaches infinity, so:
a two-period regression may have an R'J. statistic only half that of a one-period!
regression if expected returns have only small and transitory variation.
Calculations for horizons beyond two periods become very messy, but!
Campbell (1993b) reports some numerical results. When </I = 0.98, p =\
0.99:>, and aJ/a; ::::: 0, for example, a one-period regression has an R2 .
statistic of only 1.5%. but the maximum R2 is 63% for a I 52-period regres-,
sion. When the forecasting variable is highly persistent, the R2 statistic can"
continlle to rise Ollt to extremely long horizons. '

f)i{fintiliPI wilh lnft>rmcl' in Finill' Saml,uJ :

The I-statistics reponed in Tables 7.1 and 7.2 are based on the asymptotic:,
theory summarized in the Appendix. There are however a number of pitfalls ~
in applying this theory to regressions of returns onto the information vari-
able XI'
A Iirst problem arises from the fact that in the regression of the one-
period return THI on x" TI+I = P(l)XI + 1]1+1, the regressor XI is correlated
with past error terms 1]1-; for i ~ 0, even though it is not correlated with
contemporaneous or future error terms 1)1+1+,. These correlations exist be-
cause shocks 1O the Slate variable XI are correlated with shocks to returns, and
the variable XI is persistent. In the language of econometrics, the regressor
X, i5 Imtielt'rmined, but it is not exogenous. This leads to finite-sample bias in
the coefficient of a regression of returns on X,. In the AR(1) example. there
i5 a simple formula for the bias when the regression horizon is one period:

E[~(l) _ fl(1)] = _ (I + 3et» aq,t == p(l + 3</1) . (7.2.6)

I' T af (l - p</I)T
The term -( I + 3</1)/ T is the Kendall (1954) expression for the bias in the
OL'; estimate of the persistence parameter </I obtained by regressing x/+\
on XI. A~ Stamhaugh (1986) has shown, this bias leads to a bias in the OLS
estimate of the coefficient fl(l) when the return innovation 1]1+1 covaries
with the innovation in the forecasting variable ~I+l. In our simple example
Wilh uncoTfelated news aboUl dividends and future returns driving current
returns. the ratio aqda~2 := -p/(I - p</l). which produces the second
274

eqllality in (7.2.6). This bias Gill bl~ suhstantial: With p = (1.~1~17, till'
cxamplc, it cCJuals :~t)1 T when rp = o.!), 7:\1"}' whcn rp = O.~)!I, and 171/"}'
when rp ::: O.!J8,"
A sccond prohlelll is Ihal Ihe aSyJIIPtolic theory !!;i\'('n ill III(' App('ndix

r1 lay hc misleading ill tillitc samples whcn thc horil.OlI 1\ is large rl'iatiVl'
t 1 lhe sample size. Hodrick (19~)~) and Nelson allli Killl (I~)~I:\) liS!' MOlllt'
<tarlo methods to illustrate this 1'01' the casc whcrc stock returns ;11" rq,:n'sst'(1
dn dividcnd-price ratios. Richardson and Siock (1!)H!l) shol\' Ihallhl' !inill'-
s;lInple properties of re!!;ressiol\S with l<Ir~e 1\ C<lll he accOlulled (ill' using an
..'ternativl' asymptotic theory in which 1\ increases aSYlllptotic"lly ;lIlhe sanH'
rjlle as the salllple size. Scclion 2.!1.1 or <:hapler 2 discusses Ihl' applicalion
l f Iheir theory to univariate r('~rl'ssiolls of relnrns Oil past relllrlls.

j One way to avoid this prohlclll is 10 transtilrm thc basic regression so

tllat il no longer has overlapping residnals. This has been proposcd hy
Jrgadcesh (1 !J91) for the Failla and Frcnch (19HHb) rcgrcssioll or n'llIms
(~II lagg(,d returns, alld it has h'TII advocall'd ilion' gellerally II)' (:ochran,'
(~991). For e)(<IIlIple, we might ('slimat(·

1 ,.
i 1;+1 = y(..,,)(x, + ... + ·\',+1-.-) + tI,+I.J,,', (7.2.7)
I
w;hcre Ihe error terlll lit r 1.1\ is now sl'l'ially tmcorrclated. The IIl1nH'rator
,
01' the regression coefilcicnl y(K) in (7.2.7) is thc samc as Ihc n\\lIlcralor
or the regrcssion cocffldellt fi(K) ill (7.~.2), bccausc the co\'ariallcl' or x
IlIcasured at OIlC datc and,. mcasured at another date depends ollly on the
dilTcrcnce betweellthe two dates. lIencc y(K) = 0 ill (7.2.7) ifan<! ollly
if fj(K) = 0 in (7.2.2). Howcvcr it docs not necessarily follow that tcsts
of y(/\) = 0 and /3(K) = 0 have the sallie asymptotic properties .ullder
Ihc Ilull or gcncral altcrnativc hypotheses. Hodrick (1!J!J2) presents Monte
Carlo e,<idellcc on the distributions of hoth kinds of Lest statist irs; he finds
lhal thcy both lend to rcject lhc null too ortell if asymplotic nitkal values
arc used, so that thc long-horizon i-statistics reponcd in 'Ethics 7.1 and 7.2
should be trcatcd with caution. Ilowever hc also finds that Ihes<' hiases
arc not strong cnough to account (ill' the evidellce of rcturtl predirtahility
rl'portcd ill the tahles.
All important lIIHesolvcd qucstion is whether thcre arc circulllstallces
undcr which long-horizon regrcssions have grcatcr power to dcter! devia-
lions from Ihc lIull hypothesis thall do short-horizon regressions. I(odrick
((!/!J2) anc! Mark (I !/!J:l) present some su~gcsti\'e Monte Carlo cvidence Ihal
this ma), he Ihe rasc, alld Camphl'll (I~)~l:~b) also studies the issue, but the
Jilcratu;'e has 1I0t rcachcd an)' linll COllclusioll at this stage.

IISimilar hj.t~l·~ ;dflin tilt' 1(,~I(·M.itlll whl'1I the.' lu,ril.oll i~ ~n';lh'r Ih.", 011(' pC'litld. Se('
Ilo<l'it ~ (1!1II:l) ",ul M,lIk (I!l!l:.) III,. MOIII<' C,.do nid"'K" ,,"Ihis poilli.
7.2. }'mmt-Vaillf HemtionoS anti US Stork Prirf IJrlullIior .. 275

7.2.2 Volatility ·li'.l/s

III til{' pr('violls MTlioll we have l~xplon'd regressiolls whoS(' depelllkill vari-
ables arc n:llIrliS measllred over IOllg hori/.oIlS. ()I1(, lIlolivalioli for sut:h
regressiolls is Ihal assel prices al'l~ influcl1c('d hy n,[)('ctaliol1s of r'l'IUrllS ililO
the dislant flHIIIT, so long-horizol1 procedures ar(' lH'cessary if we ;\IT 101111-
dcrstand price hehavior. We now I\lrn 10 l'llIpiricli work lil;11 looks;1\ price
variabilily 1l111l'C (lircClly.
LeRoy alld PoneI' (I !Hll) and ShillCl (I ~IH I) slarlnl a he;lled d('hale ill
lhe early I ~IH()s hy arguillg Ihal slock pric('s arc 100 volalile 10 hc r;llioll;11
fOlTG\SL~ or rlllllre dividends discollllied al a CllllSl;\1)\ rale. This cOllln>-
vcrsy has sillce died dOWll, panly becallse il is 1I0W 11101'(' clearly undersloud
thaI ;1 r~jeclion of cOllslanl-dis(()UIII-ralc JIlodels is 1101 the sallie as a rejec-
lion of Ihe Eflicielll Markets Hypothesis. and p,lrlly UC(',lllse regression Ie sis
have cOllvinced Illany fmaneial economisls lhal expeC!ed stock relurns arc
lillie-varying ralhcr than conslallt. Nonclheless Ih(' volalilily lileralure has
illll'odllced sornc importalll ideas Ihal arc closely cOllllected wilh Ihe work
un multiperiod rei urn regressiuns discussed in Ihe previous section. Useful
surv'?)'s of Ihis lileralllre include Gillcs and I.e Roy (1~191). l.eRoy (1989),
Shiller (I ~)H~I, Chapler 4). and Wc~t (I ~)88a).
The carly papers in thc volatility lileralnrc IIsl'd levels of slock pritTS
and dividends, hUI hcre we reSlale the ideas in logarithmic lill'ln. This is
consislenl wilh Ihe more recent literalure and wilh the eXposilion in the
rcst of this chapler. We begin by ddining a log 1"'ljl'rljorr.lir;ht .It()(!. 11I1rf,
00

/1; == I>l[(l_p)df!lil I-k- rl. (7.:!.HI

l="

The perkct-roresighl price g is so namcd becanse frolll Ihl' fX /loJI slock

price idcnlily (7.1.:! I) il is Ihe price Ihal would prcvail if ref/liud rCllIrlls
were conSlanl at sOllie level T, thal is, if thcre werc 1\0 revisions in expecta-
lions driving unexpected returns. Equivalently. from thc fX alltf slOck price
identity (7,1.~':.!) il is Ihc price thai wonld prevail if (,xpcr\cd relnrHs were
cunslant and investors had perret:! kllowlcdgc of futllre dividcnds. Substi-
tUlillg (7.'2.H) inlo (7. I.:! I), we lind Ihal

/I; - /II '"

= LpJ(li+'+! - rl. (7.:!.9)
j="

The dilfcrcncc between p;

and III is jllst a dis('olllllcd SIlIlI or Inlml' dl'-
meaned stuck relllnlS.
Irwe now lake expcctalions ;llld usc the definilion givcn in (7. I.':.!:!) ,\II(I
(7,1.2:1) oflhe price component/I,,, we lind Ihal

(7 .':.!.I 0)
 I. 1'11'.11'1I1-\it/1I1' Udal ilJlIJ

/{I'C alllh al/'" call he illlc rpn'

lrcl as tllal CO 1II (>011('11 I oflh ('
is asso cialt 'd with challl!;illl!; ('XP sloc k priCI' wlli rll
('cl;u iolis of fulu re sloc k tTlu
(olld iliol lal ('XI)('CI;lIioli of /': rns. Thu s Ihe
-/" ItIl'aSllreS Ihe t'ffcCI of chal
Sioc k reI urliS Oil lilt' ("1mI'll! lgill g cxp( 'el('( 1
SlOck prin '. In I he AR ( I) ('xal
llple d('v ('lop ed
carl icr, Iht' cond iliol lal I'XI) (Tla
lioll of/, : - /I, isjus l x,f(1 -pcp
Ifl'x p"(" led sior k n'ltU ns arl' COll
) froll l (7.1. !!!l).
Slanl I hrou gh lime , IllI'n Ihl' righ
side of (7.~.1O) is /('ro . Tllc t-ha nd
rOll slall t-l'x p('C !cd- r('tu nl hypo
that p; -/" is a fi,,'I' cast ('fro r thl's is imp lies
IlIlrO I"lTl aled with illfo rma tioll
I. Eqlli val(, lItly , it ililp lil's kliOWIl attil lll'
that thl' stor k prin~ is a ratio llal
pcrf ",·t-l i,n's il!;h t stoc k pri .. e: I'x(l l'cta tioll of the

(7.~.11 )
Ilow Clli Ihl'S(' iell·a.s hc used
10 !t'SI 111(' hypo lhes is Ihal ('xp
relm lls are COIISI;iIlI? For silllp ccle d stoc k
lieil) , or I'xp ositi on, w(' heg-ill
llllr( 'alis lic assll mjll iolls : !irsl , hy mak ing two
Ih:11 IOI!; sloc k pric rs and divi
lioll ar), sloc llasl ic pron 'ss,'s , so dend s rollo \\' Sl;I-
thai Illey have well -def incd lirsl
1II01lH'lI1S; alld S"COIIII, 111:11 alld seco lld
IOI!; divi dl'lI ds are ohse rvah le
f\llm e, so Ihal IIII' per( i'cl- f(,re illio Ihe infil lill'
Ilici all. lido \\' \\"1' dis"lI.s~ 110\\
sigli l pric c g
is ohse rvah le 10 IIII' t'con Olll(
'-
' II"'SI' assll lllpl iollS arc re\a xed,

()rlh"g/lllfllil~ fllld \'flrif lllf'l'

-!l"/l ifl/l 'li'lll
E'I" aliol l (7.'2 .11) illip lil's Ihat
/,; - I'I is "rlh" K{// w/to infim llali
kllow n al lillie I. :\11 mlho ,l\ot oll vari able s
lalil ), Il'sl of (7.2.11) rt'l!; ressc
infol "lll:t lioll vari ab"' s alld (('SiS s /': - I), 0111 ',
for /t'I'( , cod lkie llts. If th,'
v:tri ahlrs ind\ ll'" Ihe Sloc k prilT infil l'lna lio, I
I'I itsdf , Illis is eq\l ivak llllo a rt'gr ('ssi
/': onlo /', and olli n \';lri ;lhlc s, on of
II'lIl'rl' III,' hypo llics is 10 be Icsll
/It has a IIl1il cOl'f ficic lII alld lilt, ollll 'r 'd is 1101,' Ihal
varia bll's have zero cocf ficie nts.
rt.'l!;r('ssiolls an' "aria llis of Ihe The se
IOIlI!;-II01il.oll n'lu rn regr essio
Ille pr('v ious sl'fli oll. E'I" alio lls Ilisl 'usse d ill
ll (7.~.!l) show s Ihal g -/1, isjus
SIIIII of ftllll l'e 1I1'IIII'alll'd sioc l a disc oull it'd
k relUf'IIS, so all orlh ogon alilY
is a retu rn rl'g-r essio ll wilb all I('st of (7.2, II)
infil lill' Irori llll\, whe re 1\101 '1'
arc I!;co lll('t rical ly dowlI\\'('il!;b lIisla lll relll rns
ll'd.l~
IlIsl ead ofll'Slill1!; ollll ol!;o llalil
Y din' nlr, IIIl1ch oflh e lill'r alllr
illlp lical iollS or ol'lh o,l\o llali ty t· tesls the
for the ,'ola tilil) , of sloc k pric
f;1I1101lS Slich illlp lic;l lioll . lit-ri es. The JIlost
ved Ill' I ,I'Ro)' alld POrl ('r (J9H
(1!IH I). is Ihl' 1'1111(1/111' illl''i "l/lil I) alld Shi lln
\' for IIH' sloc k pric l':

(7.'2.I~)

I'.!Thc dOh'II\\'C'igllllllg .dlll\ \\

rill' f('! '1:tli,l ic' ill IIIl' rt'gn.
~hll\\T" ill St'rti oll 7.'.!..11I'.11 'ssioll 10 h(' pO!rlilin', WI"'lt ',I"
lilt' N'.! .\',lIi'lil ill ;tlllll l\\'c'i glllt'd \\'("
lillitt ·-hur i/otl 1('111111 n·gl(· .
fOIlH 'lg('\ 10 ,,',0 ,I, lilt,
holil oll illfl(' ;l\('\, 1>1111;1111 . ~i()11
alld II.dl (I!JH~I), SCUll (p.H:,),
(19H~ •• (:haplt'r I I) 1,,1\(' IlIli It·gn·~,ioll.' .uHI Shiller
(If (IllS .\01 f.
7.2. l'rl'.lt'IIl-\'lliul' Reilliiolls (/lui US Siork l"rire lMulVior 277

The equality in (7.2.12) holds because undcr the null hypothesis (7.2.11)
II; - 1'1 must he uncorrelated with PI so no covariance term appears in the
variance 0(' I';; the variance inequality follows directly. Equation (7.2.12)
can also he understood by noting that an optimal forecast cannot be more
variable than the quantity it is forecasting. With constant expected returns
the stock price forecasts only the present value of future dividends, so it
cannot be more variable than the realized present value of future dividends.
TesL~ of this and related propositions are known as variance-bounds lests.
A~ Dliriallf and Phillips (1988) point out, variance-bounds tests can
be restated as orthogonality tests. To see this, consider a regressiQn of P,
on 1'7 - 1'1. This is the reverse of the regression considered above, but it
too should have a zero coefficient under the null hypothesis. The reverse
regression coefficient is always () == Cov[P; - PI, ptl/Var[p; - pd. It is
straightforward to show that
Var[p:J - Var[pd
Var[p; - PI]
= 1+28, (7.2.13)

so the variance inequality (7.2.12) will be satisfied whenever the reverse

regression coefficient () > -1/2. This is a weaker restriction than the or-
thogonality condition () = 0, so the orthogonality test clearly ha~ power
in SOIlW situations where the variance-hounds test has none. The justifi-
cation for using a variance'-hounds test is not increased power; rather it is
that a variance-hounds test helps one to descrihe the way in which the null
hypothesis fails.

lIllil Hool.1
Our analysis so far has assumed that the population variances of log prices
and dividcnds exist. This will not bc the case iflog dividends follow a unit-
root process; then, as Kleidon (l98!» points out, the sample variances of
prices and dividends can be very misleading. Marsh and Merton (1986)
provide a particuhlrly neat example. Suppose that expected stock returns
an~ constant, so the null hypothesis is true. Suppose also that a firm's man-
agers lise its stock price as an indicator ofMpermanent earnings," selling the
firlll's dividcnd equal to a conslant fraction of its stock price last period. In
log form, we have
(7.2.14)
where there is a unique constarlt J that satisfies the null hypothesis (7.2.11).
It can Iw shown that both log dividends and log prices follow unit-root
processes in this example. Suhstituting (7.2.14) into (7.2.8), we find that
the perfert-foresight stock price is related to the actual stock price by
00

p; == (I - p) L p}Pi+}' (7.2.15)
)=11
~78 7. Presl'1Il- lit/IIII' [{I'llliions

I
"Vhis is just a smoothed version of the actual stock price II" so its variance
([rendS on the variance and aUlOcorrclatioJls of II,. Since autocorrclatiolls
c n never be greater than one, g must have a lower variance than flf. The
i Ilportance of this result is 1I0tthat it applies to population variances (which
a e not well defined in this exalllple because both log prices and log div-
i ends have unit rooL~), but that it applies to salllple variances in every
s;lmple. Thus the variance inequality (7.2.12) will always he violated in the
rSh_Merlon example.

± This unit-root problem is important, but it is also easy to circulllvent.

, e variable P; - PI is always stationary provided that stock retuflls arc
s tionary, so any test that p; - fll is orthogonal to stationary variables will be
wrll-behaved. The problems pointed out by Kleidon (\986) and Marsh and
Merton (1986) arise when /'1' - 1'1 is regressed on the stock price 1'1, which has
a lunit root. These problems call be avoided by using unit-root I"(~gression
tlleory or by choosing a stationary regressor, such as the log divid("nd-pri~e
r'llio. SOllie lJlher ways to Ikal with the unit-root problelll arc explored in
Problem 7.5. t3

Finile-Sample Consideraliuns
So far we have treated the perfect-foresight stock price as if it were .111 ob-
servable variable. But as defined in (7.2.8), the perfect-foresight price is
unobservable in a finite sample because it is a discounted SUIll of dividends
out to the infinite future. The defInition of g implies that
T-I-·I
,,; = (1 - p) L pj(dH1 +) +k- r) + pT-I-1 p~. 0.2.16)
)=0

Given data up through tillle T the !irst term 011 the righ t-hand side of
(7.2.16) is observable but the second term is not.
Following Shiller (1981), olle stalldard response to this dillicu\ty is to
replace the unobservable I); hy all ohsCl"vahle proxy 11;:r that IIses ollly ill-
sample information:
"/'-1-1
fl;'T == (l-fJ) L fJ)(dH1'I+h-r)+pr-I-I/,r. (7.~.17)
1=0

Ilcre the terminal value of the artual stock price, h·, is lIsed ill place of the
terminal vallie of tll(· perfect-foresight stork price, fr. Several points arc '1
"Umlauf and flail (I !JH!/) ;lpply IIl1it·,.oot Il'~,.,·ssio\l Ihl·OI)'. while (;,lIlIpl)("\I ,lIul Shill .. r
(I !lRRa,h) replace the 10K Mock price wilh Ihl' lOll <livi<lcl\\l-price r,lIi". Prohlelll 7.:) i., I",,,·d
0" Ihe work uf Mankiw, Romer, and Sh;ll'iro (I!lW,) ;\lId We't (I!lRKh).
HShiller (19KI) med Ih .. "llIlpl,· <lV<"r;tK'· pri...· ill'I<",,<I of Ihe .. nd·ol~,alllph· pri ...· in his
:~:~:fnal ro.ulilion. IlIlIlal .... work, iIlC\tulill)\ Shill .... (I!IH~). lo\loW>\ the ap"road. (li,clIssed
 7,2, }Jrl',II'Il I- Valli I' [(r/a liolls (I1ul US Stadl I'lif/ ' UI'itt /pilll'

won h noti ng abol lt the vari able

II;,T' First, ircxp('ct('(1 retll rns arc COllstanl
(7,~,11) cOll tillll es to holel ,
whe ll /';,T is suhs titut ed for II;,
cons tant- expe ctcc l-ret lll'll Illod el Thu s lests of Ihe
call use gr' SCCOlld, a ralio llal
lhe stoc k pric e will affec t both III hllh hle in
aud gT' Thll s tests usin g /I;."/' illcl
bles in the uull rath er thall the aher ude buh-
naliv ('
P;,I - II, can he writ len as a disc oun ted hypoth(,sis, Thir d, th(' difk relH 'c
SllIll of dl'll H'an cd stoc
with tire slim terll lina ting at the k retu rns,
end or tire sam ple peri od '[' rath
sOllie fixed hori zon from the pres er Ihan at
cnt elate I,
II; T - /" are just long -hor il.ol l relll ril regr Thu s orlll ogO llali ty tests usin g
essio ns, wlln e rutul '(' rclIIrllS arc
geol lletr icall y disc oull led and the
hori zoll is the clld of the sa III pie
A~ one mig ht expe ct, the perio el.
asym ptot ic tireo ry for stati stica l
orth ogon ality ami varia nce- houl illfCrellce in
l<is tcsts is essl' ntial ly tile sam e as
usecl to (on<lu('( stati stica l infe the theo ry
relll 'e in long -hor izoll retu rn regr
A~ alway", in tillit e sam ples essio ns. r:.
it is imp orta nt to look at the cffC:
over lap (tha t is, the Illlll lber of ctivc orde r of
peri ods ill (7.~.!1) duri llg whic h
futu re rctul 'lls mak e a nOll llegl disc oull ted
igih k cOll lrihl lfion to tmlay's v,llu
/11)' If this is larg e relat ive to e of II;. T-
the sam ple Sill', then ;lsY"llllo
unlike!>, to he a relia ble guid e for tic theo ry is
stati stica l infc n'lll T.
Flavin (E)H:~) gives a part icul arly
dea r inlll ition fi)r why this mig
a proh lclll in the cont ext of vari ht he
ance -hou nds (('sts, SIll' poin ts
whe ncl'l 'I' a sam ple vari, ulce anJlI out that
lHI a sam ple ml';UI is used to estim
popu latio ll vari ance , ther e is SOlll ate a
t' dow llwa rd bias c;1I1.~('d hy thl'
tht' trill' Illea n of tilt' proc ess is unkn LId that
own . WIll 'lltlH ' proc ('ss is wllitc
is well -kno wn that this bias CUI nois e, it
be corr c('tn l hy divi ding th(' SUIll
by 'f' - I inste ad of 'f'. Unf ortu nate of squa res
ly, the dow nwa rd bias is Illon~
for snia lly corr l'lat ed proc esse st'Vl'n'
s (intllitively, tir('ll' is a sllr; t!kr
clfe( live obse rvat ions for thes e 11I1I 1ll>n of
proc esse s). so tlris corr et'tio ll he((>
equ;l(l: in the pres ence of seria l lIIt's inad -
corr elati oll. Now g,. is Illor e high
corr elate d th;ul III> sinc e g./, chan ly seria lly
ges ollly as dil'i l\end s drop out
pres ent- valu c form ula and disc olln of the
t farlO ls are upda led, while /11 is
by nel\' info rma tion abou t divi dend affe cted
s. Thu s the ratio of the salll ple
of g, to the salll pk varia llcl' of vari ance
/'1 is !IowllIv;rrt!-hiasl'd. and this call Cllis
the varia llce illcq ualit y in (7.~,12) e
to Ill' viol ated too orl!'11
Frol ll Ihe cqUiV;rll'lllT orvarianC in tillit e s.un pks.
l'-I>0l111ds alld orth ogon alit) , tests
probll'1ll arise s in a regr essio n cont , the salll('
ext.

7.2.] Vt'r/or'\1I11111'f..,'lI'.llil'l' tIIdh lldl

The nll'tl rods t\isr mse d in the
prev iolls two s('(l ions llan ' tire
tlln' tllat they try to look dir('('(ly C0ll1 11101 1 fea-
atlo llg-h oriw n prop (,rtil 's of the
data . This

1:1 Lel{o )' aile! S(~'ig('r\\';t1c1

(I !t~)!l) lIS(' MOIlI (' (:.II"lo IlIelllO
naJily ;lIId \'OI .. i'IIICt '·/)otl llCb le.·'IIs. ci ... 10 ~llId~· I h(' PO\\T I of oJ"lhugu.
 7. "r",lt'IIl- 1/1111" {Mal/oIlS

call /toad 10 slali~lical dillillllli('s ill lillill' samplt's. All alt('l'lIaliv,' approach
is 10 OISSIIIIH' Ihal Iht' dVllalllics or Ih,' dOli a are wdl d,~sniht'd hy a silllpk
lilllt'-S('riI'S III CII 11'1; 1,,"~-llOri/oll proPITli('s call th('11 ht' inlplllt'd frolll the
short-nllllllodl'l 1'011111'1 Ihall ('slilllall'd dirt'ctly. III lhevariallct'-holillcls liler-
alm/', this is Iht' approach ofl.l'Ro\' allt!l'ort,'r (1\IHl). Tht'st' allthors 1l01t'
Ihat ;t \,;lIiall«·-l!olllld, Il'sl dOl'S 1101 r('qllire ohs('J'vatiolls of the pnkcl-
Itll'('si~ht price I'; ilsl'!r; il 1111'1'('1\' n'(llIir('s all estilllale of IIII' \'ariallct' or II;,
which call ht' ohlain('d 110111 a IIl1iv;lriall' limc-series I\lodd for tii\'idl'llIis.
W('SI (1!lHHh) t\1'\r10PS;1 v;lIialll or Ihis plOet'dllrl'.
'Ii, S('(' how lilis appro;,ch call work, sllppose Ihal 0111' ohserv('s III('
(,(lIl1pl,'\(' \,,', tor of sl;\I(' \';Iri;Ih!,'s X, IIst'd hy mark"l partit'ipants, anti Ihal
X, follows a \'Crtor alllOn'~r('ssi\'(' (\fAR) process. Any YAR model call he
\\Tillt'll ill lirsl-ordl'l' lill'lll b\' augmt'lllillg IIll' slaic Vl'elol' with slIilahlc lags
olthl' original \'ari;Ihll's, so wilholll loss of general it)' we writ!':

(7.~.IH)

I Itorl' A is a lIIalrix 01 \'AJ~ codli.-i('lIls, alld f:1I1 is a \'('ctor or shocks 10 the

\,AJt WI' han' droppl'd COllstallts 1111' silllpikity; Oil,' call thillk of' the slale
,'('('101' as illd"dil\~ d('II\(';II\("<I \'ariahl('s.
Eqllatioll (7.:!.IH) illlplies Ihatlllllllip ....iod fon'('asts or Ihl' slale VI'('[or
X, rail bl' limlll'd h\' lIIalrix IIIlIlIiplicatioll:

(7.2.1 ~»)

This makl's il ('a~\' to Clklll;1l1' Ih(' IOllg-hori/'(1I\ for('clsts that l!t:tnlllinc

pricl's in (7.1.~~) alld (7.1.~:\), or IiiI' r(,visions or 10llg-horizoll forecasls
lit;1I d('ll'nllilll' rl'lmllS ill (7. I.:!:,) alld (7.1.~(i).

I,'dor '\/1101'1'.1,'11'\\;0111 fllIIll'r;(/' \'o/alilih'

As a lirst exalllph-. SIIPPOS(' tital litl' stal(' v('('\or incllldes Ih .. stock pricl'
I', as ils lirsl dl'llll'lIt alld litl' di\'idl'lId ii, ;IS its second dl'lI\('lIt, ",hilt: the
r('maining ..t('IIIl·lIts an' otlll'r .. ..t ('\'a II I forl'castillg variahl('s. WI' clt'linl'
\·l,(·tors d' = II (I (I ... (I I alld e2' = 10 I 0 ... 0 I. Thl'sl' v(,ctors pick
olltlh .. lirsl cil'1I1t'1I1 (/") ;lIl(lthl' SI,(,(lIl(l dl'llIt'lIt (iI,) fmlllth(' statl' V('('tor
X" llsillg Ih('sl' dl'lilliliolls alld (''I"aliolls (7.1.~~). (7.1.~:\), alld (7.:!.I!l).
Ih(' dividl'lId COIIlPOIH'III .,1'1111' Siock p .. i.-(' is

'\.

(1 "./oIL/,/('2'A/ " x , (1 (7.~.~())

II/

'I h .. slock p .. i, (. ilsdl i, '" -" (., 'XI, ,0 Ih(' ('XpI'CI('t!-n'tllnl nllllplllIl'II1 "I'
IllI' ,ltu'k pi i(I' is II,.. ditlnl'lIn' 1)('1\\'('1'11 Ih(' two. If I'xp"('\I'd rl'tllrns aI'\'
7.2. 1',t'.lfllt-Va/III' RI'/atio715 al/l/ US Stork I'rirl' Ill'havior 281

constant, then III P,/t. which imposes the restriction

el' = (1 - p)e2'A(I- pA)-1 (7.2.21)

on the VAR system. This can be tested using a nonlinear Wald test. 1fi
So far we have assumed that the vector X, includes all the relevant vari-
ables observed by market participants. Fortunately this very strong assump-
tion can be relaxed. Even if X, incluoes only a subset of the relevant in-
formation. under the constant-expected-retufll null hypothesis the stock
price III should still equal the best VAR forecast of the discounted value
of future dividends as given on the right-hand sioe of (7.2.21). Intuitively.
when the null hypothesis is true the stock price perfectly reveals investors'
information about the discounted value of future dividends. Another way
to see the same point is to interpret the restriction (7.2.21) as enforcing
the unforecastahility of multi period stock returns. If multi period returns
are unforecastable given investors' information, they will also be unfore-
castable given any smaller set of information variables. and thus the VAR
test of (7.2.21) is a valid lest of the null hypothesis.
One can also show that (7.2.21) is a nonlinear transformation of the
restrictions implied by the unforecastability of single-period stock returns.
In the VAR system the single-period stock remrn is unforecastable if and
only if
eI'(1 - pAl = (1 - p)e2'A. (7.2.22)

which is obtained from (7.2.21) by postmultiplying each side by (1- pAl, The
economic meaning of this is that multiperiod returns are unforecastable
if and only if one-period returns are unforecastable. However Wald test
statistics are sensitive to nonlinear transformation~ of hypotheses; thus Wald
tests of lhe VAR coefficient restrictions may behave dilTerently when the
restrictions are stated in the infinite-horizon form (7.2.21) than when they
are stated in the single-period form (7.2.22). An interesting question for
future research is how alternative VAR test statistics behave in simple models
of time-varying expected returns such as the AR( 1) example developed in
this chapter.
An important caveat is that when the constant-cxpected-return null hy-
pothesis is false, the VAR estimate of jidl will in general depend on the
information included in the VAR. Thus one should be cautious in interpret-
ipg VAR estimates that reject the null hypothesis. As an example, consider
an updated version of the VAR system used by Campbell and Shiller (1988a)
which includes the log oividend-price ratio and the real log dividend growth
rat('. These variahles are lIsed in place of the real log price and log dividend

'''Fur <l~laib se .. Camp,hell alld Shill.. r (IYK7. 19KKa,h). Campbell and ShiU"r aho show
how III \l',1 01111'1" ",mlt'l, of exprrtrd 'IOrlc. f .. lllrn, ill Ih .. VAR fr,lIneW()f".
 82 7. PreJI'IZI- ValliI' llf/aliollJ

-
It!

-
C"! . ('
ro
,0
,
I
'
'0
...
0

...
9
()l)

9
~

",
oq
11160 1880 1940
HJOO 1920 1960 191:10 ',!UOO

Figure 7.1. Log f/.eat Stork Prite tlwi Dividend Snies, A lin ual US Vatll, 11172 10 1 YY4

in order to ensure that the VAR systcm is stationary. The systcm is estimated
with four lags using annual data from 1871 to 1994. Figure 7.1 shows the
real log stock price as a solid line and the real log dividend as a dashcd Iinc.
Both series have been demeaned so that the sample mcan in the ~-igure is
lCro. The two lines tend to Illove together, but the movements of the log
stock price are larger than thosc of the log dividend; thus the price-dividend
ratio is procyclical and the dividend-pricc ratio is countercyclical. Figure 7.2
again shows the dcmeancd real log stock price as a solid line, but now the
dashed Iinc is the demeaned VAR estimate of I'd/> the present v<llllc of fu-
ture dividends. Because the real log dividend is close to a randolll walk, the
'~'\R estimate of I'dl is close to ci, iL~c1r and thus the variation in /', is larger
t Ian that in I'dl' Figure 7.3 shows the log dividend-price ratio as a solid line
a HI the log ratio of c1ivideud to 1''/1 as a dashed line. n Thc present-valuc
,~odcl with constant discount rates expl<lins very lillie of thc variation in
stork prices relative to dividends.
Whilc this general conclusion is robust, the smoothness of 1',1/ is sensitive
to the specification of the VAR system. In a low-order systcm with four I<lgs
I
\ 1"ITh('~(' !\t·rit.·~ hav(' 1101 h('('u dC.'IIH."III('d; 111(' h'vt'l of tht' (\ivi<h'nd-prire ratio t·'U1 he n'nlV-
(.,~." fro", tht' 1i~lIrc hy c'pollt'nll"ti,,!: th" plot(('<1 s"lid lint'.
I ,
7.2. /'rl'.lfll/- VII{lIf Uf{lI/ioiIS IIwl US S/mil {'ril/' {Muwior

.,.
c

~!

/'
:: L _____~_.....i.._~ _ __'_~~_'___ _ _ ~___'. _ _
, I Ht;O I HHO I !l00 I !J:!O I!I4O I!)(ill I ~lHll :!(){)()

Figure 7.2. l.oJ.: /Inti SloCR [',ire and blil1lalrd [)hll'dl'lul COIII/wllnll, It 1111 Ii III (IS [)ala,
187() III f'.!'N

or fewer, FII llloves closely with d,. A~ one ilJcrea~es the lag length towards
ten lag~, 11,({ becomes much smoother and more like a Irelld lille. The same
thillg happens if one adds to the VAR systelll a ratio Dr pritc to a IO-year or
30-year IllOving average of earnings, as suggested hy Call1phell and Shiller
( 1088h). There appears to be sotlle long-run llIean-revCI'sion in dividend
growth which is captured by these expanded VAR syslellis.
In cOllclusion, the VAR approach strongly suggests that the stock market
is too volatile to be consistent with the view that stock J>ri((~s are optimal fore-
cast~ of future dividends discoullted at a cOllstallt rate. Some VAR systems
suggest lhat the optimal dividend forecast is close to the ('lIITCllt dividclld,
others that the optimal dividend forecast is even sllluuther than the cur-
relit dividelld; lIeither type of system Gill accoullt «II' the tendency of stock
prices to 1IIove lIlore than one-ior-()IW with dividends.' ~ Strictly speaking,
hol\'('\'('I', onc(' the null hypothesis Ii, == lid' i., r('jected, 'UIY int('l'pretatiolJ

1"1l.,rskr ;IIHllk I.ollg (J!I~U) po,,11 0'11 11t"1 s,urk prir(' h('lI.'l'ior mllJd 1)(' nllioll.,li,,·d
if tiH.'re wc:n: ;t ullil-root rOlllpOllclit in dividend growlh. htll Ihey do 1101 pt('~('111 any dil('(t
ecol1ollH.'lric (~\'idt'lIn' lor SIKh iI COmpnll('IH. l)onalthol1 ~lIld K.1l1I'ifl;l (I~J~Hi) argile thAI
a l1onlilu't\1' dividend lon'casting 1I10dt,) ddi"'('r~ 11101"(' \'oJ.uil(' '01
t" .t.'liL' of long-rull huure

diviciellds. Thi."i r('ltIaill'i all .Irlivt' re~\('ar('h alt',t.

':IH 7, PI"l'sml-l'allll'llI'lalio/ls

'::'~
<:'.
I

-t:
<:'.
I

~
0'
1

00
oi
I

0
<'i
I

::'-!
'"I
.,.
<'i
1

to
<'i
I

7J ____ __
or:I _---'_~ _ _ ---l _ _ _ _ _ . ........I-_._~_-'- -'-_~ '----_~_-'

IHliO IHHO 1!IOO 1'1:.'0 1!140 1!)(i0 1!IHO :.'000

f'igrm' 7,3, 1.11" lJil'itll'l/lI·I>,ill' /{lIlill 11//11 f.,lill/lIlP11 I>il/itlnul I:OIII/Wllnll, /11/11/111/ (IS
tlltllt, IH7fJIII IIJ<J.J

of Ihe hehavior of /1<11 is (,(lIldilional on Ih(' informalion variahit's inclllded

i II lilt' VAoR.

Ii-dor" 1I100i'gll'\\illll.\ (/1111 [{('Ium \jt/lllilil.V

t\ COlllllHln rrilirisnl orvol~llili[)' [('S[s, which applies (~qllally [0 VAR systems
incllldin)!; prin's alld dividl'lIds. is [h<ll IIII' tillle-s(~ries process drivin)!; dh'i-
dends lIIay not Ill' slahlt- thlOligh tillle,l" Fortllnately il is possihle to allalY/.e
thl' variahility orslol'k rctlll'llS wilholll lllOddin)!; Ihe dividend process. COII-
sidl'l' a slatl' \'('\'101' X, whoS\' lirsll'lcIllI'lI1 is Ihe olH'-period stock retlll'lI alld
whosl' olher 1'II'II11'II1S an' rl'll'\,alll Iill'lTOISlillJ.?; variahles fill' re[lIrnS, With
Ihis sysl('lI\ III\' 11111'''111'\'11'11 slock 1'1'1111'11 IW(,(lIIl1'S

1"TIIe' ~lodi~~li.llli ~ldl(,1 ,11"fllt'lli ... " .... lh.1I Jillll-\,tltU- lII:lxillli/alioli I~' tn'III;I~(·I~ dOl" 1If11
nUl""lr~tili 1111' 101111 oj dind,'wl poli( \', l.dllll.1I11I (I ~'!J I) "'('.'\ Ihh 10 ;lrRllC" Iha. Ilu' ~llIdl."li("
pIUt"(,~~ (h·~t·1 ilJllIg dl\ltlt'llth I.' IIl1hlt"l\" Itl IJC' ,1.lh)('.
7.2. }',-,sl'1Il- Value IlellltiollS alld US Stork Price Behllvior

Recall that the revision in expectations of all future stock returns, '1,.1+10 is
defined as

This becomes
00

1), .• +1 el'LpiAi€,+1 (7.2.24)

• j=1

From (7.1.2G) the revision in expectatiolls of future dividends, IJd.l+l' can

be treated as a residual:

A~ a concrete example, consider an updated version of the system estimated

by Camphell (1991) in which the state vector has three elements; the real
stock return (r,), lhe log dividend-price ratio (x-u), and the level of the
stochastically detrended short-term interest ratc (X31)' Using monthly data
over Ihe period 1952:1 to 1994:12, the estimated first-order VAR for these
variahles, with asymptotic standard errors in parentheses, is

0.055 0.655 -0.520

(0.053) (0.230) (0.166)

()
Tit I rl

( ) X~,I+l

X'U+I
=
-0.038
(0.001)
-0.032
0.999
(0.003)
-0.040
-0.000
(0.002)
0.707
"21

»:II
(0.011) (0.046) (0.050)

+ ("," )
f~.l+l

f3.1+1
. (7.2.25)

,
The matrix in (7.2.25) is a numerical example of the VAR coefficient matrix
A. The R~ slatislics for the three regressions summarized in (7.2.2!» are
0.040, 0.99fl, and 0.537, respectively, indicating a modest degree of fore-
castahility for monthly stock retllrns.~o

'!<I A" Ilw n ... mri~1l1 ~slimal"s SlIgg<'SI. Ih~ log diviclt'I}(I-prir~ rJlio has a roOI eXlremety close

l<> II IIi I)' ililhis sampl<' p<,rioc!. Althollgh Iht'rt' art' Ih('l)r~lical r~as()n. for b..lieving Ihat the log
divid"IIII-prict' ralin i, stationary. ;lnrl IInit-roOl test' rt'jt·n a unit root over long ~mple periocls
in US d.II." lilt' p"rsistt'nrt' or Iht' Ing divi(lrnd-prict' ""Iio does karl 10 inference probl~ms in
III<' VAil. 'y,I'·III. Ilo<lrid, (1<J!.I2) ;. a card'ul MOllie C\I'lo stll(ly of !hl"se problem •.
 7. l'''I'~{'IlI- V(/illI' IMlIliolls

We call suustitutc thc cstimatcd A matrix into thc furllluia (7.:!.:!4) and
usc thc estimated variancc-covarian("(' matrix of thc crror V(,(·tor (" I to
calculate thc sample varianccs alld nlVari,lI\(c of thc cxpccted-rctllrn ,II\(I
dividend componenL~ uf stod, retllrns. The estimatcd expccted-retllrn com-
punent has a sample variancc cgualto 0.75 times thc variance or rcalized
returns, while the estimatcd dividcnd componcnt has a sample variance
oniy 0,12 timcs thc variance uf reali/.cd rctlll'lls. Thc rcmainill~ v'lIi.llln: or
realized returns (O.l:~ uf thc total) is allrihutcd to covariallcc l)('tIV(,(,1I thc
cxpected-return and dividcnd cump()nenL~.~1
The reasun for this rcsult is that thc log dividcnd-price ratio f()\'{:casL~
stuck returns, ,md it is itselra highly persistcnt proccss. Tbus rcvisions in thc
log dividend-price ratio arc associated with persistcnt ch'lIlgcs in cxpectcd
future returns, and this can justify large changcs in stock priccs. Thc esti-
matcd VAR process is sumcwhat morc complicated than thc simplc AR( I)
example developed earlier in this chaptcr, for it includcs two forccasting
variables, each of which is c1use to a univariate AR( I). IlowcvCl' the main
effect of the interest-rate variablc is to increasc thc forecastability or onc-
periud stock returns; il has a rather mudcst effect 011 the lung-run behaviur
of the system, which is duminated by the persistent muvcmcnt.~ of thc log
dividend-price ratio, Thus the long-run properties of the VAR system are
similar to those of the AR( \) examplc. From this and our prcvious analysis,
une wOlild expect that VAR systems like (7,2,2~) could account for thc pat-
tern oflung-horizon regressiun results, and this indeed seems to he the case
as shown by Campbell (1991), 1-\mlrick (1992), and Kandel and Stambaugh
(1989), Of coursc, VAR systcms impose morc structure on the data; but
Hodrick (1992) presents sUllie Montc Carlo cvidence that when thc strltC-

~
\re is corrcct, thc flllite-sample behavior ofVAR systcms is corrcspondingly
ellcr than t~lat of long-hori LOn rcgrcssiuns with a largc horil.On rclative to
t,lC sam pic SIZC,
I
\

I
7.3 Conclusion
I

ihc rcscarch descrihcd in this chaptcr has helpcd to transf(JI'IIl th{' way Ii-
Ijandal cconomists view assct llIarkct.~. It lIscd lU bc thoughl that cxpcctcd
arsct rcturns werc approximately constant alld that movcments in prices
cbuld hc attrihuted to ncws ahout futurc cash )laymcnt.~ to investors. Today
tllc importance of tim(,-variation ill exp(,cted rcllll'llS is widd)' re(()gnizcd.

1 11 o\'cr a IOllger period I!Wi 10 1!I/lH, till' Iwo \,a .. i.. "Cl's ;111<1111" covariallre lIa",' rollgilly
('qllal ~hare.s of the overall \'driif,n«~ of Ic.'alil.l'(\ st(Kk H..'tUIIIS. A"'Yluptotic ,lIitandard ern,rs tor the
\'~1rianre decompositiun ( ... " bt., r.,lrutncc.l \lsil\~ tIll' "Idt." 111cthud ex.pla'nt.·d in St:r\ion AA uf
II~(' Appendix. A", in th,.. pl'in· . .divid('ud VAl{ di~{·'I.~s('d aho\,(', till' dC.'fOllll'osilioli is (ollditiollill
UI~ Ih(' information variahles illdutied in Ihc: VAR ~ysl(·II1.
"/O/J/t'Il/.1 ~H7

and this h'ls broad illiplicaliolls fi)r bOlh acadetllirs and in\'('slnH'nl profes-
sioll.tis.
At th" 'lca(klllic· level. lhere is all {'xpl\l~ioll or res('Mdl Oil lhe d('tenni-
11.111" or lilll{'-varying experled H'tnrns. Econo\\\ists 'In' exploring a great
variel), oride'IS. I'rom macroecollomic IIltHkls OrH"11 husincss cyril'S to lllOlT
heterodox IIHHkls of investor psychology. WI' disclIss SOli\(' of thl'se ideas
ill Chapter H, AI a more praclical level, dy"amic assel-<lllocalioll 1II()(lels
.1IT bl'Colnillg ill(T(';lsillgly popular, The Il'chniqll(,s discussl'(1 hnt' call
providc qllallliialiv(' illPUlS for these illvcsllllClI1 strat('gies. In this contexi
10llg-horizon relnl'll rCf~ressions lIIay he allrarlivc nol onl)' ")t.
their pOle II-
li.ll statistical advanlages. bllt also hl'callse illV('stllll'lll stratl'gies hasl'd Oil
IOllg-hori/.oll retlll'll fOITGISts are likely to incur lown Ir.llls.HtioIlS cos IS.

Problems-Chapter 7

7.1 III the laIC I !lHOs corporatiolls begall to repurchasl' sharcs Oil a large
scal,'. In this prohklll YOll are asked to allal)'ze the eff(:cl of rqHlrchascs Oil
the relation belweell slock prices alld dividends,
COllsider a linn wilh fixed cash flow p('r pniod, X. Thl' lolal markel
valu(' or
the firm (including the currenl <'<Ish Ilow X) is V. This is the
preselll v,due or Cllrrenl ami future cash tlow. dis((Hlllted at a constant rail'
H: I' = (I + fO XI H. Each period. lhe lill11 uscs a II<lnion >.. of iL~ Gish
flo\\' 10 rcpurchasc shares al CUIIHlividcllti pritTs. ant! lhcn IIses a fraclion
(I - }.) of ils clsh !low 10 pay dividcnds on Iht' n'lllaining shall'S. The linn
has Nt shares ollislanding al Ihe beginning 01 pniod I (In'lol e il repllrchascs
shart's).

7.1,1 What arc lhe clim-dividelid 11I'iet, pn share anti dividl'nd per share
al lillie I?

7.1.2 Derive a relaliun belween lhe dividend-price ralio, lhe growlh rale
of dividends per share G. and the discollnl raIl' U.

7.1.3 Show lhal lhe price pCI' share eqllals lhe ('xl'l'('t('d preselll value
or dividellds per share. disculIlIled at raIl' II. Explain intuitively why lhis
fOl'lnllla is corrn:l, even lhollgh lhe linll is dcvoling ollir a porlioll of its
Gl,h flo\\' 10 dividends.

7.2 COIIsitier a slOek WIIOS(' log divide lid tI, 101101\'., ;1 1.llItiolll walk wilh
drifl:

where f,+1 ~ N(O, (]~). 1\'''11111('111.11 tht' n'tl"in'd log 1,IIe oflt'llIl'II onlhe
slock is a conslalll r.
 I. /'rt',lf'IIl- \ 'a/lit' IMfllilJlu

7.2.1 WI" lI~I' IIII' lIol;lIiOIl /.; (Ie,r "flilldamenlal vallll"") 10 dellote Ihe
I"xpl"ell"d pn'sl"lIl \'allll" or dividl"nds, discollnledllsill~ Ihl" reqllired rale
of relllm. Sholl' Ihal I'; is a ("ollslalll mllltiple or Ihe dividend /),. Wrile
Ihe ralio 1';/ /), as a fllllnioll oflh" paramelers oflhl" modd.

7.2.2 Show th;lt allotlln forlllllla for till' slOck price which ~il'es thl" sallie
I"xpenl'd rail' of rellirn is

I', = I';+(I)~,

wl!!'rl" A > () is a hlllClioll oflhl' olhl'r parallH'lI'rs of Ihl' lIIodel. SolI'I'

Ii,,' A.

7.2.:-\ Ilisnlss lhl' Slrt'II!41hs alld weakllesses of Ihis 1II00Id 01';1 raliollal
hllhhle as 1'I1IIIP;III't\ Wilh Ihl' Blallckml-W;lIsol1 hubhll', (7.1. \(i) ill Ihl"
II"X\.
NOle: This prohlel\l is ha~I'd Oil Flool alld Ohslldd (I ~191).

7.3 COllsidl'r a slock whose I'XIlt'CI"d rl'llIrn ohcys

/':,\/'111 = r + x,. (i.I.2i)

ASSlIlII1' Ihal x, /t.liows all AR( I) pron'ss,

·\·t 1 I 70 </• .\', ,. Etil. o < cp < I. (i.I.2!-;)

7.3.1 ASSlIlIl(' Ihal Ell I is III)('olTe/;lIl'd wilh IlI'WS aholll flllllrc dividclld
payllll'lIls Oil III!' slo( k. llsillg Ihl' loglillcar approxilllale franll'work Ik-
\'c\opl'd ill SCl'liOiI 7.1.:\, dl'rin' Ihc aulocovariallcc fUllctiOIl or Ilall/.I'(l
stock II'HIlIIS. ,\SSlIlIlI' Ihal Ii> < fl, where p is Ihl' parallll'll'r of lil'-
earilalioll ill Ihl' loglilll';lr frallH'work. Show Ihal Ihl' <llIlot'ovaliaIlCI'S of
slock \'('llIrtlS are a\l IIq~ali\'I' alld dil' oIl' al raIl' cp. Gil'l" all economic
illlerpn'l;llillll or \'11111' li,)')llllb fllr I'\'lllnl al\locovari·,IIICI'S.

7,:1.2 No", allo", Ell I 10 hI' IOlTciall'd with lIews aholll flllllrc dividl'lId
pa)'n II' II Is. Show Ihal III(' alllo('ovariall("I'S ofslork r('llints call hc posilin'
if Ell I and dil'idl'lId III'WS ha\'I' a slifficiclllly largt' posili\'t' covariance.
7.4 Suppose IIt;1I Ihl' 1014 "1'111111;\1111'111;11 valllt'" or a slork, lIto olw\'s Ihl'
Ilrtl(,('SS

I', = I'''' (I ~ ") (tI, - lit-I) + I't .. 1 +f,.

wlll'rl' II is a (,Ollst;IIII, I' i~ Ih .. pal';)III1'II'r or lillcari/.alioll ddillCc\ ill Seclioll
7.1.:~, tI, is Ihl'log di\'idl'lltl olllht, ;Isst'l. ;lI1d f t is a whitt'uoist' l'ITor Il'nll.

7.4,1 Sho", liIal ir IiiI' pricl' of IIll' Slock l''Iuals ils flllltlallll'III;t! \'allll',
IIII'll Ihl' approxilllall' log Siolk 1I'llIm ddillcd ill S('CliOIl 7.1.:1 is IIlllem'-
casta!>"'.
/'mh{rlll.1 289

7.4.2 Now suppose that the Illanagers of the company pay di,,:idends
acronling to the rule
rt, = (+1.11/_1+(1-1.)(//_1+1)"
",line ( and A are constants (0 < A < I), and lit is a white noise error
Iln('orreialed wilh ft. Managers partially a(!just dividends towards funda-
IIlelllal value, where the speed of a(\justmelll is given by A. Marsh and
Merton (I !IHli) have argued for the cmpirical relevance of Ihis dividend
polie),. Show that if the price of the stock e'luals its fundamental value, the
log cli\'i(kncl-price ratio follows an AR ( I) process. What is the persislence
of this process as a function of A allel p?

7.4.3 Now suppose Ihal the slock price docs not eqllal fundamental
\'alllc,hlltrathersatisfies/lt = 1I1-y(dl-vtl,wherey > O. That is, price
exc('eds fllndamental value whenever fllndamental value is high relative
to dividends. Show that the approximate log stock return and the log
dividend-price ratio satisfy the AR( I) model (7.1.27) and (7.1.28), where
the optiJllal forecaster of the log stock relllrn, XI' is a positive multiple of
the log dividend-price ratio.

7.4.4 Show that in this example innovations in stock returns are nega-
tively correhtted with il~novati{)ns in XI'
7.5 Recall the deiinition of the perfect-foresight stock price:

V == 'L}::.o (II [< I - (I)dl + I +/ + k - r]. (7.2.8)

Thl' hypOllwsis that ('xpected returns arc constant implies that the actual
slOck pricc III is a rational expectation of p;, given investors' information.
Now consider forecasting dividends using a smaller information set J,. De-
line p, == I~[II; I J,l.
7.5.1 Show that Var(jll) ::: Var(j~I}' Givc somc economic intuition for
Ihis n'slllt.

7.5.2 Show that Var(IJ; - Ptl ~ Var(g - M and that Var(p; - PI) >
Var(/It - I~I)' Give some economic intuition for these results. Discuss
cirClllllstallces where these variance inc'l"alities can be more usefullhan ;
Ihe illequality in part 7.:>.1. I
7.5.3 Nowclcfine I-'tl == k+(I ~'+I+( l-p)d'+I-P" 1-'+1 isthereturn that
wOllld prcvail Illlder the constant-expected-return model if dividends were'
lim'Casl Ilsing Ihe informatioll set j,. Show that Var(r,+l} ~ Var(r,+l)' i
(;iw sollie ecollomic illlllitioll for this result alld discuss circumstances'
whert' it can he ilion' Ilserlll than the inl'<1"ality ill pan 7.5.1. .
Note: This prohlelll is hased Oil Mallkiw, ROlller, alld Shapiro (19H5) and ..
West (1!IHHh). '
 8
Intertemporal Equilibrium Models

TIllS CHAPTER RElATES assct prices to the consumption and savings deci-
sions of illvestors. The slatic asset pricing models discussed in Chaplers
:) alld Ij ignore cOllsllmption decisions. They treal asset prices as being
determined by the portfolio choices of inveslors who have preferences de-
fined over wealth one period in the future. Implicitly tht~se models assume
that investors cOllsume all lheir wealth alter olle period, or at least that
wealth uniquely determines cOlISulIlption so that preferences defined over
consumption ,Ire equivalclll to preferences ddilled over weallh. This sim-
plilicltion is ultimately unsalisractory. In the real world investors consider
many periods in making their portfolio decisions, and in this intertemporal
selling one lJIustmodel consllmption ,lI1d pon/()Iio choices sillluitaneonsly.
lnterLel\lporal equilibrinm models of asset pricing haw tilt, potential
to answer two qucstions that have heen left llnresolved in earlier chapters.
First, what forces determine the riskless int<Tcst rate (or IIlOle generally the
rate of return on a 7.ero-hela asset) and the rewards that investors dellland li)r
bearing risk? III thc ('APM the riskless interest rate or zero-heta return alld
the reward for hearing markct risk arc exogcnous parallleters; the model
gives 110 aC(OIl11t of where they cOl1le rr011l. III the APT the singlc price
of market risk is rcplaced by a vcctor of /;ICLOr risk prices, bUl again the
risk prices are determined olltside the model. We shall Set' ill this chaptel'
that intertclllporallllodels can yield insights illto the detertllill;\nts or thest~
parameters.
A second, related question has to do with predictable variations in ,ISSCt
retllrns. The riskless rcal intcrest rate movcs over tilll(', and in Chaptcr 7 we
presellted evi<it'lHT that forecasts of stock ret IIr11S also llH)V(' over time. 1111-
pOr\'lJItly. excess stock rcturns appcar to 1)(' jllst ,IS f()Jccastahlc as rcal stock
retllrns, suggesting that the reward {ill' ht"lling stock market risk changes
over lime. Arc thcse phenolllena conSisl('1I1 wilh markel efficicllcy? Is it
possible to construct a model with ratiollal, 1IlilitY-lllaxilllilillg invcslors in
which thc ('qllilihrilllll retllrll 011 risky ,ISS\'\S v'lries O\Tr tillw in tht' w,ly de-
 S. /l/lt'I"II'III/}()m/ fql/ili/llilllll ;\(1I11t·ll

snilwd ill (:11011'1<"1 7~ \\". sll.dl Wo,(' illl(TIClllporal cqllililirilllll lIIodds 10

I'xplore Ihest' '1l1nlioll\.
SI't'lioli H.I bl'gill\ bl' SI'llilig IIII' proposiliolllhallht'l'1' I'XiSlS a .IIIUIIl1.l/ir
tlil(//lIl/l./il(/1I1" slIch lhal IIII' ('xl'l'l'Ied prodllci of allY assl't rl'tllrtl Wilh lhe
stochastic dis(olllil ElI'tor I'qll.ils OIH'. This propositioll holds I'tTy gl'lIl'r-
all\, ill lIIodds thai rille 0111 ;lIhilragt' OPPOrlllllilil's ill fillallcial lIIarkl'ls.
EqlliliiJrillllllllodl'ls wilh oplilllilillg illl'l'slOrs imply lighllillks IiI'IWI'('1I the
slochaslic dis(,(lIl11l bClm ;\IId IllI' 1l1argillalulililies of inv('siors' COllSlllllP-
lioll. Thus h)' MlIIlyill).\ Ihl' sloc\laslic disCOlI1I1 bnor 011(' call rciall' assel
prices \0 Ihl' Illldl'r\l'ill).\ prdl'rt'lIlTS of illV('stors,
III Sl'l'Iioll Itl WI' show how thl' hehal'ior of assl't prices call h(' IIsl'd
to ITach COllcillSiollS ahOll1 the hehal'ior of tlie stochastic discoulIl Elctor.
III l'arlinlbr WI' desnilw llallSt'1I alld .Jagallll;tth'IIl's (1991) procedllre ror
(·aklilatill).\ a 10l\'n hlllllld Oil Ihe volatility of the stochastic discollllt !;\rlor,
gil'l'lI allY SI'I 01' assel relllrils. Usillg 11111).\-1'1111 allllllal data Oil US short-term
illterl'st rail's alld stock retllrtls 01'1'1' Ihl' pniod IHH!l1O 1!l!l4, WI' I'slimale
Ih(' stalldard d(,l'ialioll 01' the stochastic disCOlillt /;lctor to h(, :~()lYt, ptT year
or 11101'1'.
(:OIlSlIlIlptioll-haSl'd assl't pricillg Illlldds aggn').\ale inv('Slors into a sill-
gil' n'l'n'sclllalil'e agelll, wh .. is aSSIIIIII'd 10 dnivl' lltilily frolll thl' ag).\IT-
gatl' COIISllllllltiOIi 01' IIII' ('1'0110111),. III thl'se models the stochastic discOlllI1
Elclor is IIl1' illll'rll'lII/JlJII//IIIIIIPJI/I/! mIl' 1I/.lIIb.llillllioll-the discolllltl'd ratio
of Illargillailltililin ill 111'0 SII(TCssil'l' pITiods-fill' th(' rl'(ln'Sl'llialiv(' agellt.
'\'hl' 1';/III'I"I'I//1I1/illl/l-11 II' lirs(-I,n In ('( "ulil i( 'liS lill' oplilllal COllSllm pi iOIl allli
porlli,lio rhoin's 01' lilt' l\'IIII'sl'lIlalin' agenl-GIIi be \Ised III lillk asset rL-
IIIrliS alld (OnSlllllplioll.
St'clioll H.~ disnlSSl'S a COlllilIOllir IISl'd COIISlllllplioll-hascd model ill
which Ih(' rt'pn's('lIlalil'l' agt'1I1 has lillll'-s('parahll' powt'r IHilil)'. III Ihis
11111111'1 a sill).\h' pOI 1'01 II lI'lt'r govt'rtlS hllih I'il" IIlII'T.lioll and IiiI' ,,1/1I/iri/)' III' ;1/-
Il'I'lr/ll/Jom/lII!J.llillll;IIII-lhl' \\'illill).!;IH'ss or lhe represenlative agellllll al\jllsl
planlled (OnSlllllplioli g-rowlh ill r('spolise II) iliveslillelit opportllllities. III
b('(, Ihe ('\;tsliciIY orilltl'lll'llll'oral slIhslilillioli is Ihe reciprocal of risk al'er-
SiOll, so ill Ihis IIl11dd risk-al'erse illl'('siors Illilst also he lIliWillilig 10 adjllsl
Iheir COIISlllllPlioli ).\rowlh ral('s 10 (hallg('s ill illll'n'st rat('s. The Illodel
\'xpl"ills Ihe risk pl'I'lllia Oil ;tSSt'lS h,· Iheir ("lIvari;\Ilct's wilh .IRRn'g.lle ("011-
SlIlIIPlioli ).\III\\,lh, IIIl1liiplil'll hI' Ihl' risk-aversion cl)eflici('lll 1'01' lhe rt'pn'-
selilalil'l' illl'('sior.
Usillg 101lg-nlll 01111111,11 I IS dala, \1'(' ('lIIphasize lillll' slyli/ed 1;I('(s. Firsl,
Ihe al'l'rag(' exr('ss 1'('1111'11 011 liS slorks 01'\'1' short-II'rIli dl'ht-Ihl' (''1"ily
1'lI'millm-is ;1111111\ (i',V" pCI' year. Sl'colld, aggregalt' COIlSlllllplion is I't'I'Y
SlIIoolII, Sll cOl'ari;lIln's wilh conslllnl"ilill growlh a 1'\' small. PlIlling Ihest'
l;u'ls logelhn, Ihl' 1'0\\'1'1' Illilill' 1II0dei (all onl>'lil iiII' C'l"ily pn'mililn il'll\\'
rocftiril'nl of II'lOIlil'l' risk ;tn'l'sioll is 1'1'1'1' larg(,. This is Ihe I'I/lli/)' /1I1'I1Iilllll
8.1. 'J'Ilf S/o(/l1l.1/ic J)iJcount Fac/or

/Jlm/!' of Meh,.a and I'rescoll (1985). Third, there are some predictable'
movemellts ill shon-term real interest rates, but there is little evidence of
accompallying predictable movements in consumption growth. This sug-
g-ests that the elasticity of intenemporal substitution is small, which in the
power utility model again implies a large coefficient of relative risk aver-
sioll. Finally, there arc predictable variations in excess returns on stocks over
shorl-terlll debt which do not seem to be related to changing covariances of
stock returns with consumption growth. These lead formal statistical tests
to reject the power-utility model.
III Sections 8.3 and 8.4 we explore some ways in which the basic model
call he modified to fit these facts. In Section 8.3 we discuss the effects
of market frictions such as transactions costs, limits on investors' ability to
borrow or sell assets shoTt, exogenous variation in the asset demands o~ some
investors, and income risks that investors are unable to insure. We argue that
lllany plausible frictions make aggregate consumption an inadequate proxy
for the consumption of stock market investors, and we discuss ways to get
testable restrictions on asset prices even when consumption is not measured.
We also discuss a generalization of power utility that breaks the tight link
between risk aversion and the elasticity of intertemporal substitution.
III Sectioll 8.4 we explore the possibility that investors have more com- ,
plica ted prcfcrences than generalizcd powcr utility. For example, the utility
fUll('tion of the representative agent lllay be nonseparable between con-
sumption and some other good sllch as lcisure. We emphasize models in
which utility is nonscparable over timc bccausc investors derive utility from
the level of cOlISumption relative to a time-varying habit or subsistence level.
Finally, we consider some unorthodox models that draw inspiration from
experimental and psychological research.

8.1 The Stochastic Discount Factor

We begin our analysis of the stochastic discount factor in the simplest pos-
sible way, by considering the intertemporal choice problem of an investor
who can trade freely in asset i and who maximizes the expectation of a
timc-separahle utility function:

(R.1.1 )

where l) is the time discount factor, Cl + j is the invcstor's consumption in

pcriod I + j, and U( CHj) is the period utility of consumption at I + j.
One of til(' lirst-order conditions or l-:u[1'I" equations describing the investor's
 294 8. intertem/Joml E'luiliiJriwlI Models

optimal consumption and portfolio plan is

(H.I.2)

The left-hand side of (8.1.2) is the marginal utility cost of consuming one
real dollar less at time I; the right-hand side is the expected marginal utility
benefit from investing the dollar in asset i at time t, selling it at tillle t+ 1
for (1 + R;,I+ d dollars, and consuming the proceeds. The investor e(]llates
marginal cost and marginal benefit, so (H.l.2) describes the optimum.

i
:
get
If we divide both the left- and right-hand sides of (1\.1.2) hy (f'( e,l, we

I E'[(l + U"I+I)M,+ 1], (8.1.3)

I
,where Mt+l == lJV'(C,+ 1)/ V'(C, ). The variable M + 1 in (8.1.3) is known as the
'
; stochastic discount/aclor, or /JricillgkemeL In the present model it is equivalent
! to the discounted ratio of marginal utilities .5 V'( C,+d/ V'( Gil, which is called
\ the interlem/JOmi marginal rate '1 miJ.llitution. Note that the intcnemporal
i marginal rate of substitution, and hence the stochastic discoun t factor, arc
always positive since marginal utilities are positive.
\ Expectations in (8.1.3) are taken conditional on information avail,lhle
at tillle I; however, by taking uncolHlitional expectations of the left- and
right-hand sides of (8.1.3) and lagging one period to simplify notation, we
obtain an unconditional version:

I == E[(1 + UI/1M,]. (H.I.1)

These relationships can be rearranged so that they explicitly determine

I,expected asset returns. Working with the unconditional form for conve-
~nience, we have E[(1 + /{,,)M/J = E[I + U,,JE[M,] + Cov[U,,, AtlL so

I
E[ I + J~tl = - - (I - Cov[/{jto Mtl). (H. 1.5)
ElM,]
If there is an asset whose unconditional covariance with the stochastic dis-
count factor is zero-an "unconditional zero-beta" asset-then (H. I.!'» im-
plies that this asset's expected gross retum E[ I + Rod = I/E[M,l. This can
he substituted into (8.1.5) to ohtain an expression for the excess return Z,I
on asset i over the zero-heta return:

E[Z,,] == E[Uj/-J~JtJ = -EII+J~JtJCov[UI/,hJ,]. (H.I.t;)

This shows that an asset's expected return is greater, the smaller its covari-
ance with the stochastic discount factor. The intuition behind this result is
that an asset whose covariance with MH I is small tends to have low returns
when the investor's marginal utility of consumption is high-that is, when
collSuinption itself is low. Such an assel is risky in that it bils to deliver
 8.1. niP Siorlifl.llir /Ji.I((}1l1l1 Farlo,.
295

wealth precisely when wealth is most v,tiuable to the illvestor.

Thc invcstor
thercfor c deJlJ;\nds a largc risk prcmium to hold it.
Althoug h it is easiest to uJlderst and (H.I.:~) by refl-n'IHT to til(' intertell
l-
por,d choice problem of an invcstor , the equatio n Gill bl~ derived
mcrely
frolll the ahsence of arbitrag c, without assumin g that investor
s m;!ximi7.c
well-beh avcd utility function s" We show this in a discrete- state
sl~lIing with
states .1 == I ... S alld asseL~ i == I ... N. Deline '1, as the price of
assct i and
q as Ihe (N x I) vector of assct prices, and define X" as the payoff
of ,Isset i
in state .\ and X as an (Sx N) matrix giving the payolls of each
asset ill each
state. Provide d that all <lSScl priccs arc nOIll.ero, we call further
define G as
an (Sx tV) matrix giving thc gross return on each asset in each
Slate. That
is, the typical element of Gis G ,i =
I 1- N" = Xu/ II,.
Now defille an (S x I) vcctor p, with typical delllcnt I'" \0 hc
a ~tate
Iwire vI'r/u,. if it satisfics X'p == q. An asset can 1)(" IIlOught of as
a hundlc
of ~Iale-conlingenl payoffs, onc for carh state; IIH' .llh eklllelit
of thc statc
pricc \'('((01', I'" gives the pricc of on(' dollar to bl' paid ill stOlle
5, and wc
represcn t cach assct price as the stUll of its slatc-nll ltingent payuffs
times the
appnpr ialc state priccs: fji == L,/',X" , Equivale ntly, if we divide
through by
'I" W(' gel I "" L,
1', (1+ N.,) or G'p == ~,where ~ is an (Sx I) vector of oncs.
An importa nt result is that tll('IT exists a posilive state price
ve!lor if
and (111)' if there arc no arbitrag e opportu nitics (that is, no availahle
assets
or cOlllbin ations of assets with lIollposi tive cost today, 1IOIIIH'g
ative payoffs
tomorro w, alld a strinly positiv(' payoff ill al Ieasl onc statl'). Further
more,
if there exists a positive state price Vt'ctor, thell (H.I.:\) is salisfied
for SOIll('
pusilive randolll vari;lble M. To see this, ddine 1\1, == j'./lT., where
7T, is the
probabil ity of stale .1. For ;tny asset i the relation ship G'p = ~ implies

s s
1== I>,(I+ !{,,) == L7T,M ,(I-!-!{, ,) = EI(I+!{ ,}M). (H.1.7)

which is the static discrete -statc equivale nt of (H.1.3). M, is thc

ratio of the
state price of state .\ to the probahil ity of state .1; hence it is positivc
becausc
st,lle prices and probabi lities are hoth positive.
If M. is small, Ihell stalc 5 is "cheap" ill the s('nse that illvestor
s are
unwillill g to pay a high price to rcceive wealth in state .1. An asset
that tcntis
to deliver wealth in cheap states has a rei urn that ('ovaries lIegative
lY with
M. Such all asset is itself cheap alld has a high n'llllll 011 average.
This is
the intuilion Ill!" (H. I.!;) within a disnctc- state framewo rk.
III tlte dis<Tclc-state lIIodel, asset markets arc cOlllplete if lor each
state
S, olle ('an cOlllbill e availabl e assets to get
a lIonl.<TO pa)"off in .1 ,IIHI zero

ITlle·tlieo! "}' IIl1d\'rlyillg (''1t1alioll (HoI.:l) j,diM 11\\("«1 .Ilit-lIglll

illll·\lilnoJ. ...'.\II( II ;'''i IlIgcl."ioll
(1!1Hi). The lole of fOl1diliollill~ inf(u"m.uiol1 h~l~ ht'('11 ('xl'l(II(,(/ by 11.11)\"11 alld Rirh.ud
( l!lH7).
 8. IlIln lt'lIIl w/(/ II:'l/ llililn il/l/l Mod
d\

payo n;; ill all ollu 'r SI;II,·S. A 1'1111

111"1 illlp ona ni resu lt is 11I; llthl
l'l'("(or is IIl1iqIH' ir alld ollly if ' stale prin '
assl' t Inar kl'ts are COll lpll'l l'.
is IIl1iqlle, hili with ill("clInplctl' III this case AI
IIw- kets ther l' lIIay exis l llIallY
eqll atio ll (H.I .:\). This n'slI lt clIll M's satis ryill g
lI' IIl1d ersto od hy cOll side rillg
with s"I'('f;,1 IlIilitl'-llIaxilllilill)!; ;III ('con olllY
illl'e stors . Till ' lirst -onl er cOll
hold s for 1';1( h illl'e stol, so 1';lch ditio ll (H.I.~)
illl" 'slor 's llIar gilla l IIlili ties CIII
10 COllslrllct a stoc hasl ic disc ollll he IIsed
t bno r Ihal pric es Ihe asst' ls
01111'. Wilh COI II)lk ll' III;tr ill thl' l'con -
kels, thl' ilin' slol' S' lIIar gilla llllil
corr l'lal l'd so Ihn' ;111 I'il'ld Ihl' itics al'l' plTf l'Cll y
S;III1 .. , IIl1iqllc stoc hasl ic diSCOlltl
illl'O lllpk l,' IlIark,'IS i1tl'n ' ilia), i f"Cl or; wilh
1)(' idios Ylic ralic vari atio n illll larg
alld 111'111'1' IIll1hipl .. stoc h;lst ic illal utili lies
disc ollll t !;Ict ors Ih;1l satis h' (H.I.
:-\).

S.I. I IiI/II/iii/.\' 1I111/1Id.1·

All\' lIIod el or exp, ·ct .. d assl' l rl't
IIrns Illay he vi(,wl'd as a 1110<11'101
tic disc oull t fal'lC li. IId' .n' WI' ' thl' stoc has-
disc uss IIll't hods of tl'sli ng pani
w,' ask ilion ' gnll 'rall y wha t assl' t n·tu cllla )' lIIod l'ls,
.... data llIay hI' ;Ihle to Idll ls ahuu
IlI'h ;lI'io r or Ihl' sloc hasl ic discO I Ihe
lIlI1 bllo r. IlallSl'1I alld .Iag allll
haw dl'l'e 1opl 'd ;llo\ \'('r hOli lld atha ll ( 19!1 I )
Oil thl' \'oIa tility orst ocha stic disc
Ihal cOll ld 1)(' cOllsisl"1I1 wilh olln tl;lf lors
a givl' li SI'I of asse l relll .... data
wilh Ihe 1IIlI 'olIC lilio liall' qilai ioli . The y hl'gi ll
(H.I A) alld rewr ile il ill 1','clOr
Ic.rlll as

(H.l.H)
whl 'rl't is all N-I', 'clo" or Olil'S
alld R, is Ihl' N-v l'cto r of tillll '-/
with Iypic al l'\I'IIU'lIt N ,. assl' t r('tll rllS,
i
I lOlliSI'll and .laga lllla thall aSSl
lnll' that R, has a nOll sillg lllar
covari;1I1((' llIal rix n, ill oth .... varia ll':e-
word s, Ih;lt no asse t or com hina
is tilic ollll iliol lally riskl ess. Thl' tioll ofas scl5
ll' ilia}, slill I'xis t all IIiK Ollll iliol
assl' l wilh g"o~s IlIl'all r('tll rll lall.e ro-i> l'la
I'qll al to IIII' reci proc al of thl'
III ('a II of t III' stoc hast i.. UIICOIHlitiollal
di\co lIllI Lteto r, hili I JallSl'n and
.Ia!!;anna than assu lIlc
Ihal if tlll'l'(, is SlIl'h all assl' l,
its ic\el llily is not kllo wn 1/ 1i/7111
trl'a l Ihl' IIl1l'Ollllitiollal Illea ll 7. I knf l' thl'Y
or till' sioc hasl ic disc oull t bClO
know lI 1';11';11111'11'1' M. For I'ach r as all 1111-
poss ibll' M. I lOlliSI'll and .lag ann
a I'alld idal" slO,h;l~ti( (li'c olIlI alha ll r01'll 1
l 1;1((01' ;\I,'( M) as a lin!' ar cOll
Sl't rl'llI .... s. Thl' l' shol l' 1";11 1111' lhin atiol l of as-
" .... i;llln · of 1\1,'(M) plac l's a lowl
Iht, l'ari allcl ' of aliI' stoc hasl ic 'r hOll lld on
discOlllI1 bCl or that has IIl1'all
(H.I.H). jl,J alld salis lil's
llall sl'lI a II d.l ;lg;III1I;11 lIa II Ii rSI
sllol l' how assl' l pric i n)!; tlll'o ry
IIII' ('(Il'ffil'il'lIlS li:l{ ill c\1'1 1'1'1 n ill I'S

,11;( M)
(X,I, 'J)
If AI,'("/) is 10 1,..;1 ,to(I I;ISl ic
di,,, ,,tlli t 1;ll'l or il IIIl1st satisf~'
(H.I .H),
I = Flit I H,lM ,'(M )I.
8.1. TIll' Stodw.rtic Discount Fartor

Expand ing the expecta tion of the product E[(/. + R,)M:(M )]. we
have

" = ME[" + R,] + Cov[Rto M;(M)]

= ME[L + R,] + E[(R, - E[R,1l(M,·(M) - M)]
:= ME(/. + R,] + E[(R, - E(R,J)( R, - ElR,J)'f3M]

(8.1.10)

where n is the uncond itional variance-("ovariance matrix of asset returns.

It
follows then that

(8.I.IQ
and the variance of the implied stochast ic discoun t factor is

. Var[ M;(M)] = f3~nrJM

= (/. - ME[/. + R,»'n- I (/. - ME[/. + R,]). (8. 1.I 2).
I

The right-ha nd side of (8.1.12) is a lower bound on the volatility of

an~
stochast ic discoun t factor with mean M. To see this, note that any
othe1
M,(M) satisfying (8.1.8) must have the propert y
.

Since M,"(M) is just a linear combin ation of asset returns, it follows

that.
Cov[Mt (M), M,(M) - M,"(M)1 == O. Thus

Var[M,(M)J = Var[M; (M)]+V ar[M,(M )-M,·{M )]

+ Cov[M; (M). M,(M) - M;(M)]

= Var[M; (M)] + Var[M,(M) - M,'(M)]

2: Var[M, '(M)]' (8.1.14)

In fact, we can go beyond this inequal ity to show that

- Var[M;( M)1
Var[ M,(M) J = 'I' (8.1.15)
(Corr[M ,(M). M;(M)] )

so a stochast ic discoun t factor can only have a variance close to

the lower
hound ifit is highly correlat ed with the combin ation of asset returns
M;{M).
2!J8 8. IlIil'flt'llljlllmll:'qllililllilllll /IImlt'll'

~
1/1' /Jfl/rlII/WII! Portfolio
e can restate these results in a more /;uniliar way by introdurillf( the idea
If a brl/chmnr/t /'orl/olio. We first allgment the vector of risky asscts with all
~trtilicialuncoll(litionally riskless asset whose return is 1/ M - I. Recall that
lve have proceeded lInder the assumption that 110 unconditiollally riskless
~sset exists; but if it were to cxist, its retllrn wOllld have to he 1/ At - I. We
lhen (kline the bellchmark portfulio re!llm as

I
(H. I. I!i)
\
\
1
1\'1 is straightlill'wanl to check that this retllrn can be obtained by forlllinf( a
I ortfolio of the risky assets all() the artificial riskless asset, and that it satisfies
t Ie condition (H.I.H) Oil retllrns. I'roh1c1ll H.l is to prove that Uhf has thc
~ll1owillg propertics:
I (PI) lie, is me,lII-variance efficiellt. That is, 110 other ponfoliu has
smaller variance and the salllc mean.

(P2) Any stochastic discount /;lctor M,(M) has a gre<ller correlation

with UlJ , thau with allY other portfolio. For this reasou Ubi is sometimes
referred to as a m(lxillllllll·cundalioil/lOrljoiio (sec Breedeu, Gihhons, allc!
Lit7.enberf(er [1989]).

(PJ) All asset retunts ohey a beta-prieillf( relatioll with till' bellchlllark
portfolio. Th'll is,

lH.1.I7)

where /Jib == Cov[ Ri" R ,! / Varll~,,j. When an unconditional zero-heta

asset exists, then it GlIl he" substitutl'c! into (H.I.17) to get a (Oll\'cutional
beta-pricing equation,
Two further propcrties ,liT useful (ill' a geollletric interpretatioll or the
IlansclI:!aganllathan bounds. Consider Figure H.1. I'ancl (a) is the f;unil-
iar mean-standard deviation diagralll f<lr asset retllrns, with the llIeall gross
n'turn plotted on the vertical axis and the standard deviation of rcturn
Oil the horizontal. Paud (1)) is a similar diagram for stochastic discount
/;I('(or5, with the axes rotatcd; standard dcviation is now on the vertical axis
aud lII('an on the horizontal. This convcntion is natural because in panel
(a) we think of assets' sccond lIlolllents dctcl'luining their lIIean returns,
while in panel (1)) we vary thl' l\Ieall stochastic discount boor exogenously
and trace out the consc(l'lenccs for the st'llldard (\eviati(J11 of the stochastic
(~, I, "fill' SIII("//(I,\I;I' IJi.\UJllIII Ff/I'I"I'

slop.. ' i...

Sh;" 1'1' I.lli ..

1/ .II

n(ll)

(a)

slope is
Sh;\lpt· I."io

(iI)

Figure S,I. (1/) M,'all·SlllIlllrmll h,.if//illll I hl/gli//I/ /111' .1.'.\1'/ lid /III": (") Im/,Ii,." SIIIIIII",11
l)t'l,lio{;"'I-I\kall lJiag,atll 10,. Slud/fI.\(;('IJi,\a",,,t Flit 101"\

disCOllllI fal'lOI'. III pallel (,,). the ((-;!sihle S(,I of risky ;lsscl I ('lIIIIIS is shown,
Wc allgllll'II1 Ihis wilh a riskless gross 1'1'1111'11 I/M (III Ihe I'<'llical axis; the
lIlillillllllll-\'ariall(,(' sel is Ihcli the lallgclIl lill(, 11'0111 I/;\i 10 Ihe feasihic
set or risk)' assels. alld III<' refleclioll of til<' lallgelll ill Ihe verlical axis,
PropellY (1'1) 1I11',II1S that the I>cllchlllark porlf()lio 1'1'1111'11 is ill tlie lIIi II illl II 111-
variallc(' sct, It plots Oil tlie lower I>rallcli 1)(,(,;IIIS(' its posilin' correlatioll with
the stochastic discolillt /iH'toi' givcs it a 10\\,('1' 1111',111 gIO." 1'('1111'11 th;1I1 I/M,
 Ii. 1111,.,-11'111/'0/111 I:'q II ilibrill III .1/lIdl'l5

VI'I' call 11011' sl;lle 1\\'0 1II0re properties:

(1'-1) TIlt" ral in of'siallclarcl devialioll 10 ~ross lII('an for Ihe I)('ndllnark
porlll,lio salislies

(H 1.1K)

1\II11he riglll-h;IIHI sid(: oflhis (''1"<1lion isjusilhe slope of lilt" l<ln~(,111

lin(' in palld (a) of Fi~lIn' H.I. As explained ill Chapler r), Ihis slope is
tilt" llIaXilllll1ll Sharpe ralio ((,r tilt' sel or assets.

(1'5) TIll' ratio of stall dan I deviation to llIt'all for the helK\lllIark port-
11)lio gross rei Ill'll is a lower hOlllld 011 the sallie ratio 1111' 11ll' slochastic
discollllt bnor. ThaI is,

all + H", I <

a[M,(M)J
(R.1.I9)
Ell + n",1 E(M,(M)]

PropI'rties (1'"1) and (1':» estahlish Ihal Ihe slm:haslic discOUIII !"arlor
in palH'I (h) II111S1 lit' ahove Ihe poiul where ;\ ray frolll lhe origin, wilh
slope e<luallo 1111' llIaXillllll1l Sharp(' ralio ill pand (a), passes Ihrollgh lill'
\'I'rticd lillt, ;11 I\/". As 11'(' \,;Iry III, WI' o"an' 0111 a fl~asible regioll for the
slo('hasli," discOlIlII faclor ill panel (Il). This r('~ioll is hi~h('r, and Ihus
1Il0)T rcstrini\'(', whell Ihe )1l;IxiIllUIII Sharpe ralio in palld (a) is large for

a variel), of lIle;1Il siochaslic discollnt factors M. A s('\ of ass('l reI II I'll data
Il'ilh ;1 high lIIaxillllllll Sharpe r;ltio owr a wide range or
M is ('hallel1gin~
filr ass('\ priring theor), ill Ihe S('llSe thai il requires Ihe sto('hastic disc:JImt
1~\('lor to Ill' highly \'a("iabk. HI' looking at pand (a) olle call see that SIICI' a
data sel will contain ponl'llios with v('ry ciifferent lIIean rt'1I11'l1S and similar,
slIIall siandard de\'iatiolls. A 1t';lClin~ ('xampk is lhe sel or relurllS on US
Tn'asllr), hills, whit-h ha\'!' difl"el"t'II<'!'S ill mean returns Ihat arc ahsoltlldy
small, hilt large Idali\'!' 10 Ihe standard deviatiolls ol'hill returns,
Till' ahm'(' analysis applies to n'tl1l'llS IheJllseives; Ihe calclllatiollS are
SOIlH'wllal simpler if ex('('ss retlll'llS an' used. Wrilin~ the excess relurn on
ass!'1 i o\'er some lefen'III'!' assel It (not necessarily riskless);ls 1." = H" - Uhf>
alld Ihe \'ector 01" ('X(,('SS !"t'lllrns as Z" the hask condilion (K.IA) becomes

() = EIZ,M,l. (fl, I.~()

I'\()("t'('dillgas before, w('111I'\1I M;(i\/) = M + (Z,- EIZ,J)'jjM"' where lhl'

liltk is lIS('1! to illdicate that jj is ddilU'd wilh excess retlll"lls. W(' lind Ihal
-
riM = n (- -
--I
n-
MEIZ,II. \\'1H'!"t· is til!' I'arialll'('-('o"arian('(' malrix ofeXt"('ss
)'eIIlI"llS. It ji,llows Ih;11 III<' !OI\'!'I" hOllnd Oil Ih(' variallc!' oi" Ih(' stochastic
discollnl LId. II" IS 11011'
(fl.l.~ I)
8.1. The Slo,/ta.l/ir DiscouIII Farlor

If we have only a single excess retllrn l,. then this condition

- -2 2
to Var[M,·(M)] == M (E[l,]) /Var[l,]. or

a[Mt(M» E[l,]
::=
M a Ill]'
This is illustrated in Figure 8.2. which has the same structure as Figure 8.1,
Now the restriction on the stochastic discount factor in panel (b) is that i~
should lie above a ray from the origin with the same slope as a ray from the
origin through the single risky excess return in panel (a).

Impli((llions of Nonnegnlivily
So far we have ignored the restriction that M, must be nonnegative. Hansen
and Jagannathan (1991) show that this can be handled fairly straightfor-
wardly when an unconditionally riskless asset exists. In this case the mean
of M, is known. and the problem can be restated as finding coefficients a
that define a random variable

(8.1.23)

where X+ _ max(X.O) is the nonnegative part of X. subject to the con-

straint

(8.1.24)

In the absence of the non negativity constraint. this yields the previous solu-
tion for the case where there is an unconditionally riskless asset. With the
nonnegativity constraint. it is much harder to find a coefficient vector a
that satisfies (8.1.24); Hansen andJagannathan (1991) discuss strategies for
transforming the problem to make the solution easier. Once a coefficient
vector is found, however. it is easy to show that M,"+ has minimum variance
among all nonnegative random variables M, satisfying (8.1.8). To see this.
consider any other M, and note that

E[M,Mt+] = E[M,«L + R,)'a)+)

> + R,)M,)
a'E[(L

= a'E[(L + R,)Mt+) = E[(M,"+)2]. (8.1.25)

fiut if I-:[M,M,·+] ::: E[(Mt+)2]. then E[M,2j ::: E[(M,·+)2] since. the cor-
relation between these variables cannot be greater than one.
The above analysis can be generalized to deal with the more realistic
case in which there is no unconditionally riskless asset. by augmenting the
return vector with a hypothetical riskless asset and varying the return on this
asset. This introduces some technical complications which are discussed by
I [ans('n and .!agannathan (199 I).
 H. JlIll'rlf.lllpOml l~fJllilibl'illlll Mo{lels

1+7.

I.

",(1. )

(a)

a(M)

(h)

Figure 8.2. (a) MNlII·Slmultmi IJ{1liation IJillgr(lmjiJr(l Single F.xrm A.w'l Up/11m; (Ii) /m'
/lliNi S/andmri IJroia/ioll·Mrtlll /)itlf..,'TtllIl./ilf S/tlr/UI.,/ir f)i.'OJlIll/ N,r/OIJ

A First I.ook atthr F.quit.1 l'rrllliulII l'u1.ZW

The Hansenjaga/l/l,llhan approach call he IIsed to 1Illdersl,lIld Ihe well·
ki\IWII equity premium pliZZIe or Mehra alld Prescott (19H:1) ,2 Mchra alld
I'lesco\t ,ugue that Ihe average excess return Oil Ihe US slod, markel-the
I
!
: ~C:odlral\" .1I1t1 11.111"'1\ (I\I\I~) "1'1"0.1< h 'h,' "'I"il), pn'mill'" plIuk f .... '" Ihis poilll of
,·i,')v. Koehl'oI.I"ol .. (19'11;) sur"'),, Ih,'I'"I\,'li"'I<,,"n' till Ihl' pilule,
 "

.. .
'
... .
O.HH 0.91 0.% 1.00 I.(H 1.01l
M
Figure 8.3. l·i·//.IiM,. /legilill IIII' SIII,./'a.,li,. /)i.l,.I11/ III I'flllllll III/lilil'" Ii.l' :\ II 111/01 /IS /Jllla,
UNI III I 'JI).J

equity Inrlllinm-is LOO hi~h to be easily explained by slandanl assel pricin~

models. They make this point in the context of a ti~llIly paramctrized
cOllSumplion-based model, but it CIII he made more ~l'n(Tally \lsin~ the
excess-return restriction (1).1.22). Over the period lHH!) to 1!)94,the annual
excess simple return on the Standard and POOl'S stock index over cOlllmercial
paper has a standard deviation of 18% and a Illean of 0%.3 Thus the slope
of the rays from the origin in Figure 8.2 should he O.OG/O.IS 0.33,
meaning that the sLanda~d deviation of the stochastic discoullt factor must
be at least 3~% ifit has a mean of onc. A~ we shall see in the next section, the
standard consulllption-based lIIodei with a risk-aversion codlicient in the
conventional ran~e implies that the stochastic discoullt ('actol' has a lIIean
IIcaI' one, hilt an annllal standard deviation IlIlICh less (han :U'Yr,.

:\-nh' U'IIII"II (1) six·mollih (,Ol1l1H('lri;d P;'I"'I, ,oll('d 0\"('1" ill .I.IIII1;UY Jill),. i~ IIsed
.lIId
instead of ;, Tn'<t!'tllry hill H'llInl I)('(';,ms(' TU'''.'HIIY b,1I d.lla ,11(" 1101 ,I\';,il"hlt· t'ady P;III
ill Ihe
of this IOllg s;lIllplt· p(·riod. Mt'hr.l allCll'n'~c 011 (I!JH:,) .'plil C' loge-du'l (OIlIllH·,,·i.II,Mlw(" and
'J'rl·a.,\lII)' bill r;I«· .... , wllt·lt·a., h{'ll' we lI.\t' (·OIllIlU·I( i.II,"'pcl" I alt'., 1111 ollgliOlll IIH' ~alllpl(' 1'(,1 iod
for ('oll!'oi'!('IIC),. Tilt' dlC,ire ol"!<Ilaort-I('11II .;lIt· ... 1II.lkl"\ lillie' dllkl('11( (' 10 IIIC' 1(''''" It". ·'~Ihk H.I
below gi\'e., SOIlU' \;ll11pll' 1110111('111.' Ii,., log fl.,.'\('1 n'UII"II.', hili IIIl' IIloIIU'III.'\ \lal('(1 111'1(' .11(' luI'
simple r('lllrll~.
 Fi~IIIt, ICI, ",lios(' /<mllat "lllo\\,s Il;tlls(,1I alld.lagallllatilan (19~11), ;tlso
illllstraies tilt' c'"lIil\' plt'milll}) PIlII.!I'. The lIgllre shows the feasihle region
lill lilt' slochaslic dist"OlIlIl /;Ino!" implied hy c'l"alion (RI.I~) and Ihe an-
IIl1al dala 011 n'al Siock ;11111 ("(Ilnnlt'l"cial pap('\" rt'llIrns OWl' lilt' I)('riod IWII
10 1\1~}.j. Thl' ligllfl' c1oc's 1101 IIS(' 111(' lIoIlIH'g'lIivily rest ric lion c1isctl~sed
ill IIII' previolls sl'clioll. The glohal lIIillimlllll stalldard devialiot\ ("or Ihe
SIOl"h;ISlic dis("lllllli h\ctor is ahollt 0.:\:\, corresponding 10 a IIll'an stochaslic
discOIIIII fador or ahoclI 1l.!lH ;11111 an IIncondilional riskless relllrn or aholll
!!'X,. As Ihl' lIlt'all 1II00'I'S awal' 1'1"0111 O.9H, tht' slalldard-dc'viatioll hound
rapidly illnc'ast·s. Th .. dilil'r .. tlt"<' hetll"'(,11 Ill,' kasihk \l'gioll in Figure S.:\
;lIul lilt, n'giotl ahol'(, a r;IY rrom Ibe origin wilb slopt' O.:t\ is callsed hy
Iht' facl Ihal Figllre H.:I list'S hOlld alld siock rctllrns sc'paratdr ralher Ihan
mcrd), thl' c'xn'ss rt'llIrn 011 siocks 01'('1' honds, The ligllrt, also shows lIIe;\lI-
s!;\lIII;\I'd del'ialioll poi"ls cOlTc'spolHling to variolls degrc'es of risk avcrsioll
alltl a lix(,lllillle discOlIlI1 ral(' ill a COIISlllllptioJl-hasl'd n'pn'sc'lItative ageJlt
asst'l pricillg Inocle! or Ihe tvpc' discllssed in Ihe lIext scctioll, The (irst poinl
aho\'e th,' !lori/olll;11 axis 1I;ls n'!;lIin' risk aversioll or one; sll('(essive points
hal'l" risk al'tTsioll of Iwo, Ihree, alld so Oil, The points do 1I0t ellier Ihe
ft'asihlc regioJl IInlil relalin' risk aVl'rsioll reaches a v"tlll' of ~!i,
III illll'l"pn'lill~ Figllrt, H.:\ alld similar ligurt's, 0111' should "1't'P ill Illilld
Ihal hoth IIII' \"(IJatilill' hOlllld for Ihl' slochaslic discollnt Elrlor aud Iltl'
poi illS illlplil'd hI" particlliar ass!'1 pricillg lIlodels are t'slinlatc'd willr nr"r.
SlalisticalllH'tlHllls arc a\';lil;lhlc 1(1 ICSI \\'hellll'r a paninrlar model salisli,'s
Iht' volalililY 11Illllld (st'c' for "";;lInpll' I\llrllsi<l1' 119~)·1 J. C"ITht'lIi, I ,alii, alld
I\lark II !)!J.l1. alld 11a1lSl'Il, I kaloll, alld 1,111111)(,1' [ I !l!l:l J), These IIll'tltods
lise thl' (;elllTali,,'d I\lcllrod or MOIIH'IIIS or 1!a11St'1I (I !)H~), <liscllssul in
Ih" Appt'lltlix,

R.2 Cons\lmption-R.L<;ed Asset Pricing with Power Utility

III SI'CliOIl H.I 1\"1' showed hOIl" all (''I"ation rdating aSSl't n'llInlS 10 1/1t'
slochaslic di~t 011111 bllor, (H.I.:\), cOlllt1 hl' dni\'('d frolll lite Iirsl-orclcr
cOlldilion or a single ill\"('slor's illll'l"lt'IIIJloral COIlSlllllplioll alld portli,lio
dlOicl' pmhll'lIl. This (''1"alion is Il'sl;Ill'l1 IInl' for cOII\'enil'lIft':

(X.:!. I)

It is COlli ilion ill ("lIIpirical I ('s('arch 10 aSSlIllH' thai illdi\"icillals call he ;Ig-
grq~ated illiO a sillgll' r("pr(,Sl'lIlalivl' illveslor, so Ihal aggrq?;al(' COIlSIIlIlP-
lioll call hI' IIs,'d ill plac(' or Ihl' CIlIISIIIIIIJlioll of allY llOIrlirlll;lr indivicln;d.
F.c(lwion (H.:.!.I) ,,'jlh "'III = ,~I"(r:'II)//I'((:,),whl'r(, (;, isaggregalt'wlI-
SIIIIII"ion, is klum'lI ;IS tht' ((JIII/lltl/ilioll t:,II'M, or CCAPM,
X.2. CUllmmjJtiu7I-Bmed AlleE J'/ll/IIK with Pown- Utility

In this section we examine the empirical implications of the CCAPM.

We begin by assuming that there is a representative agent who maximizes a
time-separable power utility function, so that ' " ,..

c,I-Y -I
U(Ct ) = l-y
,
where y is the coefficient of relative risk aversion. As y approaches one,
the utility fUIlClion in (8.2.2) approaches the log utility function U(Ct ) f
10g(Ct). '
The power utility function has several important properties. First, it
is scale-invariant: With constant return distributions, risk premia do not
change over time as aggregate wealth and the scale of the economy if/-
crease. A related property is that if different investors in the economy hav~
the same power utility function and can freely trade all the risks they face,
then even if they have different wealth levels they can be aggregated into
a single representative investor with the same utility function as the indi-
vidual investors. 4 This provides some justification for the use of aggregatf
consumption, rather than individual consumption, in the CCAPM. '
A property of power utility that may be less desirable is that it rigidly
links two important concepts. When utility has the power fonn the elm/icityof
i7llrrlfllljlOrai SUblli/utio71 (the derivative of planned log consumption growth
with respect to the. log interest rate), which we write as ",. is the reciprocal
of tile coefficient of relative risk aversion y. Hall (1988) has argued that thi'
linkage is inappropriate because the elasticity of inter temporal substitution
concerns the willingness of an investor to move consumption between time
periods-it is well-defined even if there is no uncertainty-whereas the co-
efficient of relative risk aversion concerns the willingness of an investor to
move consumption between states of the world-it is weIl-<lefined even in a
one-period model with no time dimension. In Section 8.3.2 below we discuss
a more general utility specification, due to Epstein and Zin (1991) and Weil
(1989), that preserves the scale-invariance of power utility but breaks the
tight link between the coefficient of relative risk aversion and the elasticity
of intertemporal substitution.
Taking the derivative of (R.2.2) with respect to consumption, we find
thatlllarginal Iltility U'(Ct ) = Ct- r . Sllhstituting into (R.2.1) we gel

(8.2.3)

~(;"",,\I;III ;",d Shill"r (I!IH2) show lh.lllhis n·,ull\:CIll'I;lli/cs III a modd wilh nontrJ.d~d
;1,,,,'1, (1IIIiIlSlIl.,hle idiosyncratic risks) if consumplion and a.set prices follow diffusion pro-
f ..SM·S ill ;1 rOlltinllOlls-time mudd.
 06 8. Illlerlempoml Equillbril/JII MIHirLI

1
\ hich was Hrst derived hy (;1 osslllan and Shiller ( 19H I ), followill~ the closely
I;elated continuous-time lIlodel or Breeden (1979). A typical ()1~eClive or
empirical research is to estimate the coefficient orrelative risk aversion y (or
its reciprocal Vt) and to test the restrictiollS imposed by (H.2.:~). It is easiest
to do this if one assumes that asset returns and aggregate COIISllIlIption
are jointly hOllloskedastic and lognormal. Although this itllplies (Ollstallt
expected excess log returns. and lhus cannot fil the data. it is useful for
building intuition and understanding methods that can be applied to more
realistic models. Accordingly we make this assumption in Senion H.2.1
;lIld relax it in Section 8.2.2. where we discuss the usc of HallScll's (19H2)
Generalized Method of Moments (GMM) to test the power utility model
without making distributiollal assumptions Oil returns and cOllsllmption.
Gur discussion rollows closely the selllin,ll work of Hansell and Sin~lcton
(1982. 1983).

8.2.1 J>Ol/J1'r Ulilily ill fl 1.og71onllfll Model

When a random variable X is conditionally lognormally distributed. it has

the convenient property (mentioned in Chapter 1) that.

logE,[Xl == E,[log Xl + ~ Vartllog Xl, (H.2.4)

where Var,[log Xl == E, [ (log X - E., [log XlfJ. If in addition X is con-

ditionally homoskedastic. then Var, [101-( Xl = E[(log X - E,[lol-( X])~l =
Var[log X - E,[log Xl). Thus with joinl condilional IOl-(llUrmality and !ro-
moskedasticity of asset returns and consumption. we can take 10l-(s of (H.2.3).
usc the notational convention that lowercase letters denote logs. and obtain

(8.25)

Here th'e notation ax, denotes the IInconditional covariance orinnovations

l'~ov[x'+I-E,[xt+tJ.Yt+I-E,[y,+dJ.anda; == a xx •
I Equation (8.2.5). which was nrst derived by Hanscn and Silll-(leLOn
(:1983). has both time-series and cross-sectional implications. In Ihc tillle
shies. the riskless real intncst rale obeys
I
~ ~

I
I
rJ.t+1 == -lug8 - Y ; ' + yE,[6'l+lj. (H.2.G)
I
ljhe riskless real rate is linear in exp(,cted consllmptioll growth. with slope
cbcflici~lIt equal to thc roefticicnt of relative risk avcrsion. The equation
c~n be reversed to express expected conSulllptioll growth as a linear function
ofthe riskless real interest rate, with slopc coefficient Vt = i/y; in hlct this
r\'lation hetwecn cxpeclI'd conS\llllptioll ~rowth alld the interest rate is what
dl'lilles thc elasticity of inlertemporal suhstitlltioll.
I '
8.2. CClII.lltIII/Jlicm-Ba,\fil A.\.lfll'ri(i,,~ wilh {'(Jwn Ulility

The assllmption ofhollloskedasticity m;li... cs tlH'I0f!; risk premiulI\ 011 allY

asset over thc riskless real rate constant, so expectcd rcal returns 011 other
asscts arc also lillcar ill expected ("ollslImptioll glOwth willi slope codIicicllt
y. We have
a'.!.
EI [l"j.1+ I - If' .If I I -1 -'-
:! = ya". (H.:!.7)

The variance term on the left-hand side or (H.:1.7) is a.l~'t1Sen's In~~<t\lality

adjustment arisillg rn)fll thc filet that W(' arc cksnihing expectations or log
returns. W(' call eliminate the lIecd ft)r tltis adjllstm(,lll hy rcwritillg the
cquation ill terms of the log or thc expected ratio of gross H'tllrns:

Eqllation (H.'2.7) shows that risk prcmia arc determillcd by thc codliciclIluf
rclativc risk aversion timcs covariance with conslIInption growth, or course,
we have alrcady presentcd evidencc against the implicatioll or this mockl
that risk prcmia are constant. Nevertheless wc explore the lIIodei as a lIseful
wa)' to develop inluitiun and understand ('('onollletric techniqlles used in
mol':: general models.

A SI'(olltll.ooh (// Ihr !~I!llily l'rnlliuJIl !'/lUU'

Eqllation (8.:1.7) clarifies the argllment or Meltra and l'res(oll (198:» that
the equity premiulII is too high to hc consistcnt with ()hserv{~d consumption
behavior Ilidess investors arc extremely risk av('I'S('. Mehr.1 and I'rescoll's
analy';s is complicated by the Ltd that tltey do lIot IIS(' observed stock. 1'''-
tums, but instead calcll!;\lc stock retllrns implied hy tIl(' ((Hllllerbnual)
aS~lIlllptioll thaI slock dividends c(lllal consllmptioll. Problem H.~ carries
out a loglinear version of this calculation.
Onc can appreciate the cquity prClllillll1 plll.l.lc tllOl(' dircrtly hy ex-
amining- the momcnts of log real stock and cOll1m('l'('ial papcr rClllrJIS and
co IISU III ptioll growth shown in Table H.I. The asset rcturns arc measured
anllually over the period 188910 1994. Thc mean exccss log rClurn ofSlOCKs
over COllllllcl'Cial paper is 4.2% with a standard devi<llion of 17.7%; using
til<' Illl'muia for the' lIIean ofa lognormal random v.u·iabk, this implies that
the mean exn:ss silllple return is 6% as stated earlier.
A~ is convcntional in the literature, thc consumption measure used in
Table 8.1 is consumption of nondurables and scrvices. r, The covariance of
the exccss log stock return with log consulllption grow'th is the correlation
of thc two scries, limcs the standard deviation of til<' log stock retllrn, times
the standard deviation of log conslIllIption g-rowth. Becallse consumption
ofnondllrablcs and services is a sllloolh series, log ct>nslIlllplion f!;1()wth has

:IThi . . illlplicilly asstlllU'S that utility i,1I M'IMI "h'(".H I {)'.'" lili!'o ICIIIII of 'OIl"iIlTIlPlioll alld olht"1'
~()"rn'sof tllilily. III S('rtiol1 HA we disnl!\.'io W'I),' ill wlli, Ii tllI'I .'\ .... IIIIIIHIOII ("all ht' ,d,iX(.'d.
.,,,,1 H. /lIlnll'lII/lOml Flfllilibrilllll Mill"".!

'/i,M,' 8, I, ,11,,1//1'1//1 iiI ((I1i1/l1I//'lil/li /[11111111t (/w/II.I.1t'1 /I'/Un/I.

(:ml'"ialioll wilh (:",'"ri,lllrt: wilh

Sialld.lni
\';11 i;,"I,' ~Ic'all n HlSIlillpl i, HI fI.IISlllllptioll
d"vi.llioll
~rowth ~ro\l'lh

(:UIIMIIIIIJlioll ~Io\\'lh 0,0 I 7'!. Il.Il:I'!.~ I,OO(lO (l.OOI I

Slo(·k rl'llim 1).(lI;1J1 1I,lli7·1 O..l~)()'!. O,OO'!.7
<:1' H'llIfII 0.0 lin O,(I'd·1 -0.11!'.7 -1I.OOIl'!.
Slo('k-(:1' H'lum IWII H n,l??1 OA!I7~) O,OO~!1

(:"'\\IIII'l'lillll ~IUIIIII i., II ... , 1•. I1'~'· ill lu~ ,,·,,1, umllllll'lioll of lIollc!IIf.,Ioh-, allel w ...·i(' .. s, TIl('
,lurk 1I'llIm is II ... III~ "'011 "'lIlm oil lIlt' S&l' :100 ilH\t-x sill(,(' I'/:!Ii, allel III .. n'lum Oil a
(0111(>:11'0110'" illelt'\ "Otll (:""'''1\;11\ a'HI Shill"r (l!/HI) h(·for .. l!/:!Ii. Cl' is Ih,' n'al r('lurll '11\
1~l\Ioulh "Otlllllt',riall'''I''·I. hOllghl ill.l:lllll;1\ r aud IOIl .. eI ol't'r ill.luly. All eI;lla a ...• 'lI\uII"I.
IKK'I hI I !I!\.! ,

a slIIall sl.lIIt1anl deviation or only :I,:I'}!,; hence Ihe excess slock rCllIrn hots a
.... \'ariall .... with log "OIlS'lIlIptioll g .. mvth or Ollly (),O():~ despile Iii .. !;tn tllal
Ihe ('orrl'ialillll or lilt' Iwo serit's is aholll 0.:,. SlIhSlillililig Ihe IIIOJllClIts ill
'Elhlc H.I illlo (H.~.7) shows lhal a risk-awrsion codHcicll1 of 19 is reC]lIircci
10 iiI Iht' ('qllill' \I\,t'l\Iilllll.h This is JllII('h greater thall 10, tht' maximum
v;lhlt' I'Clllsi(kred pbllsiblc by Meltr;! alld ['r('SLott.
It is worth lIotin).( tklt titl' implied risk-aversioll coefficicnt is sensitive
10 Iht' limillg- (,Olll't'lltioll IIsed I()\' (,OIlSlIlIIplion. While asset prices arc
1II('asllrl'd at lite ellel or ('ach periCHl, (,OIlSIlJllPlioll is IIIt'asul'Cd as a flow
durill)!; a period. III ('orrelatillg asset rl'turlls with LOIISlllllptioll gro\\'th
011(' ('all ass II II\(' lhat 1I\('aSllred nlllSlIlIlptio\l represt'll ts hegillllillg-o(~pcriod
('OIlSlIlIIptioll or I'lld-ol~pl'riod (,OIlSIIIIIPlioll, The lilrtlWr assllmplion leads
Ol\(' to ('orrdatl' IIII' 1'1'1111'11 OVI'I' a Ill'riotl wilh Ihl' ralio of lilt' Iwxt period's

(,OIlSlIlIlptiOillo this pniod's ("OIlSlllllptioll, while tht' lattl'l'asslllllpliolllea<is

Ill\(' 10 rondal(' tht' rl'llIrll 0\'1'1' a period with th(' I'atio of Ihis period's

COIISlllllPlioll to lasl period's ('OIlSI\IIIPlioll. The ronnel' asmlllptioll, which

1\'1' IIS(' hITI', gil'l's a IIllIeh Ilighn ('orrelalioll I)('tw('ell assl'l I"I'I\II'IIS alld
rOllslllllplioll glOwlh ;\I\(I h('lln' a lower risk-'ll'l'rsioll cot'flici('lIt thall lht'
latt .... asslllllpliol1. 7

h'(';'hh- K.llqU)1 h 'lie' "lnIlU'III.' 01.1"('1 Ic'llIllI,alld ('OIlSllIlIllIioll ~ro"'lh \\'Iu:n·as'.'qu~"\nn

(K.'.!.7) n't}lliu', Ihc 1I10IlU'III.' fli iIlIlO\'.lIilll1' ill ritt'.\" ~crit.'s. \';,ria,jull in nJlllli·
llo\\'('\'t', I"t·
lion;11 (',(!C'.-h·d IC'IIII''''' ,1I"I"OII'IIIII(llioll J.!.l"owlh '('t'm~ \u IH' "n;," "Hlmgh tllal 1111' IIIOlllt'lIl'\
01 iUIIU\";llioB' ~lIt· :-.illIlI.U 10 IIII' IIlolll('UI' ot th\' L\\\' St'11t':'\.
't ~IU,'''iI1l,UI. "'klino .•lIltl Silillt'l (1!11't7) 11.111111(' Ilti~ prohlelll ilion' LII dllll~' h~' ;1"i!\IIIIIIIIJ.{
;111 1IIlflc-Ilyilig (OlllllllllJlh-lilllt' lIIodc" .11111 del i\'ill.~ ils illlplic.llicHI"i tOI' liIlH··;t\'('ragc·d lIaLL
8.2. (.'ol/.wlII/Jlion-Basnl Ass!'1 Pricillg with Power Utility

These calculations can be related to the work of Hansen and Jagan-!,

nalhan (1991) in the following way. In the representative-agent model
with power utility, the stochastic discount factor Mt+1 '= 8(Ct+J! C,)-r,
and the log stochastic discount factor 17l,+\ == log(8) - y ACt+t. If we are
willing to make the approximation 111,+ \ ~ Mt+ \ - I, which will be accu-
rate if M,+ \ has a mean close to one and is not too variable, then we have
VarIMt+d ~ Var[ 17l,+il = y2 Varf Ac,+il. Equivalently, the standard devi-
ation oflhe stochaslic discount factor must be approximately the coefficient
of relalive risk aversion times the standard deviation of consumption growth.
Using the Hansen:Jagannathan methodology we found that the standard de-
viation of the stochastic discount factor must be at least 0.33 to fit our annual
stock market data. Since the standard deviation of consumption growth is
0.033, this by itself implies a coefficient of risk aversion of at least 0.33/0.033
= 10. But a coefficient of risk aversion this low is consistent with the data
only if stock returns and consumption are perfectly correlated. If we use
the fact that the empirical correlation is about 0.5, we can use the tighter
volatility bound in equation (fU .15) to double the required standard devi-
ation of the stochastic discount factor and hence double the risk-aversion
coefficient to ahollt 20.

The IliskfTf'l~ Rale Puzzle

One response to the equity premium puzzle is to consider larger values for
the coefficient of relative risk aversion y. Kandel and Stambaugh (1991)
have advocated this.1I However this leads to a second puzzle. Equation
(8.2.5) implies that the unconditional mean riskless interest rate is

(8.2.8)

where Ii is the mean growth rate of consumption. The average riskless in-
Lerest r~\le is determined by three factors. First, the riskless rate is high if
the time preference rate - log.5 is high. Second, the riskless rate is high if
the average consumption growth rate Ii is high, for then the representative
agem has ~\!1 incentive to try to borrow to reduce the discrepancy between
consumption today and in the future. The strength of this effect is inversely
proportional to the elasticity ofintertemporal suhstitution in consumption;
in a power utility model where risk aversion equals the reciprocal of in-
tertemporal substitution, the strength of the effect is directly proportional
to y. Finally. the riskless rate is low if the variance of consumption growth
is high, for then the representative agent has a precautionary motive for

"011,' Il,i~hl Ihillk Ihal illlmsp"Clioll wOllld hl' ",fficil'flIlo rule oul very large vdlue. of y.
Iluwt'wr "-alldd alld S""llhal~h (\!19 I) poilll 0111 Ihal illlrmp"n;on call deliver very different
..slilllal<·s "I' risk a'·.. rsion cJ'·p .. ncJinl( on til(" .il." of Ih .. I.:amlll .. con.idered. Thi. sugge'15 Ihal
introsp,·rtion C;lII ht- mi.,I("ading or th,lt ~cml(' llIort" J.{t"Ilt"ral IIlnclt-1 of utility i~ n("edect.
310 8. /lllerlem/lOral F:'1uilibrillm MotirLf

saving. The strength of this precautionary saving clfect is proportional to

the square of risk aversion, y~.
Given the historical average short-term real interest rate of I.WX" the
historical average consumption growth rate of 1.8%, and the historical av-
erage'standard deviation of consumption growth of 3.3% shown in Table
8.1, a y of 19 implies a discollnt factor li of 1.12; this is greater than Olle,
corresponding to a negative rate of tillle preference. Weil (1989) calls this
the riskJree rate PUllU. Intuitively, the punic is that if investors are extremely
risk-averse (y is large), then with power utility they must also be extremely
unwilling to substitute intertemporally (1{1 is small). Given positiw avnage
consumption growth, a low riskless interest rate and a positive rate of tillle
preference, such investors would have a strong desire to horrow frolll the
future. A low riskless interest rate is possible in equilibrium only ifinvestors
have a negative rate of time preference that reduces their desire to horrow.
Of course, these calculations depend on the exact moments given in Ta-
hie H.I. In some data sets all even larger coefficient of relative risk aVCl"sion
is needed to lit the equity premium: Kandel and Stambaugh (I!J!ll), for
example, consider a risk-aversion coefficient of 29. With risk aversion this
large, the precautionary savings term -y~a;"/2 in equation (H.2.H) n~duces
the equilibrium riskfree rate and so Kandel and Stambaugh C\O not need a
negative rate of time prderence to lit the riskfree rate. A visual impression
'tlf this elTect is given in Figure 8.3, which shows the lIIean stochastic dis-
count factor first decreasing and then increasing as y increases with a fixed
li. Since the riskless interest rate is the reciprocal of the mean stochastic
\discount factor, this implies that the riskless interest rate first illl:I"l'ases and
\then decreases with y. The behavior of the riskless interest rale is always a
:problem for models with high y, however, as the interest rate is extn:mcly
rensitive to the parameters g and a 2 and reasonable values of the interest
ate are achicved only as a knife-edge case when the elfects of g and a~
Imost exactly offset each other. .

r s the Equity Premium Puule a HO/lUst Phenomenon?

other rcsponse to Ihe equity prcmium puzzle is to arg\le Ih<ll it is an
Irtefact of the particular dala set on US stock returns. While we have not
eported standard errors for risk-av{~rsion estimates, careful empirical rc-
earch by Cecchelli, I.am, and Mark (I !)94), Kocheriakota (I 9!Hi), and oth-
rs shows that the data can rc:iect risk-aversion coefficienL~ lower than ahout
o using standard statistical methods. However, the validity or these tl'sL~
ilepends on the characteristics of the data set in which they arc used.
. Rietz (1988) has argued that there may be a /lfSO /lroblem ill these data. A
ileso ptoblem arises when there is a small positive probability of an important
cvent, and investors take this prohahility into account when selling market
prices. If the cvent docs not occllr in a particular sample period, investors
8.2. COI/,I/III1/,/illl/-JJIl.lnl !\.1.11'/l'ririIiK wi/Ii "1111"'1" ('/ili/v :111

ma)" appear to he irratiollal ill the sample. While il Ilia), SCCIII illlplilllsihk
that this cOlild he all important prohlem ill ]()() ycars of data, Rietz (19HH)
arglles that all ('("ollolllic catastrophe thill destro),s '1lmost all stock-lIIarkl'l
vallie Gill be extremely lInlikely all(1 yet have it major depressillg clfect Oil
stock prices.
A related poillt has becnllIade by l\rown, CO('t/manll, alld Ross (199:,).
These authors argue that financial econol\lisL~ rOIl({'lItratc 011 th(~ US st()('k
market precisdy hccause il has surviv(:d alld growlI to \>c("(l1l1e the world's
largest markel. In some other lIIarkt"ls, such as those of Russi,t, illvestors
haw had allthcir wealth expropriated during the last 100 years and so there
is 110 continuous record of market prices; in others, suclt as the Argentille
markct, returns have been so poor that today these Inarkcts 'IIT regarded as
cOlllparatively less important elll('rging markets, If" tltis sllr\'ivorship crfect
is important, estilllates of average US stock returns an' hi,lsed upwards.
Althollgh these points have SOIll(' validity, Ihcy arc IInlikely to he the
wholc explanalion for tlte eqllity premilllll plIl.I.k. The diflinilty with the
RiLll (I ~)HH) arglllllclIl is that it reqllires Ilot ollly all cconolllic catastrophc,
hllt (,Ile which arrccts stock market investors lIlore sniollsly than investors
ill Sh('rHerm (!chI instruments. The Rlissian exalnplc suggests that a (alas-
tropll(: causes vcr)' low returns Oil dehl as well as on equity, ill which rase
lhe peso prohlem affects estimates of lhe average lewis of retllniS hllt lIot
cstilllatcs of tile eqllity premium, Also, there seems 10 he a sllrprisingly I;lrge
equit), premiulI\ not oilly ill lhe last 100 years of US data, hilt also in US data
from e.lrliei" ill the 19th Century as showil hy Siegel (1l)~14) and ill IIat;1 from
other t'o\lntrics as shown hy Call1l'hdi (1!1\l(ih).

Tillll'- Varia/ioll ill J::>:/II'r/ed Asset He/unts IIll1i COII.IIlIII/J/ioll (;,OIo{h

Eqllation (8.25) gives a relation betweell rational expectations of asset re-
turns and rational expectations of COIlSUlllptioll growth. II implies that
expectcd asset returns arc perfectly correlated with expl'ncd cOllsumption
growth, bllt the standard deviatioll of" cXl'eClcd asset retllrns is y timcs as
large as the standard devi;lliOIl of expened constlllll'tion growlh. Equiva-
lerlll)" the slandard deviatioll of expected (onsulI\ptioll growth is J/r = I/y
limes as large as the standard deviatioll of expected asset retuI"Ils.
This suggests all alternative way to estimate y or VI. Ilallsen ,111(1 Sillgle-
ton (I~m:l), followed hy Ilall (1988) alld others. ha\'('l'roposcd illstnllllcntal
variables (IV) regression as a way to approach thc prohklli. If we (Idill(' all
error tcrlll 1)1.1-1 I == I"l.Itl - E,[ri.,111 - y(6./,·!·1 - 1'.,\6/" II), Ihell wc (all
rewrite equatioll (H.25) as a regressioll equatioll,

'i.'+1 = /I,+yl'l.I·HI+llt.lll. (Ii.:!.!')

III gl'neralthe crror Icrlll '11.1+1 will hc ("olTdatcd wit h I cali/cd COIlSlllllptioll
growth so 01.') is lIot all appropriate estilllatiollllJ(,tlHHI. Il00vc\,er '/1.11/ is
,.I'!. .'I, IIIII'I/I'III/J()ml I-.",/Ilililll'i/lll/ M"t!I'!.\

(X,:!, III) '\"" c= r, + VI/i" , + (,,111

Ikllllil l,'iJ ~I-'I.'g\· reg) ,'''lull, y '!l'sl Te,"
(ill'lnll\\I'l\h) /,,, (s'" ,j (H,,:!,~I) (H,':!,IO)

(:OIlIIlU, .. d.d p.tl"'1 O.~7:1 0,11:11 -I.'IH·I -II.IIXH (I,lOli O,O:!H

(I) 11111(111) 10"IX'.) (I.:IIH) ((1.11:1) (II,III).!) (II.:!:',I)

SI"C~ illd,', II,IIXII 0,0:11 .. li.:II;;. -11.100 II.OtIH o.ooi

(I) 111.1)71 ) (O"IX'.) (:•. ·I:!H) (II.I)~II ) (1I.li7:1) to.7W.)
._._-_._-.- ._- ------ ._---_.-
(:11I1II1I1'rci;!1 l'al"'1 1I,:!!)7 O.IO:! -II.~):.:\ -II.IIH II.:!:! I O.t)~) I

(I alld :!) (0.11111)) ((1.1·1:.) (0.!i1'7) (0.1 II~) (O.()()()) (11.1)% )

SI,,, k illd,':I. 0.1 III O.III:! -II.:!:I:. -II.IIOH II. I Of. 1I.0~I7

(I ;(\Id ':!) III. I WI) (0.11'.) ( 1.1;:.0) (11.0:.') (O.W.ti) (II.OT.)

I.ng 1(',11 (011\111111'11011 gl'I\\lh 1.11'" ,lIId .1""1 I "I II 1"1 I trio _In' 1I1('~I'tllcd in ,1111111,11 lIS d;ll.l, I S~~J
III I~f~) I. Tilt' (011111111' IW;IfIt·" ''i-'i,'I''I.lg(· I q~It'"iulI~" H'PIU I Iht' U'! ~I;lti"'tic:.\ .uut ioilll 'igl\ll\.
(,lilt I' l('n'l, 1111114' '·'pl.III.III .. \ \.11 i.lltl,', ill I q~1 ,·, .. iults of n'UUII' ,IIHI (OIl'"IIIPliuli gl 0\\"" 011

ttw in .. \run\\·"". Tht' (011111111\ Iu-.ukd )"', ,lIul VI 1I'Iuln I\\'o-,I;lg(' It'ol,1 "11l;t!"c'!'I ill'llllIll('llIal·
\·;tI i;,hlt,~(I\') c'!'Ililllollt·, II' ,tH' polI.IlIIt'h'l' l' .Hul 1/1 in l(·gn':-.siuH' (K.'L~') ~HHt (K.1.10} I (,:-'P"f-
Ihel\". Tht' (011111111.' 11('.II,,"d "1i.'.,1 (~.:!.!I)" ,lIlIl"Tt'.,1 (H.!!. 10)" repIJl! Iht' J('!. 'lali!'llic~ arul.1l1illt
,ignilirotllft' 'c', ... I, 1I11}w C'\l'l.llI.II'lr~ \";11 i.lbl('!'1 ill f('gn's.,iou:\ ul IV I(').{n·:\~iull n'.'"dtlu,t!" (X.~ H)
alld OC!.IO) UII lilt, It\\lrtUlH'Uh. Th,' ill'" \U\H'llb include' ('jlhe'r uUC' l.lg (ill 10\\'S marked
I), or Oil(' awl I\\'o i;lg' (ill lOW, 11I:lrkc·d I .lIul :!) of 'ht, 1'1'<11 COlllllH'rriallMpc:r rate.', tlH.' n..',\\
C"C1l1'illlllplioll gln\\·th 1;lIc', .lIulllu' log di\"idt'lld-prin' r;,lIio.

11111'01'1('1;11('(1 wilh ;1111' ";11 i;lllks ill Ih(' illf()l'Il1atioll set al time I, llellee allY
lagged ,'al iailltos (orrl'lal('d ",ilh as~l'l rl'lIlI'llS CIII Ill' IIs('d as illSlnlllH'lIts ill
;111 IV 1('gr""iull 10 ('Slilll;II" th!' ,'o!'lIi( i"111 or r<"lati\'(, risk av('rsioll )'.
'\;Ihlc H.~ illllstr;II,'s t",O-\t;lg(' Itoast S'lIl;II'l'S ('stililatioll "I' (H.~.~). III Ihis
1;lltk II\(' ;",,'1 \1'1111'1" ;I\'(' th(' 1(';11 ('ollllll('n'ial pap(T 1';11(' alld n'al stock
H'tllnl 1'1'0111 'Llhk 1'.1, alld ('U"SIIIII)llillll ~r()\\'lh is lIi(' allllttal growth r;ltc
01' n'al IIIHlllttr;lhlt·s alld s,'n'in's nH"ttlllplioll. Thl' illstnlllll'ttts ar(' dlher
OIl(' 1;lg, or 0111' ;11111 tll'O I;lgs, 01' IIII' 1,(,;11 cOlJllllcrl'ial p;tp('r r;lt(', thl' n'al
I'ollsttlllilliott glll\\lh r;I!l', ;11111 Ihl' 11114 divid(,tld-price ratio,
)0'01 ,',II h ;ISS('t ,11111 sl'l 01 ill'tl ttllll'lItS, Ihe t;llIl(' firsl reports the If
sl;lli\lics ;\1111 sigllililaill" ","('Is fOI lirsl-\tage r('gn'ssiolls of III(' ass('t n'ltll'lI
;\1111 (,OIlSttllll'lioll gro\\th rate Ollto III(' illstrllll\(,lIts, 'I'll(' lahl(' th(,11 sholl'S
til(' 1\' ,'slilllat" .. I')' lI'ith ils S(;lllIl;)nl 1'1'101', alld-ill Ih(' ('011111111 h('aded
8.2. COIl.WIIl/ltion-Based Assrt PririllK with I'owrr Utility . "sf

"Test (H.2.9) "-the R2 statistic for a regression of the residual on the in~
strulllents together with the associated significance level of a test of the
over-identifying restrictions of the model. This test is discussed at the end.
of Section A.I of the Appendix. .
Table 8.2 shows strong evidence that the real commercial paper rate is;
forecastahlt', and weaker evidence that the real stock return is forecastable.:
There is very little evidence that consumption growth is forecastable. 9 The i
IV estimates of yare negative rather than positive as implied by the underly-,
ing theory, but they are not significantly different from zero. The overiden-;
tifying restrictions of the model are strongly rejected when the commerciall
paper rate is used as the asset. •
Olle problem with IV estimation of (8.2.9) is that the instruments are
only very weakly correlated with the regressor because consumption growth
is hard to forecast in this data set. Nelson and Startz (1990) have shown
that in this situation asymptotic theory can be a poor guide to inference
in finiw samples; the asymptotic standard error of the coefficient tends
to be too small and the overidentifying restrictions of the model may be
rejected even when it is true. To circumvent this problem. one can reverse
the regression (8.2.9) and estimate

(8.2.10)

If the orthogonality conditions hold, then as we have already discussed the

estimate of 1/1 in (8.2.10) will asymptotically be the reciprocal of the estimate
of y in (8.2.9). In a finite sample, however, if y is large and 1/1 is smaIl then
IV estimates of (8.2.10) will be better behaved than IV estimates of (8.2.9).
In Table 8.2 1/1 is estimated to be negative, like y, but is small and in-
significantly different from zero. The overidentifying restrictions of the
model {"Test (8.2.10)") are not rejected when only I lag ofthe instruments
is used, and they are rejected at the 10% level when 2 lags of the instruments
arc used. Table 8.2 also shows that the residual from the IV regression is
only marginally less forecastable than consumption growth itself. These
results arc not particularly encouraging for the consumption model, but
equally they do not provide strong evidence against the view that investors
have power utility with a very high y (which would explain the equity pre-
mium puzzle) and a correspondingly small 1/1 (which would explain the
unpredictability of consumption growth in the face of predictable asset re-
turns).

"tll poslwar 'l""nerly dala Ih~rc is Slroll~cr cvid~lIce of prediclable Ydfialion in cOllsum~
liOl' ~rowlh. Camphdl alld Mallkiw (I !/!/O) ,how Ihallhis varia lion is associaled wilh predictabl<1
ill(,OIlU- ~r{}wlh. '
· 314 8. 11Itertemporal Equilibrium Models

8.2.2I'ower Utility awl Grllrmliud Method of MOlllrll(.\

So far we have worked with a restrictive loglincar specification and have

discllssed cross-sectional and time-series aspects of the data separately. The
Generalizcd Method ofMomclIL~ (GMM) of Hansen (1982), applied to the
consllmption CAPM by Hansell and Singleton (1982), allows us to estimate
and test the power utility modd without makinp; distrihutional assumptiolls
and without ignoring either dimension of the data. Section A..2 of the
Appendix summarizes the GMM approach, and explains iL~ relation to linear
instrumcntal variables.
When GMM is used to estimate the consumption CAPM with power util-
ity,using the same asset returns and instruments as in Table 8.2 and assuming
white noise errors, the overidentifying restrictions of the model are strongly
rejectcd whenever stocks and commercial paper are included together in
Y the system. The weak evidence against the model in Table 8.2 becomes much
I stronger. This occurs because there is predictable variation ill rxrr.I.1 returns
I on stocks over commercial paper. III Such predictable variation is ruled out
\ by the loglincar homoskedastic model (8.2.5) but could in principle be ex-
\ plained by a heteroskedastic model in which conditional covariances of as-
11
I set returns with consumption are correlated with the forecasting variables.
I The GMM system allows for this possihility, without lineari/.ing the model
or imposing distributional assumptions, so the GMM rejection is powerful
evidence against the standard consumption CA.PM with power utililY.
Faced with this evidence, economists have explored two main directiollS
for research. A first possibility is that market frictions invalidate the standard
consumption CAPM. The measured returns used to test the model lIIay
nol aClually be available lo investors, who llIay face transactio liS costs and
constraints on their ability to borrow or shortsell assets. Market frictiollsllIay
also make aggregate consumption an inadequate proxy for the consllmptioll
of stock market investors. A second possibility is that investors have more
complicated preferences thall the ~implc power specification. We explore
!
each of these possibilities ill the next two sections.

8.3 Market Frictions

We IlOW consider various market frictions that JIIay be relevant for asset
pricing. Ifillvestor~ face transactions CoSL~ or limits on their ahililY to horrow

I"Reran Ihal i/l Chap"" 7 w(' 1'''''''/lI('d ("\'id,'II(',' Ih.1I Ih(' divid('/ld-I'rin' ralio liu'('(a.<ls
('xrcs~~I()(k rt·tllnl~.
The di\;dc·IHI.p,irc ratio is Ollt' (,r,lle illstr\lmenL~ lI~c.'d h('Ic".
11011(' rail understand lhi,'ii hy cOllsidering" h('ll'ro~ked;,t~tic Ver siull of IIH' liIlC.';lI i/c:d lIlodei
(11.:.1.;.) i/l whirh II ... I'"ria/ln" h"",' lillie ,"h.<cripL<. C'llllphdi (I!JI:l7) a"d Ilarv('y (I !JH!I) apply
(;MM HI lIIodel~ of this (n)t" wllifll imp('s(" til<" u'strirtieul thai ,,~s('t r("I'lnl~' rc)l)(lilit)ll.lIl1l(·'lfI~
lire lill('ftf flillfliolls 01" their fonditional !'ic'umcl 1Il0111C.·111.~. We djsclls.~ this \YOI k further in
ehal'lI'" 1:.1.
8.3. I\/(lr/(I'I Frjctj(lll.~

01' sell assets short, thell they l\Iay have ollly ,\ limited ,\hility to exploit the
empirical pallnlls ill relllnls. III SCl'lioll K.:\. I WI' show how this call aher
the basic I Jansen and .J'l!{annatltan (I !)!) I) analysis or Ihe VOI,llility of Ihe
stochastic discount faclor.
The sallie s\)rL~ offricliolls lIIay lI\ake aggr('g<lte COIISlllllptioll all illade-
Cjtlate proxy for the consumption of stock market illV('stors. III Scctioll K.:I.2
we discllss SOllie of the evidence Oil this poill\, alld thell 1(.lIow Camphell
(I!)!l:'a, I!)!}(i) in developill~ a represelltative-agcllt asset pricillg theory ill
which the consumption of the represelltative investor IIlTd 1I0t he ohserwd.
The theory IIses a generalizatioll of power utilily, due to Epsteill and Zin
(l9H9, I!)!ll) and Weil (1989), thal.breaks the lillk I)('tweell risk aversioll
and illlertemporal sllbstitlltion. The !'esldting l1Iodel, ill the spirit of Mer-
Ion (I !17:h) , is a 1Il1litifactor model with restrictions Oil the risk prices of the
factors; hence it call be tesled lIsing the ecollollH'tric methods disclIssed in
Chapter Ii.

8.3.1 Mllrket FrictiollS lind I/Il/l.\/'lljaglllllllllllllll lJound.s

The volatility hounds of Hansen and.lagannathall (I !)!) I), discllssed in Sec-
tion H.I.I, asstlme that investors call freely t raclc in all assets without ill-
cllrring tralls,ll'tions costs alld withollt lill\i\~ltions Oil hOI rowing 1)1' short
sales. These assumptions arc ohviously rather eXtrt'IIIC, hut they have hl'clI
relaxed by I It: alld Modest (19!)!i) alld l.ullnH"r (I !I!H). '11) understand the
approach, note that ifasset j call1lot he sold sllOrt, tlH'lIthc stalldard equality
n~strini\}ll E[ (I + H,,) M,] = I must I... rcpLI<"-.! hy ,\II ill<'<1' ,,'(il>' n·,trinio"

(K3.1)

If the ineCjllality is strict, lhen an investor would like to sell the asset hill is
prel'ellted from doing so by the sllor\saics constrain!. Instead, the investor
holds a lero position ill the assel.
SllOrtsaies constr.\inLS may apply to some assets but not others; if they
apply to ~tll assets, then they Can be interpreted as a .IIJ/lifl/() wIlllmillt, in that
they ensure lhat an investor canllolmake investlllents today th,1l deliver neg-
ative weallh tomorrow. AsslImillg limited li~,bility for all risky assets, so that
the minimum vallie of each assettOIlJOITOW is I.ero, <I portfolio with nOlllleg-
ative weights in every asset also has a minimullJ vallie or {no tomorrow.
Invcstors may also face borrowing nlllstraints that limit their ahility to
sell assels to lillancc cllIIsllmptiolltod~\y. Sill'll c()llstr~\inls ddiver inequality
restrictions of the forlll (H.:~.I) for all raw asset rctul'llS, hut the standard
equality constraint holds for excess rcllll'lls since the investor is frec to short
one asset in order to lake alon~ positioll in another asset.
Shorts~\ks l'ollstraillts call also he used to 111(Hkl proporti()n,\ltr~lllsac­
tiolls costs of the type that Illight re.stllt flllill a hici-,ISk sl'lcaci that elm's not
 X. III/"r/t'm/lllm{ 1~IJII;I;b";1I11/ Ml!tifis

dl'JlI'lId Oil IIII' sill' 01 a Iladl', Whl'lI Ih('l"(' are IrallsaCliolls COSls, Ih(' aflcr-
Irallsanioll-t'oSI Il'tllll1 Oil all ~ISS('t hOIl)!;hl loday and sold IOlllorrow is \lol
Ihl' nl'galil'(, of lilt, ;lfln-lralls;lclioll-COSI r('llim Oil Ihe salll(, ass('1 sold loday
alld houghl had. tOIIlOITO\\', Thl's(' two r('lllrns can 1)(' 11I(';tSllr('<I scpar,lIc1y
alld COlli hOlh hI' illclllded ill Ih(' s('1 of rellirns ir Ihey arc made sul~ierl 10
shollsales n IIlst r;li II ts.
III Ihl' prl'SI'lI("(' 01 shortsaics cOllslrainls, Ihe l'('clOr I'qualily (H.I.H) IS
Il'placed hy allot her I'('ctor 1'(l'lality

wller(' 0 is all IIl1kllOWII \'('("101". 'I'll(' 1II0dd i\llpli(~s variolls Il'slliniom on

o sllch as the rl'slri("lioll Ihal /I, ~ I lill' all i, Volalilily bOUllds call 1I0W
II(' lillllld lill' (,;I("h ifI hy <"IlOmill)!;, slIhjecl 10 11\1' reslrifliollS, Ihe vaillt' or
() thai d(·lil'('I"s thl' loweS( I'ariall("(, for Mt(M). 11(' alld Modl'sl (l~l9!i) lilld
Ikll hy cOlllhillill)!; hOlTowillg rOllslraillls, a r('slriclion Oil II\(' short sale or
Tn'aslll"}' hills, ;11111 ;ISSI'I-spl'cili(" Irallsaclioll cosls Ih('y call greally 1'1:<111('('
Ihe'l'olalility hOlllld Oil Ihe slochaslic dis('ollrll (;I('(or.
This ;llIal),sis is I'xln'lIIl'ly ('ollst'lvalivc illihal 0 is chosl'lI 10 lIIinimize Ihe
I'olalilily hOlllld Wilholll askillg whal IIl1dnlyill)!; 1'<Jllilihlilllll wOllld support
Ihis dlOit't' fill' (J. If Ihl'fl' al(' SIlIlS\;llIlial lJ'allsaniolls COSIS, for examplc,
Ihl'lI (,\'('11 risk-II('lIlral Irad('rs will 1101 sci I 011(' ass('1 10 hlly allolher a\\cl
wilh a highn Iclllrll III1I1'SS IIH' n'lIlrtl dilf('ITlltT cxn'('ds Ihe Irallsaniolls
cosls. 11111 IIII' OIlI'-pl'liod Ir;1I1sanioll cOSIS will nOI 1)(' relevanl if Iraders
call hlly lilt' hi)!;h-n'lllnl assel ;IIHI hold il for lIlall}, periods, or if a Irader
has III'I\' wealth 10 ill\'('sl alld IlIliSt p.IY Ihe COS! of pllrchasin)!; Oll(' assl'l or
lilt' olhel'. Thus tilt' work 01'11(' alld Modesl (19\)!» alltl I.llItll)('r (1~194)
is exploratorv, a war 10 gel a "'lise Ii,,' Ihe ('xtl'lIl 10 which /IIarkel frictiolls
loosell Ihe hOlillds illlplit'd hI' a frit-liolll('ss lIIarke\.
SOliII' allihors ha\'(' tril'e! 10 solvc I'xplicitly liJr Ihl' assel prices Ihal arc
illlpli(,d hy cqllilihlilllll II10dds wilh Irallsacliolls COSls. This is a dinkllit
lask ht'C1IIS(, Irallsacliolls ('osls lIIake Ihe investor's decisioll prohlelll 1'0/11-
paralivd\' illlraclahk I'xccpl ill vcry special cascs (SC(' Davis anti Norman
(1'190». Ai\,;lgMi alld (;nllcr (I~)<l!), Alllihud anc! Mellc!l'Ison (1~)Rti),
COllSt;lIl1illidl's (1~IHli), I lI'aloll alld l.llcas (l!l!lIi), and Vayatlos (l!l~l:) h;IYe
h('gllll 10 1l1;lk(, SIlIl II , pmgn'ss (III Ihis lopic.

S. 1.2 MI/II. I'I ,·j·it/illl/l alltl rI,!!;,t.,I'/"WI/" CIIll.\l/II//l/illll /)(I/a

Th(' )'ej('t'lioll ()1'11lt' slalldard COllSlllllPlioll CAI'M Illay bl' dill' ill parI 10 dif-
linlhil's ill llle;ISIII illg ag)!;rl')~all' cOllsllmlJlion. Thc cOllsumplioll (J\I'M ap-
pli('s loInit' CllllSllllllllilllllllt';ISIII'l'd al a pOill1 ill tillie, hilI lilt' al'aibhle t\;lIa
an' lillll'-a)!;gl('gaft'd alld Illt'asllr('d \\'ilh I'rmr. Wilcox (I !l!l~) dl'scrihes the
s;llllplill)!; pron'dlllrs IIst'lI 10 cOllslrll('\ ('OIlSlIlIIplioll dala, while Crossmall,
li.J. Ma,.kl'l Frictions

Melino. and Shiller (1987) and Wheatley (1988) have tested the
lowing for time-aggregation and measurement error. respectively. N.n,no'hl,,;':':;'
speaking. these data problems can calise asset returnsweighted by measured
marginal utility of consumption. (1 +ll,.1+ 1)i5 (CHI / C1r- Y• to be forecastable '
ill the short run but not the long run. Thus one can allow for such problems
by lagging the instrumenL~ more than one period when testing the mode\.t2
Doing this naturally weakens the evidence against the consumption CAf1,M,
but the model is still rejected at conventional significance levels unless very
long lags are used. t

A Illon~ radical suggestion is that aggregate consumption is not an ad-

equate proxy I<)r the consumption of stock market investors even in t~e
long run. One simple explanation is that there are two types of agents ,in
the economy: constrained agents who are prevented from trading in asSet
markets and simply consume their labor income each period. and uncon-
strained agents. The consumption of the constrained agents is irrelevant:1O
the determinatiOI} of equilibrium asset prices. but it may be a large fraction
of;iggregate consumption. Campbel\ and Mankiw (1990) argue that pre-
dictable variation in consumption growth. correlated with predictable vari-
ation in income growth, suggests an important role for constrained agenr.
while Mankiw and Ze1des (1991) lise panel data to show that the consu~
tion of.slOckholders is more volatile and more highly correlated with the
stock market than the consumption of nonstockholders.
The constrained agents in the above model do not directly influence
asset prices, because they are assumed not to hold or trade financial assets.
Another strand of the literature argues that there may be some investors who
buy and sell stocks for exogenous, perhaps psychological reasons. These
noise traders can inOuence stock prices because other investors. who are
rational utility-maximizers. mllst he indllc'~d 10 accommodate their shifts
in demand. If utility-maximizing investors are risk-averse. then they will
only buy stocks from noise traders who wish to sell if stock prices fall and
expected stock returns rise; conversely they will only sell stocks to noise
traders who wish to buy if stock prices rise and expected stock returns fall.
Campbell and Kyle (1993). Cutler. Poterba. and Summers (1991), DeLong
et al. (1990a. J990b), and Shiller (1984) develop this model in some detail.
The lIIodel implies that rational investors do not hold the market portfolio--
instead they shift in and Ollt of the stock market in response to changing
demand from noise traders-and do not consume aggregate consumption
since sOllie consumption is accounted for by noise traders. This makes the

I~c.ullphdl alld Manl<.iw (1!190) discuss this ill the COil text ofa linearized model. Breeden.
Gihbolls. alld Lillellber!:er (1!lIl!1) make a rdated poim. arglling Ihal al sharI horizons une
shulIl,1 rrplace conslllllplion with Ihe T('lIlrn 011 a portfolio COmlf\lCled 10 be highly Forrelaled
with 101l1:"r-nall IIlOvemellls in colslI"'pti,,". IIraillard. Nelson. alld Shapiro (lWI) filld Ihat
Ih,' cOllsllmption CAPM works heller at 10111: horizons than at short horizons.
 31H 8. J/lIf'l'lempora/ J~ljllilill/illl/l Models

1Il0del hard to test without having detailed information on the investment

strategies of diflerent market participants.
It is also possible that utility-maximizing stock market investors are het-
erogeneous in important ways. If investors arc subject \0 large idiosYllcratic
risks in their Jabor income and can share these risks only indirectly by trading
Va few assets such as stocks and Treasury bills, their individual cOlISumption
Ipaths may be llIuch more volatile than aggregate consulllption. Even ifindi-
Ividual investors have the same power utility functioll, so that any individual's
\consumption growth rate raised to the power -v would be a valid stochastic
:discount faclOr, the aggregate consumption growth rate raised to the power
i-v may not be a valid stochastic discount factorYI Problem H.:~, based on
Mankiw (1986), explores this effect in a simple two-period nlOdd.
\ Recent research has begun 10 explore the empirical relevance of im-
Iperfect risk-sharing for asset pricing. I-Icaton and l.ucas (l9!H;) calibrate
\individual income processes to micro data from the Panel SlIIdy of [ncome
nynarn.ics ([>S[D). Because the [,S[D data show that idiosyncratic incollle
ariation is largely transitory. Heaton and l.ucas lind that investors can rnin-
rnil.e its c1Tects on their consulllption by borrowing and lending. Thlls they

t ind only limited effects on asset pricing unless they restrict borrowing or
SSlime the presence of large transactions costs. Constantinides ami Duffie
(1996) construct a theoreticalmodcl in which idiosyncratic shocks have per-
~I\anellt eflects on income; they show that this type of income risk can have
large effects on asset pricing.
1 Given this evidence, it seems important to develop empirically testable
intertemporal asset pricing models that do not rely so heavily Oil aggregate
consumption data. One approach is to substitute consulllption out of the
consumption CAPM to obtain an asset pricing model that relates mean
returns to co variances with the underlying state variables that determine
consumption. The strategy is to try to characterize the preferences that
an investor would have to have in order to he willing to huy amI hold the
aggregate wealth portfolio. without necessarily assuming that this investor
also consumes aggregate COlISlllllption.
There are several classic asset pricin~ models of this type set in con-
tinuous time. most notably Cox, In~erso\l. and Ross (I 9H5a) and Merton
( I973a). But those models arc hard to work with empirically. Campbell
(1993a) suggests a simple way to get an empirically tractable discrete-time

I:I-n;i, i, an example ol.le",(',,·, 1"'·'I"alil),. Si"n' """l:i"allllilily is "o"li,,('ar. Ih .. average

01 in\'l'stor~' marKillalllti1iti(~s
of (OtlMIIHPliou is 1I0t gt'IH'I";'llIy the same as the marKilial utility
"r ;I\'('r"gc (omumptio". Thi, prohl"111 <iis"!'!"'ars wll,'" investors' individual fonSlllIlptioll
sttf';un~ l\ft" perfectly correlatrci with OIH' ""other ~\S they will he in f\ (omp\t·tt" nlj" kl'\S st·ttinv;.
(;ro~~man ~lIl(l Shiller (I YH~) P(,illl (Hit liial it also (Ii~"lpp(·an in a contin'IOtl~litnc model wilen
Ill(" prufe~~r.~ for individual fOIl.'iillll1priou MrC'am~ and a. . .O\(·( prirr~ .Ire.- c1in1.l~ion~.
8.3. lV/fir/wI Joiidiul/J 319

1II0d<:l IlsillJ.; lhe lIlilily spedlit-'llioll (il-vdopcd hy I·:.l.~lt'ill "nd Zin (!!IH!l,
I !l!) I) ;llld Weil (19H!), which wl' 1I0W Sll III III <I ri I.C •

SI'/)(lIl1lil/~ Hi.l/i Allt'niull tllUl/lllnlt'm/JOml SUI'.llilulioll

Epsteill, Zill, alld Weil build 011 the approadl of Kreps .1IId l'orll~llS (I !)7H) 10
devclop a IlJOIT lIexible version oflhc basic power IItilil)' llIodel. ThaI model
is re.,lrinil'c ill Ihal il makes the elasticily of illtl'rlelllIH)r,d slibslitlilioll, V',
the reci procal o/"lhe coerticielll o/" relalivc risk aV('I"sioll, V. Yel it is 1101 (kar
thaI Ihese lwo COllcepts should he lillked so liJ.;htly. Risk 'lV('lsion dl'snilws
Ihe (OIlSlllllcr's reluClallC<: to sllhslillll(' (,OIISlllllplioll "noss sl,l\l'S of IIIl'
world .111(1 is meanill).;ful even III all all~l\\p()l<ll setlillg, whl'l'l',\s Ihe daslIrily
of illlClll'lllporal sllbstitutioll descrihl's Ihe cOnSIIII\\'r's willinglless It> slll~
stilllll' COlISlll11plion over li\l\l' alld is \\\l',lllillghd ,'\"'11 ill <I dch"rmillislic
seltill).;. The EPSll'ill-Zin-Wcillllodc\ \"l'laills mall)' oilhe allraLlive fealures
of po\\'t:r IItilily hm breaks Ihe link hetw(,(,1l Ih" p"r,\Il\I'tITs V and",.
Thl' Epsteill-Zin-Wcillll~jective fllilnioll is dl'lillnl \"l'\msivcly hy

f;
lJ, = {
(I - 8)('~" -/-.5
' r
(I':, [(/'\'-1)' I)"
! }
(H.3.3)

where Ii == (I - y) / (I - 1/ if!), Whell II =

I Ihe I<TIIISioll (H.:I.:\) hl'COIIH'S
lillear; il COlll thcli hc solved flJrw<lrcl 10 yield lhl' LUlliliar lime-separahle
power lItilily model.
The illt('rlellJporal budget CUllslrainl jill' a rqJr('sclllaliv(' ag(,1l1 can be
wrill('n as
(H.~.4)

wherc j,\~+l is the represel1tative agenl's weallh, and (I + f{m.l> dis Ihe relurn
on Ihe "market" portfoliu of all inVl'Sled weallh. This I'orin of Ihe bndgel
conslraitll is appropriate fur a complele-markets model in whidl wcallh
includes human G\pilal as well as financial asselS. Epslein allli Zin Ilse
a complicaled dynamic progralllmil1J.; "'Wlmenl 10 sh()w Ihal (H.3.:\) ,\\HI
(H.3A) together imply an ElIler eqllalion of Ihl' fonnl-l

1=1':,
('. - i
(j(~)
}II {·----l
1 I-II (I -/-{{,.I;I)
] .
[{ (., (I -/- {{m./lI)

lfwc aSSIIIIle Ihat assel returns a 11<1 COIlSulIlplion ,Ire h()lJIoskcd<lSlic <lnd
jointly logllol'lIl<lI, Ihl'lI Ihis illlplies Ih<ll lh(' riskless 1'(';11 illl('Jesl r<ltl' is

II - I ~ II .> I.
1'/.,+1 = -log8+--n --·_-o--j-I··,II\(,tll. (H.:l.li)
~ III 'lV''!. I VI

HTIH'\"(' ;\n: in Lin typos in t'()u;\\ioi\s (let) lhltHlgh (1~) 1)1 Fp:-'ldu ;Ulll/.iH (I~.~)J) ""hirh
f.(iv(' illh'I"III('<ii;ll(" slt'p., ill liIe cI(', i\'aliotl.
 H. /1I(n(I'III//O,.(/1 /':" II ilil"i II III All/dl'ls

'I'll<' pn'miulIl 011 rish assels. illclll(\ing II\(' mark('1 portfolio ilst'lf, is

.,
er-
E,I 1;,/111 - ',','ll + --'-
~
o a"
V; + (I - O)a,.,. (lU,7)

This says Ihal Ihe risk pr('Jllilllll 011 ass!'1 i is a wcigh\('(\ comhinalion of
assel i's co\'arialll,(, wilh ('OIlSUlllplioli growth (divided by Ihe (,Iasticity orill-
Il'I'l(,lIIporal SUhslilulioli 1/1) alld ass('l i's covariance wilh th(' markel re\llrn.
Th!' weighls al'l' /I and I - {/ resp!'('li\'('ly. The Epsldn-Zill-Wdllnodd Ihus
lI!'sls Ih!' conslllll(>lioli CAPl\l wilh power Illilily (0 = I) alld th!' Iradiliollal
SIalic CAPM (1/ == OJ,
It is 1t'lIIpting 10 USt' (H.:I.7) logetlrer with ohsC\'wd dala Oil aggrq~al('
l'IllISlIlIIplion and slock lIIark!'1 relnrns 10 estimale 0111(\ test Ihe Epslein-
Zill-Wcil IIlw\el. Fps\('ill ;\IId Zill (HI!l1) reporl results Ihis type. In a or
similar spiril. Ciovallnilli and Wei! (!9H9) lise the 1II()(ld 10 rl'inlerprel the
results 01 Mankiw and Shapiro (I !IH(;). who found Ihal h!'las wilL the lIIarkel
ha\,,' greal!'r I'xplanalon' pow(')' (1I' Ih!' cross-seclion,1I pailI'm or rellirns
Ihan do Iwtas wilh consllinplioll; Ihis is ('onsistent wilh a vahll' or (} dose
10 11'1'0. Ilow("'('r Ihis I' 1'0 ('I' d II 1'1' ignorl's Ihl' (;1('\ Ihal Ihe inlt·rt(·IIIJloral
hlldgt'l cOllstr;tinl (H.:I.·I) .dso lillks ('onslllll(lIioll alld llIarkl'l lellirns. \Ve
now show lhal lhl' hlU(g('1 (,(JIlsIl'ailll ('all II(' usecllo sllhstilllle consulllption
(lut (l11\1(' ;ISSI'I pril'illg 111I)(kl.

SItb.\lillllil/~ (.'111/11I1II/J/io/l O/lIIl/liJl' M,"11'1

Call1phell (It}~l:tl) POilllS 0\11 thaI one ('an loglillearize Ihe illl(,),It'll'poral
hudg('1 cOllsllaillt (H.:I.·I) arolllld Ihe lIIeall log ('OIlSUIll(llioll-weallh !"tlio
loohlaill

t\ "'/I I "" r",-, t I -1 Ii I· (I - ~) «(, - "',). (H,:I.H)

wi II' II' fI == I .-, <'xp(;:-:--U;) alld Ii is a ('OIlSI;UII Ihal plays no role ill what
()lIows, (;olllhilling Ihiswilh III(' tri\'ial ('qualiIY t.1II1-11 == t.('I~1 - t.(t',+I-
11', I_I J. soh'ill)!; tilt' rt'silltillg dilf('l'cII(,(, <'qllatioll forward. alld lakillg ('xP('c-

latiolls. WI' ('all wril!' Ilw luul)!;t'I (,oll~lrailll ill lhe limll

. [~ , .
I., L...-/l (l",,II,- t;I,+,)
1-- 1
'J +~.
(III
P
(H.:'-!l)

This <'qu;llioll ,~a\'s Ihal i1111!' ('OllSlllllplioll-W('alth ralio is high. Ihl'II lire
a)!;CIII IIIlIsI I'XP('('( eithn hiV;h r('llIl'Ils Oil w('alth ill Ihe fill III'(' or low ('011-
SlIlIlptioll growlh ratt's, This Itlllowsjllsl frolll tilt· approxilllale hudgel ('011-
sl rai III wilholl t i1\1 posi II~ a II\' Iwiravior;t1 aSSll1ll pI iOllS, II is di rl'cll), allalogolls
H.3. Markl'l Frictions

to the linearized formula for the log dividend-price ratio in Chapter 7. Here
wealth can be thought of as an asset that pays consumption as its dividend.l~
If we now combine the budget constraint (8.3.9) with the loglinear Euler
equations for the Epstein-Zin-Weilmodel, (8.3.6) and (8.3.7), we obtain a
closed-form solution for consumption relative to wealth:

C( - WI = (l - 1/I)E I
[ ~.
L
J~I
pl r,n.l+i
]
+ p(kI -_ 11m)
p . (8.3.10)

HereJ~ on is a constant related to the conditional variances of consump-

tion ~rowth and the market portfolio return. The log consumption-wealth
ratio is a constant. plus (l - 1/1) times the discounted value of expected
future returns on invested wealLh. If 1/1 is less than one, the consumer
is reluctant to substitute intertemporally and the income effect of higher
retUrFlS <Iominates the substitution effect, raising today's consumption rel-
ative to wealth. If 1/1 is greater than one. the substitution effect dominates
and the consumption-wealth ratio falls when expected returns rise, Thus
(8.3.10) extends to a dynamic context the classic comparative statics results
of Samtwlson (1969).
(8.~.I·O) illlplies that the innovation in consumption is

cl+I-E,[c,+tl :::: r m.,+1 - E,[rm.,+tl (8.3.l1)

+ (1-1/1) (EI+I[~pjr"'I+I+j]-EI [~pjrm'l+l+j])'

An unexpected return on invcsted wealth has a onc-foHme effect on con- .
surnption. no matter what the parametcrs of the utility function: This fo)-
lows from the scale independence of the objective function (8.3.3). An
increase in expected future returns raises or lowers consumption depend- :
ing 011 whether 1/1 is greater or less than one. Equation (8.3.11) also shows'
when consumption will be smoother than the return on the market. When ·1
the market return is mean-reverting. there is a negative correlation between .
current returns and revisions in expectations offuture returns. This reduces
the variability of consumption growth if the elasticity of intertemporal sub- I
Stitlltioll 1/1 is less than one bllt amplifies it if 1ft is greater than one.
j':C)1I3tion (8.3.) 1) implies that the covariance of any asset return with
consumption growth can be rewritten in terms of covariances with the re-

1"Cunphdl (1\19:~ .. ) and Camphell and Koo (1990) ~xpl()re the accuracy or the loglinear
apprnXill\;lIioll ill Ihis (onlext hy comparin)( the approximate analytical ."IUlion for optimal
consumplion wilh a numeric;" solulion. In an eX"tnpl" c;"ihr~led 10 US Mod, market dala,
Ih,' Iwo SOlllliolls "re close lO)(ether provided Ihal Ihe inveslor's elasticity of intertempor.1I
WhslilUlioll is It's, than "hullt :t
1322 II. 11I11'I'll'lllpom/I:'l/ui/iIJll/t1l/ Models
I
\
illlfll on lhe market and revisions ill expectations of fllllln' retllnts on the
Imarket:

(H.:~.! ~)
I
!where

~'I' == Cov, [ri.'+l, E,+l [tPI -E, [fpJ

r",.I+I+J] (8.3.13)
1'",.1+1+ / ]]'
I 1=1 1=1

fIll is dermed to be the cOV<lrialll:e o\' the return on ;lsset i with "news"
r,bout future returns Oil the ll\',lrkd, i.e., revisions in expected future re-
~urns.
I Substituting (8.:1.12) into (tel.7) and using the definition o\'O in terms
pr the underlying parameters a all(! Y, we obtain a cross-sectional asset
pricing rormu!a that makes no reference to consumption:

1-.,' [ ri.,+d - I'}.I+1 2"' : : :

+ 0, YO'IIl + (y - 1)0,,,. (8.:U4)

Equation (8.3.14) has several striking features. First, assets can he priced
without direct reference to their covariance with consulIlption growth, us-
ing instead their covariances with the return on invested wealth and with
news about future returns on invested wealth. This is a discretc-time ana-
logue of Merton 's (1973a) continuous-time model in which assets arc priced
using their covariances with certain hedge /J{)rtjo/ios that index changes in the
investment opportunity set.
Second, the only paramcter of the lIlility function that enters (8.3.14)
is the coefficient of relative risk aversion y. The elasticity or intertelllpora!
substitution", docs not appear once consumption has been substituted out
of the model. This is in striking contrast with the important roll' played by
'" in the consumption-based Euler equation (8.3.7), Intuitively, this result
comes from the fact that", plays two roles in the theory. A low value of
'" rcduccs anticipated /IuCluations in consumption, but it also increases
the risk prcmiulIl required to compensate for any contriblllion to these
/Il1ctu,\tions. These offsetting efi'cns lead", to cancel out of the ;Isset-hased
pricing formula (8.3.14).
Third, (8.3.14) expresses the risk premiulII, netoftheJenscn's Inequal-
ity a<ljustrJlcnt, as a weighted SIIlIl of two terms. Thc first term is the assct's
covariancc with the market portfolio; the weight on this term is the coefli-
cicnt of relativc risk aversion y. Thc sccond term is the assct's covariance
with ncws about future returns Oil the market; this rcceives" weight of y - 1.
When y is less than one, assets that do well when there is good news about
future retufIls 0\1 the market haw lower mean returns, bllt when y is gr('ater
,)
Ii,}, Mil/III'! i'iirlio/ls

than one, such assets have higher Illean n'tUrllS, The intuitive explanation
is that such assets are desirable hecause thcy ('nahl(' the CllilsunHT to profit
from illlprovcd invcstmellt opportunities, hut undl'sirahle hl'clllse they n'-
ducc the cOllsumer's ability to hedge against a deterioration in investment
opp()r\lIlli\ie~, Whe,1l Y < 1 the form('l' cfkCl dOlllinates, and consumCl"s
arc wiUing to acrept a lower return in order 10 hold aSSI'Is Ihal pay on'when
wealth is most productive. When y > I the laller dkct dominates, and
consulllers requin' a higher return to hold sudl "ssl'ls.
There are several possible cirnlmst,llHTS Ilnder which assets Gill he
priceriusing only their covariances with the returll Oil the Illarket portfolio,
as in the logarithmic version of the static CAI'M. These cases have heen dis-
cmsed illllw lileralure Oil inlerll'mporal asset pr'lcing, but (H.:t I 'I) makes it
particularly easy to undersland Ihelll. Firsl, if the cod'licicnt of reialiVl' risk
aversion y == I. then the opposing efkcts of covariance wilh inveslment
opportunities cancel out so thaI only covariance with the market relurn is
rclcvalll for asset pricing. Second, if the in\'eSllll('Il! opportunity set is con-
stant, then 0/" is zero for all asseL~, w again assets CUI be priced using only
theil covariances wilh Ihe markel reI 11m. Third, if Ihe relurn on Ihe market
fo\lO\;s a univariate stochastic process, Ihen news about future rdurns is per-
ICCII), correlated with the currenl return; thus, covariance with the (,\IITl'lIt
retlll'Jl is a slIfficiellt statistic fill' covarialll,!, with lICWS ahout luture returns
and l',Ul he uSl'd 10 price all assets. Camphell (I !)!)(;a) aq';lIl's Ihat the lirsl
Iwo caSl'S do 1101 Ill-scribe US data evell approxim;lIcl)', hilI Ihat Ihe third
case is !'Illpiricall)' relevall!.

A 'Iliin/ I.oo/i (lllflr 1:'ljuilJ I'rPllliulIIl'uulr

(H.3.11) (,;,11 he applied to the risk premiulll Oil the ,"ark!'t itself. Whell i =
111, we gel

When the markel relllrn is unforec;tstahlc, Ih(')'c are 110 revisions of ex pet'-
lalions ill futllre retllrns, so a/I/I, == O. In Ihis case tl,(' l'<Jllity premium wilh
theJensen's InequalilY a<ljustmenl isjust ya;" and the coefficienl ofrclalive
risk aversiOll Gill he eSlimated ill llw m;lllll(~r (If Friclld and mume (1!17:»
by taking the ratio of Ihe equily premilllll to the variance of the markel
rellll'll. Using the Illllllbers from 'I:thle H,I, Ihe estimale of risk aversion is
O.0!'>7!i/O.031;, = I.H2H. This is the risk-avcrsion coefficient of an investor
with power utility whose wealth is entirely illvested ill a portf(>lio wilh all
unforecastable rctunt, a risk premium of :,.7;>% per ),ear, ;lIld a variallce
of ().():~ l:i (st,tlldard deviatioll of 17.71';;, per ycar). The ('onsulliptioll of
wcll 'Ill illVl'stor would .liso haV!' a st;I111\;1I<1 dl'Vi;ltioll of 17.7'1'1" pCI' year,
This is Ell' ~realcr thall the \'obtility olllH'asull'd ag~rl'gall' (OIlSIIIllPlioll ill
 8. l"I""/~IIII)(jmll':if"ili/J/'illl/ M()(I~/.\

'nIhIl' H.I, which ('xplaills \\'h)' the risk-aversioll ('slilllal(' is 1I111ch lower than
Ihe ('OIlSUllIllIiofl-hased eSlilllal('s discussed earlier.
The Frielld ;11\11 BllIllll' ( I ~17!) procedlll'e call hI' sniollsly misleading if
Ihe 11I;1I1el relum is sl'I'i;t1ly co ....ebled. If high stock felurns are associaleci
with dowllward rl'\'i~iolls ofhtt\l\'(' retllrns, for l'xamplt·, thell a .." is lIegativc
ill (H.:I.I !I). With y > I, Illis rl'dlln's 111(' equity risk prellliulII associaled
willi all}' 1('\'1'1 01 Y alld illCrl';ISes Ih(' risk-aversioll coefficiellt lIeeded to
l'xplail\ a givel\ eqllit)' pn·lIIilllll. 1I\IIIitively, whel\ alii" < II Ihe IOllg-rlIn
risk of slock Illarkl'l illvcstllll'lIt is less Ihall Ihe short-rull risk hccause the
market t('lIds to 1l1eall-i'l·\·(·rl. IlIv('stors wilh high y Gln~ aholll long-mn risk
r"lhn Ihall shorHlI1l risk, so Ihl' Frielld alld Hhlllll' calrlliatiol\ oV('rst.llC5
risk and rOIT('spOlulil\gly tJlIt1t-rst;II('s Ihe risk aVl'rsioll Iwededtojllstify lhl'
('(Illity pn·lIIilllll.
Camplll'lI (I!)!ltia) sllows Ihal Ihe estimated coefficielll or relative risk
aversioll rises hy a bClOr of 1('11 or 1l10re if one allows fill' the empirically cs-
tilll"ted degree of 1I1(';1l1-rt'\'('rsioll ill postwar monthly US dala. III long-run
allllllal US data tile dlc('( is less dralllatic hilt still goes ill the same direrlion.
(:alllplll'lI also shows Ikl\ risk-awrsioll eSlilllates illcrcasl' if olle allows for
hlllllall capilal as a COII1JlOIIt'lIt of I\'(·allh. In Ihis seIlS(~ onl' can clerive Ihe
e'lllil), pn'lllilllll JllIlI.k withollt ;IIIY din'('( n:krellcl' 10 cOllslImption data.

till J..'quilibriwl/ II luI/ifill/or ..t.l.l~/I),'i(illg Model

Wilh a few IllOIT aSSlIllIptiollS, PCI.I 'I) can he IISl'c\ to c\t'rive all t'f)lIilihrilllll
IIllllrif;I('lor ;lss('1 pricillg Illodel of tilt' lyP(' discussed in Chapter Ii. We wrile
tht' I'('tlll'll 011 lIlt' markt·t as tIll' lirstl·I(·I\lt'lIl or" K-clcllll'1l1 state vecto;' x,+ I.
Tht' othn dt'IIH'nts an' v;lriahks that an' knowll to the market hy the ,lid
ofpt'riotl/+ I alld arc rt'h'\'allt "H'II,n'casting I'll till"(' r('turlls on tht' lIlarket.
W(' asslll\l(' that tht' \'('("\01' XIII (,,!lows a first-ordt'r v('('\or .\Il1on·grt'ssioll
(VAR):

Ax, + I' ttl. UU.I()

Tht' asslullplioll that tIll' "AR is lirst-ordn is nol rt'slriniw, sinn' a highn-
onk!' VAR 1'0111 ;Ih,'al's ht' stack('d into lirst-onll'r form.
N('xt 1\'(' ddilll' :1 ,,'·1'1('111('111 v('('tor cl, whost' first ('lellll'lIt is Ollt' alltl
whost' olht'r dl'IlH'llls an' :111 /1'1'11. This Vl'l'lor picks OUI Iht' n'al slock re-
turn r""/t I frolH lilt' \'('('101' XIII: "III,1t I =:: el'x/+I, and r",.I+1 - E, rm,l+1 =:::
d'(III. Th(' li ..,t-lIllln VAR gCllnat('s simple lI\lIltipt'riod fim'l'asts of fu-
1111'1' n'llIrns:

F,l/m./1 I I ,I (i·U.li)
8.3. Markrt Frictions

It follows that the discounted sum of revisions in forecast returns can beI
wriuen as
00

== el'LpiAiE/+t
J=I

(8.3.18)

where t.p' is defined to equal e l' pA(I - pAl -I, a nonlinear function of the
VAR coefficients. The clements of the vector t.p measure the importance of
each state variahle in forecasting future returns on the market. Ifa particular
element IPk is large and positive, then a shock to variable k is an important
piece of good news about future investment opportunities.
We' \lOW define
(8.3.19)
where ( •. 1+1 is the ktll element of (1+1. Since the first element of the state
vector is the return on the market, ail :::= aim. Then (8.3.14) implies that
. 2 K
E1[rj.I+!l- Tj.I+1 = - a~ + yail + (y - I ) LIPkO'ik, (8:3.20)
k=l

where 'PM is the kth element of t.p. This is a standard K-factor asset pricing
model of the type discussed in Chapter 6. The contribution of the intertem-
poral optimization problem is a set of restrictions on the risk prices of the
factors. The first factor (the innovation in the market return) has a risk
price of AI :::= Y + (y - I )ipl. The sign of ipl is the sign of the correlation
between market return innovations and revisions in expected future market
returns. As we have already discussed, this sign affeclS the risk price of the
market factor; with a negative !PI, for example, the market factor risk price
is reduCt·d if y is greater than one. •
The other factors in this model have risk prices of AA = (y - 1)rpk
for k > I. Factors here are innovations in variables that help to forecast
the return on the market, and their risk prices are proportional to their
forecasting illiportance as measured by the elements of the vector t.p. If a
particular variable has a positive value of IP., this means that innovations in ;
that variable arc associated with good news about future investment oppor- ;
tunities. Such a variable will have a negative risk price if the coefficient of .
relative risk aversion y is less than one, and a positive risk price ify is greater
than OIlC.
Campbell (I99(b) estimates this model on long-term annual and post-
World War IIl110llthly US stock market data. He estimates CPI to be negative
and lar~(' ill absolute value. so that the price of stock market risk At is much
 32& H. JlItl'rtelllIJOral/~qllilill1"i1l1ll Models

smaller than the cocfliciclIl of risk aversion y. The other ('"ctors

ill the
model have imprecisely estimate d risk prices. Althoug h some of
these risk
prices are substant ial ill magnitu dc, the other filClOrs have minor
effects on
the lTIean returns of the assets in the SlIIUY, because thcsc asscts
typically
have slllall covarian ces with the other factors.

8.4 More Genera l Utility Functio ns

One str,ligin forward rcspol1se to the difliclIlties of thc stami<lnl

COlISlll1\p-
tioll CAPM is to gellcl'alil.c thc utility function . We have alrcady
discusse d
the Epstein-Zin-Weil Illodel, hilt there arc othcr plausibl c ways to
vary the
utility spccific ation whilc rctainin g thc attractiv e scale-in dcpcnde
llce prop-
erty of power utility.
For example , the utility function \\lay he nonsepa rable ill COIlMlll
lptioll
alld SOIllC other good. This is easy to handle ill a loglinea r model
if utility is
Cobb-Douglas, so that the margina l utility of consum ption can bc
written as

(!:IA.l)
for sOlTle good X, and paral\le ter y~. The Euler equatiol l 1I0W h(,(,0111(, 5

1 T, I (XI+I)-
= \"1. [ (I + H',I.e I}/) ((;I+I)-Y X, Yt} ,
Assumi ngjoint lognorm ality and hOl\loskedasticity, thi~ call he wrillcll as

(H.4,3)
Eichenb aum, Hansell, and Singleto ll (I !JHH) have cOllsidercd a Illodel
of this
form where X, is leisure. A~challer (I!lH!'J) and Stanz (19H9) have dcvelop
ed
models in which X, is governm ent spendinp; and the stock of dllrilhlc
)!;oods,.
respectively. Unfortu nalely, nOJ\(~ of these extra variables greatly
improve
the ability of the consum ption CAI'M to fit the data. Thc difflcuh
y is that,
at least in data since World War II, these variable s arc not noisy cllough
to
have much effect on the illtencll lponil llIarginal rale of suhsl itllli()II,I
';

'I . lI.4, I If (I{,il JoimlialioH ,

/A llIore promisi ng varialio n of tIll' hasic 1II\;dd is to allow for nOllscpa
rahil- '
lity ill utility ovcr time. COI\Sl',II\\illilk~ (I ~l~lO) and S\\lIdal"l~san (I
~lH~l) have
i
I ,"'Aho: a~ Call1phdl ;111<1 Mankiw (t<l<lO) poilll 0111. ill J>o~lwar dala,lh""
"i' pn'dicl,\"I~
\larlatiOIl til COn~lIll1ptlOll Krt,wlh th~lt IS unCOITt+.\ lt.'d
Wllh pH'(hctahlc V'U"I;,l1um III n';'llll1t("rc~l
nll("~("v("n aft«"r Ollt" allow~ for pn'diClahlt' variation
ilildstlrt', ROV('rlllllt 'nl ~p(·'HIiIiR. or <lun\hle
g()()(15.
\
8.-/. 1',,1011' (;l'llmtlUtiiify I'itllftillll,~

"rgllcd fil!' the illlportall<T of /wbil./ill'll/fllioll, a positivI' dl<:l'l of today's (,(1II-

slllllption on tomorrow's III a I'/-:i nOli utility of COIISIIlIlj>tiOlI. I len' we discuss
SOIlll' sill1ple ways to iJllplellH'lIt this id!'a,
S('\'!,!,,11 Illoddillg bsues arise at the outset. Wc write the period util-

ity fUllctioll as U(C" X,). wlwre X, is the lilll('-v'lryillg hahit or sllhsistenn'

lI'Vl'l. Till' first isslle is till' fUllctional /(11111 fiJ!' li(,), Ahel (I!I!IO. 199G) has
propos!'d thai [/(.) should he a pow('/' fllnction Or the ratio C,;X,. while
Call1plwll and Cochralle (I !l9!i). COllstalllillicles (I !I!IO). allcl SlIlHlaresall
(19l')~) have IIscd ,I power fllllrtioll of th!' dilf!'!'!'II("(, (;,-- X" The sc(ollcl
isslle is lhe cfli.'rl of all a/-:ellt's OWII dl'(isiolls 011 1'111111'(' levcls of hahit. III
stanclard illll'/'Ilfl/-/wbillllodcls sllch as thos!' ill COllslalltillidcs (1!)!IO) and
SUlldarcsall (I !)H!). hahit depcllds Oil all ag!'llt \ OWIl I'onslllllillioll alld
the agl'lIt takes aCcollllt of this whell choosillg ho\\' IllllCh to COIISUIllC. III
/'xtl'flllIl-lwbitIllOdcls sllch as Ihose ill Abcl (19!)O. I!)!lti) allel Caillphell 011111
Co(i1raIlC (I!)!)!i). habit depellds Oil aggrq~atc (OIlSlltllptioll whit-h is IIl1al~
I(-t:ted hy allY Oil(' agclIl's decisiolls. AI)('I calls this ""I(hill~ "/, It,itlr flrr jUllf,lrJ.
TLe Ihird isslle is Ihe speed wilh whirh hahit r!'a('ls to illdividllal or aggre-
gall' (OIlSlIllIplioll. Ahel (1990, l!l!lti). DIIIlIl allc\ SillgletOIl (I!)H(). alld
Fersol1 ,1I1d Constall\inides (I !l!ll) llIake habit dqwlld Oil OIlC lag of rUIl-
SUIII pliOll, whercas Constantinides (I !)!H), SlInclan'san (I !)H!I), Camphell
alld (:ocilr,III!' (I !)!):,), and l\catoll (I !)!):)) IlIak!' kliJil r!'a('( onl), gradually
to Ch'llIgCS ill COIlSlllliptioll.

/{alio Motll'!.l
FolltJI"illg AI)('I (I!I!IO, I!)!)(;). suppose' Ih,ll .111 .Igelll', IIlilil)' (,III Ill' wlillell
as a power functioll of lhe ralio Ci / XI.

,~ «(.i~I/X'I-,)I-y ,- I
li, = J~,L.-lil (HA,'O
/=(1 1- Y

where X, sllllllliarill's the inlluell!T of pasl nlllSUlIllJlioll levels Oil toclay's

utilit\', X, rail he specified ,IS all ill\el'llal hahit or as .UI l'xll'lllal hahit. Usilll!;
Olll' Llg of COIISlllllptioll for silllplicity, we 111,1)' il,I\'('

x, = (;;"

the ill Il'I'lI;lI-hahi I specificatioll whn!' ,III agellt's oWIi pasl (,OIISlIlIIllIiolllllat-

x, = f; I' (HA.(;)

lhl' ('xtl'l'lI'll-h'lilil spnilk'ltioll whn\' aggrcg'I\(, p.IS\ ('omulIlptioll (;1_1

mailers. Sillcl' thnc is a represelltati\'(' agellt, ill l'qllilihrillill the a~ell\'s
COIISllllljJlioli IIlIlSt ofrours(' c(l',al ,Iggrq~at(' (OIlSIIIIIPlioll, hilI th!' IWo li)l'-
JIllllatiolis yield difkn'llI \-:1111'1' (''1l1aliolls. III hOlh l''1l1'lliollS the p'lraml'll'"
/( go\'('J'I)s Ihl' <ll'greT or tillle-llollseparahility.
 I 8, 1111/'1'11'111/101111 fl/II ililll'i II 11/ '\/Odr/I

\ III Ih(' ililn lI.tI-It'lhil sl'e(itic alioll, lilt' dcriv.lli oll of lilt' EIII('\'
I "«II,lIio ll
is cOlllplic lI('d hI' til(' bCI Ih'lI lillie-I COllSlllllPlioll an,'('[s Ihl'
! slIlllllla lioll ill
(H"I.,I) Ihroll~1t tilt' 1('1'111 dall'd I -I- I as w"'l <IS IIII' It'l'lll (bll'lI/,
I
I
WI' ha\'1'

This is r"lIdolll al lilllt' 1 h('c<llIs(' il d"pellti s 011 ('(msllll lplioll

al lilli" 1+ I.
SUilSlill llilig ill 1'01 X/ alld illiposil lg Ihe cOlldilio ll Ihal Ihl' ag('lll's
OWII COIl-
Slllllptio ll "(I",lls aggrl'ga lt' COIISIIl\lplioll, this h,'('OIIl(' S

'11'/'1(' - (~fJ' .11(,·r r .("'I)'-I l(,-y(,

•
, " '/ -- '/ .. 1 /(')
, , - - uk '/ 'ttl 'ttl '/' (fU,fI)

If Ihis IIHul,,1 is 10 caplllrl' Ihe idl'a of hahil formatio ll,

J
Ihl'lI \\'(' Ill'('d
K(Y - I) ~ 0 to ('l\Slln' Ihal all illcrl'ase ill yeslerda y's COIISlllllplioll
in-
rn'"s,'s IllI' margina l lllilil)' or COllSlllllPlioll Imlay, TIlt' ElIll'f (,(Jllatio
ll .. an
no", he wrill,'11 as

I UU,!l)

I
\\'1\1'1'1' Ihe I'XIH'l'I'lliolis operalo r Oil Ihe II'f'I-halid side is IH'('('SS'
Il, Iweallse
of Ihl' r,lIldolllllt'SS of i/U lilC,.
Thl' a/lalysh sillll'lili l's cOllsidt' l'ahly ill the ,'xlt'rna l-hahil specific
alioll.
,.... III Ihis case (H.-1.H) alld U\.'1.~I) call 1)(' COJllhiIH'" 10 giVl'

'I (H.4.10)

• If 1\'" assullle hOlllosk nlaslicil 1' alld joillt lognonn alilY of assel
rOllsllll lplioll gro\\'lh, Ihis illlplies 11\(' followin g rt'slrinio J\s
n'tlll'l,S alld

I
Oil risk prelltia
alld Ihe riskll'ss I'('al illll'reSI I'al,':

;'•1
(HA.II)

.... ,1
i':qllalio ll (H.·f.II) S;lys Iltal lite riskless real inlt'resl rail' eqllals
(H.4.12)

ils val\le

I
Illldl'r power IIlililY, I('ss ~·(V -- I )1\1'/. I lolding conslIJl lplion
I pe('\t'd "()\ISIIIIIPlioll 101l101TO\\, conslan t, an ill('f('as, ' in consum
Il'nla)' illlTeas( 's til(' IlIai'),:illallitilil), or COIISlllllPlioli loday.
today alld ex-
ptioll yes-
This lilah,s Iht'
~ n'pITS('l Ilali\'(' agl'1I1 \\'alll 10 horrow from lhe ruture, driving
lip lhe real

I
.' illlt'l'l'SI rail'. Eqllalio ll (H.·l.l~) dl'scrihi llg Ih(' risk pn~llIi\l1
l\ is I'xanly Ih ..
I sallie as (H.~.7), lite risk Pl'l'lIlilllll rorlllllia 1'01' Ihe power lIlilily
I mod"'. The
\'xlt'1'Il,,1 hahil Silllpiv adds a 1"1'111 10 Ihe Elller e'lualio ll (HA,
10) whi('h is
\

I I klloWII al lillie I, :l1l1llhis do('s 1101 alii-I'I Ihl' risk pn'llIilll ll.
( " I ,\I\('I (1~1~IO. 1~I(Ui) IH'\'('I'll wkss arglll's Ihal t'OII('hillg lip wilh
I 1lll'.lollcs('S

•I...
call "l'Ip 10 n:pl"ill If,,' eqllily p,elllilli ll pIli.!"'. This al).!;III1tt
'lit is hased Oil
\ IWO cOlIsidn alioJls. Fil"I, Ihl' an'rage "'\,1'1 or Ihl' riskless raIl'
ill (H.·!. I I ) is

\
8.4. Afar, Co/fmt Utility FWldiulIs

-log8- y 2 a ; /2+(y-K(y-1 Jig, where gis the average consumption growth

rate. When risk aversion y is very large, a positive K reduces the average
riskless r,lte. Thus catching up with the Joneses enables one to increase
risk aversion to solve the equity premium puzzle without encountering the
riskfree rate puzzle. Second, a positive K is likely to make the riskless real
interest rate more variable because of the term -K(y-l)ilc, in (8.4.11).
If one solves for (he stock returns implied by the assumption that stock
dividends equal consumption, a more variable real interest rate increases
the covariance of stock returns and consumption O"i, and drives up the equity
premium.
The second of these points can be regarded as a weakness rather than
a strength of the model. The equity premium puzzle shown in Table 8.1 is
that the ratio of the measured equity premium to the measured covariance
ai, is large; increasing the value ai, implied by a model that equates stpck
dividends with consumption does not improve matters. Also the real interest
rate does not vary greatly in the short run; the standard deviation of tht ex
posl real commercial paper return in Table 8.1 is 5.5%, and Table 8.2 shllwS
that ahollt a third of the variance of this return is forecastable, implying a
standard deviation for the expected real interest rate of only 3%. Since the
standard deviation of consumption growth is also about 3%, large value~ of
K and y in equation (~.4.II) tend to produce counter factual voJatilil}i in
the expected real interest rate. Similar problems arise in the intemal-h~bit
model.
This difficulty with the riskless real interest rate is a fundamental prob-
lem for habit-formation models. Time-nonseparable preferences make
marginal utiliry volatile even when consumption is smooth, because con-
sumers derive utiliry from consumption relative to its recent history rather
than from the absolute level of consumption. But unless the consumption
and habit processes take particular forms, time-nonseparability also creates
large swings in expected marginal utility at successive dates, and this impl~es
large movements in the real interest rate. We now present an alternat~e
specification ill which it is possible to solve this problem.

Difference Models
Consider a model in which the utility function is

(8.4.13)

and for simplicity treat the hahit level X, as external. This model difTers
from the ratio model in two important ways. First, in the difference model
the agent's risk aversion varies with the level of consumption relative to
habit, whereas risk aversion is constant in the ratio model. Second, in the
I

i330 8. l71trrtem/JOmll~qllililJ/illlll Mot/rLI •

dilference model cOlISulllption must always be above habit for utility to he

well-defined, whereas this is not required in the ratio model.
To understand the first point, it is convenient to work with the surplus
consuJllption ratio St> defined hy

Cr - Xr
Sr == Cr
(8.4.14)

The surplus consumption ratio gives the fr,lCtion of total consumption that
is surplus to subsistence or hahit requirements. If habit Xr is held fixed
as consumption Cr varies, the normalized curvature of the utility function,
which would equal the coefficient of relative risk aversion and would he a
constant y in the conventional power utility model, is

-CUcr; Y
(8.4.15)

This measure of risk aversion rises as the the surplus consumption ratio Sr
declines, that is, as consumption declines toward habitP
The requirement that consumption always be above habit is satisfied
automatically in microeconomic models with exogenous asset returns and
endogenous consumption, as in Constantinides (1990) and Sundaresan
(1989). It presents a more serious problem in models with exogenous
consumption processes. To handle this problem Campbell and C.ochrane
(1995) specify a nonlinear process hy which habit adjusts to consumption,
remaining below consumption at all times. Campbell and Cochrane write
down a process for the log surplus consumption ratio Sr == log(.'),). They
,rsumc that log conSllmption follows a random walk with drift g and i.nllo-
ration Vt+l, ~Ct+l "" g + Vr+l' They propose an AR(l) model for 5r:

I St+1 = (i-tP)s+tPJr+J..(Sr)Vr+I' (8.4.16)

I
~Iere s is the steady-state surplus conslIIllption ratio. The parameter rp gov-
' rns the persistence of the log surplus consumption ratio, while the sensi-
ivity function A(sr) controls the sensitivity of .In I and thlls of log habit Xrt I
[:o innovations in COlISUllIlJlion growth tlr+l.
I Equation (8.4.16) specifics that IOday's habit is a complex nonlinear
I'unction of current and past consumption. By taking a linear approxima- .
lion around the steady Slate, however. it may he shown' that (H.4.Hi) is ap-
I
17Risk a\'("fsioll may .tlso hl' 1111~a~IIH'd by the Ilormalilcd curvature of tilt, ."allle.' ftlllrlioll
j maxil1lilen IItility exprc"cd as a fllllClioll of w(';llth). or by the v<lI;llility 01 Ih,' stochastic
, i"-OII1II faCIo<. or by Ihe l1I<1xillllllll Sharp" .alio 'IV<lilable ill ;"\SCI mark,·". Whik Ih"se
Ipl"a~\lrc~ or risk avcrsioll .ut' diffe.'n'l1t frol1l ('ach 01l1('r ill this modd. th;:'y ;1111110\'(' jn\'('rs('ly
1'irh Sr. NOle that y. the curvatlln' par.IIIlCler ill wilily. is no longer a nwa~llH' of ri'ik a\'('o.iol1
il' this lIIodcl.
8.·1. MOH' (;I'III'llIllfliiily hllll'lill//.\

proxilllateiya Iradiliollal hahit-filrlllalioll Jllockl ill II'h ieh lo~ hahit respollds
slowl)' to 101-{ COIlSIllllptioll,

(H.4.17)

where h = III( 1 - S) is the steady stale valu(' of x- f. The prohlem with the
traditional model (8.4.17) is that it allows conSulllptiol\ to (;,11 helow hahit,
resultillg in inlinite or negative margin'll utility. i\ process for 51 defincd
over the reallinc implics that consumption can never (;t!1 helow hahit.
Since hahil is cxternal, the marginal utility of consumption is ll'«(~)
(C1 - Xtl- Y = SI- r CI- r . The stochastic discounl Elctor is thcn

u'(CI+ I) ('\+1 (;1+1)")'

Mt+1 == 8 = 8 ---'- (8.1.18)
u'(el ) SI (;,

Inl~lc standard powcr utility model SI = I. so Ihe stochaslic discount f;IClor

is just consumption growth raised to the power -y. To get a volatile stochas-
tic discount bctor onc necds a larl-{C value of y. In Ih(' hahit-(ill'matioll
model one Gill instead get a volatile stochastic di~c()11I11 f;lctor 1'1'0111 a volatile
surplus consulllption ratio SI'
The riskless real interest rate is rdaled 10 Ih(' slOlhaslic discollnli;ll'tor
by (l + H;+ I) = 1/ EI (MI + I). Taking logs. anel using pH. IIi) ,\llIl (1-\.4.11-\).
the l()~ riskless real interest rate is

~ 2
r{1-1 = -log(o) + yg - yO - <P)(s, -~) - Y ?-\,\(.I,) I- I]l. (8.4.19)

The first two lerms on thc right-hand side of (8.4.19) arc familiar from thc
power utility model (8.2.6), while the last IWo terills arc new. The third term
(Iillear in (SI - '5»
reflects illlertelllporal suhstitutioll. or mean-revcrsion
in marginal utility. If thc surplus conslllllption ralio is low. the marginal
utility of COIISIIIIlIllioll is high. However, the surplus COIISUlllptioll ratio is
cxpcctcd to revert to its mean, so marginal utilily is expeclcd III f,llI in the
future. Therdi)J't', lhc consumer would likt' to borrow and this drives up the
cfJuilihrillm risk rree interest ratt'. The lillll'th In", (lint'ar in IA(s,)+1 )~)
reflects prccautionary savings. A~ tllH'cnainlY in(Teases, conSlllllcrs hecome
more willing 10 savc and this drives down tll(' cqllililllilllll riskless intercst
rate.
If this mode! is to gCl\crat\~ 51.lhk re.t! intnest r"t(·~ like those observed
in the elata. the serial correlation p"r.lIllt·tc(' c/! lIIust he n('"r (JIIC. Also, the
scnsitivil), tllnrlion '\(SI) III list declinc wilhl, .'" IIt"t IlIl(Tllaillly is high whell
 I, is low alld 1IlI' prec aUli
ollar y savi llg I('rlll offs els the illte
lioll 1('1"111, 1/1 1;11'1, Cam phel l a/ld r\(,lI Ipor al subs titu-
Coc hral le para mel rize Ille A(I,)
so thai Ih('s(' 1\\'0 1!'rIllS exac lly fUllc tioll
oftse t I'ach olhe r ewr ywh ef(',
('oll Slal llris kll's s illl(' n'sl rail', illlp lyill g a
EI'I'II wilh a cOIISI,uII riskll'ss illl!'
r('si ralc all(lralldolll-\~alk COII
li,," , Ihl' ('xll' l'Ilal -lIah il IIllulcl SIIlIlP-
(';111 prod uct' a larg e equi
sloc k pric l's, alld prt'd irrah ll' exce lY pn'lI li 11111 , vola lile
ss Sioc k relll fllS, The hasi c mec
lillH'-Vari,llioll ill risk al'('rSioll. hall ism is
Whe ll COllSlllllPlioll falls n'lal i\'('
resu ltillg illcr casl ' ill risk aver sioll 10 habi l, Ihl'
dri\' es lip Ih(~ risk prcm iulII 011
such as sloc ks, This also dri\' es risky ;Isseis
dOWII the pric es ofSl ocks , help
why sloc k r('lu nls an' so milc h illg 10 expl ain
mon ' vola lile Ihal l cons lllllp tioll
riskll'ss re,ll illll'fl'SI ral(' s. grow lh or
Call 1phl 'li alld (:oc hral le (I~}~}:l)
calih rale Ihei r lIIo dd 10 US clala
sum plio ll alld divi de/l ds, sol vi II!!; Oil (011 -
/ill' ('qll ilihr ium sioc k pric es i/l Ihe
of Ml'h ,.a .lIl1ll'leSCOI\ (1~)H!'i). Irad ilion
Thl' l'l' is also SOIllt' work Oil hahi
Ihal us('s al"llial sloc k rl'lll l'll dal,l l form alio n
ill Ihe Irad iliol l of I lOlliSI'll allel
10/1 (I~}H:!. I~}H:I). llea lo/l (Iq~} Sillg le-
:l), I,ll' ('xa mpl e, eSli malc
mod i'! allo\ \'illg ((lr lillll '-agg rega s all illlC rtlal -hab il
lioll of Ihe dala alld for som ('
Ihos e go(u ls lilrll lally desc rihe dura bilil Y of
d as 1l011l1llrablc in Iht' nali onal
(,OIlIlIS, Dllr abili ly (';111 1)(' Ihou inco llle ac-
ghl O(';IS Ihl' opp osit l' or habi t
th"l COIlSUIliptioll (')oq)(,lIl1illll'l' lilrll lalio ll, ill
tod" " lowe rs Ihe Inar !!;in allit ility
tioll ('XPI'llIlilllr!' IOIlIOITOW. (!ca orco llsIl IllP-
toll lilld s Ihal dlira hilil Y pred omi
hi!!;h fn''1u('III'i('s, alld habi l ((lI'I nall 's al
llatioll al lowe r i'rt'q llt'nl 'ics. Ilow
hahi l-f(ll 'Illal ioll Illo dd. likl' Ihe cl'cr his
silll ple pow ('r ulililY 11111111'1, is
tislically. l'I:ic('ft'd sta-
BOlh Ihes e app roac hes aSSUllll'
Ihat a~grt'R,l\e cons ump lioll is
ill~ pron 'ss ror Illar gina the IIriv-
l IIlility, All altcl 'Ilal ive view is
('uss ed ill S('('lioll H.:\.~, Ihe ('OIlS Ihal , for reas ons ,lis-
II IIIpt iOIl or slo(' k mar ket inve slor
bl' ad(' '!"a td" pro" il'd hI' Illa( 'l'oc s lIlay 1101
('oll omic dala on <l!!;grt'g,llt' con
Und er this I'ie\\' till' dril'in!!; pro(T sum ptio n,
SS for a hahi l-lim ll,lI ion 1II0dei
a proCI'SS Wilh a f'('asollal>le IIwa shou ld be
n alld siall dard devi alio ll, hUI
hi~ltl)' ('OI..-l'Iall'd wilh ag!!; n('e( \ nOI he
I'I'gal(' ('OIlSlIllIplion.

S,,,,2 I"wh oillg im/ M(/(II'II IIf !'rrfn

'Pnrr.1
I'SydlOlo!!;iSIS alld ('XPl'l'illl(,llt~tl
l'('ol lolll islS haVl' foul ld Ihal ill
lal Sl'ltillgs, p('op ll' 111;1\..(' dlOi ('Xpl'I'illlell-
('l's that dilfe r ill sew !'al !'I'SP
siall dard III(u ld 01 ('X 1)('('\ ('II IIlilil I'ctS frOIll lhe
Y. In r('sp olls( ' 10 Ih('s t' lillllill!!;s
dox "psydlOlo!!;ical" III1Hlels or ullo rtho -
prl'f('I'I'III't'S have he(,11 sugg esle
1'1'1'1'111 resl 'ard l l"ls IlI'g ull 10 appl d, and SOIll(,
y Ihl's l' tnol lds 10 asse l pricill!!;.I
H

1"(1"'1111 ~"I,,'o.,II""'"'II""
ill, 10,,1 .. 11"/:,11""",,1 R.·(", .. (HI1I 7) alld
KIt'I " (1\11111),
lJ.4. Mort' Gmaal Utilit., rtmctionl

Psychological models may best be understood by comparing them to .

standard time-separable specification (8.1.1) in which an investor maximizes

(8.4.20)

This specification has three main componen15: the period utility function
U( e,), the geometric discounting with discount factor 8, and the mathemat-
ical expectations operator E,. Psychological models alter one or 'more of
these components.
The best-known psychological model of decision-making is probably the
prospt'rllheory of Kahn em an and Tversky (1979) and Tversky and Kahneman
(l992). Prospect theory was originally formulated in a static context, so it
does hot emphasize discounting, but it does alter the other two elements of
the standard framework. Instead of defining preferences overconsumption,
preferences are defined over gains and losses relative to some benchmark
outcome. A key feature of the theory is that losses are given greater weight
than gains .. Thus if x is a random variable that is positive for gains and
negative for losses, utility might depend on

. {XII-~ly~1 if x ~ 0
vex) === ,_, \ (8.4.21 )
-A~
1-)'1
if x < O.

Here YI and Y1 are curvature parameters for gains and losses, which may
differ from one another, and A > 1 measures the extent of loss aversion, the
greater weight given to losses than gains.
Prospect theory also changes the mathematical expectations operator
in (8.4.20). The expectations operator weights each possible outcome by itS
probability; prospect theory allows outcomes to be weighted by nonlinea~
functions of their probabilities (see Kahneman and Tversky (1979» or by
nonlinear functions ofthe probabilities ofa better or worse outcome. Other,
more general models of investor psychology also replace the mathematical
expectations operator with a model of subjective expectations. See for ext
ample Barberis, Shleifer, and Vishny (l996) DeLong, Shleifer, Summers,
and Waldmann (l990b), and Froot (1989). I

In applying prospect theory to asset pricing, a key question is how the

benchmark outcome defining gains and losses evolves over time. Benartzi
and Thaler (1995) assume that investors have preferences defined over
returns, where a zero return marks the boundary between a gain and a.
loss. Returns may be measured over dilTerent horizons; a K-month return'
is relevant if investors update their benchmark outcomes every K months.
Benartzi and Thaler consider values of K ranging from one to 18. They show
that loss aversion comhin~d with a short horizon can rationalize investors'
334 8. IlItrrtfllljJOTilI J~qllili{JI-;1I1II Modell

unwillingness to hold stocks even ill the face of a large eCJuity premium,
Bonomo and (~arcia (I !m:{) obtain similar results in a consullllHioll-hascd
model with loss aversioll,
In related work, Epstein and Zin (1 !)90) have developed a parametric
version of the choice theory of Yaari (1987). Their speliliGllion for period
Ulility displays jirJt-ordrr 11.111 flVelJioll-the risk premium reCJuired to induce
an investor to take a small gamble is proportional to the standard deviatioll
of the gamule rather than the v,lriance as in standard theory. This feature
increases the risk premia predicted by the model, but in a calihration ex-
ercise in tile style of Mellra .\1lU l'rescull (198:», Epstein and Zin find that'
they can lit only about one third of the historical equity prellliulII.
Another strand of the literature alters the specification of disulIllltinp;
in (8.4.20). Ainslie (1992) and l.oewenstein and l'rclee (1992) have arp;ued
th,ll experilllen tal evidence suggests not geometric discounting hut hYIIr.rb"lic
discounting: The discount factor for horizon K is not /)K uut a functiol\ of
the form (1 +/)IK)-~'/~I, where both /)1 and /)2 are positive as in the standard
theory. This functional form implies that a lower discount rate is used
for periods further in the future. l.aibson (1996) argues that hyperbolic
'jiSCoUntin g is weIl approxi,matedh Y~utility sP,ecification

I U(e,) + fiE, [2:>51 U(C,+j)] , (8.4.22)

I ~I

i
\yhere the additional p.\rallleter fi < I illlplies greater discoulllinp; over

~
Ie ne\(t period than between allY periods further in the future.
Hyperbolic discounting leads to time-inconsistent choices: Because the
( iscount rate between any two dates shifts as thc dates draw nearer, the
ptimal plan for those datcs changcs ovcr tillle evcn if no new infi)J'lllation
. rrives. The implications for conslImption and portfolio choice depend
n the way in which this time-consistency problcm is resolved. I.aibson
(1996) derives thc Ellicr equ,llions for conSlllllption choicc assulllinp; that
tie individual chooscs each pcriod's conslllllption in lhat period without
I eing able to constrain future consumption choiccs. Illlcrestinp;ly, he shows
t lat with hyperbolic dis(oullling the elasticity of intertelllporal suhstitution
i. less than thc reciprocal of the coefficient of relative risk aversioll evell
\~hen the period utility fUlIction has the power form.

8.5 Conclusion

Financial ecollolllisL~ have lIot yet produced a generally accept(,d model

of the stochastic discoullt f;lrlo)"' NOl1l:lheless sul>stalltial prop;n:ss has heen
made. We know that the stochastic discoullt f;lr\or must be extrcmely volatile
['/lib/nils

if it is to \:xplaill the cross-sectional pattel"ll or asset retlll"llS, We also know

that the cOllclitionalexpectation of the stochastic ciis(,(Hlllt factor IIllist be
cOlllp;lrativc1y stable in orcler to explain the stability or the riskless real
intert'st rate. These properties pllt st'wrc restricliolls Oil the killcls of asset
priring llIoclcls Ihal «Ill he consicinc(\.
There is increasing interesl in the idea thai I isk ;tv('Ision lIIay vary over
tilll\: with the state of the eCOlIOllly, Tilllc:-v;lryillg risk ;lv\'rSiOIl C',I11 explaill
the i<lrge body of evicience thai e)ln:ss n:11Il1IS tlll sttl(ks anti other risky
assels ;\1'\' prediCl;dlk, One IlWdlanislII Ih;\\ roUI prociU\T lillie-varying risk
aVCl"sion is habit fOrlnalioll ill the \Ililily fUI\('\ioll of a repn'sclIlaliw ;Ig\,nl.
But it is "Isll possible that invcstors appear to h;lvc' tillle-val),ing risk aversion
because thcy trade on the b'lsis of irrational c:xpcTlations, or Ihat tilllc-
varying risk aVC'rsioll arises from the interactions Ill" hett'lOg\'neous agellts,
Grossmall alld 'I.holl (I ~9(i), for example, prt's\:lIt a model in which two
agcllts with different risk-aversioll cod'ficienL\ trade with c,ll'h other, Olle
of t1w agents has all exogellolls lower bOllnd Oil we;ilth, and the resulting
c(wilihriUIlI has a time-v,\I),illg prke of risk, This is likely to be all a(live
011'\:.1 for flltllre research,

Problems-Chapter 8

8.1 Prove that the benchmark portfoli~ has the properties (1'1)
throllgh (l'!i) stateel Oil pages ~!IH allel :~OO clf this chaptn.
8.2 COII,ider all ecollolllY with a rC'I'I'\'S\'lIlalivC' agl'lIl who has power
Ulility with coefficicllt of relative risk aversioll V. The agent receives
a lIonstorahle endownlellt. The process for the log elldowment, 0)'
crl'livaiently the log of cOllsumption (" is

where the coefficient ¢ lI\ay he either positive or ncg<ltiV\". If<(l is positive

thclI endowlllent ((uctuatiolls are highly persist\:nt; if it is lIegative then
they have all illlportant transitory COlllponent.
8.2.1 Assullle that consumption and asset ret"rn~ alT jointly log-
lIo\"lllal, with constant variances and covariaIlCl:s.
i, Usc the represelltative agc'nt's Euier C'quations to show th,1\
the expcneel log return IlII any asset is a linl'ar ftlnction of the
I'xpe\'lecl growth rate of thc' I'ndOWIIIl'nt. What is the slope cod:
lic'iellt in this rciatiollShip?
ii, Use the reprcsentativl' agl'lIt\ EIII('\" eqllatiolls to show that
the ciilkrc'lICT betweell the I'xpl'ctl'd log rl'llIrli Oil allY asset alld
the log ri.~krrl'l' illterl'st rate, pillS oIH'·II.d/lhl' ("I'll variallce of
 Ihl' 10J.!; ass('1 11'1111"11 (callihis Slllll the "prelllilllll" Oil tltl' assel). is
propolliollallo 1111' cOlldiliollal covari;\Ilce o/"Ihe lOR assl't relllrn
willt rOllslllllplioll ).\1"O\\'lh, Whal is Ihl' slopl' nll'r1il'il'1I1 ill Ihis
rdalilHlship'
"
"
!t2.2 To a dosl' ;Ipproxilllalioll. Ihl' IlI11'XPl'l'll'(\ relllnt 011 allY
assel i call Ill' \\'rilll'll ;IS

1",./11 - F,I",.,II = I·.'ltl [tflI6t1,.t+I+i] -EI[tfli6t1,.Itl+l]

/ __ 0 J=-IJ

- (Eft I ['f; pir",tl+i] - I~, [t pir'.lt 1+1])'

}.-I }-I

wh(,11' tI,.1 is IIH' (lividclld paid Oil assel i al tilllt' I, This approxillla-
tioll was dcvelopcd as (7.1.~:1) ill Chapter 7,
i, lise Ihi~ expressio\l 10 caIn date the IItll'xpe('\cd n'llIl'II 011 all
(''1l1il\' whil'h pa),s agJ.!;1'('J.!;alt' ('()IlslImption as ils dividend.

ii. l I~I' Ihis \'''pre~sio\l 10 Cakllbll' Ihl' IIIH'XPlTll'd t'('tllrtl 011 a

r('al cOII~ol bOlld which has a fix('d real dividl'lId each pniod.

K.2.:~

i. (:akll\;tl('llw (''Illill' prl'lIIilllll alld tIll' ('ollsolbolld prl'llIillltl.

ii. Show I hal I h(' boltd pr(,lIIilllll has the opposite sigll to 1> altd is
proportiollalto the sqllare o/"y. Cive all econolllic inlerpretalion
of Ihis r('slllt.

III. Sltow Ihallhe e'l"iIY pn'lIIilllll is always htq-\l'r Ihan the hO\ld
prl'lIlilllll. and Ill\' dilfl'1'('\H'C betweell Ihelll is propol'liollallO Y,
Ci\,(, all ecolloltlic illl('rpr('lalioll of Ihis r('sllil.

i\', Rdall' 1'11111' disClI\~ioll 10 III!' I'llIpirirallill'l'allll'l' 011 Ihe "('Q-

lIil\' pr(,lIIilllll pIlZlk."

R.:l C:olIsidn a I\\'o-pniod world wilh a cOlltillllllll1 of COIISlIllIlTS.

Each COIlSlIlIlI'r has a raltdotll ('llIlowlI\('nl ill Ihe S('coIHI period alld
COIISIIIIII'S (111)' ill the sl'nl\HI pl'liod. III till' firsl pl'l'iotl. Sl'l'lIrilil's arc
Iradl'd bill 110 IlIotH,\, challJ.!;!'s hallds IInlillhl' Sl'(,(lIld pl'l'iod. All COIl-
SIIlIll'l'S havl' loJ.!; IItililY OVl'r sl'colld-pl'riod (,Ollstllllplioll,
H.:l.l SUppOSI' I hal all ('( HISI 1Illl'rs' l'\l<loWIIIl'Il Is arc I hI' sallie. They
arc 1/1 ,,-jIlt proh.lhililY 1/'2 alld (I-II) 11/ wilh pro!JahililY 1/'2. \,'hl'l'l'
() < 1/ ...: I. SIIP(lOS(' Ihat a dailll 10 Ihl' sl'colld-pl'riod aJ.!;J.!;I'l'!{all'
l'Iulo\\'lIll'lll is Iraded alld tkll il cosls {Jill l'itlll'rSlall', payahle illthl'
SI'COIHI period, (:Olll\llll\' til<' l'lillilihrilllll prin' /1 alld Ihl' 1'''lll'l'Il'd
IT1111'1I (lll I hi' dailll.
8.3.2 Now suppose that in the second period, with
all consumers receive m; with probability 1/2. a fraction (I-b)
consumers receive m and a fraction b receive (l-a/b)m. In the"
fIrst period, all consumers face the same probability of being in the ".
laHer group. but no insurance markets exist through which they,
can hedge this risk. Compute the expected return on the claim.
defined above. Is it higher or lower than before? Is it bounded b~
a function of a and m? I,
. '(
8.3.3 Relate your answer to the recent empirical literature on the,
determination of stock returns in representative-agent models. Tol
what extent do your results in parts 8.3.1 and 8.3.2 depend on thel
details of the model, and to what extent might they hold more!
generally? '
Note: This problem is based on Mankiw (1986).

•
 9
Derivative Pricing Models

THE PIUCI:,\(; OF OPTIONS, warrants, and other "nll/alilll' securities-financial

secnritics whose payoll's depend on the prices of other securities-is one of
the great successes of modern fmaneial economics. Based on the well-known
La;v of One Price or no-arbitrage condition, the option pricing models of
Blac;;' and Scholes (1973) and Merton (I ~17:)b) gained all almost immediate
acceptance alllong academics al\(I investment professionals that is unparal-
leled in the history of economic science.'
The fundamental insight of the B1ack-Schole.~ and Merton models is
that under certain conditions an option's payoff (',1lI he exactly n~plicated
by a particular dynamic investmcnt stratcgy involving only the underlying
s((}ck and riskless debt. This parlicllbr strategy fIIay he constructed to he
sl'ljjlwlI/rillg, i.e., reqlliring no cash infllsions except at the start and allowing
no cash withdrawals until the option expires; since the strateh')' replicates
the optiol\ 's pay ofT at expiration, the initial cost of this sdl~linallcing invest-
ment strateh')' mllst be identica\to the option's prict", otherwise ,Ill arbitrage
opportllnity will arise. This no-arbitrage condition yields IH)t only the op-
tion's price but also the means to replicate the option synthetically-via the
dynamic investlllen t stratq,')' of stocks ,lilt! riskless debt-if it does 1I0t exist.
This lIIethod of pricing optiolls has since been used" to price literally
hundrcrls or othcr types of dcrivative sccurities, sOllie considcrably more
COlliplex th,lII a ~illlplc option. In the majority or these cascs, the pricing
formula can only be expressed implicitly as the solution of a parabolic par-
tial difrerential equation (PDl~) with boundary conditions and initial values
determined by thc contractual tcnlls of each security. 'ji) obtain actual
prices, the 1'01': IIIUSt be solved 1Il1llicrica1ly, whirh lIliv;ht have been prob-
lematic in 197:~ when mack and Scholes and Merton IiI's! published their
papers but is 1I0W cOllllllonp1acc thanks to the hreakthroughs ill rOlllputel'

I See 1\(01"11.,,(,;11 (I~'~':i, (:h"I"'" II) lor ,. li"dr "n 'JlIl.' 01 III<' i.llcll,·, 111,.1 hi,'ory 01 I Itt'
m"ck·Srhol,·,/t.kI"lOIl Oillioll/ll irill~ /CII"IIIIII,,"
 I), /J,.,.illlllil','/'ririllg '\/11111'11

ll'(hllolo~\' 0\'('1" the p~lsl litree dec~lIks, Ahholl~h a dclailcd discussioll or

"('ril'ali\"(' pri( illg IlIo,It'ls is 1)('\'011" Ihe scope or Ihis ll'xl-llH're an' lIIallY
ullin ('Xrdlt-III SllllITt'S slll"h ;1., (:ox alld Rlibinsleill (I!IH!,), 111111 (I!I!I:\),
alld Mt'ftoll (I ~1'lfI )-W(' do prol'ide IIrid' n'vil'ws or
Hrowlliall !\lol iOIl ill
Se("(ioll ~),I alld f'. Ic-I"I 011 \ deril'alioll or Ihl' Hlack-Scholes Ii 11"111 lila ill Seclioll
!l,:! ror rOIll'I'ninl("(',
11"1111 i("a III" ;d IhOllgh I'lil ill).!; d!'li 1';11 il"l' securi t iI'S is oftI' II It igl dy COl lip II ta-
tioll-illtellsin', ill prill("iple it !c;II'es ItTI'lillle room ror Iradiliollal slalistical
illfl'n'll<T silln'. I,,' th .. \"('1"\' 11;11 lin' or tlH' lIo-arhitrag" pricillg paradi).!;III,
Ihen' "xists 1111 ",,1'1 III tenll" to Ill" IIlillillli/.l'd alld 110 ('OIT('SPOllllillg" slatisli-
Cli (htClualiom III ("1I1I1t'11I1 "'illl, Aftn all. irati opliotl's pritT i,d('lentlitll'ti
exa("(II'-lI"illiOIlI e!Tor-as Slllll(' (possibly lillll'-I';lryilll-:) COlllbill;llioll of
prirt·s Ilr oliter Ir.ull·d ;ISSI'IS. II'h I' II' is 11\1' Ill'l'd till' slalislical illfcn'IH"(,?
Methods stIch as rq!,n'ssioll ,,";\lysis do tlol SI'I'III 10 playa role 1'1'1'11 itl Ihl'
applicalioll of oplioll pricillg IllOdds 10 dala.
II0i"l'vl'r. 1111'1(' ;111' al leasl 111'0 aspl'("(s or Ihl' ill/IIII'II/flllalioll or dl'lil,;t-
live pricillg Illlldds llial do illl'lllve slalislical illkn·11Ct· and WI' shall ronls
on thl'lII ill litis tlla),ln, The lirsl aspe("( is IIII' 1'1'0),1('111 orl'slilllalitlg Ihe pa-
rallll'lers IlrnlllliIlIlOIlS-lillll' prin· pro('('ss('s which are illPUIS for paramelric
deril'alil'l' I,ri"illg IIlIIIIIILIS, \VI' II'" Iill' "uodilil'r Ill/muII'llil ill d('snihillg th,'
deril'alil'l' pri("illg l'olllllll.IS ("IIlIsiderl'd ill Ihis chapler h('(";(IISI' s(,I'(Tal 1/0/1-
IltlHllI/l'lrif approadll's 10 pricill~ dl'l'iI'atil'l's have n'(TIIII), 1)('1'11 proposed
(sel', 1'01' I'xalllple. A'il-Sahalia II ~)I):! I. Ail-Sahalia alltl 1.0 II !)!)r,]. 1llIlChill-
SOli. 1.0. alld I'o!-\~io 11 1.1'1,11. alld RlihillSll'ill [I!I~H l>.~ WI' sh'll! t'llll-;i(\t'r
llollparallH'lrir d('ril'ali\'(' pririll!-\ modl'ls ill Chapll'r I~, and (Ints Oil i,SIl('S
SllITOUIHlilll-: p;lrallH'lric Illodds ill S('nioll 9,:t
Th(' sl'colld aspl'cI ill\,oll'~'s the pricill~ or path-depelld"111 dl'rivalive's
hr MOIlIt· Carlo simulalion, A dnil'alil'l' security is saitilO 1)(' Imlll-rl''IH'IIr1m[
ifils payolfdl'lll'lIlis ill SOil\(' 11';1\' Oil Ihl' ('nlin' /mlll oflht'lllHkrl),illg assel's
p,.i(T dllrill).!, Ihe dl'ril'alil'l''s lili-, For (·xample. a pllt optioll which giV<.~s
Ihe holdl'r Ihe righl 10 selllhe IIlldlTl~'illg 'IsseI al ils aVt'rag(' prin'-where
Ihe avcrag" is calntl"ll'd 01'1'1' lhe lili- or lhl' OpliOIl-is palh-(lt-pelldl'lll
I)('('alls(' IIII' awr;l).!,e pri'T is a fllll("lioll of Ihl' IIl1dl'r/yill).!, assl'l's elllirl' price
palh, Although;1 ho\\' 'III;III'li('al appl'llXilllalilllls 1'01' pricillg" pal h-tll'j)('1 Hkill
tlnil'alil'l's do ....;i,l. hI' Ell' Ihl' IIlosl dkrlil't' melhod Ii II' pridlll-: Ihl'llI is
IIv M Illl 11' (:,lI·lo SilllllLilioll, This r .. ises s('\'('ral isslI(,s sllch as ml'asuring
Ih" a(Tllral I' or ,illllliall'd I'rin',. Ii<'tl'nllillillg Ih,' 111111111,',. of silllltlatifllls
rt"I"irt'l\ lor a dl'sired 1<-1'1'1 01 a("(,lIran, ;IIHI tlesigllilll-: Ihl' simllialiolls 10

:'1" lunll.,,' 1n the' lI,ulrlit'II,11 p.II;IIIU'IIU' .II'I"O.lf}) ill h'hic h ,ht' prin' p,.on'" "f ,he"
hillg .",,,"t j, IlIlh "I)!'( ili"d "1'111.1 lillilc' IIlIlIIhc', oJ II II I.. 1I4I\\,1I P;II,IIIWII'I'. c.g ... 1 IO!!.llur-
III It kl
III;" dillll,iull \,ilh 1111)..1111\\11 ~hlll .tlut \111.111111\ p.tt.ttHl'klS, ~I (l(H'par~'HIc.'Hic: .'pproac.h dot,!'!.
111)1 "p"\"ih" ,t", 1'1"" ))lOt t"", "'plu iii\" ;11111 ,IIIt'mp" It) inkr it hUll) Iht· ,tlt.l \IIHIt" Iti,Hll~lhlt·
,q~lIttlil\ t OlitlillOlh,
 9.1. llmw nian MOlion

mak e the most econ omi cal lise

of com puta tion al reso urce s.
Ihese issues in Section 9.4.

9.1 Brownian Motion

For cert ain financial appl icati ons
it is ofte n mor e con ven ient to mod
as evolving cOlltinllously thro ugh el prices
time rath er than discretely at fixed
For ex·,llllpk. Men on's deri vati on dates.
of the Black-Scholes opti on-p ricin
mula relies heavily on the ability to g foJ.
adjust port folio hold ings cont inuo
time so as \0 repl icate an opti on's usly in
payoff exactly. Suc h a repl icati ng
lio stratCj.,'Y is ofte n impossible to portfol:-
cons truc t in a disc rete -tim e selling;
pricil)g formulas for opti ons and othe henc~
r derivative secu ritie s are alm ost alwa
deri ved in cont inuo lls lime (sec Sect ys
ion 9.2 fora mor e deta iled disc ussi
on). l

9.1.1 Constructing Brownian Moli

on
The lir~t formal mat hem atic al mod
el of 11nanc~a~ asset prices-de~e1oped
Bac hell er (1900) for the larg er purp
ose of pnc mg war rant s trad mg on
by\
Paris HOl lrse -wa s lhe cOlltinllO\lS-t the;
iJnc rand om walk, or Brow nian mot
The refo re, it shou ld not be surp ion. '
risin g that Brownian mot ion play
cemr,11 role in mod ern derivativ s such a.
e pric ing models. This cont inuo
proc ess is closely rela ted to the disc us-t ime
rete-time versions of the rand om
desc ribe d in Sect ion 2.1 of Cha pter walk
2, and we shall take the disc rete -tim
r,mdolll walk as a slar ting poin t in e
our heur islic cons truc tion of the Bro
mot ion. 4 Our goal is to use the wni an,
discrete-lime rand om walk to defi
sequ ence of cont inuo us-t ime proc ne a,
esses which will conv erge to a cont
time anal og of the rand om walk in inuo us-
the limit.

The Dism le-T imf Ran dom Walk

Den ote by {IJk I a disc~ete-time rand
om walk with incr eme nts that ,tak
only two values, 6. and - 6.: e on

with probability 1(
with probability 1(' (9.1.1 )
EO 1- 1r,

whe re (k is 110 (hen ce p. follows the

Random Walk 1 mod el of Sect ion
Cha pter 2). and pu is fixed. Con side 2.1.1 of
r the following cont inuo us-t ime proc
JJ,,(t), I E 10, TJ. which can ess
he cons truc ted from the disc rete
-tim e process

:lTh"r~ an' tlvO n(tlahle excep

tions: the equilihriUll1 appr oach uf
til .. hillOlni,,1 "ptiOll'pricinl: \node Ruhinstein (1976). and
l of Cox. R()ss. and Ruhinstein (1979
~Fo .. ;,11''' ''(' rigoro,,~ cll'riv.uioll ).
. Sf'" nillillgsJry (J~)(;H, Section 37).
342 9. Denlm/illl' [Tiri"g Mtldfis

/'(1)
r,6

!
I
1
4~

I
!
36

26

16

O~----~----r---~r---~-----r-----r----~--~
()
2" :;" 4" 5" T= ,,"

Figure 9.1. Sam/,ie /'al" of II /)i.I(TPle-Time /umtUlm WillI!

(p,l. k = 1•...• 11 as follows: Partition the tinl(~ interval [0, T] into 11 pieces.
each of length h = T/ n. and define the process
E [0, TJ, (!1.1.2)

where [x] denotes the greatest integer less than or equal to x. /',,(1) is a
rather simple continuolls-time process, constant except at limes / = "h,
=
k I, ... , n (see Figure 9.1). .
Although P.(I) is indeed a well-de!lned continuous-time process, it is
still essentially the same as the discrete-time process II, since it only varies at
discrete points in time. However, if we allow 11 to incr~ase without hound
while holding T fixed (hence forcing h to appmach 0), then the lIumber
of points in [0, T] .tt which 1,,,(1) varies will also increase without bound.
If, at the same time, we a<ljust the stcp size 6. and the probahilities rr and
rr/ appropriately as 11 increases, then /I,,{t) converges in distribution to a
well-defined nondegenerate continuolls-timc process NI) wilh continllous
sample paths on [0, T]. .
To see why adjustlllcll L~ to 6., rr, and rr' arc necessary, consider the mcan
and variance of /1.( T):

E[j,,,(T) 1 n(rr - rr')6. (9.1.3)

Varl/,,,(T) I (~1.1.4)

A.. 1I increases without bound, the lllean ,\Ill! variance ()r P,,( on will also in-
9.1. JJmlllllifl/l I\-/olioll

crease without houlld if I:;,rr, and rr' are held fixed. '1.) ohtain a well-defined
and 1I01ldegencrate limiting process, WI' must maintain finite mOlllenL~ f()r
III/en as 1/ approaches infillilY. III parlicular, sillc(' W!' wish to ohtain a
cOlltilluous-lillle version of lhe r,lII(\olll wOlI I<. , we should expclt the llIean
and v,lriance or the limiting process II( T) to he lilll'OIr ill T, as in (2.15) and
(2.I.G) for the discrcte-time random walk. Therefore, Wl' 111IIst adjllst L\, rr,
and rr' so that:
T
lI(rr - rr')1:; -(rr - n')o. -> ILr
It
T ,', ~
41lrr rr' I:; ~ --Inn 1:;- -> (T r. (\1. \'(i)
It
and this is accomplished hy selling:

rr -I ( ILfi,) .
1+--
2 (1

n
, ~
2
(I _fi,) , 11
(1
I:; (T Ji,. (9.1.7)

The adjustlllt'llts (!1.1.7) imply thai the step sil.!: dClTeases as " inCTeases,
but at the slower rate of lifo or fit. 'I'll!' probabilities cOllverge 10 ~,also
althe I-ate of fit, alld hence we write:

~+()(Jh),
I
n = ~+()(fi,), rr' =: I:; = 0(,/1;). (!).I.H)

where O( fi,)
denotes terms that are of the same WYllfllOlic Older as fi,."
Therefore, as II incrcascs, thc random wall<. PIICI') v<lries illore frequcntly
on lO, '1'], hut wilh smaller step size I:; and with lip-step alld down-step
probabilities approaching ~.

:"IA fllllniull {<It) is .said to he of the !,<\l\\C: ;,symptoth' old('1 .\~ J.!"<h)-d('"oh·d hy j(h) . . . .
O(K(h»-if (itt' 1i,lIo\villi-{ rt'i;uioJl i.'\ .'iatislic.'d:

() < Ii"'~
I'(/d
1.-.11
< "'-'.

A lilllnio" f(iI) i, ,aid 10 hl' ol""",,dlt'r a'YIIl!,loli( ordt'l a.' gUIl-dell"led Ill' I (Ill ~ o(/:(II))-if
I (iI)
lilll-- = tI.
1,-." 1'( II)
SOIlH' l'X;UIlPIt'·" ora~}'IlIplOli(" ordl'r rc.'i.uiuu,,, al('

,,- 1'.// - (Ill,l.

,"I '.J, IJrrilllllil'l'l'ririllg J'Vllltll.fS

'1111' (,'olllill/lll/I\:rillll' I,illlil

By calndatillg till' IlIoll\l'lIt-gl'neratillg lilllrtion of 11,,( '1') alld taking ils lilllit
as 1/applOadl(,s illlillil\', il IIla\' he showlI Ihal Ihe dislrihutiou o/" II( 'f) is 1101'-
111011 wilh IIIt'all/l'/' alld \';11';;111('(' (J~,/,; Ihlls /1,,('1') cOllverges ill dislrihulion
to a N(I' 'f'. o~'/') ralltillill \,;lri;\(,II',
In bet, a nllllh sll"!lIlg!'r 1I0lioll o/" ('onvergl'nf(' relates 1',,( 'f') 10 I'( n,
which illl'oke.s Ihl' /lIIill'·"il/l/'III;OIlI/I tii,l/l'ihllliol/.\ (FDDs) or Ihe 111'0 slochas-
lie processl's, ;\" FI)() of a stochastic process /1(1) is the joint distrihll-
lioll o/" ;111\' lillil(' 1111111\1('1' or ohsl'I'l'aliolls of thl' stochastic pron'ss, i,e"
{(/,(lI), /'(/~l."" I'(lm)), 11'11('1'(' () <. II < ,,' < III/ ::: T, It call hI' showlI Ihat
1//11111' F\)lh of IIII' shuh;ISlic (lI'tH'l'SS /,,,(1) (lIoljllsl Ihl' randolll \'ariable
1',,( '1')) nlll\'('1 gl' 10 Ihl' FllI)s or a \\'1'1I·ddin!'d stochaslil' pron'ss I'( I).'; This
illlplil's, 1(11' I'xalllplt', Ih;1I Ihl' dislrihlliion of 11,,(1) convl'rgcs 10 Ihe dislri-
hlliinn of 11(1) Ii II' 01111", 10, '/'I (not just at T), th,lt thejoillt dislribulion of
1/1,,(0),/1,,(:\),/1,,<711 ('olll'ergl's 10 lhcjoillt distrihution o/" 1/,(O)'IICI}./I(711,
allds()OIl,
IlI'addilioll 10 IIII' lIorlllalil), o/" I'( 'f'), Ihe Jlor/uHlir 1"'IIt'I',1.I /1(1) possl'sses
Ihl' lilIlowing IhnT pl'IlpI'nil's:

(Ill) For 0111\' II ;lIul/~ such Ih;1I 0 -:: II <. I,~ ::: '1':

(9,1.9)

(R2) For 0111\' II, I~, I" alld I" SllI'h Ihal 0 ::: II < I~ ::: 1:\ < I, ::: '1',
Ihl' ill('\'I'IIU'1I1 I'( I~) - I'( 'I) is slalislically indepcnc\l'lIt of the intTcllIcnl
11(/1) - /'Ud,
(RJ) Th!' S;llIIplc I';tlll~ of 1,(1) al(' ('olltiIIlIOltS.

II is a rl'lIlarkallll' bn liI;1I 1,(1), whit'h is Ihl' n'ldll'al{'c\ arillilllt'lir llm1< l /liflll

I/w/ioll or II'imn/mlff'II, is l'ollll'kll'ly cllar"l"tl"ri7.ct\ by these thrt'c properties,
If WI' St't /1 == () ;11111 (J == I, WI' ohlaill slal/t/ard IImul1Iiall 11I/11ioll which we
shall 111'11011' hI' /lUI. ,V('orllillgly, "'(' lIIay ..c-cxprcss 1,(1) as

1,(1) =: 111 + 0 /1(1). I E [0, 'FI, (!),1. 10)

'Ii, clt-vc\op !tilthI'I inluition 1<lr 1'(/), ('onsider tilt' following ('ondiliollal
1II01l1t'lllS:

EI I'(/) I'( I,,) I 1,(111) 1- 11(1 - III) WI.II)

\';11"1/,1I) I'( I,,) I (T~(J - 10) (11.1.1 ~)

.. , lH' (lIH\I'lgl'l)! I' ill i Ilih. touplnl \\ith.\ In hnil "I fotltHtlulMl t .IHI',I II/.:",nn\, 1'1 ,llll'ci
".,."k I on\l'lgl'lif (',.1 jIO\\", 1111 1(111) ill d('II\ill~ ;1""IIIjIIO(if apP"","llIIotiiOlh lur III(' \I;lll,lic ;11 1.1\\"
.. IIII,IU\' 1lIIIIlilH',II ,',lilll.lIlIl '. Sn' Billill~''''\' (1~lliH) luI' lunl",1' d"l .. ih.
9.1. IImwTliau Motion

····,.1

I
I" II

Figurrl 9.2. ,'iflll//Jlt I'fllh fI/IIl COJl(lililJlwl !:X/JUlfllioll '1 ft Jlrorunilln Molion with Drift

Cov[p(ld, PU~)) :::= COV[p(lI), p(t~) - pUt! + PUI)] (9.I.I3)

Cov[p(lJ),!J(t2) - PUI)]
+ Cov[p<tll, PUll] (9.1.14)
2
Var[pUI)] == a tJ. (9.1.15)

As for the discrete-tim~ random walk. the conditional mean and variance
of p(t) are linear in t (see Figure 9.2). Properties (82) and (B3) of Brow-
nian motion imply that its sample paths are very erratic and jagged-if
they were smooth. the infinitesimal increment B(t+ h)- B(I) would be pre-
dictable hy JJ(t)-BU-h). violating independence. In ract. obsen'e Ihat the
ratio (JJ(t+h)-ll(l») / h does not converge to a well-defined random variable
as h approaches O. since

Var [
JJ(t + II) - lJ( t} ]
= (9.1.16)
II II

Tllt,rt·rort" thl' derivative of' Brownian llIotion. Jr (I). does not exist in the
ordillary St'llSt·. alld although the sample paths of Brownian motion are
t'vl'rywht,rt, cOlllinllolls. Ihey art' lIowhere differentiahle.
 46 9. Derivative Pricing Mudel.!

9. J. 2 Slocllfl.\lir f)iJJrrl'1ll/(lII~(f1Ult/01l\

rDespite this fact, the infinitesimal increJllent of Brownian motion, i.e., the
limit of B(t+h)-/J(t) as It approaches an infinitesimal of time (dl), has
earned.the notation dB(t) with its own unique interpretation beGlltse it has
become a fundamental building block for constructing other continllous-
time processes. 7 Heuristically, /J(t+II)-8(t) can be viewed as Gaussian white
noise (see Chapter 2) and in the limit as II becomes infinitesimally small,
dB(t) is the "continuous-time version" of white noise.
I It is understood that dlJ(t) is a special kind of differential, a ~turlUlstic
·difft'Tl'1Ilial, not to be confllsed with the differentials dx and dy of the calCII-
'Ills. Nevertheless, dB(t) does obey some of the mechanical relations that
ordinary differentials satisfy. For example, (!l.1.10) is often expressed in
dilTerential form as:
d/J(t) = Ildt + a d/J(t). (9.1.17)

However, (9.1.17) GunlOt be treated as an ordinary differential equation,

and is called a stochastic differl'1ltial equatiun to emphasize this fact. For ex-
ample, the natural transformation djJ(t)/dl = J1 + dB(I)/dl docs not make
sense because d8(t)/ lit is not a well-defined mathematical ol~ject (although
dB(1) is, hy definition).
Indeed, thus far the symbols in (!l.1.l7) have little formal colltent be-
yond their relation to (9.1.1 O)--one set of symbols has been defined to be
equivalent to another. To give (9.1.17) independent meaning, we mllst de-
velop a more complete ullderstandinl-( of the properties of the stochastic
differential dB(t). For example, since dB is a random variahle, what arc its
moments? How do (dD)2 and (dB)(dt) behave? To answer these questiollS,
consider the definition of dB(t):

d/J(I) == lim IJ(I

h-dt
+ h) - B(t) (!l.l.IH)

and recall from (3 I) that increments of Brownian motion are normally dis-
tributed with zero mean (since J1 == 0) and variance equal to the dillcrencing
interval h (since a = I). Therefore, we have

E[dlJ] lim E[/J(/

!,-,II
+ II) - U(t)] = 0 (9.1.19)

Var[dlJ] lim \-:[(/J(I + II) - /J(t»~] dt (!I.I.~O)

"-+"1
E[(d/J)(dlJ)j liIllE[(lJ(t+h)-/J(t))~1 lit (!1.1.21)
Y 1,-.. ,11

'! 7/\ rOlllpl"I" ali(I rit;" .... "s "xp",ilio" of II, ow"i"" 1II0tio" all,1 S(,;r1""lir dill""-"li.,1 '-'I"a-
Ilio"" i. heyon" the .r0l'~ of Ihis I<"X I. 11''''1. I'orl. ,,,,,I 510"" (1 \172. Chap(('" 4-li). M<"lIoll
;( I !I!IO. Chapl,'" :1). ;11,,1 S, I""., (I !IHO) 1" ovid,' <"x("dl<"111 ("ov<"""t;<" of Ihi. 111;11,·, i,,1.
9./. 1I11111111i(/1i Molio/l . 347

Val'/ (tI/I)(1I1I) /

0(1It) (!l.I.22)

I-:/(IIII)("I)J lim E[ (/J(I

),-+11,
+ Ii) - II(I))/d = 0 (!).1.2:{)

Var/(dll)("I)J lim 1-:/ (/J(I

II_,ll
+ h) - n(l))~"~ / = o(IIt). (!l.1.24)

From (B I) alld (9.1.1 !J)-(!1.1.20) and we see Ihal II lIt I) m,IY he viewed as
a llormally dislributed random variable with l.e\'O IIIl',11\ ami illlillilcsimal
variance dl. Althollgh a variance of til may scem like no variance at all,
recall that we arc in a world ofilliinitesimals-after all, accordillg to (9.1.17)
the expected vallie of "1)(1) is Ildl-so a variall('e or III is not lIegligihle in a
relalive s('nsc.
However, a variance of (dt)~ i5nq~ligibk in a rdalive sense-relalive 10
dl-since the sqllare of an infinilesimal is lIluch smaller lhan the infinitesi-
lIlal itself'. Il'we treat terms of order 0(111) as esselltially I.ero, lhen (9.1.21)-
(:1.1.24) shows lhat (dlJ)t and (diJ)(dl) .... e hoth llOll-slochastic (since the
vari'lIlces of the right-hand sides arc of order 0(111) hence the relatiolls
(dm'! == til and (dB)(dt) == 0 are satisfied nOljusl in expectatioll bUl exaclly.
This yields lhe well·knowll JIIultiplicalion rules lor slochaslic dilkrelliials
summ;lrized ill Tllllc !I.I. To sec why II\('s(' rllks ;lle IIs('llIl, OIlSlTI'('lhal we

"[able 9.1. MII/li/dimlio" ""/1'1/'" II",."(/\Ii, tli/lI'II'"llIdl.

x till ill

1111 III o
III o ()

can 1101" calcillale (dl)~:

("I)~ (Wil + arilJ)~

Ilt(dl)~ f- fT1(lIm~ + 2Ita(II/i)(rit)
atlil. (9.1,26)

Thi, siltlPk calcillation shows lhal althollgh 1If! is a randolll variable, (dP)t
is llOI. I t also shows Ihal til) docs hehave like a r;Ill<lom w;t1k illlT('lIlelll in
lhal Ihe I'ari;lll(,(' of til) is proporlionallo Ihe <li/kn'll( illg illinval til.

(;f(!/I/I'il';r /i/iJ1llllil/li Atolioll

If the ;lrilhllll'lic Browlliall lIlo1ion IJ(I) is I.lkell 10 he Ihe price of sOl1\e
assel, I'ro)l('\'ly (III) shows Ihalprin' IhaJlgn O\'l'1 ;111)' iJlIlTval willlJe JlOI~
m;llly <lislrihlll('(1. Bllt siJlce the StiPPOIl of Illl' IIOIJlI.t1 di,llilllllioJl is lite
('lit in' rl'al lilll', lIonllall}, di~lrihllll'd pricc ch;lIlgcs imply Ihal pricl's Gill
hl' lIl'galiw widl posilivl' prohahility, Ikci\usl' virtually all financial assels
enjoy lilllited li;lhililr-111(' Illaxilllllm loss is capped at -I OO/x, or Ihl' total
illVl'Sllllt'lIt-IH'g;lIiv(' pric('s ;\1'(' ('IlIJlirically implallSihle,
As ill Sl'clioll\ I.'t.:! of Chaptl'r I and 2. I.I of Chapter 2, Wt' lIlay dimi-
lIalt' Ihis prohll'lIl hI' dl'lillillg II( I) 1(1)(' Ihe lIalurallogarilhlll or prin' 1'(1).
lIndn Ihis (1I'Iillilioll,/111) call Ill' an arilhnll'lic I\rownian motion wilhollt
vio\;lIing limiled lia),ilil\" silln' Ihl' prin' 1'(1) =
I'/,(I) is always nOIl-ncgalive.
TIll' pritT prlln'ss 1'( 1\ == /,/MI is said to ht' a ~I'OI/II'/lj( Umlllll;fll/ 1II111ioll or I()~n/lr­
II/{/{ diffusion. W(' shall examint' Ihe statislit'al propcl'lics ofholh arithmetic
,Il\(l gt'lllll('lrk Brownian lIIolion ill rOllsidt'rahly lI\on~ detail ill SerliOIl (1.:-\.

/11;\ /.1'11111/(/
Although till' (irsl ('olllplelt' nlatht'llIatit'allhelll)' orBrownian lIIotion is dll(,
10 Wil'ner (I\l~:l) ,x il is Ihl' st'JIIinal wnlrihlllion of Itti (19!i I) thaI is largely
rcspollsihlt, lill' I he t'IIOrlllOIlS 11111111)('1' orapplir<lt ions or Brownian 1lI0t ion 10
prohh'l)IS illlllathl'llIatirs, statistirs, physics, chcmis\I)" hioloJ-.'Y, cn!!;inl'erillg,
anti or COllrS(', lill;tllrial el"lllIOlllics. In particular, Ito constructs a broad
dass of cOlltirlllOlls-tinlt' stochastic pro('('SSt'S hased on Browni,llI lIIotioll-
1I0W \.:.I\O\\,II as /11; /111/(1'.111'.101' Illi Jlorlu/.llir tiilfl'l'l'tIliri/ t'!fualio/l.\--which is rlo.INI
IlIltll'r ~(,IIt'ral 1I01l1illl'"r IrallSfill'lllatiolls; thal is, an arhitrary lIolllinear
f'tlllrtioll fl/I, t) of an !til pItH'('SS /1 alldtilllt' I is itself"n Itil proCl'ss.
Morl' imporlantly, 1«; (I ~)51) provides a (ill'mllla-III;:1 1.I'III1I1I1-for cal-
I'Illating I'xplicitly thl' sto(hastic cliffcrl'lItial equalioll that govl'rns the dy-
lIamics or f(/I, I):

ill ilf ,il~f 2

--till -I- -;--111 + ;;-.-" (ti/) . (9.1.27)
illl .II • II/r

Thl' lI\odl'st tl'rlll "1('11111101" hardly dOl'sjllstire 10 Ihe widl'-ranging impact

(~).1.~7) has had; this I'owl'l'ful tool a\lows liS lO quantify tht' t~voilltion of
(olllpll'x stochaslic sysl('nlS ill ;1 singll' stl'p. For example, Il't /) clt'II0le the
IO~-l'rin' pmn'ss III' all a\st't alit! SIlPPOS(' it satisfit's (9,1.17); what an' the
dynalllics of Ih(' prict' l'roll'ss 1'( /) = I,/'III? Ilt;'s I.t'mma providt,s liS with all
illlllll't1i;ltt' alls\\n:

j) I' I a2 /' "

(\).I.~~)
ell' -til) -I- C -(tI/)·
all ! a/)~

KS,'(' .ll'li'UIi. Sillg"I, .lIul SIIIItII"I.. (I~)~th) ItH .tII ('x("('lIclll hi~llJ .. k.tI l(·t,o~p(,l"li\'t' 01
\\,i"IIt,. \. Il':\(',udl whit h illl hlllc'~ "'\t'LIl ;Irlil ks ,lluHII '.Vi('lIcr\ illtlU(,IIf(' OIlIlHHI«'nl fill;tIU"j.tI
('('(HUllUifs.
Y.2. A lJriejR£lJilW of Derivalivt' J'rl(jllJ; MrlJlOds

= t Pdj) + ~ eP(dp)2
::= P(/1dt+adR)+~P(a2dt)
dP ::= (/1 + ~a2)Pdl + a PdB. (9.1.29)

In contrast to arithmetic Brownian motion (9.1.17), we see from (9.1.29) :

tltatthe instantaneous mean and standard deviation of the geometric Brow-'
nian 1II0tion are proportional to P. Alternatively (9. i.29) implies that the'
instantaneous percenlage price change dP / J> behaves like an arithmetic Brow-
nian motion or random walk, which of course is precisely the case giv~n the
exponcntialtransformation.
Wc provide a considerably less trivial example of the power of lt~'s
Lemma in Scction 9.2: Merton's derivation of the Black-Scholes formula.

9.2 A Brief Review of Derivative Pricing Methods

Although we assume that readers are already familiar with the theoretical
aspects of pricing options and other derivative securities, we shall provide a
very bril"frcview here, primarily to dcvelop tcrminologyand define notation.
Ollr derivation is deliberately terse and we urge readers unfamiliar with
these models to spend some time with Merton's (1990, Chapter 8) definitive ~
treatmcnt of the subject. Also, for expositional economy we shall confine
om attention to plain vanilla options in this chapter, i.c., simple call and put
options with no special features, and the underlying asset is assumed to be
common stock. 9
Dcnote by G(P(l), I) the price at time I of a European call option with
strike price X and expiration date T > I on a stock with price P(I) at time
1. 10 or course, G also depends on other quantities such as the maturity date
T, the strike price X, and other parameters but we shall usually suppress
these arguments excep~ when we wish to focus on them specifically.
I [owever, expressing G as a function of the currenl stock price pel), and
not of past prices, is an important restriction that greatly simplifies the task
of fincling r; (in Section 9.4 we shall consider options that do not satisfy

" 110""\'<'<, Ih" lechni'lllel reviewed in Ihis sec lion have been applied in simitar fashion
II) 1i"·,.,,lIv hlll\,Ir~," or olher Iype. or derivalive secllr;lies, hence Ihey are considerably more
){~II ...."I Ih,," Ihey lIlay appear 10 be.
11I1{l"r,,1I Ih'lI " ((/1/ option gives the hold"r Ihe ri){hl \0 purchase Ihe underlying assel for
X alld " /111/ "pliml gives Ihe hulder Ihe righl 10 ,ell Ihe underlying ;USel for X. A EUrr>/Nali
oplil)l\ i, \lI1<" 11t"1 call he exercised only on the malurilY dale. An Ammcnn oplion is Ohe thai
(';1111)(" t·Xt·n'is~d 011 or I"jo" th~ malUrily ,Iale. For simplicity we 5hall deal only with Ellropt'all
oplioll' ill Ihis fh"pl~r. See ('.ox alld Ruhiosleill (I!lW», lIull (1993), alld Merton (l99(» for
ill,lillllioll,,1 d"lails and difTerences belweell the priCing of American and Europt'an options.
 9. /)rrillillillr I'lirillg Mudrls

this restriction). III ,l<ldiliulI, Black ,lIId S~:h()les (1\17:~) 1\1<11<1' thl' rllll<lwil\~
assumptions:

(Al) TllI'rr 1/1"(' 110 mfll/u'l im/II'lji'flioll.l, r.g., 1(1).'1'.1, Imll.mflillll.1 f/).II.I,lhorl.lfIll'.f
rollolimilll.l, (llId lradillli is flllllill /WIlS (I lid ji"ifliulllrss.

(A2) Thrrl'iJ IIl1lilllilnl riJhll'.Is blllTIIll'illg IIlId ll'/uiil/g at Ihf {"(/IIlillllllll.l/y rUIII-
!wlII/til'll mIl' of rPlllm r; 11I'lIff II $1 illllf.I}/111'111 ill sllfh 111/ lI.I.Irl /lilt'/' IIII' lillll
illlmlll[ T groW.1 Iu $1 . r or . ALtl'l'l/alillt'ly, if 1)( t) is Ihl' dllll' I /JI'ifl' of II di.\fI)ulIl bUild
IIIl1luril/Ii (II rillll' T willi Jllfl' llallll' $1, 011'11 fo)' I E [0, TJ thl' bOlld /JI'ifl' dYlltIIllif.l
(1)'1' giIlrII fry
<If)(!) = r{)(t) til. (9.2.1)

9.(AJ) Thf.llork 1"10' 1(1',lI/lllif.1 (Ill' gil'('11 by f/ gl""l1f'1rif JJmwllillll II/lIlillll, 11"..lII/l1lillll
rll Ihr/Ill/moillg lit; .lllIflimlir dij/('Il'11lial ('qllalioll (II' I E [0, '1'1:
\ dl'(1) = Jil'(t) dl + a 1'(1) tllJ(t), 1'(0) = I'" > O. (9.2.2)
1
Illhl'),1' B(I) is (I staHriem[ HroWlliflll motioll, alld al [rasl 11111' illlll',\lor Ob.ll'l1lrS (J

wilhoul rrror.
I

\(A4) TIII'!'r is I/O (lrbilrage.

l
I 9.2.1 Thp BlUfk-S(hOle.1 (mel MI'!'lull AfJ/nuflfh

he ~oal is to narrow down the possihle expressions for G, with the hope of
btaini!lg a specific formula for it. Black and Scholes (l!17:~) and Merton
f \9731» accomplish this by considel'ing relations among the dynamics of
te option price G, the stock price P. ami the riskless bond V. To do lhis,
Ie first derive the dynamics of the oplion price by ass\llllill~ thai (; is only a
fJunction of the currenl stock price I' and I iL~c1f and applyin~ h(.,.s I.elllma
~see Section 9.1,2 and Merion [I ~m(J, Chapter :~ J) to the function (;( 1'(1). Il.
~hich yields the dynalllirs of Ihe option price:

(9.2.3)

where
I [ a(; (1(; a~/'~ iI~(;J
- ItI' -
(; ill'
+ -ill + -~- --
il/'~
(!1.2.4)

I [ ;/(;]
- al'-
e; ,JI"
Unforlunatcly. this expression (1m's nol S('eIllIO provide any ohvious reslric-
lions that might allow us 10 lIarrow dowlI the rhokes for G. One possibilily
is to s('t I', ~'qu.d to SOIll(' "r~'\l\lirl'd" r.It~' Orll'turll r", 0111' that \'I)III~'S frolll
equilibriu\ll eOllsidl'ratiolls of th~' I"<IITI'SPOlldillg risk of the Ojltioll, IIlIlCh
like the (:APM (sec (:haptn :1), If SUdl all I" COllI lw id\'lltilinl, the cOlldition
/1 x = r" n'duces to a PDt-: which, under SOUI\' regularity ,Uld houndary condi-
tions, possesses;) IIniqlle sollltioll, This is the approach lakl'n by Black allll
Scholes (I !)7:~).11 Ilowcvcr, this approach r('qllires 11I0/(' sl rllCl lire Ihan w('
hav(' illl[Josl'C1 ill (A I )-(A4 )-01 flllly articlllat('d dYllalllic IIlOtlc! of(,("(lIlOllIic
<'<jllilibrilllll in which I;, can he d('I('rlllilH'd l'xplicilly 11I11.~1 h(' .~p('("i'ied,
:-'krton (1!17:~Il) prcscllts all altcrllaliVl' 10 IIII' ('qlliliinilllll approach
of BLick and Scholes (I !)7:~) in which Ihl' S,IIIH' oplion-pricillg 'lmllllia is
olll,lined IHtI wilholll any additiollal asslllllpliollS Iwyolld (A I )-(A4). lie
does Ihis hy ("ollslrlicting a portfi)lio of slocks, opliolls alld riskll'ss hOllds
that n'qllir('s 110 illilial Ill't investlllent alld 110 additiollal fllllds h('(we('11 ()
alld .,., a .\{'Ij-ji 1111 II I"i "K portfolio where IOllg posit ions are nJlllpll'tl'ly lill,lIl~"('d
h)'s\tort positions. Spccifically, elenole hy ',,(1) tlrl' dollar ,lI110llnt illl'l'stnl ill
the slock at dall' I, 1./(1) the (Iollar alllollllt inwslI'd in riskless honds at (\atl'
t v'hlch lllature at date T, and 11:( t) the dolLlr ,ll1l011ll\ invcsled in the rail
opti'lIl ,II date t. Then the zcro lIet illV('stllll'llt cOllditioll IllOlY he expressed
as:
VI C [0, '/'1. (!I.~Ui)

Portfolios s,lIisfying (\l.~U» ,Irc called mllilmgl' portfolios. 1\11'11011 (1\)(;\)

sholl's Ihal Ihe illstantanCOIIS dollar ret Ill'll dllo Ihis arbitrage portfolio is:

I"
til = - til'
I'
+ -I"/) Il/) + -'-I~(; dC. (9.:l.7)

where Ihe ,to("hastic diflcrcnlials til' alld Ii/) ,liT givl'lI ill (~).:l.2) alld (~).:l.I)
rcspectively, alld de; lollows from !tt)'s l.elllllla:

I,~r.dt+ 0x(;dll (~).'2.H)

/d'i1G/iJl' + iI(;/iit + "~F-il~(;/iJl'~

I', - (;
(~). '2.~)

a l'iJ G/iJl'
(9.2.10)
(;

SllhSlit\llill~ til<' dYllamics or 1'(0, /1(1), OIlId (;(1) inlo (~1.:l.7) ,lIId imposing
(!).2.ti) yields

til = [(I'-·')lt,+r'I,:-")I,:l"t+[rrII,+oK/~ldJi(t). (!l.'2.11)

11111 1',11'1;1111,11, I\I,I('~ ,",,1 SriI"I,', (1\17:\) ;)."11111(' tiI;11 Ihl' ( .. \1',\1 h .. ld" ,11,,1 "i1I,lin I;, h\'
~\PPt'.\Il1lg 10 tht' ~l'nH Ily~m"\I"kt'I-\itll' n·I""11ll whirh link... l'X)U'( a'il 1 t'\11l H~ 10 Ill'l.L f lowen'r.
Ihl' C:AP~I i~ 1101.1 dYII.lIllie lIIodd dh'(I'liIiIHitlill r{'llIrll."! .llId 1I1t'1(" ;II{' .'''"It' ,"hllt, hlll."Iigllil-
irant tlu' CAPM .1IIe1 nJlIl111111111,-IIIII(' opliolt.prit iug lIIodd.~ (."( .•.. 101
il1("lIlI:..i.,j('JH i('!'\ ht'tWl'('1I
cxal1lpk, I)Y),\'ig ;lIId Il1gcl!'oooli II !IH:! I). N('\'f.'llIu'k.,:... RllbilJ.,lC"ill (1!17fi) plfl\ id('" .1 drll.llui,'
l'Qllilihrillili l1Iudd ill whidl til(' HI.1Ck·SdlOlc·, 101111111.1 III tick
 hil rag c' pO l'll illi o to ht'
rOlllpl('wly ri,~ldt'ss ill
n',l li(' ( IlIi:-';1I
Now kl liS fili lill 'l
is 1I0 IlSI OI' It;I \/i(
' 0/1 '1'/. Thi.\ /Ilay hI' gu ara lJl eed
to.
l l1l1
till ' S(,II~(, Iha it,\ n'lI

III' ('l\IlOSillf.( 1.< "-,

all d II' =
I; I,:
,,1111;11
W: ?I :!)
VI E ((), ',1'/,

illl pl\ 'ili g /";1 1

,1I'
J/~(/} <In ' IIt{ ' Ill
llll hn or sha rI'S of
I E 10. TI. IIh erl ' J/I~(() ;IIU \ lrillg /t'r n-r isk
til!' ('\'( '1'\' ll! ill Ill! ' s('II~!illal
lill ll. \'I's IH' I'li\ 'd\' . Ill'
1111' ~Iock all d IIII' IIl' isl all ! thr oll gh lill
lt'. ho th 11;(1)
IIlItc,s {)( ;(I )/a /' is nll
por tfo lio . No ll' Iha l 111<11 thi s po rtli llio is risk les s at all
I'-valyillf,( 10 ('!lS lII'( ' il Pis kll ow n
all d 11;(1) II I lIS 1 Ill' liIH d~l'd .I\l d - ,I (;(1 )1
nli llio is .;ai d 10 Ill' /JI'r/i'/'t/y Il/'
IIIIl C'S. SlI l'h ;1 po
io
as IIII ' III'I~I!" mli".
lid (\I. :!.I :I) fill' al! { E In,
'1'1 yit 'lds a "Yl lf/m if' po rI fol
IlII jlos illg ' (\I. :!.l i) .. l Ihl' 1I S\I \'('' '' its
i",' (·st llH 'lll . Bil
s all d n'( jlli n's 110 I\('t ens tles s,
slr.. tq,·Y Iha l is lis\ ..ks oll ll'n vis l' Ihe l'!' wo uld ('xi s\ a
illm lls l he JI'I 'O,
/iJl '(',
a 1l0Ils1ot'haslil"
l'isklt'ss «1) 'lla
ret
lllit '
urn
l'0n lO, lio \11 ';lIl 'g" tha I ri,'
leis a POSilivI' \'('(111'1
1. Th nC

I...i. 10 avo id arh iu'; lgc

, il IIII1SI II(' ill(' caS «'
Iha l

, IS' has Iwt'lI ade ll'd III J{K

(') to ('m pha si! .c Ihe
bn \1\; \1

I i Wh l'fl ';1 lim l' aq.? ;\\\lH'IH

il I'ar ies Ihr oll gh lill ll'
;t,' 11'1'11.

sill llll l' Ilo-O\fhilragc

COJlditioJl n', llI n's tftc
pos sib le

\ I~
Sur pri sill gll ', Ihi s
"(lI Id- ord t'r 1i1l1';1" par abo lic
a s('(
('h oir es of (; loj llsl Oil"
('x pn' ssi oll wh i .. h is j
•
I...i
Pil E II", (;:

:!
I.. '. if! ( ;
-0
il/'~
i l l ; ; ) ( ; - I'{; =:; II,
-1'- - - - -I- r/' --
ill'
- +- - -
ill

llll dar y cO lld itio lls:

(;(/ J( T), 'J') =::
j
' I(.!lowillg 1\\' 0 hO

• slIh jl,\, 1 (0 Ihl (,(HIlSI', Iht '

~bxu'rn-x, O\'
all d qO ,1) :::: 0, Th
" IIll i'll ll' sol uti olJ is, Ill'
j
I.... I
1\lac);-Scholcs !l1l'1l1ub:
{~l.~. Hi}
j

I• ...••- \
log U'( !)/ X) -+-
fl
(I'

jT ::i
+ ~n~)('r-I) W~,17) j

log U'( lI/ Xl 1- II' - ~(J

~)('{'-I) j
I...! \
l
I
I
nJ T- 1
(~J.:!.I ~)

j
Ii: \ j
• \
9.2. A il,;fJ Rl'view oj Derivative Pricing Methods

where <1>(.) is the standard normal cumulative distribution function. and

T- t is the time-to-maturity of the option.
The importance of assumptions (AI) and (A3) should now be appar- ,
ent: it is the combination of Browian motion (with its continuous sample
paths) and the al~lity to trade continuously that enables us to construct:
a perfectly hedged portfolio. If either of these assumptions failed, there,'
would be occasions when the return to the arbitrage portfolio is nonzero,
and stochastic, i.e., risky. If so, the arbitrage argument no longer applies.
Merton's derivation of the Black-Scholes formula also showcases the
power o\" Ito's Lemma, which gives us the dynamics (9.2.8) of the option:
price {; that led to the PDE (9.2.15). In a discrete-time setting. obtaining i
the dynamics of a nonlinear function of even the simplest linear stochastic
process is generally hopeless, and yet this is precisely what is required to
construct a perfectly hedged portfolio.
More importantly, the existence of a self-financing perfectly hedged
portfolio of options. stocks, and bonds implies that the option may be syn-
thetically replicated by a self-financing dynamic trading strategy consisting
of only stocks and bonds. The initial cost of setting up this replicating port-
folio of stocks and bonds must then equal the option's price to rule out
arhitrage hCGI\lse the replicating portfolio is self-financing and duplicates
the option'S payoff at maturity. The hedge ratio (9.2.13) provides the recipe
for implementing the replicating strategy. .

DIllion Sl'1Isilivilies
The sensitivities of C to its other arguments also play crucial roles in trading
all(1 managing portfolios of options, so much so that the partial derivatives l2
of G with respect (0 its arguments have been assigned specific Greek letters
in the parlance of investment professionals and are now known collectively
as utlticlll smsitivities or, less formally, as the "Greeks":u
~
Delta t..
ac (9.2.19)
-
aJ>
a2 c
Gamma r - ap~
(9.2.20)

aG
Theta H - iJt
(9.2.21 )

11'1'1 ... It· fill ""ani;,l d.. riv.lliv~s- in this COll(,'xt rer,·!"s. or collrse. to instantaneous rates or
change. This i~ 1Il1fortlll\ate Cuiliricit"I1Ct' or It'nninoloJ.,,ry is usually not a source of confusion,
hili f('adtOrs should hewart".
nOf nll,r,,·. "\'<'I(a" is not a Gr .... k l~((~r ane! V is simply a script V.
354 9. Dr/iva/ill' Pridng Models

iJG
Rho R - (~J.~.22)
iJr

aG
VC)!;<I V - W~.~:{)
iJa

For the Black-Scholes formula (!J.~.I(;), these option s(~lIsi'ivi'ics call he

evaluated explicitly:

/),. - 4>(dd (!J.~.~4)

4>(d, )
r - (9.~.~:i)
/'aJT-1
1'(1
(.,) - J1Ct <P«(ll) - Xre-'(T-II<t>(d~) (9.~.::!G)
2 T-I .

R = (T-t)X,- ,(T-II<t> «(tl ) (!J.2.27)

V - J>-!T-l 4>(<1 1) (9.~.28)

where 1/>(-) is the standarci normal probahility density function. We shan

have occasion to consider these l\leaSUres <l)!;ain once we have dcveloped
methods for estimating option prices in Section 9.3.:t

9.2.2 The Marlingau Approach

Once Black and Scholes (1973) and Merton (1973b) presented their option-
pricing models, it quickly became apparent that their approach could be
used to price a variety of other securities whose payoffs depend 011 the prices
of other securities: Find some dynamic. costless self-linancin)!; portfolio
strategy that can replicate the payoff of the derivative. and impose the no-
arbitrage condition. This condition usually reduces to a PDE like (9.~.1:i),
subject to boundary conditions that are determined by the specific terms of
the derivative security.
It is an interesting bct that pricin)!; derivative securities along these
lines docs not require any restrictions on a)!;enlS' preferences other than
nonsatiation, i.e., agenL~ prclCr more to less, which rules out arbitrage op-
portunities. Thcrcli>re, the pricing fonnuhl for any derivativc security that
call be priced ill this I;lshion mllst he idelltical for all preferellces that do
1I0t admit arbitrage. III particular, the pricing formula Illust he the same
regardless of agenlS' risk tolerances, so that an economy composed of risk-
neutral investors must yield the same option price as an economy composed
of risk-averse inV('slOrs. IIlIt undl'r risk-neutrality, all assets Illust earn the
same expected rate of relllrn which, ullcler ;Issumptioll (A:.1) , must e<ju;11
the riskless rate r. This fUlId,lIlwlItal illSi~ht, dm' 10 Cox ;IIHI Ross (I \17(i) ,
simplifies the computation of optioll-pricill~ f(ll'IIlIlI;IS ('llol"ll1ollsly 1)('('allS('
in a risk-m'lltral ('COIIOIllY the oplioll's pri.-(' is silllply Ih" "xpn led vallie of
it:- payoff ,lis«HUllc(1 al lhe riskless raIl':

G(l) = e-'\I'-') 1':,[MaxIIJ'(/') - X. 011. (\1.:.1.:.1\1)

Ilowever. the cOllditiollal expeetatioll ill (\1.2.:.1\1) IIl1lst he eV;lluated with

respect to the r;1IH\om variable 1"( 'f), not 1'( T), whnl' I" (T) is the termillal
stock pricc adjll.lted jor risk-lIeutmlily.
Specifically, ullder assllmptioll (A~), tlH' conditiollal distrihutioll of
1'( T) give II 1'(1) is simply a lognol'lnal distrihlltioll with Ellog 1'( T) 11'(1) I =
log 1'(1) + (JI - ~)(T-l) and Var[log I'(T) 1/'(1)1 = a~('r-I). Under risk-
nelltrality, the expected rate ofretllrn ((II' all assets IIlIlSt be r, aud hence the
cOlldilional distributioll of the ri.l/I-IIPlllmliU'd 1<TllIinal slock price 1'- (T) is
al.:o logllormal, bllt with E[log PC/,) I 1'(1») = I()~ 1'(1) + (r - ~)(T-l) and
Vartlogl'(T) 11'(1») = a~('r-l).
For obvious reasons, this procedure is called the ri.I/t-lIl'lIlml /nirillg
method alld under assumptions (AI) through (A'1) , tht' expectation ill
(9.2.2\) may he evaluated explicilly ;IS a fuurtioll of lhe sl;uHlanlnOl'lllal
CDF and yields the Black-Scholes f(muula (\).2. Hi).
To emphasize the generality of the risk-nl'lItral priring method in valu-
ing arhitr;lry payofr streams, (9.2.29) is often rewrillen as

(;(1) = p.-.('f'-I) 1':;[Max[I'(T) - X.OI].

where the asterisk in E; indicates lhat the expectatioll is to he taken with re-
spect to an adjusted probabililY distribution, adjustcd to be consistenl with
risk-nelltrality. In a morc formal selling, Harrison and Kreps (197\) have
shown that the a(ljusted probability distribution is preciscly the distribution
under which the stock price follows a martingale; thlls they call the a(ljusled
distribution lhe equivalent martinKlIle mPll5UTf. Accordingly, the risk-nelllral
pricing method is also known as the 1/I{/rliIlKfllt' fJlicillK fer/lIli'll/t'. We shall ex-
ploit this procedure eXlensively in Section 9.1 where we propose 10 evaluate
expectations like (9.2.30) by MOllte Carlo sillllllalioll.

9.3 Implementing Parametric Option Pricing Modc\s

Ikcallse there arc so many diflerellt typcs of options ;lIHI other derivative
securities, it is virtually impossihlc to dcscribe a cOlllpictl'iy gCll('J'al method
for implementing all derivative-pl'il'illg fill'lllulas. Thl' IMrtinilar features
of earh dnivativc security will oftcn pia), a ('('1111';11 roll' ill how ils prit'illg
 (), /)1'/'h'lIlil'l'I'/'irillg A!1lI11'!.1

IC>IIlIlIla is 10 1)(' appli('d IlloSI dknil'dr Bill Ihl'l'e are s('\'nal ('0111111011
aSI'('CIS 10 e\'('I"\' illlpl"lIH'lIlalioll of' a /HII(/IIIt'/rir o(liioll-pricilll-( /lIodel-a
Illodel in ",hich Ihe III ice dYllamics of Ihe ullclerlyill~ s('cllrily. called Ihe
IUIlt/I/IIII'1I1111 filII'!, i~ spccifi(,d "I' 10;1 fillite 1ll1l1l1H'r o('parall\ete('s-;u\(1 we
shalilill'lis Oil IIH's(' COIIIIIlOII ;\SI\('('IS ill Ihis SC{'(iOIl,
'Ii, ~illiplil\' Il'llllill"I"gy. IIII,,"SS "Ihcrwisl' sl;tll'd W(' shall IIS(' Ihl' I('I III
{l1,liollto IIIcall aliI' gell <'I'a 1dni\'alil'(' ~(,cllrily. alld Ihe 11'1'111 ,1/01'1, to lIIeall Ihe
dt'lil'alil'e s('nlril\''s IIllderlyillg I'II1I1LIIII('1I1a1 asse\. Althollgh 111('1'1' are c('r-
lailll), asp('CIS or SOli\(' dl'ril'alil'e se('lilil ies IIial differ dramalically from lho\c
of slalldan I (''I" ill' opl iOlls alld (';1111101 1)(' described ill ;lllalogolis lcrllls. Ihey
III'('d 1101 1'011('('1'11 liS ;11 Ih(' CIIITI'III 1('\'cI of' gl'lIeralilY, Alkr tll'vclopillg a
('0 h 1'1'1'11 I rrallll'work li,r illlplcllH'lIlillg gell('ral pri('illg Ii,nllllias. wc shall

IlIrll 10 IllOcii/iraliolls lailoJ'('d 10 panicllla .. derivalive securilies,

1),1.1 1'1/ll/lIIdl'/' 1',\lillllllioll 0/,;\,\'\1'/1'/11'1' /)yl/lll11in

Till' 1t'l'11I "p;tr;\III\'lril''' ill Ihis sCl'lioll 's lit Ie is lIIealll 10 1'lIIphasil.l' Ihe rc-
1i;1II ('(' 1)1';1 rlass 01 oplioll-pricillg fOlmulas 011 t\l(' paninilar asslIlllptions
('olll'I'millg the l'll1l1iall\('lIlal assel's plin' dYllamics, Although Ihese lalher
SllOlIg assllmpliolls 0111'11 vi('ld c1I'galll and lrartah1l' expressiolls for Ihl'
o(llioll's price. IIi('y ar(' lypicallv cOlllradicled hy the dala. which docs 1101
hode wcll for IIIl' plicillJ,!; /ilrmIlLI's SIICC(,SS, III raci. pl'l'haps thl' most impor-
tant asp('C( of' a SIII'('('ssl'lIl empirical illlplclll('1I1alion of' any oplion-pricing-
lI\odel is cOIT('nl), id('llIiryinJ,!; Ihe d)'lIamics of the slock prict'. and IIrlCer-
lainly J'l'J,!;anlillJ,!; Ihcse price dYllamics wilileacllls to consid(,r 1I()11/J(lrt/IIII't' ric
alt('l'IIali\'('s in (:lIapl('l' I~,
Bllt lill' IlIc IIIOIlIt'III. let liS assert thai the specilic form or Ihl' slock
pricc proccss /'( I) is known lip to a V('Clor of unknowlI paralllelers 0 which
lie~ in SOIIIl' paralllctl'J' space e.
and Ihat it satisfies Ihe /iIIiOlvinJ!; stochaslic
eli/fen'ntial (''Illation:

tll'(I) 1/(/', I: n) til + h(l'. I: (3) tll1(l). I E [0, 'J'). (!U,I)

where 11(1) is a standald Wil'ller proc('ss alld 0 == [0:' (J' l' is a <lix I) Vt'cto\'
of II II kllo\\,11 P;II:lI11I'l('IS, '1'1\1' hlll('(iolls IIU'. I: 0) alit! h(l'. I: ('J) arl' ('alkll
Ihc dr;ji ;\lHI/liJ/il,;"" tlllll'liollS. rl'sp('('livl'ly. or Ih(' (fwjjirifllljilllfli()I/,\ colll'l'-
liwly, For (·';;lmph-. till' h)J,!;llOI'lIl<l1 dilfusion asslIlI\l'd hy mack and Scholes
(1!17:\) is gil'(,11 IIv Ihl' fllllowill~ coe/'lil'j('nl functions:

{/(/'. I: 0)

hI /', I: tJl (11' (!),:U)

<).3. /mlJifmmtillK /'IIT1lmftrir 01l/iOIl Priring Models 357

In this rase. the parameter vector (J consists of only two elements. the con-
-stants a and fl. H
In the more general case lhe functions a(1'. I; 0) and b(P. I; (3) musl be
restricted in some fashion so as to ensure the existence of a solution to the
stochastic differential e'l\lation (9.3.1) (see Arnold [1974], for example).
Also. for tr~\l'tability we assumc th,lI thc codlicient functions only depend
on the most recent.price 1'(1); hence the solution to (9.3.1) is a Markov
process. This assumption is not as restrictive as it seems. since non-Markov
processes can often bc re-expresscd as a vector Markov process by expansion !
of Ihf .1/"lfS. i.t' .• by incrcasing the Iltllnber of stale variables so that the col-
lection or prices and state variables is a vecLOr-Markov process. In practice.
however. expanding the states can also create intractabilities that may be
more difficult to overcome than the non-Markovian nature of the original
price process.
For option-pricing purposes, what concerns us is estimating 0, since
pricing f'()('(nulas for options on p(t) will invariably be functions of some or
all of the parameters in O. In particular, suppose that an explicit expression
for the option-pricing function exists and is given by C(P(I), 0) where other ,
dependencies on obscrvable constants such as strike price, time-to-maturity, I'.
and the interest rate have been suppressed for notational convenience. 15 An ,
estimator of the option price Gmay then be written as G C(P(!), 0), where =
o is some estimator of the parameter vector O. Naturally, the properties of
(; are closely related to the properties of 8. so that imprecise estimators of
the parameter vector will yield imprecise option prices and vice versa. To
quantify this relation between the precision of G and of 8, we must first
consider the procedure for obtaining 0.
MaximulIl Ukelihood t:'slimalion
The most direct method for obtaining 8 is to estimate it from historical data.
Suppose we have a se'luence of 11+ I historical observations of pet) sampled
at non-stochastic dates' 10 < II < ... < III which are nol necessarily equally
Sl)(l(f(/. This is an important feature of financial time series since markets
are generally closed on weekends and holidays, yielding irregular sampling
intervals. Since P(t) is a continuous-time Markov process by assumption,
irregular sampling poses no conceptual problems; the joint density function
f of the sample is given by the following product:
n
f(I1I.···.I',,;(J) = ./ilml;9)nf(P..t. I PH./Jc-I;O), (9.3.4)
.=)
II NOlI' III"t "Ithongll th .. drift awl dilln,io" fnllflioll' dql(,lId Oil distillct parJlllett'r vector.;
(t Ii. th('~(" Iwo \'('('tors m;ty COil rail) sOllie pal.tlllt"ler."i in common.
;u,,1
"'h'('11 if (; call1lot be obtained in closed-Conn. (I is a ne,,·s.'ary inpttl Cor numerical solutions
or (; ;\llIlllIlIst still he estimated.
358

where p. == 1'(1.). jilU{d is the marginal density lilnction of and n.

j(P•• i. I Ph-I. ik-I; 9) is the conditional density function of I'~ given I'~_I,
also called the lramilioll rlfll.lily IUJI(lillll. For notational silllplkity. we will
write I(I'h. Ik I Pk-I. Ik-I; 0) simply as ./i.
Given (9.:\.4) and the observations "II .....
1'", the p.. ramC'tn \"I'ctor
llIay be estimated hy the lIIethod of IIlfIxil/l/l//l IiIIP/i}wor! (scc Scnioll A."
of the Appcndix and Silvey 11975, Chapter 41). To ddilu' the Illaximlllll
Iikclihood estimator O. kt [(0) d('llote thc (0t:-likl'li//IIlld/illldiol/, IIII' lIallirid
lugarilhm of Ihe joillt densil)' IiIllClioll of ,~" . , . , "" viclI'ed as a fUllction
of 0:
[(0) . == L" log ji,.
k=1I

Thl' maxinllllll likelihood eslilllalor i.~ Ih('11 given hy

o == arglllax [(0). (!I.:I.(i)

(he

Under suitable regularilY ('oIHlitions. iJ is consislcnt and has tht, li,lIoll'ing

\Iorlllallimiling distribulion:

I iI~{(fJ)]
J/i(iJ - 9) :.:.. N(o, y-I (0»). I(O) =::; lim -·E - ----;
[ " ilOilO
. (1).:1.7)
,,~'"

where I(O) is called Ihl' il/fiJl'll/lllill1l //llllrix. When 1/ is large, III(' aSYlllplo,ic
distributioll in (\I.:t7) allows liS to approxilllal(~ III\' varia lit'(· oj (j 'IS

. I .
VarlO] "" - y-l(O). (\U.H)
1/

andlhc infimllalioll matrix I(O) ma), also he eSlimaled ill III(' lIalliral way.

. I ;/1 [Ii})
1 = ---.
II ilO i/O'

Morcover. iJ has l)(,l'lI showlI 1(1)(' aSYlllpIOli('all), ertici('111 ill til(' class or all
cOlIsiSIC1I1 alld IIlIif(JI'IIII), asymptotically lIonnal (eUAN) I'stimalors: Ihal
is, il has Ih(' smalksl asymptolic variallt'1' of all l'slilllalor.~ Ih"l are etlAN.
h('lIcc il is Ihl' pr('ll-rr('(llIH'thod oreslilllatioll Wh('IH'\'('r ll-asihl('. ()rcollrsl'.
1Il:lxi III II III likdihood ('slilllatioll is ollly ll-asihle whell Ihl' likdihood fllll(-
li\)n ran hl' ohtailled ill rlo~('(l fllI'IlI whirl.. ill 0111' I';\S('. Il'qllin's ohuillill).\
Ihc Iransilion (kn~ily fllllctions./. ill dosed forlll. Unfortllllilldy,,, dosl'd-
form expression for Ji for alhitr"r), clril't alld diffllsion fllllctiolls clIlnol he
ohtaillcd in gcneral.
IlowevCl'. il is possihle 10 charaClni/.I·[J, illlplicill), a.~ Ihl' sollllioll 10 a
PilE. In partinrlar. fix Ihe ('olldiliollillg variahles I'k-I alld 'k I and 11'1/1, he
9.3. /1Il1Iil'1IIt'IIIi11K Parametric Olilioll I'ricillg MOIIt,!.,

a fUIIClioll oj" 1'" alld I,,; to cmphasize Ihis, we drop the suhscript k from thc
argumcJlls alld writc fiJP, t 11',,_1, I.-d. ThclI it follows froll\ lhc Fokkcr-
Planck orjo/1C1arrl equatioll that .1~ IIIUst satisfy the !i)llowill!!; (scc 1.0 [19HH]
fill" a derivatioll):

YA (!UUO)
ill

with !niti;ti COllditioll

(!13.11)

where 8(1'-1'" il is the Dirar-ddta (ullnioll lTIIII'ITd OIl I'k-I. Maximum

likelihood l'stilllatil)l\ is feasihll' wht'llt'n'!' (\I.:~.IO) (;111 Ill" solwd l'xplirill)'
;\IIclthis c1qJl"llds Oil how rOlllpli .. aled Ihe "'H"ni(iellt hili( liolls (/ alld b ar('.
()II .... ./k is oblailll'd. iJ ("all be "olllplltcd 11111111'1 i.. ally givell the dat;1
n, ... , I'". 'Ii) illterprct this l'stillialor, II'C IIIIISI .. her\.. Ih.1\ _the regularily
rendiliolls f()I' Ihc cOllsislcncy alld aSYlllplOtit- lIorlllality of 0 are satisfied.
III ~Cl\lll' elses of illterest Lhey are IIO\' For exalllpk, a h)!!;lIonll,\1 diffusioll
=
"I' I (I'd I-\- (T I' d Ii violates the st"t iOIl<lril)" rl'lj niH·IIII·II\' nUl in this GISI', a
silllplt- log-Irallsfonllalioll oj" Ihl' ttll;\ dol'S salisly Ihl' rq~ul:lril)' "olldilioIlS:
'I, '~, ., ., I,,. where 'i. ~ log Jlk/ I'k-I, is a sl<llioll;lry ,'I'IIUCI)(T. M<lxillllllll
likl'lihood ('slilllatioll oro lIlay Ihl'nl)(' pl'l'lol'lllcd wiill I'k), \\'1' shall rellll'll
!o Ihis I'X;IIIlPIl' ill Se("lioll 9 ..'1.~.

(;/11'\1 L,lillllllil/I/
for 111<111)' "OIlll>illaliolls of rod!i(it'lll fllll"liolls (/ :11)(1 Ii, (!'.:I.IO) r:lIl1lol
he S(llvl'Ci explicitly, hellcc lor th('se caSl's 11I:lximlllll likelihood estimatioll is
illkasilJk. All alll'l'llative proposed hI' I bllS(,1I :lIld Schcillkm;tll (19~1:») is to
apply I !ailSI'll's ( I!IW2) ).';{'lIcr"li/.l't! IIH'thod or mOIl\{'IIIS «;M M) estilllatOl",
whirh Ihl'y I'XI!'IH!IO the rase o('slrirll), st:ltillll,lI), (,llIl1illl\l)\Is-tiIllC ~brkll\'
procl'SSt'S (s('('I\t('Appelldix ('or all O,POSilioll o(,(;~li\l).
The l'ol'lIs orallY (;MM prOCl'dllre is,oi'COIIISl', thl' 111(11)('111 cOlllliliolls
ill \\'hich illl' l'al'alllcit'l' Vl'('(or 0 i" illll'licill)' dl'lilll'd, Till' (;1\11\1 estimator
is Ihal [>;II':IIIIl'I('\' \'('clor iJ thatlllillilllil.l's thl' "dislallc(''' \>('1\\'1'1:11 Ihe sampk
1110111('111 concliliolls alld Ihcir popllialion ('Olllllerparis.
TIll' pl'o[>cllit's 0(' a CMM eslilllalor dt'lll'lId n ilic:lIl), Oil lilt' choic(' or
11101111'111 COlldilioliS alldthe dislallC'(' 1I\('lril', ;llleilol' sl;1I I< 1:\1'(1 disl'!'('(('-lil\l('
CMt"! ;lppli(;tliOlls, Ihcs(' two isslI(,s It:!\'(' 1)('('11 stlldil'd 1(llit(' tho\\)u).';hly.
i\lollll'lIl COllC!iliollS are I)'pira\ly S\\gg('stl'cl hy thl' illtn<lctill\\ lIr (()\Hlilioll-
illg illi'ollll;ltioll alld Oplilll<llity or el[lIilihritllll cOlidiliollS such as Euler
eqllaliolls, ('.g., the OI'lliogol/(/lily (/IlIdil;O/l.1 or lilll';lr illSll'lllIIt'lIlal variahles
('Slilll;llioll (Sl'!' Ihl' Appelldix, Seclioll A.I). III SOIlI<' cases, till' optimal
(ill ,III as\'lIIplolic sCllse) distalll'l' 1I\('lric CIII 1)(' IkdlU,(,ci ('xplicitl\' (sec"
·II)\) 9. /)rril'lIlilw [',-irillg i\J"til'l.l

I{II' exalllple, I Llilliltoll II!I!H, Chapter 14]), and efficiency hounds Gill he
obtaillcd (SC(' Ilalls('1l (19W,) alld IlallSen, Heaton, and O~aki (19HH»).
Bllt for cOlltillllOlls-tillw applications in linance, especially those il1\'olv-
ill~ derivativc sC('llritics, IlIlICh less is known ahollt the properties of C~IM
cstilnators, 111<\('1'(1,011(' of I bllS('1I alld Sc\teinklllan's (I~)~):') lIIain cOlltri-
hllliolls is to sltow how 10 )!;('I\t'ralt' 1\10111('111 UlllditiollS ({". UlllliIIlIOlIS-(illll'
Markov proc('ss('s wilh dis('f('\('lr salllplt'eI data. Although a cOlllplell' l'xpo-
silioll of( :MM eSlilllalioll (til' contillliolls-tilllc procl'sses is he),(lIld Ihe scope
of Ihis I('xt, Ih(' n'lIlralthruSI of Ihdr approach can be ilIl1slr;lIed Ihrough
a simple exalllplt'.
Suppose 11'(, wish 10 cstimatc Ihc parameters or
Ill(' /(llIo",illg statiollary
diffllSioll process:

tip = -Y(/I- JI) tit -1- (1 till, /1(0) = /I" > 0, Y > 0, (!).:~. I~)

This is a cOlltillUOlis-tilllc \'l'l'siol\ of a stalionary AR( I) proccss wilh IlIlcon-

ditional Illcall II (SI'(' SC('lioll !).:I.'I for further discussioll), and hCII("<.' il
satisfies the h),potl\('sl's of 1hnsl'n anel Scheinkman (199:».
To W'IH'ral(' 111(11)('111 COJldiliolls for (jI(l)1. I lallS(, II and Schl'illkillan
(1!)9:» IIS(' the ill/illit,.,imtll g"III'mtu,- 11... a\so known as Ihe IrYlll;ill "/11'1'11 tor,
which is Ihl' lilll,'-dt'fil'ali\'(' of a condiliollal expectation. Speci(icallv,

, t! .
D"I·I == -1""[']' (!l.:t 13)
til
",herc Ihc ('XPCCl;tlioIlS operalor E"I·I is a conditional cxpeclation, ((l'ldi-
t iOllcd Oil 1'( (I) = /'.,.
This opcralor has s('vcraJ illlporlani applicatiolls for dcrivillg 1ll01ll1'nt
('()I\(lilioll~ of diffusiol\s. For exalllple, consider Ihl' following hellrislic ral-
c,,!aliOIl or Ilic I'Xlll'Clalioll of tlr

E.. I "/11 E"I-y(/, '-11) rltl + E,,[a till) (9.:tH)

-),(E"I/II - /1} tit + aE,,!dlll W:I.I:»

tlF .. I/11 --yO':"I/'1 - JI} tit (!).:'Uti)

tI
---F"I/I) -y(E,.I/,) - It} (~),:~.17)
til
'D"I/'I -y(F,,!I,j - It}. (!I.:UR)

wherc (!I.:I.I ,I) ~llld (~I.:\, 1:1) folio", fmlll tlte bCltl1t' t'xpcclalioll of a lill,';tr
ftlllction is Ih(' lilll'~" (IIJlllions o( III<' ('xpc('\atioll, (!I.:1. It;) 1()lIows frolllille
S~IllH' proper! 1'1 01 til(' d i ({(-I(, II IiaJ (Illl'la Ior and from Ihe 1;t<'1 IIta I i IHTl'IllCnls
of Brownian nlolioJl lIan' I.('n> ('xp'Ttation, and (!1.;{.17) is ;\Ilotltt'f way of
l'xprl'ssing (!U.J Ii).
9.3. Implementing Parametric Option Pricing Models 361

Before considering the importance of (9.3.IS), observe that (9.3.17) is a

first-order linear ordinary difTerential equation in E.[p] which can easily be
solved to yield a closed-form expression for Earp] (note the initial condition
Euf/)(O)] = Po):
E.[p] = pu e- yl + )1.
By applying silllilar arguments to the stochastic difTerential equations of l,
l, and so on-which may be obtained explicitly via Ito's Lemma-all higher
moments of p may be computed in the same way.
Now consider the unconditional version of the infinitesimal generator
V(·] == dE(·]! dt. Aseries of calculations similar to (9.3.14)-(9.3.1Sl follows,
but with one important difference: the time derivative of the unconditional
expectation is zero, since p is a strictly stationary process, hence we have the
restriction:
VIp] = -y(E(P] - J.t) = 0 (9.3.19)

which implies
E[pJ = )1 (9.3.20)
and this yields a first-moment condition: The unconditional expectation of
/' must equal the sleadY-51ate mean )1. :
More importantly, we can apply the infinitesimal generator to any well-I
behaved transfonhation fO of p and by Ito's Lemma we have: I

(9.3.21)

which yields an infinite number of moment conditions--one for each /-:

related to the marginal distribution of /(P). From these moment conditions, :
and under the regularity conditions specified by Hansen and Scheinkman ~
(1995), GMM estimation may be performed in the usual way.
Hansen and Scheinkman (1995 l also generate multipoint moment con-
ditions-i:onditions which exploit information contained in the conditional
and joint distributions of f(pl-making creative use of the properties of
time-reversed diffusions along the way, and they provide asymptotic approx-
imations for statistical inference. Although it is too early to say how their
approach will perform ill practice, it seems quite promising and, for many
lti'l processes of practical interest, the GMM estimator is currently the only
one that is both computationally feasible and consistent.

9.3.2 f..Stimatingcr in the Black-Scholes Model

Til illustrate the techniques described in Section 9.3.1, we consider the
illlplelllclIlation of the Black-Scholes model (9.2.16) in which the parameter
cr must he estimated.
 62 9. neill/alitit' J'lirill/i Motirll

A common misunderstanding about a is that it is the standard deviation

If simple returns U, of the stock. If, for example, the allllllal stalldard
leviation of mM's stock return is 3orX" it is often assumed that a = (J.30. 'Iil
. ee why this is incorrect, let prices P(t) follow a lognormal diffusion (!I.:!.:!)
'. s required by the Black-Scholes model (sec Section 9.2.1) and assume, for
<;xposilional simplicity, that prices arc sampled at equally spaced illtervals of
length II in the interval [0, T], hcnce Ph == P(lIh), /, = 0, I, ... , II and T =
~III. Then simple retllrns Uk(lt) == (IV Pk- I ) - I arc lognormally distrihuted
with mean and varj,lIIce:

E\ /lk(h) J ~," - I (!I.:t2'2)

Var[Jlk(It)) e~I"I . [0'

f II - I) • (!l.3.'2:~)

Therefore, the magnitude of IBM's a cannot he gallged solely hy the 30%

estimate since this is an estimate of JVar[ Uk ( II)] and not of a. III particlllar,
solving (!1.3.22) alld (!I.3.'2:~) fill' a yields the /(Illowing:

I ( Var[Hk(lI)] )JI/~ (!I.:t24)

a = [ h log I + (I + E[l4.(h)J)~
Therefore, a mean and standard deviation of 10% and 30%, respectively,
for IBM's annual simple returns implies a value of 2li.8% fill' a. While
:~O% and 26.8% may seem almost idelltical for 1I10st practical purposes,
the fonner value implies a l3Iack-Scholes price of $8.48 for a one-year call
option with a$35 strike price on a $40stock, whereas the lallervalue implies a
Black-Scholes price 01'$8.1 () on the sallie option, an economically significallt
difference.
Since most published statistics 1\)1' equity retllrns arc hased on simple
returns, (9.3.24) is a IIseful formllia to obtain a quick "ballpark" estimate of a
when historical data is not readily available. If historical data al't' available, it
is a simple mailer to compute the maximum likelihood estimator of a using
continuously compounded ret lints, as discussed in Sections !l.:t I and !1.3,:t
In particular, applying !til's l.elJllII<l to log l'(t) <lnd substitutillg (9,'2.'2) fill'
d!, yields
tllogJ' = (/1- ~a~)"t+ad/i = atll+ad/J (~l.:~,'2:I)

~
'her\.' a == Jl. - ~a~. Therefore, contilluously COll1pounde(\ rClUrlls I),(h) ==
I )g(/'k/P~-I) arc liD lIorlllal randolll variables Wilh mean all and variance
~It hellce the sample variance or ,;.(It)/Jh should he ,j good estimator of
riz; ill 1;lct, the sample variallce of Ii,(h)/Jh is the IlI<1XiIllUm likdihood
('stilllator or a, More ro rill <III y, ulld('\' (!I.:t'2:) the likelihood hUH'lioll of a
s\ullple of cOlltinuously ('olllpounded I'('lurns 1'1 (It), .... r,,(II) is

H 1" .
= -;-log('27Ta-II} - -.,- "'(th(lt) - all)~
'1
.e(a,a) (!I,:~.'2(;)

I 2 '2a-1I 8
and ill this case the Inaximllm likelihood ('stilllators fi,r IX and (12 can he
ohl"illed in closed limn:

(93,27)

(!I.:I,2H)

Moreover, hecause the rdiL)'s are liD nortnal rantiolll variahles under Ihe
U)'Il<llllics (!I,2,2), the regularity conditiolls (ill' the cOllsistellcy ,lIId asymp-
totic Ilormality of thc cstimalor a2 arc satisfied (see the Appendix, Scction
A.4), There/im', we arc assured thaI eX and at
are as),lllplOtically efficient
in the class of (:UAN estimators, with aSYlllptotic covariance lIIatrix givcn hy
(!I,:I,K),

Im',t:;t'/({r1y S({IIIIJi,'r1 nrl/II

1~) s('t' why irregularly sampled d"ta poses 110 problems for cOlltillllOus-tillle
prO':csscs, ohs('rvt' that the samplillg interval It is arbitrary and can change
lIlid-s'lIl1ple withollt affectillg the flllll'tionallill'ln of the likelihood fUllction
·(9,:'\.~(i), Suppose, for cxample, we measure returns ;111 II II all)' for the lirst 1/1
ohs('I'\'ations and thenlllonthly fill' the next 111 ohservatiolls, If II is lIIeasured
in 1I11i" of olle y(,ar, so that h = I illdicates a OIH'-),('ar holdillg period. the
111~IXil1llll11 likLlihoo!l estimator of (T'l 1'01' thl' "1 + 112 ohservations is given hy

when~

Obs(:rvl' that the secolld t(TIll of' (!I,:1.2Q) 111;1\' 1)(' rl'\\'rilt(,11 'IS

which is silllpl)' the varialll'<' est ililator of In( lilt III)' ('( )111 i Illl( >llsly ('olilpollnded
retllrns, r('scaled to an annllal f'n'qll('IH")',
Thl' cas(' with which irregubrly salilpled (Lit;l Clil hl' ;1( ('ollllllodat('(1
is olle of' thl' greatest adv;ll1tages o\' ('olltiIlIIOIIS-IiIll<' slo('\J;lsli(' processes,
Ilowl'Vl'r, this advalltagl' COUll'S at SOIlIl' cos\: this great flexihility is the
reslIl! or strong IMrallletric J'('stri('lions lhal each continllOlls-lime process
impost's 011 fill its fillite-dimellsiollal distrihutiolls (see SI'r1ioll 9.1.1 for the
definition of a fillite-dillll'llsional dislrihlllion). In p<lrticlllar, lhe sLOchas-
til" diffc:renliall'quatioll (~1.:t2:)} illlJ)()ses independence and normality oil
(//1 illcJ"('nH'lllS of log 1'(1) alld lincarilY of lhe mean and variance in lhe in-
cn'lIl('1I1 illtl'!"v"I, IWllcl' Ihl' cOlltilJllOlISly compollnded relllrn hetweell a
Friday and a Monday mllst have three tillles Ihe mean and lhree lime.~ the
v","iallce of Ihe cOlllillllously ('OlllpOUIHll'd rclurn hetween ;\ Tllcsd<lY <lnd <I
Wednesday, Ih(' Tuesday/Thursday 1'1'1111"11 IIIl1S1 have lhe same dislrihution
as the Salurday/Mollday 1'1'1111"11, and so Oil, In fact, Ihc spccific<ltioll of a
continllous-tillle stochastic proCI'SS slIch as (9,~.2!i) includes an infinity of
paramctric asslllupliollS. Therefore, Ihe conveniellce Ihat continllous-time
stochaslic proc('sses affords in dealing wilh irregular sampling" should be
weighed carefully agaiusl thl' llIauy illiplicil asslIllIpliollS lIial cOllle wilh il.

(:(/lIliJl /U1l/.\-/{/'fllld A I.V III/J/ol in

Siuee we 1"<111 ('stilllatl' a alld (f frolll arhitrarily sampled data, a /latllral
"lIeslio/l to ("onsidl'l is how to salllple relurns so ;\S to ohtaill the "hest"
I'.~tilllator? An' I () ;1111111;11 observations preferable 10 100 daily ohsl'lvatiolls,
or shollld W(' IlIat("h Ill\' samplillg i/ltnval (0 the horizoll we an' IIltilll:ttcly
illll'rl'sled ill, ('.g., thl' lilllc-to-III;llllrity of the optioll WI' wish 10 valtw?
'n, address t hes(' i~slles, ("onsidn agaill a sample of 11+ I prices I{ .. 1)\, ... ,
I'" ('IJllall), span'd ;\1 illtn""ls of !t'lIgth II over tlll' lixed lime spall [0, TJ so
that I'k == I'(kll), k = 0, ... , /I, alld T == lilt. The asymptotic variallce tIl' the
maxilHlIlII likl'lihood ('stim-"Ior of I Ct (f~ l' is 111('11 giVt'1I hy (~1.?>.7), IVPirh
lIIay 1)(' ('l"alll;lIed explicit I)" ill tllis case as:

(T'!.
\';\r I (i I "'"" r
(9.:L\O)

2(f'1

\'arla~1
'"" II
(~I.;).:) I)

(>hs('rvl' thai (~).:\.:\ I) docs not dqH'lId Oil th(' sampling illterl"al h. As
/I ill\T('asl"S withollt hOlllld while 'f' is fixed (h('lIce It "e{T('ases to 0), a~
h('(OIl\('S 11101"1' precis(·. Tllis sllggests I hat till' "hest" ('slimator 1'01' 11 ~, Ih(' olle
with smallest asymptotic v;lriall("(', is the olle hased Oil as l\IallY ohservaliolls
as possihle, n'g"rdlcss oflVh;\t tlll"i .. samplillg illlerval is.
III t('l"('stillgly, thi,~ reslllt docs lIot hold fill' the ('stilll<\lor of a, whose
aSYlllptotic vari;1I11'I' dl'JH'lIds Oil T alld lIot 11. More freq 111'11 I samplillg
withill a fixed tilll\' spall-of'tl'n (ailed f"lllIli7l1IOU,\-rf'fmd asymptotics-\\'ill
1101 illcr(';\se IIII' pn'I'isioll or It, ;11 It I till' "llI'sl" I'slima\or 1'01' (1 is 011(' hased

Oil as IOllg a lilll(" spall as pilssihk.

 " ......
Y.3. I111JJ/mutnting Parametric Option J'riri71g ModeLl 365

Table 9.2a. A~ymt)loli{ SlflllflflTd errors for a.

II

" I
ii
I
IT.
I
~
I
r.:i
I
m
I
ill m
I I
T:"ffi
2 (1.2000 0.2H211 0.4000 0.56:)7 O.Il()O() 1.1:,14 1.6000 2.2627 S.2000 4.5255
4 0.1414 0.2000 0.21128 0.4000 0.5657 0.1l000 1.1314 1.6000 2.2627 3.2~
H 0.\000 0.1414 0.2000 0.2H28 0.4000 0.5657 O.HOOO 1.1314 1.6000 2.262
It; 0.0707 O.l(){)() 0.1414 0.2000 0.2828 0.4000 0.5657 0.8000 1.1~14 1.6000
:12 0.0500 0.0707 0.1000 0.1414 0.2000 0.2828 0.4000 0.5657 0.8000 1.1314
64 0.0354 0.0500 0.0707 0.1000 0.1414 0.2000 0.2828 0.4000 0.5657 0.8000
12H 0.0250 0.0354 0.0500 0.Q7()7 0.1000 0.1414 0.2000 0.2828 0.4000 0.5657
256 o.m 77 0.0250 0.0354 0.0500 0.0707 0.1000 0.1414 0.2000 0.2828 0.4000
512 0.0125 0.0177 0.02:'0 0.0354 0.0:'00 0.0707 0.1000 0.1414 0.2()()(J 0.2828
1.024 O.OOIlS 0.0125 0.0177 0.0250 0.0354 0.0500 0.0707 0.1000 0.\<\14 0.2000

A>ymplOtic standard error of [; for various values of nand h, assuming a base imerval of h 1 =
=
year alld (1 0.20. Recall thai T '" nh; hellce the values n 64 and h = =
1/ I 6 imply a sample
of 04 oh,("rvalio[Js equally spaced over 4 years.

Tables 9.2a and 9.2b illustrate the sharp differences between <i and 2 by a
reporting asymptotic standard errors for the two estimators for various values
of n and It, assuming a base interval of h= I year and Q' =0.20. Recall that
T=71h, hence the values n=64 and h=ft, imply a sample of64 observations
equally spaced over 4 years.
In Tahle 9.2a the standard error of &declines as we move down the table
(corresponding to increasing T), increases as we move left (corresponding
to decreasing T), and remains the same along the diagonals (corresponding
to a fixed n. For purposes of estimating a, having 2 observations measured
at (i-month intervals yields as accurate an estimator as having 1,024 observa-
tions measured four times per day.
In Table 9.2b the pattern is quite different. The entries are identical
across the column.s-only the number of observations n matters for deter-
minin~ the standard error of &2. In this case, a sample of I ,024 observations
measured four times a day is an order of magnitude more accurate than a
sample of 2 observations measured at six-momh intervals.
The consistency of (,2 and the inconsistency of & under contiriuous-
recorel asymptotic>, first observed by Merton (1980) for the case of geomet-
ric Brownian motion. is true for general dilTusion processes and is an artifact
of the nOli-differentiability of diffusion sample paths (see Bertsimas, Kogan,
and Lo [19!l6) for further discllssion). In fact, if we observe a continuolls',
record of 1'(1) over any finite interval. we can recover without error the dif-
fusion coefficient a(·). even in cases where it is time-varying. Of course, in .
!, 3(j(i 9. lJr'rill((lil".I,,.i"i"~ AlIII/eLI

Table 9.2b. A.\ym/Jlol;r ,\/flllrlflul,'rmn ./to ? '!.

I,
1/ - - - - - - _ . _ - .. -'--, _.. _-- .
I I I I I I I
iii 1:! r.:i l:!x '!"h m ilfTi

2 0.0400 O.IHOO 0.0400 O.(HOO 0.0100 0.11100O.(HOO 0.11-100 0.0·1110 11.111011

4 0.O21l:1 O.02H:i O.02H:1 O.O:lH:1 O.O:lH:1 O.O:lH:1
U.O:lH:1 O.O:lH:1 o.o:!ln II.II:!H:I'
II IUJ200 0.0200 (1.020U (J.0200 O.O:lOO 0.0200 O.O:lUO 0.0200 1I.0:!01l II.O:!OO
IIi 11.11141 11.0141 0,0141 11.111·11 0,0141 0.0141 (1.11141 11.(11,11 11.0 I,ll 0,01,11
:12 11.01110 U.OInO O,OIUO O,OIUU 0,11100 0.0100 0.01U0 0.0100 0,0100 0.011111
li1 !l.OO71 0.0071 11.0071 I!.OO71 0,0071 0,0071 0.0071 0,0071 0,11071 11,111171
1211 U.IIO:,O 0.00,,0 O.OW,O O.OW,O 0.00,,0 O.OW,O 0,00:,0 O.IIW,O 11.00:.0 0,011'.0
251i, O.OO:!', O.(){I3', O.OO:!', 0,00:1" O,OO:!!", O,OO~" O.OIJ:i', 0.00:1:, O,OO:!!". 0,00:1:,
,,12 o.om!:, Il.OO2', O.OO:.!:, 0,002" 0.002" 0,002" O,OO:.!', 0,002" 0,0112" 0,002"
1,024 IUlOI!! Il.OOl1I 0.00111 O,OOIH O.OOIH o,OOIH O,OOIH O.OOIH O,OIlIH O,OOIH

A'\ymp\otir slc\1\(\anl ('nor of;' '! for \',W11)\\:o\ ""hu':" of n .Hul h, ass\\min~ f.\ hasl' ''''''1 \',,\ 01 IJ = 1
year and (1 = 0.20. Recall Ihal '/' '" 1/1,; I"'n('" II ... \'alll(,s 1/ ' " li4 .111<1 I, = 1/ I Ii illll'l\' " "lillI''''
of 64 ()hs(~lYJ.\i()ns t'q\lc,\ly :'olMfl'd o\'(.'r .\ Yl'ars.

practi<:e we never ubserve continuolls salliple paths-the nOlion or t'oltlin-

uous time is an approximation, and the magnitude of the approxilllation
error varies frOIll onc appliGllion to the next.
tis the satllpling interval becollles finer, other problems may arise slich
as the effects of the bid-ask spread, nonsynchronous tr'Hling. anll related
market microstructure issues (sec Chapter 3). For example. Sllppose we
\jdecicle to lise daily data to estitllate a-how sholiid weekends and holidays
he treated? SOllie choose to igllUl'c thelll altogether. which is t,\tllalnllllnl
to assuming that prices exhibit 110 volatililY when markets arc closed. Wilh
I the coulltcrfactual implication that Friday's closing price is always ('qual to
I Monday's opening price. Altel'llatively. we may use (~).:t~~l) ill al('o\tlllillg
; fur weekends. but such a procedure implicitly assumes that Iht' prict' proCI'SS
Iexhibits the SIIIIIP volatility when markets are closed. implying Il1alll1l' Frillay-
to-Monday retul'll is three times lIIore volatile thall lhe MOIHla)'-lo-Tttt'sday
I retttrn. This is also cOllnlcrfactttal. as Frellch alld Roll (l!lH(i) havl' shown.
The hetlcliL~ of more frequent salllplitlg must be weighed againsl the

I coslS, as llIeasttl'ed by Ihe types ofhiases associaled wilh 11101'1' finl'ly sa III pled
dala, Unfurtttllalely, Ihere arl' 110 gelll'ral gttidelines as to how 10 lIIakt'
such a tradeoff--it musl he iliadI' on an individllal basis with 111l' pal'licular
applicatioll alld data at hand. II>

I
I"S,',· Ik ... ,il\l"s. Ko~,,". ",,,I \... (\\I\lIi). \... "",I M.II·Killl,,)' (1!IH!I), I"'nllll (1\1\11). .11111
IShiller ill1d Prrnm (I~}H:) for;1 lHore detailed illl;lIysis o{" III(' inleraniuns lK'tw.... 1I \.lIupling
lilll<'l'\·,,1 "lid ~"t11I'I,' .i/'(·,
1),3, Imph'IIl/'lllillg /'1//'(;1///'11';(' ()f/lioll I',irillg '\/"dd,

'), J, J (LI/(I/Ili/"lillg Ih",'m'i,iCJI/ CJj (Jjllilll/ ",.i""':,lill/(/lon

()l1rl' IIll' Il1aXilllllllllikdihood ('slimal.,r {} 01'1111' 11IJ(11'I11'i1lf.: assl'l's par.lIl1-

,'Ins is o\)lail1l'd, Ihl' m'lximllll' li\"~lihood I'slil1lalor 01 IIII' opliol1 pril'\,
(; lila\, hI' r0I1SII'lIl'I('(1 by iIlS .... lil1~ 0 il110 IIII' OI>liol1-I" il'il1~ lilrll1l1la (or
il1lo Ihe 11 II II H'ril'al alf.:orilhm Ihal W'lH'rall'S Ih" pricc)." Sil1ce 0 cOl1lail1s
,'slilll"liol1 1'1'1'01', (; == (;(1'(1),0) will also cOl1lail1 I'slill1aliol1 I'1T0r, al1d 1'01'
Iradil1g al1d hl'df.:il1!!; applicaliol1s il is il1qll'r'lliVl' Ihal IV,' havl' sollie lIIea-
Sllrl' orils pn'Cisioll. This call 1)(' l'ol1SlrllCil'l1 "y "l'l'lyil1f.:" lirsl-onkr'(;lylor
,'Xp.IIISiol1 10 (;<1) 10 calclllal" ils aSyl1qllolic disil illlllioll (SI'I' Secliol1 A.·I
orlh,' Appl'lIdix)

fit(i; - (n (!1.:1.:12)

(!I.:t:\:I)

1,llerl' (; == (;(/'(t), 0) alld I(O) is tilt' illfonll<lliolllllairix ddined in (!l.:t7).

Th':rd(II'I~, )ill' lar!!;c 1/ the varial1ce or (; may he "Pl'l'Oximalcd hy:

Varl i;J (9.:~.34)

alld 1'1 Illay he eslimaled ill thc natllral w"y:

i!G(/'(I), 0)'
- - - - I- (0) -------..
I' i/(;(/'(I), in
i/O i/O

III 1I111rh Ihl' sa III I' way, the precisioll or IIII' ('stilll"lors of all opliol1's sl'lIsi-
til'ity 10 its ar~lIll1cllts-thl' oplion's delta, f.:alllllla, Ihl'la, d\(), al1d vega (St'C
Sl'ctiol1 D,:!, I )-may also be readily 'ilialltilil'li.

'lJII'li!flrli-SrhlJll',1 (;fl.ll'
As .111 illllslr"liol1 of' Ihl'sl' reslllts, rOl1sider Ihe ,'a,,· or iliad.. alld Schol,'s
(I !17:{) ill which I'{/) )(Iilows a ~('om('lri( llrowl1i'lIl 11101iol1,

"/,(1) = 11/'(1) "I + (] ,'(/) ,/11(1)

alld ill whirh Ihl' ollIy pol 1';\11\1' I.... of illll'l(',1 is (J. Sill\'!' thl' Illaxillllllll
likelihood I'slilllalor a~ or
a~ has all as:'lIll'lolic distrilllltioll f.:in'lI hy

17Thi., 1(l1l()\\'~ 110111 Ih<." prillriph' of ill\",11 i;1I1( c; Tht' IIlaxillllllll lildjhClod ('slim.llor of il
nonlinear hlllnioll 01 " par.mlt'lel" n'r(nI i~ tlu' IIOlllillt'.11" fllIlflioll of lilt' parallll'It' .. \'('("for's
lIIaxillllllll lik(,lihood ('Milllalor. S('t', lor (,X;lIl1pl(', "dlll.1 (I~Jh").
j/i(a~ - ()~) ::.. N(O, ~n I) (~e(' Sectioll 9,3,2), the asymptotic distrihUlioll
of the Black·Scholes CllI.oplioll price estimalor {; is

'/'-/ ') ""

I', == TI'-U)(T-I/I-(dl), (!).:1.:\7)

whnc 1/1(.) is the slall(i;[rd IIOrlll;t1 prohahility dCllsity fllllction and til is
~i\'t'n ill (!1.~.17).
From the asvm)llolic I'ariall(,('
paralive sialic n'sldlS lila\, hL' deril'L'd:
I,
~ivl'll in (!1.3.:17). SOlll(' simplc com-

-
j) I', r;-;:--. .•
== -I'n" 'J'-(-i)-(dd d.,
iJI',
iJl' ~- ax
iI I I
<1('1'-1)

(9.3.39)

TIll' rollowillg- illcqualilies lIlay /111'11 he ('slahlishe<i:

iI I', I'
() iff - :5. {I (!).'~.'lO)
X>
iI I,
ill'

o iff
J>
-x ~(.) (9.3.41 )
ax < -

ill;
i)(T-tJ
> (I if x" rf
iJI'(
> 0 if {:\ < I.
ilU'- tJ
",h(' 1'('

.(. cc)II .. /I
" .

. (.! ~)i'r./I
" .

IT::j
- - - ( r+-
(T'!)
.
n ~

IUl'qualilY «1.:1.·10) shows liI;11 Ihl' ;lccllracy of i; dt'creases witli Ihe kl'd of
Ihe Siock plin' ;IS long ;IS Ill<' r;lIin of' Ihe slock price to thc slrike price is less
Ihall 1'1,110\\,('\'('1', ;IS III<' .slock pri«' illcreasl's heyond X(I,lhe acnlracy of
9.3. Implelllnttillg Parametric Option Pricing Models

,.. ,.
Table 9.3. Cutoff values for co71lparatitJt stalics of \j.

T-t (I C2 1/(,/ C,

1.0015 0.9967 1.0033 0.0482

2 1.0029 0.9933 1.0067 0.0682
4 1.0059 O.9H67 1.0135 0.0964
H \.0118 0.9736 1.0271 0.1363
12 \.0177 0.9607 1.0409 0.1670
24 1.0358 0.9229 1.0835 0.2361
48 1.0729 0.8518 1.1740 0.3339

Gbegins to increase. Inequality (9.3.41) shows a similar pattern for VI with

respect to the strike price. ,
Interestingly, inequality (9.3.43) does not depend on either the sto~k 0\
strike prices, and hence for shorter maturity options the accuracy of G wilT
increase with the time-to-maturity T -to But even if (9.3.43) is not satisfied,
the accuracy of Gmay still decline with 1'-t if (9.3.42) holds.
Table 9.3 reports values of CI through C3 for various values of T -I assum-
ing an annual interest rate of 5% and an annual standard deviation of 50%,
corresponding to weekly values of r = log(1.05)/52 and a = 0.50/vfs2.
Given the numerical values of C2 and l/c2, (9.3.42) will be satisfied byop-
tions that are far enough in- or out-of-the-money. For example, if the stock
price is $40, then options maturing in 24 weeks with strike prices greater
than $12.09 or less than $38.02 will be more precisely estimated as the time-
to-maturity declines. This is consistent with the finding of MacBeth and
MerviIIe (1979, 1980) that biases of in- and out-of-the-money options de-
crease as the time-to-maturity declines, and also supports the observation
by Gultekin, Rogalski, and Tini~ (1982) that the Black-Scholes formula is
more accurate for short-lived options. 18
Through first-orderTaylorexpansions (see Section A.4 of the Appendix),
the accuracy of the option's sensitivities (9.2.24)-(9.2.28) can also be read-
ily derived, and thus the accuracy of dynamic hedging strategies can be
measured. For convenience, we report the asymptotic variances of these
quantities in Table 9.4. .

9.3.4 The EfJl'cts oj Asset Return Predictability

The martingale pricing method described in Section 9.2.2 exploits the fact
• that the pricing equation (9.2.15) is independent of the drift of P(t). Since

1MTIlt"fC.· alt', of fours~, other po~siblc explanation!'. for such empirical regularities, such as
thl" pn''''IlC<' or slofhaslic v<ltatility <lr a lIli"pl"cilicllioll of th .. 'lOck price dynamics.
 37() 9. J),.r;l/tlli!'I' I',.il·illg Mllllrll

Table 9.4. ,bP"I"lIlir 11,lIi,I/l"I'.1 1I//IIlIdl·Sd""I'.I mil/ilia .1I'II.1ilit lily 1'1/111/(1//111.

Estimator Asymptotic Variallc!'

~q,t(d,) d~
~ 1"'(1/, d, - If

~ (.\TI"-I)(' """d'1>(d,»)'
~ (Vd, tI~)~

Th("~(" i\~)1l1ph){ir \'ariaun',1Ii an' ');\S('(\ (HI 11u' a.'iSIIIIII'liluJ tllat tilt' ,'at iall( (' (':-01illl.'1111" n'l. i:'\ thl'
m.lxhnum Hkt'lihontl c:nimator whirh h.\s ;,\~ympt()tif c.li:-.tt ihutiol\ jJi{n ~ - fT:.') !.!.. lif(H, '20. 1).
'1 h"'l<"e jii(l'(u t
) - 1'(0"» ::. N(n. 'l0"'(iI/:(ot)/ilot)1) wh.· .. " /o"(01) i, tit.· "I',i,," ,.·",i,i,';ty.
Ful)uwinK Mtllutard (nIiVellliolis. thl' l'xpl"{'s,,,ioIlS n~p(}n('d in the tahlt· an' Ih(' ;1... Yltlplolir \'.lri~
ance. oJ" jii(F(a t ) - 1'(0 1 ») and II II 1St ht· divided hy tilt' "'"1plt: ,il.c " to oiliaill tilt' a.'Ylllllllllir
\..uitl.nu:~ of tht' (lIIJ1lonna\i/('d) ~l'Il!'oiti\'il it"s f{o'.!),
I
I

i the drift does not enter into the I'Di': (9.2.15). fi)r purposes of pricing options
it may be set to any arbitrary fUllctioll or constant without loss of g'..·lIl'1"ality
(suoject to sollle regularity conditions). III particular. under the l'CJuivalent
martingale measure in whit:h all asset prices follow Illanillgalcs. tlte optioll's
price is simply the present discounted value ofiL~ expected payoff <Illllatmity.
where the expectation is cOlllputed wilh respeClto the ri.I/('"Pulmli1."rI/)/O(fH
1"(1):'

til" (I) := rl" (I) til + a '" (I) tiB (!I.:H4)

I
I d log 1" (I) "/,'(1) := (r - a2~) IiI + a"n.
!Although the risk-neutralized process is not elllpirically ohs....vahk.I~1 It IS
, Ilel'enhcless an extrellll'ly cOllvenient tool for evaluating the prilT of an
oplioll Oil the slock wilh a dala-gl'lll'l"aling process givl'1l by 1'(1).
Morl'over, lite risk-nl'utral pricing approach yidtls the following illlpli-
cation: as long as the llilfllSitlll codlicicllt for the log-price pron'ss is a lixed

I'll tuwc"\'c"r, UI\((C.'I ('(.'nat" ("(Iluliliol\:r<. it <:.\11 \1(," ('~tltI1.ttc.·tl: :-'C.'l', fOf ('xalll",,". AII-S,dl;"i .• and
1.,,,( 1!I\l(i) •.Iarkwenh ;lIlIl RlIhi"'t .. ill (1\1\1;.). Ruhi"''''ill (1\1!I<1), Shimko (tll\I:I) .. lIIII S.... tioll
I :.1.:1.-1 (II" Chapt"r 1:.1.
I), J, 11II/,lf'lI/f'lIlillg I'(I/(IIIII'/,.i,. O/Jlillll I'Jirillg ,\111""',

cOllslall1 (J, Ihell Ihe Black-Scholes lill Illliia yidds Ihe to!Ted oplion pricc
regardless of' Ihe specificalion alld ,lIgll II 1('11 Is of' lil(' drif'l. This holds 11101('
gCllerally fill' any derivalive assel which C,III he prict'd pllrely hy arhilrage,
alld II'hl'le Ihe IIl1derlyilig assel's log-plitT dY"'lIl1ics is desnih('(1 hy all hil
dif'rllsiollwilh cOllslall1 diffllsion codficielll: Ihe dl'livalivt"pricillg f(lI'IlIlIla
is fliliCliollally illch-pelldelll or Ihe drill ;1I1t1 is dt'It'lIl1illt'<1 pllrely lIy Ihe
diffllsio\l coerlicil'lll alld III(' COlllracl spccilicaliolls of Ihe dl'rivaliw assel.
This may SI'('1lI p,II',lIloxic,,1 silln' I\I'() sltlcks wil h Iht, sallll' n hilI tlilh-ITIII
drins will yidd Ila' SOIiIIt' IIla('k-SdlOl<'s I'rin', yel Ihe slo('k wilh Iht' largn
drift has a I:tq!;l'r eXIH'(,\l'd relllnt, implyillg Ihal a call oplioll Oil Ihal stock
is 1I10/'(' likdy 10 ht' ill-lhe-lJIolley al IllalllrilY Ih;1I1 ;1 call oplioll Oil Iht' stock
wilh lilt' sillall('\' <irifl. The resollilioll of'lhb p;lIadtlx lies illlhc ohservalioll
I hal all hOllgh lil(' cXl'c('\ed payoff or lilt' clll opl iOIl Oil I he LlIger-drift slOck
is illdt't'd larg('\', il 1II11S! he dis(,(lIl1l1ed Oil a highl'l rail' or rl'llInt-ollC Ihal
is COllllllellSllrall' wilh Ihe risk alld ex PI,(, I('(I 1'1'1111'11 ofils wHkdying slOek-
alld Ihis high('\' cliscolIlll rail' I'xaclly olbels Ihe LlIgI'l' "XI)(,(,l!'t! payolf so
'hal Ihe pn'SI'\l1 vaillt' is Ihe salllt' as Iht' pritT or Ihl' rail 0\1 IIIl' stod, with
III" 'Illaller drilL TllI'rdore, Ihe fad Ih,lI Iht' drill pLlys \It) dirl'('l mk ill
Ih .. B1ack-Scholl's fill'lllllia belies ils importallt.·c, The salllC t'('ollolllic f(lIH'S
Ih;1I (klenllilll' lhe expCl'led ITlllrIIS or siocks, hOllds, alld olhlT fill,lIIcial
a~\('1s ,\\'(' also Oil work ill pricillg opliollS,
Thl'''' cOllsidcraliolls art' 11'" i11iPOrl,1I11 ",1"'11 II", drill is ;"sllllll'd 10
1)(' cOllslall1 Illrollgh lillll', 11I1I if'cxpI'(,leti 1'('llIf'IIS are lillle-\'aryillg so Ihal
siock rellll'lls art: prl'dil'lahll~ 10 SOIlIt' degl'('l', Iili, pn'dicl;"lilil~' mllsl 1)('
la\<.I'1\ illio <1<'('011111 ill I'slimatillg (J,

n/(, 'li('l/(/iIlK (hll.lii'ill-Uh/('lIiJnh 1'1</<1'.11

'I() SI'('how a lime-varying drift can inl/lIl'nce opl i()\1 prices, we f(lllow 1.0
and Wang's (1!)!)5) analysis hy replacing Ihe gl'ollll'lric I\f()wnian mol ion
assumillion (1\:\) of'lhe Black-Scholes model wilh Ihe «.lIowing slorilaSlic
difll'l'cillial equatioll f(lr Ihe log-prilT plocns /'(1):

d/I(!) == (-Y(/J(t) -- Jill i JI)dl +n dll, (9,3Ali)

Wlll'lT
y ~ 0, I E: 10, (0),
Unlike tilt' ~I'ollll'lric I\rolVnian tllolion dYllamics 01 Ihe original Black-
Scholl'S llIoclel, which implies that log-prin's f(lllo\\' ,III ;lIilhllll'lir random
walk with lID IH.rm,d illerl'lIlt'lIls, lhis log-price I)\(l( I'SS is the slfm ofa I.I'\()-
IIlI'an stationary ,llllolTgn'ssive (;allssian proccss-;UI ()rtIstl'in-Uhll'lIbcck
proc('Ss-allci a dt'llTlIlillislic lillear tlt'IIC!. so WI' cdl this tilt' III'I/{lilig O-l/
proc('ss, /{I'I\Tilillg (!).:t,J(i) as
shows that whclI /IU) cit-I'iatt·s frolll its trelldld , it is pulled
hack at a rate
proport iollal to its cicl'ialio ll, wh('l'e y is Ihe speed o!(uljUJI 1IIf11 I.
This rcvcrsio n
to Ihe Ilclld illChllTS prl'dicl;l hilil)' ill Ihl' relurns of this assct.
To develop flll'lhn illtuitio n for the propert ies or
(9.:t4(i) , cOllsid n its
explicit SOIUlioll:

(9.:l.4H)

frolll which w(' call Oill'lill Ih(' ullcolld itiollal JIIOlllellts alld CO-IIIC
IJIIl' II IS of
cOlltillllOIlSI), COlllPOlIlHlcd r-period relllnlS rl(r) == P(t)-"(I-r):~o

Elldr)1 liT (9.:\.49)

\'ar! '/( r >I r > 0 (~),:UO) .

.,
(1'
( :O\' f Ii, ( r ). li~ ( r ) I - - I ' -y(l,-/,- r) [I - I-Y']~
'.
2y
II -/ r < I',! (~),::l,:l I)
I
Conl'i( r), III' (r) I -- [I - I'-Y'l,
2
Sillcl' (~),:\..J(;) is ;1 (;allssia ll process, Ihe 1Il01l}('nts (~1.:1.·19)-(~),3,:1
I) (Olll-
pletely charaClt ·rilt· Ihe liJlitc-di lllt'lIsiol lal distribu tiolls of I, (I)
(see Sectioll
~),l.l Itlr the defillitio ll of a fillilt'-di lll(,lIsio nal
distrihu tion), Ullli,'c the
arilhlllc tic Browllia ll IIlOlioll or ralldolll walk which is lIonst,ll
iollary 'md
ortell said 10 hc tli/li'Il'wl'-I/(/liol/f/}~v or ,I Jlor/uUli c Irnu/, the
trclldin g O-U
pn)~'('SS is said 10 I~,I' Irl'lltl-,l/l Iliol/(u)' siJlce its dcviatio
lls frolll trcnd filII ow a
slallona ry proccss, ·1

fOlulitiollC 'cI 011 lIfO) = /1" in dt'lil1in~ Iht, dellc'lule

:.'IISilll (' Wt' 1i;1\'(,
d I()~~prift· pro("('."i.s,
it is a ~Iiglll ahus(' 01 h'llIIillCilo gy to (all 11It'~t· IIHJlUt'lIts "uJlcullcl irioIMI",
Ilo\\'t'\'('r, in this
fit'" Ih,' di,tillnio ll i.1ri prilllal il)' ~c'JII;lIl1i( ~illn' lilt'
c:nllclili()lIin~ v.lriahk is lIlort' of all initial
nmdilioll lhan.1I1 illl"ollll"li oll \,;II·jahlC'-il"\\'(' dt'fillt' Iht' hq~illllillg
: oirilllt" as I = () and Ihe
flilly oh"'rv"hlt - >1.11 lill~ \',tI"" 01/,(0) '" I'". d"',, ('I,:l,1~1)-(~I,:\,r.~)
;Ir!' 11I"'lIlldil illll.tI IIIOIll('lll'
rdativt, 10 ,!I"M' illil;;11 ("OIHlilioll!'oo, \\'e' ~";tli ,uloptlliis definition
01 all1llH'OIH litiol1;IIIII IIIIH'ut
tilioligho ul liIc' rc"1I1ailHic-r of llai~, ".IPlt'l.
:!I All illlplicllio ll uf 11 "IHI",t;"io ll;U it), is Ihal lilt' variau('('
of r-pt"riod returlls ha.1ri a finite
limit as r iIHT(,;IM" \\"illwHI !,Olllld, ill Ilti.1ri ( ... ~" n '.! /y. wht'J"t'as
Ihis variallct' increas(,s linearly
with r 1IJ1(kr a r;lIIdom \ ....all. \\,I!ik IH'lId-st;lI ioliary
prof('sst's art' oht'll simplt·J' 10 (·~tililate.
"H'Y Ita\'(' ht'('11 n ili,·i/C'd tI~ 1I111e;lli.lriti( lIuldds of financial
;1~S('t prict's sinn' they do ltol "(ford
w('11 with 11i(' (0111111011 illtlliliOlllh~lll()lIg('I-hol i/oll ;,ts:o.t't rt'IIII"J1S
('xhihit llIol"(' .. bk 01 th~lt prirc
IOI"l'(";lSt'\ ('xhibillll on' 1IIIr(' I laillt\';ts tlu' 1(11('( ;I.,t hOI i/llU
grows. Ilo\\,t'\,(,,,, if lIu' ~ollr('t· of stich
illillilioll i~ ('lIIpiri,.1I 1111,("1 \·~lli'lil. it III.IY wl'll Ill' ({llIsistt'!}1
wilh Irt'lul-M.u ioll;.lrily silln' it is
IIOW \\'('II-llloW lIlkll fiu .IIIY fi II Itt' .'1'1 Clf cI.lla, (rc'IItI-M~lIioll~lrily
:.uul t1i1f"t'IC·lIft'·!'\I~uiollarity an'
\"ittllall\' illtii,lillglli!'ooh;lhl(' (,t"", fUI (,,\.lIllpl,,, St·, lion
'2.7 in Ch~lp(('r~. <:ampb,'11 allci 1'(,11011
I t'I~III. I t.""iil,," II'I~II. c :/"'1.11'" 17-IHI, ","1,/,,· """'Y Oil ..... "1I11il 1001" I'",)('r> 11,,·\' cill'),
1).3. illllilfillfllling Paramfl71c 0lilion I'I1cing Moilris 37S'

Note that the first-order autocorrelation (9.3.52) of the trending 0-

U in<TemenL~ is always less than or equal to zcro. bounded below by -4.
and approachcs - ~ as r increases without bound. These prove to be se-
rious rcstrictions for many empirical applications. and they motivate the
alternative processes introduced in l.o and Wang (1995) which have con-
siderably more flexible autocorrelation functions. But as an illustration of
thc impact of serial correlation on option prices. the trending O-U process
is ideal: despite the differcnccs betwcen the trending O-U process and an
arilhmetic Brownian motion. both data-generating processes yield the same
risk-neutralized price process (9.3.44), hence the Black-Scholes formula still
applics to options. on stocks with log-pricc dynamics given by (9.3.46).
I-\owever, although the Black-Scholes formula is the same for (9.3.46).
the a in (9.3.46) is not necessarily the same as the (J in the geometric
Brownian motion specification (9.2.2). Specifically. the two data-generating
processes (9.2.2) and (9.3.46) must fit the same price data-they are, after
all, two competing specifications of a single price process. the true" DGP. M

Therefore. in the presence ofscrial correlation, e.g.• specification (9.3.46).

thc Ilumerical value for the Black-Scholes input (J will be different than in
the case of geometric Brownian motion (9.2.2).
To be concrete. denotc by TI(r), s~[TI(r)J. and PI(r) the unconditional
mean, variance, and first-order autocorrelation of Ir/(r)}. respectively.
which lIlay be defined without reference to any particular data-generating
process.~l The numerical values of these quantities may also be fixed without
reference to any particular data-generating process. All competing specifi-
cations for the true data-gencrating process must come close to matching
thcse moments to be plausihle descriptions of that data (of course. the
best specification is one that matches all the moments. in which case the
trllc data-gcnerating process will have been discovered). For the arithmetic
Brownian motion. this implies that thc parametcrs (p,. a 2 ) must satisfy the
following relations:

rt(r) p,r (9.3.51)

ih(r)] (9.3.54)

PI (r) o. (9.3.55)
I

From (93.54). we obtain the wCll-known result that the Black-Scho\es input
a~ may be cstimated by the sample variance of continuously compounded
rcturns IT,(r»).

Nev<·nil,", .. ,.,. 1.0 alld Wallf: (I ~9:») provide a f:rrwf;tlizalioll of Ihe Irending ()'U process Ihll
contains Modla!lotir lrt"lHis. in which case tht" variance of returns will increase wilh the holdirik
pt·riod r,
:!'!()fClHlrSt·, it IlltlSI he as.~llmed thallht" mOIUel)[S t'Xisl. fJ()wever, even if they do not, a sirn-
ilar lUll murt' il1\'ol\',·d may he ha.\t"d 011 location. seait:'. and association parameters.
argullIt"llt
f
374

In the case of the trending O-U prm:ess, the pai'amt'tt'rs (/1. y, (1~) nllisl
satisfy

r,(f)

r ::: ()

I
t pdT) = -"2[I-r- Y' ] , W:t:IH)

tbserve that these relations mllst hold for the 1}()lmlaiioll vallil's of Ihl' pa-
rameters if the trending O-U process is to he a plausihle dt:sniplion of Ih('
pGP. Moreover. while (9.3.5li)-(9.3.5H) involve population values of Ihe
iJarameters. they also have implications for estimation. In particlilar. un-
der the trellding O-U spccification. thc sample variance or conlillllollsly
tom pOllnded rcturns is clearly Iwi an appropriate cstimator fiu' (1 ~.
\ I-I()ldi~g thc IIncoIH\itioll.ti variance of ret lints fixed. the particular

r
~'aluc of (1~ now depends on y. Solving (9.::1.57) and (93':'H) for y and
yields:

y
J

-- log( I + ~PI (T J) (!l.:\.:I~l)

f

52 (If) y( I - 1'- Y' r I ~

~
.\ (r,) [
T
y T (I - f - yr r I ]. (!I.:UiO)

\ hich shows the dependence of (1~ ()J) yexplicitly.

I In the second equation of (9.::I.liO). (12 has been re-explesS(-c\ .IS Ihe
llroduct of two terms: the first is Ihe standard Black-Scholes inputuntin the
assumption that arithmetic Brownian motion is the data-gencrating process.
and the second term is an ,H\jllstlllcnt factor required by the trending O-U
specification. Since this a<!jllstment bctor is an increasing fun("!ion or y.
as relllrns hecome more highly (negatively) alltocorrclated. options 011 the
stock will hecome more v.t1uahle ("fims !lfIri!/ll.l. More specifically, (!l3.liO)
may he relVrillell as the following <'''plicil fllnrliOIl of PI (f):

(~l. :I.(i \)

Holding lixcclthe nncOlH\i lional variance of ret I\I"ns J~ [ Ii (T) J. as the" hsolute
value of thc autocorrelation increases frolll 0 10 ~. the vallie of (1 ~ inlTeases
without hOUIHI. 2:1 This illlplies that a specificati()~1 error ill the dynalllics of
.1(1) call have dramatic cOI1Se(l'wlI(CS for pricil1~ options.

;l"\\'l' lonl~ 011 lh(' "h!'oohlll' valu(' of tli(' aUIOnJlTt"I.lIiOIi lo Hvoid nmlll!'ioll in 1II~,kill~
nJll1pal"i~JI'~ ht-lwf>Cn n'sulls Ic,r Ilc"HOIli\"dy alllnccnrc'I,II('(1 .llld pc)sili\'('ly alllclftJlTt'l.llc.'cl asst't
'·clllrm. See JAl ;lIul W;III~ (I!N:.) for fllnller d,-Iai"-
 9. .>. jllll'/l'IIlI'nli ng j'fl/w//('/lir 0l'lion I'rici ng Mod!'/.,

.\s Ihe l'ellll'lI intcrval r derreases, il call 1)(' showlI Ihal Ihl' adjllslllwlll
faclor 10 .\~lli(r)l/r in (!l.:t(il) appro;H'h('s IIl1ill' (IIS(' 1:llt/pilal's 1'1111').
III Ihe cOlltilluous-lillW limit, thc stalldard devi;llioll of cOlllillllollSly com-
pOll IHlt-d ret u rtIS is a cOllsistellt esl iilia Ior Ii 'I' a ;1I H II he clkcls of predictahil-
ill' OIl a vanish. The illtllitioll (,(III1CS frolll Ihe raI'l th,ll a is a IIwaSllre of
/()((J/1/("lIlilil)~lhe volalility of illfillilesilllal pricc challges-alld Ih('l"(' is 110
prcdictahilily OV('I" allY illfillitesimallilllc illll'l'val hy cOllslructioll (see Sec-
lioll 9.1.1). TIH'rd()re, Ihe illfhlcll(,(, of prl'llitlahilily 011 cslimalors tI)r <T is
alll'lilpirical isslle which depellds 011 Ihe dcgr(,c of prcdicl,lhilily relativc 10
hoI\' lill('l), thl' dala is sampled, alld IIIl1sl hI' address('d Oil .1 C;I.\(·-hy-c;I.\(· ha-
sis, I lowcvl'r, wc pn>vidc a 11l111l('rical I'x'lIlIpk ill III<' lI('xl Sl'clioll ill which
til<' IIlagllilllclt- of Ihcsc cllccls is qllalllili('(lliH'1l1(' Black-Scholes casc.

Arlill.l(in~ 1111' Ji/(/(l!-Sdw/I',I j'imlllll(/ Jil" j'lI'Ilir(II/li/i(y

Expl'l'ssioll (!I.:~.lil) provides thl' 11('('('ssal')' illplll 10 Ihc BIoI('k-Sdloles IilJ'-
1ll1l10l I'm pricillg opliolls Oil all ass('1 with Ihl' Irending 0-\.1 (IYllalllics. If
tlH' IlllCOIHlitiollal variallcl' of daily retllrns is ,1"1,.,( I) I, alld iflhe firsHmier
altlo,'ol'l'('i;lIiOIl or r-period retltrllS is 1'1 (r). IhclI III<' pric(' of a call optioll
f is gi\'(,\l by:

1:"" (/'(1). (: , 1\, T. I, a) (~U.ti2)

log( I + :!I''' r ))
1111r) Ie (-~,()I. (!).:l.ti:11
r (\ 1 + '2pt\r)}I/. "'::'-1)'

alld rli ,lIId rI~ arc cklilled in (!1.2.17) allcl (!).2.1X), l'('spl'lli\'('I),.
Expl'cssion (!I.:{.(i2) issilllply the IIbck-Scholcs forllllllot with all acljusted
volatilily input. The a(ljustlllellll~lctor lIIultiplyillgl:!I,.,( I) I/r ill (!I.:Ui:l) is
easily labulall'd (sec 1.0 and Wang [I!l\l!">\); h('ll(T ill pranicl' it i~" simple
ma \\cr to ,IC!j lISI the Blac k-Scholcs li)l'll1ula Ii II' n('ga Ii\'(' a UloCOtTeial ion of
tlH' forlll (!).:t:,H): Multiply thc usual variance ('slilllalor '~I ,.,(I)l/r hy thc
appropri,\\(' 100e\or 1'1'0111 Table :~ or 1.0 alld ''\',\llg ( I ~I~I:,), ,IIHI IIS(' this OIS (I"
ill [h(' Bbek-Srlloks li,nllllia.
NOll' 11101[ 1'01' all valll(,s 01 I'1(r) ill (-1,. Ill, Ih(' lae[(lI IIlllltipl)'ing
.I~ [ r, (I) l/r in (!).:l.Ij:~) is greater than or C'lIl,tll:' OIl(' and inlTcas('s in the al>-
soilltc valliI' or Ihe first-ordcr autocorrelation cocflil'il'1I1. This illlplie~ thaI
oplioll pric('s lInder the trcllclillg ()-\ 1 ,'pc('ilil';llioll ,11(' always gr('atn thall
or equ;1i to prices under the standard Black-Scholes spccilication, alld titat
oplioll pric('s arc an increasing fllll('[ioll or Ihc ahsoilltc 1';lllIC of Ih(' first-
or(\n ;lIl\ocolTl'iatioll c()l'niciclIl. TIIl's,' aI'\' pllH'ly !'<'aIIIH'S "fill<' Ir('\\(lillg
O-U process alld do lIot gcncrali/,c to othcr sp('C'ilicatiolls or thc clrift (sec
1.0 alld WOIllg 11!)~I!iJ (()I' cxamples orolhn pallerns),
:nli 9. /)n71'rtli!ll' Pricing Modi'l.l

'fhblf 9.5. (J1,lillll Il//iI'\ 1111 1/\.11'/.\ /IIi/h 1/1'~I//il/l't.y f/1//o(()rIl411Inl,1'I1II7IJ.

Tll'lI(lill~ ()-lJ I'rke. with l)«iI)' {I, (I) ==

Strikl' 1I!.11 "·S! h"k, ..
-
I -.10 'r '~·;-r--·:~o -r=~~~-T-~·'F'
!'lin' !'Iin'
.-.0:.

Tilll"-ltI-/I!atlll ilY '/'-/ == 7 Days

-
:\0
:\:)
.\1)
10.0:.'H
:).O:~4)

O.Hli:1
10 O:.'H
'.0:17
OHW.
10.0:.'1{
:'.0:11{
O.!IIO
r~-J···~r~-]~---·
10.0:1H
:>.<14:1
0.!17:1
10.0:.'H
:,.0:.1
I.Oli:.'
10.0:.'1{
:>.<)7·1
1.2 Iti
I().O:.'~
:,.1 ()~
1.:11>:-1
·1'. 11.1111 11.111:1 O.I/lti 0.02·1 0.(l·1I 0.0112 0.1 :17
:.0 0.000 0000
. _~I.~~J _~:~~__I~~~~~. __ ~I~I~ ._(I~~I.~~
== IH\! \);I),S

·n
Tilll<"I0-/vlallllil)' 'J'-/
I
.- -. ------- -------
I
:10 I 11.211'. I 11.:l:Ili 11.:1!).1 115,IH 11.7Hli 1:!.2:~H 1:!.7:!:)
:1:. 7.'.:.11 I 7.lilfi I 7.7·lti 7.!)!)H H.%:. !U1l1 !Ui(iH
10
·Ir.
1.710
:.'.11111
.1.11:>1
2.'1:!:!
I ·1.!17Ii
:I.IHH
!,.:!Hli
:\.:\Iil
!1.nH
•
.\.HI_')
li..l!1I
r.t r
-1..>.1.)
7.:!-1-1
.,r: ..•11.,
-r:

'.0 I. r,~)~ l.tiH7

Tilll('·I"-~l.lIll1ily
I 1.7!17 :.'.07;\
. __._--- ----
2.·IH:!

'/'-/ = :lli4 Da)'s

:1.21 ,I :>'9Ii:~
- -- -.- - - -- - - - - - - - ---
I
... -.- .. -- .. -- --- . -
:10 1:.'.7:,:1 I 1:.'.11-1', I:.'.!I:,O 1:1.2IH I :I.ti:!() I·U·!!) 1:;.102
!
:1'. '1.\'1:1 I
I
~U)~:2 ').7W 111.1 :>:~ 1O.lilil II.rrH:! 12.:)01
·10 li.'(1)11 7.01i1 7.:.':\·1 7.liliO H.2W !I.:H:. ItI.:WI
.1:. ·1.'111
I ".10:.' :•. :.'H:I :1.7:~j! (i.:\7·, 7.·17H H.:,'ili
:,0 :1.111'1 I :Ui·I:, :I.H:.'I ·1.:!ti I ·I.H!Hi (i.()O:~ 7.IOh
I I

hol(·,( .dl optioll 1'1 i( (', on a hypodwClC..d $·HI ~cod;" UHdt'r an ~u itlHH(.'tic
(\ItIl)l.1l (..,01\ u( (U.u ~ "\(
(\10\\'''';''' "lo(iOI\ H" ~us .\ 1"'l\thllg (h l\~H"l\-llhkl\htTk IHun· ....!\. (or log-pl"in.. ~. a~~\l1Billg a
... LUHl.ud ({(·\,',"'UH ui '2 10\ d.ul\' {HHliH\10\l~ly (UI\I})lH\utktl n:lurns, ~Ul(' a daily continuously
1'
{,

(umpuu",h'd riskh"('t' ,.Ut' 01 !og( I.O:')j:\t;"L ;\~ <tUloeOI n·LUion ht't OI1U"S brgt'r in ~\hst)l\ltt·
\";,Iu,', option ))1 it I'~ ilH 11·.\ .... '·.

:111 /':m/Jirim/I((III/m/i/lJ/
'«. gallgl' Ih,' "llIpil i.. ;1i .. t'lI'V;III ... · or litis adjllsllIlt'lll {ill' alllocolTl'ialioll,
');lhtt· 'I.:...quu" ;1 (OllIP:lIisoll 01 HIa,'k-SdlOks pric('s Ilndn arithmetic
Browllian IllOlioll ;"ul ""dl'r II", In'lldillg Orllsll'ill-Uhl{'nl)('ck proct'ss for
\,;11 iOlls holdillg pniods. slrikl' pri",·s. and daily ;tIIlOcoITl'ialions from -!:i
[0 --.!:,'Y" {iu' a h"po[h('[il'a! $.J() s[oek. Tht' III1COIldi[ion;1I stalldard dcvia-

lion of t\ailv 1",'!lIIIlS is held flxl'd al :!'J., per day. Tht' Black-Scholes price is
eaicll\;I[l'ti a .... ording to (l).~. \til. sl'lIing n t'<jllailo tht' IIllcondilional stall-
dan! <!l·\·ialioll. Tit,· trl'lIding (l·l J prices are ralrlllated hy solvill!{ (9.:t57)
alld (ll.:\.:,H) for fT gin' II r :111<1 [hI' r('llIm ;tlllo('orrl'latiollS PI(T) of -0.05,
-0.10. -O.:!O, --0.:10, --0.·10, and -0.·1:" ;lIIcl usinJ!; these valucs n in the or
1\I;\tk-Sdloll'\ {"IIlIIlLI ('l.~. \ti). \\,111'\"1' T = I.
9.3. Implementirlg Parametric Option Pricing Models

The first panel of Table 9.5 shows that even extreme autocorre~tion in
daily returns does not affect short-maturity in-the-money call option prices
very much. For example, a daily autocorrelation of -45% has nQ impact
on the $30 7-<lay call; the price under the trending O-U process is identical
to the standard Black-Scholes price of $10.028. But even for such a short
maturity. differences become more pronounced as the strike price increases;
the at-the-money call is worth $0.R63 in the absence ofautocorrclation, but
increases to $1.368 with an autocorrelation of -45%.
However, as the time to maturity incrc,\.~es, the remaining panels of
Table 9.5 show that the impact of autocorrelation also increases. With a
-10% daily autocorrelation, an at-the-money I-year call is $7.234 and rises
to $10.343 with a daily alllocorreiation of -45%, compared to the standard
Black-Scholes price of $6.908. This is not surprising since the sensitivity of
the mack-Scholes formula to a-the option's vega-is an increasfng func-
tion of the time-to-maturity (see Section 9.2.1). From (9.2.28), we see that
for shorter-maturity options, changes in a have very little impact on the call
price, but longer-maturity options will be more sensitive.
III general, the effects of asset return predictability on the price of deriva-
tives clepends intimately on the precise nature of the predictability. For ex-
ample. the importance of autocorrelation for option prices hinges critically
011 the degree of autocorrelation for a given return horizon r and, of course,
on the data-generating process which determines how rapidly this autocorre-
lation clecays with r. For this reason. Lo and Wang (1995) introduce several
new stochastic processes that are capable of matching more complex pat-
terns of autocorrelation and predictability than the trending O-U process.

9.3.5 Implied Volatility Estimators

Suppose the current market price of a one-year European call option on a
nondividend-paying stock is $7.382. Suppose further that its strike price is
$35, the current stock price is $40, and the annual simple riskfree interest
rate is 5%. If the Black-Scholes model holds, then the volatility (1 implied
by the values given above can only take on one value--{).200-because' the
Black-Scholes formula (9.2.16) yields a one-tCK>ne relation between the op-
tion's price and a, holding all other parameters fixed. Therefore. the op-
tioll describen above is sain to have an implied Il()lfllilily of 0.200 or 20%. So
COlllmOll is this notion of implied volatility that options traders often quote
prices lIot in dollars but in units of volatility. e.g., "The one-year European
call with $35.000 strike is trading at 20%.n i
. Because implied volatilities are linked directly to current market pri~es
(via the Black-Scholes formula). some investment professionals have argtled
that they arc betlere~timator!lofv()latility than f'~timlllf(yfll tm!W"tf NNM41ltm·1f1,
llala '!leh .... lit . '",......
t"
,,." 1I(.1·~,.,r,n"( "fI' I~'i'(, '/.011 If( '/,. "'(fff/(#fi4 "II/hUtll'
\
 9. /)1'I"illlllitll' I),.i(il/~ Mlltld,

SiJ1(1they arc based on nllH'lIt prices which presumably have expectations

of tl e future impounded in them.
-!owevcr, sllch an argullIellt ovcrlooks tlte fact that an illlplied volatility
is i11~imately related to a specific /ml'flllll'lrir option·pricing lIIodel-typically
thc B1ack:Scholcs model-which, in turn, is intimately related to a particular
set ~If dynamics for thc undcrlying stock price (geollletric Brownian motion
ill tl e B1ack·Scholes case). llcrein lies tlw prohlem Wilh illlplicd volatilities:
If th B1ack-Scholcs forllluia holds, then the parallleter a can he ret'overed
with III m-or by inverting the Black-Scholes fOnJllli<I for any olle option's price
(eacpl of which yields thc sallie lIulllcrical value for a); if the Biark-Scholes
fornbula does not hold, then the implied volatility is difficult to interpret
sincl' it is ohlailled hy inverling tIll' Black-SdlOlcs /i)J'lnula. Therdi)('(', using
the mplied volatility of one option 10 ohtain a llIore accllrate «1I('Clst of
vola ility to he used in pricing othl'r options is dther 11I1II('ccssary or logically
ill('~nsistelll.
{o see this 1II0re clearly, considn Ih(' argument that implied volatilities
an'lpeller ()recasts of flltlln~ volatility because changing market t'(IIHlitiolls
calls'c volatilitics vary throllgh time stochastically, and historical volatilities
canllot acljust to changing market conditions as rapidly. The fillly of this
argulllcntlies intire lilCtth,tl stochastic volatility contradicts the assllmptions
requircd hy thc Black-Scholes modd-ifvolatilities do change storhasticall),
thrungh tillie, the mack-Scholes formllia is no longer the cOlTcrt pricing
formula allll all implied volatilit), derived from the Black-Scholes /i>nllllia
provides no new information.
Of course, in this case the historical volatility estimator is elJuall), IIseless,
since it need not enter into the correct stochastic volatility optioll-pricing
/(lJ'IlIltla (in ract it does not, as shown by Ilull and White ll9H7 J, Wiggins
119H7J and others-sec Section 9.3.(j). The correct approach is to IIS(' a
historical estimator of the unknown parameters clllering into the pricing
formula-in the Black-Scholes case, the parallleter a is related to the his-
torical volatility estimator of continuously compounded retllrns, bllt IInder
other assllmptions for the stock price dynamics, historical v~)latility need 1I0t
phI)' such a celllral role.
This raises all interestill!{ iSSllt' n~!{anlill!{ the validit}' of the Black-Scholes
/i)flllula. If lhe Black-Scholes formula is indeed t'(lI'rect, thell tht~ implied
volatilities orany set of optiolls ont he sallie stock lIIust be 1I11/1l1'rimll)' ilil'lllil'lli.
()f course, in practilT til!'y n('ver ar(,; thlls til(' assllmpliolls of lile IlhH'k-
Scholes lIIodel canllotlitnally be true. This should not cOllie as a cOlllpletc
sltrpriS('; aha all the assumptiolls or the Black-Scholes IlIlHld impl)' Ihal
options are redundant securities, which e1iminatcs the nccd for organil.cd
optiolls markets altog(,ther.
The ciifficlllty lies ill d('tnminillg which of the man)' Black-Scholes as-
smll)ltions arc violatcd. If, for example. tltc Black-Scholes model /;Iib ('111-
(/ J. IlIIjill'llll'lIlillgl'f/rfil/lI'lnr (Jjllillll I',irillg ;\/"r/,./,

piritidl\' I)('callse stock prices do not 1()lIow ,I IOf.:1I01lJl.t1 dilfllsion, we lIIay

Ill' ilhk 10 specil)' all alterllate pritT pron'ss Ih.1l lils ill(' data heller, ill
which case the "illlplit'll" parallwt('r(s) of options Oil tite SilllH' stod;, may
illdel'd he nUlllerically identical. Altenratiq'ly, if Ihe Black-Scitoles model
bib l'lllpiricillly hecause ill practic(, it is illlpllssihk to tl;uk cOlltilllHHlsly
dUI' 10 transactions costs and other illstitlllioll,t1 cOllstrilillls, thell 111,11 kets
arc n('v('r dYllalllically complete, optiolls an' lIeH'I" rnirnHl;llIt serllritit,s,
and we sholiid never cxpect "illlplied" parailleters of optiolls on the sallie
slock 10 he 1IIIIIH'rically idelltical I()J' any oplion-pricillg I()rlllula. In this
case, Ihe degrce to which implied volatilities disagtn' 111,1)" 1)(' iUI indicatioll
of h,lI\' "redIIlHLIIII" options really arc.
The 1;lcl thill opliolls Iradns quo\(' pri, es in 1"1 IllS olBI,l<k-Scholcs
itllplied 1"01;llilities has no direct hearing Oil their us.-lllille.,s flOll1 a pric-
ing point of view, hut is a relllarkahle \('Stillllt'llt to till' popularity of the
Bl.lck-SdlOks f()J'lIl1da as a COllvellil'lIt heurislic. Quolillg prices ill telms of
"Ii, "''' rillher than dollars has 110 br-n'adling ('c()llolllic illlplicatiolls sim-
ply \)"(";IUS" there is a well-kllowlI Olle-to-Oll(' IIIi1ppillg lJelWl't'll ticks alld
tlol\Ms, Mon'()\'n, just hecause optiolls tratlns quoIt' prices ill I('\'IIIS of
Blilck-SrilOks illiplied volatilities, this docs 1I0t illlpl)' tklt they arc IIsillg
the mack-Scholes model to .11'/ their Inin's. Inlpii('(i \'o\;ttilitil's do COIII'l'),
inll)l'Ination, hilt this illilmllation is idl'nticid to Ihe illlolllliitioll cOlltailled
ill lltl' IIIi1rket pri'Ts oil whirh the illlpli('(1 voliltiliti"s .11'<' haSt,d.

(J. 1.6 SI",-!/fI.I/;,·, lii/f/it/;l), ;\I"r/r'/I

ScqTal empirical studies have showlI that the g,'olllctric Browlliall llIotioll
(9.~,~) is Ilot all ilppropriate model for (Trtilill st't'mil)' priccs. For cxam-
pk, Ikckers (19K:I). Black (1971i), B1allJH'rg alld (;ollcdes (I ~}74), Christie
(19H2}, Failla (I%:>}, 1.0 al\d MacKilliay (i~)HH, I~)~)()c}, ami MalHlelhrot
(I ~l(;:~, I ~)71) hilvc dOCulllellted importallt departures flO II I (9.2.2) for US
stock returlls: skcwlless, excess kurtosis, snial correlatioll. alld tillle-varyillg
voJ;llilitil's. Although each of thesc elllpiried rq,;ularities has implicatiolls
for optioll pricillg, it is thc last olle that has rCteivcd tlH" lIloSI attelltioll ill the
rcct'llt derivatives litcrature?1 p;trtl), hecau,c volatilit), pla),s such a cClltriti
role ill tit(' /\Iack-Scholes/Mcrtoll l(lIIl1Ulatioll alld ill illdllslry practice.
II', ill Iltt' gl'olll('tric Browlliall lIlotioll IIl<>dci (~).~.:!) tite (1 is a knowlI
det<'lillillistic flillctioll of time aU), thell thl' I\lack-.'icitok, formula still
ill>plil's btlt with a rl'plared hy the integlal ,I;'
0(1) ilIon'! till' optioll's
Iift-. I I()\1'l'I'('/', if (T is stochastir, till' situatioll ht'colIH'S 11101 e (olllpkx. For

'lIS"I'. Jol' t'X;UlIph-. Alliin alld N~ (I~)!U). n.dl.lIld f{tllIl.l (Iqql), B('f"c'" (I~IXII), (AI"
(I~'r.). (;old('11I ... ,.~ (I!I~II), Ilt-slnll (I!I!I:I), 1101111, ..... , 1'1.,1"11. ,,,,,I ,,1,,\1'11," (I!I~I:l),111I1I
"lid l\'loil<' ( t !Illi) ,.101011"111 "lid Sh.IIII'o ( I ~IH7" S. oil II 'IHi, .. , 1101 \\'):gll" ( I'!Hi,.
 i). "nilllllilll' I'm/11K ,\l/JIM.I

I'\alllpll', supposc' Ih;u Ih(' itliuLtlll«'llIal assl'l's c1)'nalnics are given hy:

til' 1I/'tlI I- (J I'dll" (!).:I.Ii4 )

dn li(n )", + /1(n)1I Un, (!).:I.Ii:I)

11'11«'1'1' (1 (.) alld 11(·) ;lIt· ;11 hi I1';111' 11111(1 iOIiS or volali lily rr, and /I" and Un arc
,Ialldanl Browlliall 1I10liollS wilh illslalllalH'ous ('olTl'ialioll d/l" dll, =
fJ ill.
III this case, il iliaI' 1101 1)(' possihle- 10 dl'l('rlllillc the pritT or an option hI'
arhitral-\(' arl-\llIlu'lIl' alolll', IiII' Ilu' 'illlpic reasoll Ihal Ih('r(' ilia), 1101 exisl ;l
dVllalllic sl'll~lillallcing ponl'olio stralc'gy involving SlOcks and riskless bonds
Ihat elll p('rl(>('(11' I'l'plictl(' Ihl' opli()II's payolf.
I "'"I'isticalll', slodl;lslic I'oblilill' illllOdu('('s a second sourc(' or
1111('('1'-
1;lillll' ililo the rl'plicatillg portli>lio alld if this 11lH·('rtainty (lIn) is lIot per-
Ic'('(11' cOl'relall'd with Ihl' IlIlcertainl)' illhel'ellt ill th(' stock pl'ic(' process
(II,.), Ihl' rl'plicalillg portlillio will lIot 1)(' ahle to "spall" the possihll' O\lt-
COIIJ(', Ihal all oplioll 111;1\' rl';t1i/(';11 Illallll'il), (WI' Ilarrison ;lnd Kn'ps II D7~) I
alld Ililllie ;In<l IllIang II tIW,! (i,r ;l more rigorolls discussion). ()I' cOllrs,'.
if (1 11'('1"1' IIw pri(!' of;1 11;1<1('<1 ;"'t'l, Ihl'lI IIl1dl'r relalively weak reglllarilY
cOlldiliolls Ilwr(' lI'ollld n;iSI;1 <l1'I1;lllli( s('If~{illallcing port{(llio slralt'h'Y C()II-
sislillg of SI!lcks, hOlld" alld Ih(' \"(11;l1ilill' asset Ihal cOllld pl'rf('ctl)' r('plical(,
11)(' opl iOll.
III II/(' allsl'IH"!' "llhi, ;uldiliollal hedging s('cllrity, the on I)' availahle
IIwlll()d IiII' pricillg "pliollS ill lilt' pr(,'I'II(,(' of stochaslic \'ol;tlilil)' or til('
IOlln (~),:I,I;:') is 10 appeal 10 a dl'll;lIllic I'qllilihriulI/ IllOdl'1. Perhaps 111l~
~illlpit'si approach is 10 a"tTI I hal Ihl' ri~k associated with stochasl ic volati Iii\'
is 11111 prin't\ ill ("I"ilihri"lll, Tllis is III(' approach lak(,11 hy 111111 alld Whil(,
(l'IH7) Ii,,· III(' ca\t' ",h('/(· \'"I;llilill' lililoll'~ a gt'olllt'lric BrowlIian 1II01iO!l

til' 1lI'tli -I- (J I'dll" (9.:U;(;)

(X(1~'" + ~(1~dll". (cl.:1,()/ )

IIv asslIlllillg Ihal l'obt'''·III' is IIllcorn'LtI('d wilh aggr('gall' ('OIlSlIlIlPlioll, Ihl'y

sholl' Ihal el)llililllilllll ()Jllioll price, an' giVl'1l lIy Ih(' ('xp('Clalioll or Ihl'
Black-Schoks rontlllLt, 11'1 It ')"1 , Ih(' ('xpt'dalioll is lakl'lI wilh r('sp('rl 10 III('
avera!!;(' volalilily o\'('r Ihl' oplioll\ Iiii-.
lJsing Ihe tl\·II;lIl1ic ('(I'lilihrillill llIodels 01' Carlllall (1!)7(ih) alld Cox,
III gerso II , alld \{os, (1~IWlh), Wiggills (1~IH7) dl'riws Ihe c<Jllilibrilllll price
of vola Ii Iii)' risk ill all ('("0 IlO II II' wh('l"e agt'lIls possess logarilhlllic IIlilily I'lIlIc-
liollS, \,iddillg;\11 ('(I'lilihrilllll cOlldilioll-ill Ihl' form ofa I'D\<: wilh rCrlaill
lIolIlHlarl' cOlldiliolls-ror Ih(' illsl<1I1 1;11 1('0 liS ('xpc('(cd ITIIII'Il or Iht, oplioll
pritT. Olh('l" d('l"il';llin'-pri<"illg mod"', wilh siochaslir volalililY lake Sillli\;11'
aJlpl'oadICs, ill<' dilli')"t'IJ("(" cOlllillg fro/ll lilt' Iype o\" l'qllilihrilllll 1I10dcl
('1111'101'('<101' Ih(' dlOic(' "I' 1'J'('kn'IHTs Ihal agl'lIls exhihil.
Y. J. hlllJ/mlnltillg PtlTametrir
OIJtion Pricing Models

j'lIrllllleter Estimation is
LS of stochastic-volatility mod els,
One of the mos t chal leng ing aspec vabl e yet OD,t lOn-l lo.:m l!"
ess arc uno bser
that real izati ons of the volatility proc of the proc ess driv ing a.
of the para met ers
form ulas are inva riab ly func tion s orta nt
atte ntio n devo ted to this imp
To date . ther e has bee n relatively little arily beca use
s like (9.3 .64) -(9.3 .65) prim
issue for cOll tinu ous- time proc esse dis-
in estim atin g cont inuo us-t ime mod els with
of the dim cult ies inhe rent ntio n has been devo ted to
grea t deal of atte
crct ely sam pled data . 1Iowever, a ition al hete rosk edas -
auto regr essi ve cond
a rela tcd disc rete -tim e mod el: the pter J 2
2) and iL~ rnanyvarianLS (see Cha
ticity (AR CH) proc ess of EngIe (198
[199 2]).
and Bollerslev, Cho u, and Kro ner
ivat ed by issues othe r than opti on pric ing.
Alth oug h orig inal ly mot g cont in-
spir it of som e of the corr espo ndin
ARC H mod els doe s capt ure the er (J 994 ), Nels on and
by Nels on and Fost
lIolls-time mod els. Rec ent stud ies prov ide som e imp orta nt
(1991, 1992, 1996 )
Ramaswamy (199 0), and Nels on 6) and Nels on and Fos~er
ar, Nels on (199
links hetw een the two. In part icul disc rete -tim e
(1994) deri ve the cont inuo us-r
ecor d asym ptot ics for several
inuo us-t ime proc esse s
ARC II proc esse s, som e of whic
h conv erge to the cont
The emp irica l prop ertie s of
gins (1987).
of !-lull and Whi te (1987) and Wig dou bt be the subj ect pf
ored but will no
I.hese estim ator s have yet to be expl
iUll lre rese arch .

Di.fn·rtr-Timr Models ilibr ium

with a disc rete -tim e dyn ami c equ
Ano tha app roac h is to begi n t's pric e dyn ami cs
h the fund ame ntal asse
llIodel for opti on pric es in whic is typic ally imp ossi ble to
el. Alth oug h it
arc gov erne d hy an ARC H mod [inu ous- time vers ions mus t
rete lime . cOJ1
pdc e secl lritie s hy arbi trag e ill disc tilit ;
,d equ ilibr ium argu men LS as well in the case of stoc hast ic vola
appe 10
cOll tinu ous- time fram e-
y in leaving the
hel) ce (her e is lillie loss of gene ralit take n by Ami n and Ng
is the app roac h
wor k alto geth er in this case. This cs-
deri ve opti on-p ricin g form ulas for a variety of pric e dyn ami
(1 ~)9~). who , stoc hast ic in-
ump tion grow th vari ance
stoc hast ic vo[atility, stoc hast ic cons rete -tim e dyn ami c
ps- by appl ying the disc
tcre st rates , and syst ema tic jum inst ein (197 6).
(1979) and Rub
equi libri um mod els of Bre nna n irica lly
Disc rete- time mod els arc also gene rally easi er to imp lem ent emp
l tran sac-
arc sam pled disc retel y, fina ncia
sinct' virtually all histo rical data estim atio n and
rete intervals, para met er
tiOl)S <In' typically reco rded at disc cast s are prod uced
data reco rds. and fore
hypo thes is testi ng involve disc rete in mod -
. For thes e reas ons, ther e may be an adva ntag e
at disc rete hori zons vativ es with in a disc rete -
H and pric ing deri
elin g stoc hast ic volatility via ARC
limt ' equi libr ium mod el. er
o oITc roth er insighLS that are hard
Ilow l'ver , cont inuo us-t ime rnod elsd Jlplc , the dyna mics
disc rete -tim e fram ewo rk. For exal
10 Cllll lt· by with in a
:\82 y, })nil/{/Iil", ",.;r;lIg Modd.!

of nonlinear functiolls of the data-gclleratilig process an' almost iml)("sihk

to ohtain in discrete tillle, hut in rOlltillllOIlS time Itil's dilferl'lItiation nlk
gives an explicit expression for such dynamics, Th('~lretical insights into
tlw equilibriulII structure of derivatiws prices-I!)I' cxampk, which slalc
variables alTcct derivativ(,s prices alld which do not-arc also moJ'(' readily
ohtained in a continuous-timc framework such as Cox, Ing('l'soll, ;lIld Ross
(19M5b). Thcrclorc, each set of models oilers sOllie vaillahle illsights that
arc 1I0t cOlltaincd ill the othcl:

!9.4 Pricing Path-Dependent Derivatives Via Monte Carlo Simulation

Consider a contract at date () that gives the holder the right hUI Ilot the
ohlig.llioll to sell olle share of stock at date T for a price equal to the max-
inllllll of thai stock's price over the period from 0 to T, Such a contract,
oftcn called a loohiJ(lcl! oplion, is ('k-ady a pUI oplioll sillce il gi\'('s Ihe holdn
Ihe optioll to sell at a particular price at maturity. However, ill this case the
strike price is stochastic alld determined ollly at thc maturity date. Because
thc strikc pricc dcpends Oil thc /,alh that the stock price takes from 0 to T,
and not just on the termillal slock prire I'Cn, such a contra<"l is called a
/lIIlh-dr/IPIIIII'III optioll.
Path-dependent optiolls have become illneasillgly popular as the hedg-
ing nccds of invcstors hecomc cver lIIore complcx. For example, many
mllitinational corporations now cxpend greal elTorts to hedge agaillsl ex-
changc-ratc nllctllations since hu'ge portions or their aCCOlllIlS r('ceivahle
and accounts payable are denominated in f()rcign currcllcies. OIlC of' Ihe
most popular path-dependenl opliolls arc roreign currency (/tll'mg~ mil' or
Alillll options which gives thc holder the right 10 buy foreigll (mrellry OIl a
rate cquallo lhe average of the exchange rates over the lire ortl!e ('ol\lr;lcL~:'
Palh-dcpendellt options may he priced hy the dynalllic-hnigin h ap-
proach orSection 9.2.1, butlhe rcsulting I'DE is often intractabk. The risk-
lIeutral pricing method offers a considerably simpler alternativc in which
the pOlVcr of high-speed digital computers mOl)' he exploited. For ('xample,
considcr the pricing' of the option to sell al Ihe maximum. If' 1'( t) dellotes
Lhe date I stock price alul }1(0) is the inilial value of this put, we havl'

11(0) ,,-.rE' [1\hXr

0:.../::
1'(1) -1'(TlJ (~IA.l )

'.!:'Tht" I('rm ""-",i.tll" ('OIlH','i fl"ollllh(' Lin Ihal sud I options \"'l'n' tina ,u'ti\'('\ywrillt'll 011 ~llJrk.~
A,ian (·xdlall~f,:!\. BloCIII,,' th,'M.' l'xdl;m~l's an' usually smalh-rll!,1I1 tlwil ElIIC)P(';lIl
l.ltlilJ){ 011

tHul American rOllntl'rp,trl~. Wilh u'lali\'('ly Ihill trading alld low d'lily \'ohmH', pritT:" 011 slU:h
'x(hangt"~ are ~nll1t"\\'hat (·.,~i(·r 10 II1tlllip1l1aw. To millill1i/.f.' ;111 option's ('SPO!\UU' to tht· risk
J'f~'tJ("k-l' ..in' manipulation. ~11Il'\\, option wa.1ri ('I"('ale" witla 111(' ."'(·ra~l' oflill' :o-.1I.d'IH in's 0\'(''-
flU" optiou's lile' playing till" role olth(' 1t'llIIin.1I Mock prin',
9,-1, I'ri"illg I'(//It-I ",/It'lIdl'll/1 "',h'lI/iJl'" \ 'ill ,1101111' (.'1/110 S/lIIlIll/lill1l :1:-1:1

" " E' [ 1\1;1', I'i

o I I
I)'] I " I, ' 1/ ' 1"1) I (!I,I.:!)

" " E' [ 1\1;"

II I I
1'(1)] I'i 0). (!I.-I,:I)

wlwn' F.' i, IIII' "slll"'laliolls "llIT,II"1 willi n"I"TI III II", I i'\..'"l'\III~III' .. oh-
a!Jilily disirillillioll or ('qlli",,1<-1I1 1II""lill),!;;"" 1I1l'~1S11I",
OI'SlT\'(' Ih"l ill goillg I'mlll (')"I.:!) III ('),,1.:1) \\',' h.IH' ", ... llhl' 1;lIllh;l1
II,,· n'I"'('I"<I pn's"111 I',dll(, 01' 1'( F) disc"I1I1I,'d .11 illl' I i,skl,'s, I'~II,' " is 1'(0).
Thi, h"ld,s !JI'CIII'" II',· h;l\'(' IIsl'd Ihl' .. isk·,Il·III .... 1 1"'1"" 1~lIi,,", "PlT"lol' E'.
;lilt! 1111<1 .... illl' l'isk-lInlll',,1 pl'o!J,d,ilili,'s illiplicil ill I'~' ;dl ;ls,,,'I, IIl1lst 1'.1/'11
;111 "'lll"'I('d "'llIrn 0\1'; h('lll'l' " " E'! I'('J') 1 '-'- 1'(0).
'1('I'I';dll;II" (!I.'I.:~) I'i" 1\101l\e (:"d" ,i111111.11 i,,", \\,' ,illllll"I,' 111"11\ ,,\111-
pk 1"lIhs "I' [1'(t)I. lilld Ihl' III;lXillllllll Ii1',,,"(, II ,'."
I, ,,111'1,1,' p"lh. or ",(,Ii·
nllioll. "lid ;I\'('''''g'' IIII' pn'S('1I1 discollIlI"d I'"h,,' "j' ill(' 1I1."illl" 0\('" ,"I ill('
n'plic;lliolls III l'i..1d ,III ('xp',(,I"d l;lillI' "HT .dlll·pli, .lIilllls. i,,·,. ,III ,'slilll"I"
oj'II(O), 'I'll''' i,SSIII'S "l'isl' illlllll'di"Il'i\: 11,,11' do Ill' sillll"'I1,· " nllllillllO\lS
s,'lIlph' p'llh. ,IIICI how llI;1ny I'l'pli("lIiolls do \\'(. 11('('.1 1'''1';1 n',lsollabh' preciS!'
"slilll"tl' ot' 11(0)'

9,-1,1 /)i,\(//'I,' li'"I1I\ COlllillIlOII,\ '1'/111"

Ih I hl'ir I"'/')' ""1111'1'. digit,,1 ('Ollll"ll''/'' ,II',· illc'I),,,blc or Sillllll;llillg 11'\11)'

,'Ollli"IIOIIS pheIlOIlH'II"; bill as" pI',"'lic;t1 III"II,'/' Ihl'y al'(' 01'1(,11 ('''p"lIk
or I'n"'idillj.\ "x(TI1"1I1 "I'I'I'oxill\;\liOl", III p'''li ... d,,,. it w,' dilid" 0"1' lilll(,
illl'·''I'"I[O. '1'1 illio II disen'I(' illl(', I'af,; ,.,,' h "rll'lIglh It. ","l ,illllll"ll' pl'icl's
~II ""1'1. dis""l'l!' d"ll' kit. k = 0 ... ,. II. Ihl' rl's\l1t I"ill Ill' "II "pproximalioll
10" cOlllillllOIlS ',\llIple p"lh ",hiI'll (';III II(' 1II;llk slll .... ·ssil'l'l\' lIlorl' pre('iS('
hy ;dlowillg II 10 grow ;llId II 10 ,1I .. illk so .IS 10 I,,('('p lixl'd, r
For I'x;lmpk, ('oll.sidl'r Ihe CIS" or g,'olll('lri, I\rowlli.1I1 IIIOlioll (!I,:!,:!)
1'01' I,llit'll till' risk-lIl'lItral dYllamics ;11" gilI'll hI'

tll"(1) = IP'U) til + (J 1"(1l tfll(l),

I',: 1"(0) ('xl' [t 1;(11)] .

.=1
D('spitl' 111(' 1;1,1 tll .. 1 Ihl' ~imIiIOlI('d p;IIII I'" IOIri(" (/1111, OIl 1lIllllipll's 01 It.
till' "I'prll:-iimatioll IliaI' 1)(' III;\d,' ,lIhilLI,.ih pn'('i,1' hI' i'H'('easillg '1 ,\lid
Il\('rd,)\'(' d('('('('asillg h-as II ill('\('''S('S I,'illlol" hlllllHI. I',; HIIII'('rg('s "'I'lIldy
III (~),'I.'I) ('('(' Seetioll ~),1.1 1(,1' 11111111'1' dis(,lIssioll). [Jllfilllllllall'iY.III('I'('
OIrl' 110 g('II('I'OII nd('s fi,l' 1111\\' IOIrg(' II 11111\1 he 10 l'il'ld ;111 ;I(k'l"al(' apl'l'l':-ii-
Ilialioll·-.. iloll.sillg II 11111,1 1)(' dlllll' Oil 01 (',1",·1"'·(',1\(' h.l.si~,
.hl, Y. /) ..1"11'1//1111' "til"iIlK i\/oddl

1).'/.2//011' MIIII)' Silllll/illioll.\ 10 I'l'Ijimll

Wc ((III, howcver, plm'ide SOIll(' rlear guidelines for choosillg the lIullll)('r
ofn'plicatiolls /I/to sillllllat('. Recall that our MOille Carlo l'st i ilia It, of /1(0)
illvolv('s a silllpl(' ;tvcrage aaoss rl'plicatiolls:

I
({(O) =0 /' ,J -
/1/
L }",, -'
11/

{'(O), (9.4.1;)
",I

I
\\'hen'I{'J~ ~=" is Ihe jlt. 1I'I'Iicaiioll or salllple palh oflhl' slock I'ri("('I'I"I)('"
IIlIch'r Ihl' risk-lIl'lIlral disiriblliioll which, illlhe case of (9.4.4), implies Ihal
}I =0 r - ~, Bill SillC!' hy l'tIllSlntrtioll Ihe }~" 's ,In~ liD randolll variahles wilh

finite po;itive variallc(', the (:clltrall.illJil Thcorem illJplit's thaI ror large 111:

0;(11) == \'<11["-'1' }~,,]. (~).4.7)

There/1m', lill' large 11/ an approxilllat(' !I:,% ('ollli<ll'lI("e interval for II (0)
lIIay he readily ("(lIlstnt('t('d ['mill (!1.1.7):

,1.!)()(1,(II) , 1.%(1,,(11») "

PI'
( 1/(0) - - - ' - - - < 11(0) :: /1(0) + r.:. = O,!):).
fo vIII
(9.4,~)
Tht' elwin' 0[' III thlls depellds dir('nly 011 Ihe desired ac('macy of li (0).
If, lill' example, 1\'1' reqllire a /i(O) thai is wilhin $0,001 of /1(0) with !)!i%
conflcl('lIn', /1/ nnlst he chosell so that:

1.%(1,( II) 1.% )~ "

::: 0.001 /1/ > (- -- (1- II.
- 0.001 ,()

l\pil'ally \';lll I;" I is 1111\ knowlI, bIll it (';111 he reaelily ('slimaled froJlI the
simlliations ill tlJ(' ohviolls \\';1)':

- I ~
\'arll'",1 = - L( \', , - _1',,)-,') (!I.-1.IO)
1/1 /_1

Sinn' IIII' n'plicltioll~ ;\\(' \II) hy cOIISlntctioll, l'slilll;llol's sllch ;IS (9.4.10)
will gClln;lll\' I... "I'I'\' \\'..rI·I ... it;ll'l'd, COlIl'l'lgillg ill prohahilily IIllhdr cxpel'-
taliolls r;lpidly alld, 11'111'11 JlloJll'I'lv 1I111111;lli/('d, ('/)I\\'('rgillg ill distrihutioll
just as rapidly 10 Iheir lilllilillf,!; dislrihuliolls.

I), -I. 1 (:III11/"IIi.\II/1., luilli 1/ (:/II.I('(/-/-imll SII{lIlioll

III thi' special 1';,,(' 01' Ihl' oJllioll 10 sl'll al Ih(' IIlaxillllllll wilh a gl'ollH'lric
Hroll'lIiall lIIotiol\ price plOn'ss,;1 r!os('<!-liH'1\\ solutioll Ii II' Ihe oplioll price
9.-1. j'ririllJ!,j'1I11t-1)I'/JI'IIII1'111 lJnilllllillf.1 ViII MimiI' Carlo Simulation 385

is given hy (;oldlllan, Sosin, anel Catto (1979):

II (0) = P(O)t-,T<p (_~)

oft
[I _ 0
2r
2
] - P(O)

+P(O) ( I+~r2) [ I-<P (_(1:~!2'1')] (9.4.11)

where a == r - a:! /2.

Thert-fore, in this case we may COlli pare the accuracy of the Monte Carlo
estilllator /i((l) with the theOl"etical value fI(O). Table 9.6 provides such a
cOlllparison under the following assulllptions (for simple returns):

Annual Riskfree Interest Rate 5%

Annual Expected Stock Return 15%

Annual Standard Deviation of Stock Return 20%

Initial Stock Price 1'(0) $40

Time to Maturity 'I' I Year.
Frolll the entries in Table 9.G, we see that large differences between the
con tinuous-time price fI (0) = $4.7937 and the crude Monte Carlo estimator
if (0) can arise, even when III and n are relatively large (the antithetic estima-
tor is defined and discussed in the next section). For example. H(O) and
H(O) differ by 30 cenlS when n = 250, a nontrivial discrepancy given the
typical sizes of options portfolios. '
The difference between /itO) and 11(0) arises from two sources: sam-
pling variatioll ill li(O) and the discreteness of the simulated sample path~
of prices. The former source of discrepancy is controlled by the number
of replications m, while the latter source is controlled by the number of
ohservations 11 in each simulated sample path. Increasing m will allow us to
estimate r:" [Ii (0) 1with arbitrary accuracy, but if n is fixed then E" [H(O)]
llced not converge to the continuous-time price H(O). Does this discrep-
allc), illlply that MOllte Carlo estilllators are inferior to closed-form solutions
whell such solutions are available? Not necessarily.
This difference hig-hlights the importance of discretization in the pric-
illg of path-dependent securities. Since ''ie are selecting the maximum ove'
/( ('xpollt'lltials of the (discrete) partial slim L~=I r,·,
where k ranges from 0
to II, as II il1creases the maxinllllll is likely to increase as well. 2 t; Heuristically.

~h/\hhllllgh it is prohahle that the.' maximulII of the partial sum will inrrt"a~ with n. it
i... 1I0t gll;U";I1H(·(·(l. A. . We illfl('OIS(, II in 'l';,bk ~Ui. Wt" gt'IWfClIt";" llt"W indt")>t"nc\f'lll t-andmu
S("'1I11'II(T II; 1;'=1' and ,heft' is ;,dway~sc))nt' challct" IIla1this I)("W sequenre with mure tenns will
1H"\·(·r1h('h-~'\ yic.·}(\ ~ll1al!("J' panial Slims,
 I). f)rri!lfIti!,,·f'Ii,.;lIg .\I1I11t·11

Jah/,' 9.6. ,\101111' t:llt/" "\/illlll/IOIIII/ /ouiduII!.- o/IIUJII /"itl',

(:,11<1 .. Auli,lo .. , i..

" SE(il(O)1 SEI i/(II)1

100 ·I.:IHIH 0.011;:, ·l.:\li·I·1 O.Olllili

:1;,0 ·1.·1\111 O.Olli·1 ·1.:,1 :lli O.OOfrli
:lli:, ·1.:,·17!) O.Olli:, ·I.:.IiO:1 O.llIlIili
:,OU ·1.:,7·11; 0.0 II;:, ·l.liOO7 1l.llIlIili
t!,o .1.I{,!l\) O.Ollili ·1.li·II·1 O.llIlIili
I.OOU ·l.li·HH O.Ollili ·l.Ii·I\I:1 O.llIlIili
:1.1l1l1l l.Ii70li 1l.1l II iI", ·1.701l1 O.IHlIii
:,.flOO ,1.717:, fl.olli", ·1.7:!W fl.Olllili

~lunH' (:,111" ('~Iilllalol ollhl' plitt' ul.1 011<"-\"(',11 look-h.It·" pUI opliuil \dlll (Olllillllltll'·IIIIU'
(~lIhh'h\l\-Sosil\·(;~\lto Prl(l' II(O)=S·1.7~):\7. E,ldl fu\v "UI"I("polub lu all ilide-pencil'lIl "'I III
.. im1lI,lllOII' of 100,0110 u'plicatioll' 01 :o.:lllIpk pilila .. 01 h'l1g1h II. FUI Ih,' .lIl1ilht'lif ·\.111.11'"
!'<olt\\"tu'''u,. "'oKh !'I.\'(IUl'nr\' (II Ill) l;uutom \.ul.lh::-. i~ u. . nl h\iu'-tlll' uliv,ill,d ~('('Hl'lU t' ."ul
ib IIl·g.lIht·-yit'hling" tol.d of~OO.UO(J !\.lIlIpk pal II ... or 1011.1100 IIt·g.ui\"dy (UlIC'I,lIt'li p.llr, 01
1';1111 •. SElli(llll a, HI SElli(l)) I .'1"(' II ..· ";O'HI., ... \ ,."'.,,., "I lillll allel ('1111 .... ·.'1"·. li,d\".

the maximum of the daily dosillg pritTS o/" f' OVIT thc ycar (II = :!:,O Iradillg
days) must he lower thall the lIIaxil\lllll\ o\" IIIl' d;lil)' highs o'n Ih;11 S;I/Ill'
year (" .... 00). Therc!i)l"e, the cOlltillllOlls-tillle price lJ((l), whi("h is doscr
to the maxilllullI of the daily highs, will almost al\\'a)'s cxn'l'd tlH' silll1datioll
price {flO) which is disCfl'tized.
Whid, price is \Ilore rclt-v;1I1l dqJl'llds of ("ollrsc Oil the 1(T1I1S ollhe
particular rOlltr~lft. For exampl(', avcrage r;Il(' optiolls Oil f()("('igll cxchallge
uSllall)' spedly ,,,,nit-iliaI' datcs ollwhi("h th('cx("h<lllgc rate is IIl('aslll"(·d. ami
it is all\lost always dthn a lIIarket dosillg rat(' (such as till' ('(IITespolldillg
SP~'t rate oflhe IMM 1IIIIIlTS dosillg) or a ("('llIral hallk lixillg ralC. 111 hOlh
("a ('S, th(' ilion' rd('valll pricl' wOllld h(' 1\1(' simlliatioll pricc, silln' Ihe »;llh
II( p('lltklln: is with lTsperl to the dis("rele S('t "\"I/Il'asllrnl rates, ;\IIt! 1\01 all
idJ'alizl'c\ ("OlllillIlOIlS pro("('ss.
1
! '
1).4.'/ (."()II//lIIlrll/ll"a{t'.jjll /1'''1),

'nil' two lIIaill ('\1I\("erlls 01 ,IIIV 1\I0llte (:arlo simlliatioll are a("("lIra("y alld
'OIllPllt.,tiOll." cost, alld ill mosl ("a~es thel"(' will he I("adeolls hetll'('I'll the
til I• • \s II'C S.IW ill SerliOIl !I.·L:!, til(' ~talldard error of the MOllte (:arlo
es1illl'Il.0(" ~i«() is illH'rs!'iy I~ro~)ortioll,d to the sqllare root of Ihc 11 II III her
01 rephcallolls III, hell("(' ,I :,O'lc, rnlllciloll III the stalldard C\Tor rcqlllres
"'~I\' till\('s th(' 1II111I1In of n'pliclliolls, ;\lHI sO Oil. This t\'P(' of MOlltc
(:+10 prolTlhlll' is olt('11 d('snilll'd as IlIldr' MOlltl' Cado (see I LIIlllIHTsky
C),'/, I'rit"illg 1'I//h-lh'/lI'lIdl'li/ /)l'Ii1'(//;I'I',1 \';1/ MOil/I" (;ru/o SUIIII/I//ioll :IH7

alld I \;lI\d~clllllh II~}()'II Ii II' ,'xalllpl('), rllr oll,i()\1\ ""\SOilS, TIll"rdilu', "
11I11I1\)l'r or l/l/ril/IIU'-/nilldio/l tl'dllli'l"('s h"q' h(TIl d",dop('d to illlpro\'l'
the l'fficil'lIcy or silllillatioll estimators, Althollgh a thorollgh disClissioll or
th,'S(' tCChlli'lIH'S is bl'yolld the scop(' or Ihi, In(\, 1\'(' sh,II\ hridly revi('\,' "
11-11' or 1III'IIl hl'J'l',~7
t\ silllpk I('chlli'llle «II" illlprovillg Ihl' pn«>I"III;II"T "r 1I101l\(' (:arlo l'S-
lilll;1I0rS is \0 replan' estilllates hy their popilialioll ('('"lllnp"nS Wh('IJeI'tT
possihle, fill' Ihis rl'dllces salliplill~ variatioll ill Ihl' ('slilllaIOl, For l'X;1I II pie.
whell sillllliatill~ risk-liculralized ass('1 rl'lul"lls, III<' S;lIl1ple Ill<'all or each
rcplicatioll will allilost IH'ver he l'qllal 10 ils populalioll III('all (Ihe riskless
rate), 11111 W(' elll CO\Tl'('\ this samplillg \';llialioll "'lsi I)' II)' ,,,Idillg I Ill" differ-
('lilT \)('III'('CII Ihl' risklt-ss raIl' alldlll<' saillplt- IIwall 10 each ohscrvalioll or

Ih .. n'plicalioll, Ir this is dOlle fill' each rl'plicalioll, Ihl' n'sult will I)(' a Sl't
01 n'pliLlIiolls wilh 110 samplillg ('\Tor ror the IIIl'a II , The dlicicllcy gaill
("'1'('11(1- Oil Ih(' ('xl(,1I1 10 whit-I! sampling ('ITOrS Ii,," Ih(' 1I,,'au contributes
10 i1,,' ""'Tall sampling varialion or Ill<' SilllUI;lIioll, hUI ill n};lIl), CIS('S III<'
iIUill"o\'l'nll'lIl C;1ll he dramalic.
,\ rdalcd Il'chllirple is to exploit olhl'r «))"IllS or populalion inlill"llla-
lion, For cX;llllplc, suppose we wish tn ('slillla[(' E'I /( X) 1 ;md we lilld a
random variable g( l'l sllCh that E"I g( l')j is rlOS(' 10 F.' 1/(.\') 1alld E"1 g( l'll
is kllOWIl (this is [he population illfimllatioll to 1)(' n,ploi[nl), 1·:"U(.\'}j
mighl 1)(' Ilw pritT or IIcwly rreatl'd palh-dqwnd('II[ dnil'ali\'(' which mllSI
be l'Slilll;lIl'd. "lid E· [g( l') J [he markl'l (lrin' or ;111 ('xisling derivative with
simil"r \'IJ;lr;IClnistics, hellce a similar eXplTI<llioll, II)' c>-pr('ssillg E" [.I (X) I
as lite sllill or E'I g( Yl J alld E'U( X)-- g( }') I, Ih .. n'l'('(t;r[ioll 10 he ('sti-
11I;t[ed is de('ollll'osed illto two t(,rllIS wherc [hc firs[ [nlll is kllown alld thc
S(,(,(IlH\ 1<T1ll 1',111 be simulaled with Illllrh sillalln sampling variation, This
lerhlliqlll~ is klloll'n as tire rrllllmlllflrill!t'lIIelhod-g( is Ihe ('onlrol variall' n
li.r I( Xl-and its slll:ress depends Oil how dose E· [g( l') 1 is to E" [{(X) J,
Another 1'0 rill or populatioll inforlllatioll Ilral CUI hI' l'xploilcd is sYlIlllle-
try. Ir, fi)r (');alllpl(', lire population dislribu[ioll is s),IllIlIl'tri(' about ils 111(',111
and this mean is kllowil (as in the ('ase of risk-IH'Ulr;\li/.ed assel returlls),
tltell 111/'2 repli(';lIiolis call yield III sample paths sill('e ea('1t r('pli('atioll ('all

-"'";"S(·\,(·t;tllt'xl:-. plo\'idt., t'Xfdlt'l\1 rOV(·I.\~t· ollh\s lHiHed.t!. II.\HI"\('I~lt·\· ,\\\<1 llouutsnunh

(I~)(i·l) i.':1 rI~I.'!'<oir. ('(mri:-'l' btll ('omplt·!t', K..do!'<o .IIHI\1\'1 II 11 od;, (1~IH(i) prll\idl,.1 IHol(' dt't.lih-d
iuul U}Hi".I\l't\ \'''l)t}~i''tm Ill" :-;.ill1ilar IUeth·riai. Fi:\111l1,Ul \1 ~)~H)) 1:-. fIHl~llh·r ..\h\y lUI)} l' flHllP' t.·h('11~
!-ii,,' and ('0\'('1':\ :-1('\"('1",11 ;ul\'i1l1ct'd topics tlol found ill olh('r ~101l1(, (:.11101('\1' \111"11 ;I.~ M.II "'0'
("h.lill :-';1lllpling. (;ihh, .~;lIl1plil1g. randolll IHIl1'. alld .,iIlIlJi.IIt"d ;III1H',llillg. Fj,IJlII.1II (1~1~lIi)
.,bo (ontai1ls mallY applir'lIiolls, t'xplit"it algolitlllll' lor 111;111\' 01 Iht' l('rillliqIU'., lo\"('r"d. ,wd
FORTRAN ~oll\\,;lIt' (1111111 ;111 lip silt,) lor ral1dolll I1l1mhc.'1 gc.'IIt'r;llioll, Fill.tll". Fang .lIul \\',lIlg
(I ~I~)'I) p"l'~l'llt .1 nlmpan illlroduniollltl" Ill'W ;Ipprn,ldl to ~If)ltlt' ( ·.n It, .. itlllll.Hjoll ha!'<oc.'d 011
pUldy Ch-tt'llllilli""if' :-..lIl1pling. ,\lIhollgll il i ....,liIlIOf) t',l1",," 10 It'll 110\\' llii, ,'!'IHo.1t It ('OIllIMIC·.,
\0 \lit' "'nU' tr;Hhlioll,\t \\H'lho<l~, F.mg ;\utl \\'."I~ (I~I',H) I)1O\l(k o.,O\l\t' IHll\glllug \·~,""plt':-'
.h,11 10(11.. qllilt' pHlllli,illg,
 Y. /)1'I11Iftlilll' }'ririllK "'oddl

1)(' ....dlectell .. throllgh ils IIwall to produce a mirror-image which has the
sallie statistical propcrti('s, This approach yields an added hendit: nega-
tive correlation alllOllg p;lirs or replicatiolls. II' the slllllll1<1nds or thl' MOille
Carlo estililator ;11'(' 1II011OtOlH' I'lIllctions o('the replicatiolls they will also he
lIegati\'dv ('orrd;lted, iUlpl\'ing ;\ sillallt'l' \'ari'lIlCt, ror the estilll;ltol'.
This is a simple ('xailiple or a more general Icdllli(lue kllown as 1\11'
1IIIIillll'lir /111111111'.1 1IH'lholl ill which correlatioll is in<lll('('d across rcplicatiolls
to re<lllcc the v;\ri;III((' or the SIIII\. A IIHIl'(' rorlllal motivatioll ror this ap-
proach comes Irolll tIl(' followillg theon'ln: ror allY cstimator which ('all be
expressed as thc Slllll or randolll variahles, it is always possihle 10 cn'ate a
strict hlllctiollal dqlt'ndell(,(, hctweell the slltlltl\allds which I('a\'('s the es-
timator ulIhiase(1 IlIll vields a variallcc that COIll(,S arbitrarily close to the
lIIillilllulII variallce pmsihlc with these ralldom variahles (SCI' Ilamlllcrsky
alld Mauldoll II \):1(; I), ()r co\lt'se, I he challenge is to (OIlstrtlct SIKh a rUlIc-
liollal dq)(,IHh'IH,(" hUI ('\'('11 if Ihe oplililallrallsforlllalioll is IHH apparellt,
suhslanlial ef/ici('lIcy gaillS call he achieved hy simpler kinds orclqlt'lIc1t'II(('.
\'ariallc(' reductioll ('all also lit' accomplished hy more sophisticated
sampling lIH'tliods. III .l/lIIli/in/IIIIII/,/ill;;, the support of the hasic .. andolll
va .. iahle X heillg silllulaled is partiliolled inlo a (illilc IIl1mher or illt('('v;tls
alld nlld .. 1....lolIl!· (:ar\o sillllllaliolls arc per/(II'I)I('d ill each illterval. Il'tlH'IT
is less variatioll ill I (X) with ill ill tl'I'\'als Ih;llIlIfHlSS the intervals, the s'l1l1plil\!-;
variation of Ihe estilllalOi or E'U (Xl I will he ('('duccd.
11II/lIIrlllll(('IIIIII/dill!!. is amon' sophisticatcd version, samplill~ 1II0re be-
quenlly ill regions oltht' SIIPP0r\ \\'lIell' Ih('('e is tIIore variation in J( X)-
where samplillg is Illore "itllportatlt"-insl('.u\ of samplillg at rcgular i'llcr-
vals. All ('veil tIIon' sophisticated versioll of Ihis tIIethod has r('c(,lItly bcell
proposl'(l hy Fallg alld \\';lIlg (I \)~H) ill witich replications are gellerated dc-
t('l'lIlillislically, 1101 ralldolllly, accordillgly 10 all algorithm thaI is desiglled to
millillli/e tlil' s;ullplillg varialioll 01 IiiI' eslilllator dircctly. II is still too carly
to say how this approad,-cdlt-d tit(' lIullliJl'J'-lhf()rplic IIIcthod-compares to
Ihe tJ\OJ'(' Iradiliollal !'...lolllt' (:arlo estilll'llors, hUI it has already fOllnd its way
illlO Iht' Iillallci;1I cOllllllllnil)' (s('e, ((II' example, Paskov alld Trauh [19!)5])
all(lth(' prdimillary filldings St't'lII ('IH'Ollraging.

:\11 l/I/1.l/mlioll "I li/lll/1/1/' Nl'lillrlillll

'Iil illustrate III(' pOlelllial pow('/' of\'ariall('('-rcdllclion 1('c1l11iqllcs, we ('on-
stnKt all antithetic·variates estimator of th(' pricc or lhe ())I('-year lookback
put optioll ofS('Cliolll).,I.:1. For ('.lch silllulal<'c1 pricc path I}'/. I
~=U' allother
CUI he ohlaillcd without furthn Sitllitiation hy reversing Ihe sign o('each or
tl\(' LI1HIOllll" g('II('J'ated II\) stalldard lIonllal variates Oil which tl\(' pritT
palh is has('d, viddillg a s('('ollcl p.llh T/: Ir IL" which is lIegalively (,OIT«'Ialn\
willt th .. lirst. 11111 ';lIlIplt- p;lIh, 01 \I',i.I~=" arc g('II('ralt'd, tIl(' J'('sultill!-(
9. -I. }'ririllli }'alh-J)fllrndl'lll J)flil/alivfS Via MUlllf Cllrlo Simulation

antithetic-variates estimator f/(O) is simply the average across a1l2m path~

fiCO)
I (II<
== e-,T 2m L
ljll + LIn)
ljJl - 1'(0) (9.4.1 ~)
]=1 ;=1

where

The relation between antithetic-variates and crude Monte Carlo can be more
easily seen by rew;iting (9.4.12) as

I r TI~ I TI~_)
11(0)
(
-2 e- - L..- 011 + -21'-' - L..-lj. - P(O) (9.4.13)
TIl j=1 m j=1

1 '" y +Y
e-,T - ' " ~ - /'(0).
mL..- ')
J=t ~

Equation (9.4.13) shows that ll(O) is based on a simple average of two av-
I I
erages. one hased on the sample paths ~~ ==0 and the other based on
! I
Fjit ;~O" The fact that these two averages are negatively correlated leads to
a reduction in variance.
Equation (9.4.14) combines the two sums of (9.4.13) into one, with the
averages of the antithetic pairs as the summands. This sum is particularly
easy to analyze because the summands are lID-the correlation is confined
within each summand. not across the summands-hence the variance of the
sum is simply the sum of the variances. An expression for the variance of
ii (Ill then follows readily

Var(ii(O)] == e
-2,T 1
-Var [ - - fj,,]
lj1l+ - (9.4.15 )
m 2

== e
-2rT
;;
1(12 Var[ lj"l
1 -)
+ 2' Cov[ lj., lj.]
'a 2 (n)
-'-(1 + p) (9.4.16)
2m

where a;(n):=Var(e-rTlj.l==Var[e-rT~II] and p:=Corr[e-rTlj., e-rT~nl.

Equation (9.4.15) shows that the variance of II (0) can be estimated by the
product of f-rTf m and the sample variance of the IID sequence (OJ.+ ~.)f21.
There is 110 need to account for the correlation between antithetic pairs be-
cause this is implicitly accounted for in the sample variance of{( lj.+ fj.)f2).
Equation (!I.4.IG) provides additional insight into the variance reduc-
tioll lhat antithetic variates affords. The reduction in variance comes from
:1!I0 ,

Iwo SOIlITl'S: a dOllhlillg of Ihl' 1IIIIIIh('l" of r('plicOIlilllls rrlllll III 10 '2111, .lIld
Ilw 1;l('tol' 1+p which sItollld h(' less tltall 011(' if tltl' ("OITelOItioll 11<'1\\"("'11 til('
antithetic \'al'iates is lIegali\'e, Notl' that l'WII if the correlatioll i~ positin',
Ihl' \'ariallce of li(O) will still he lower thall the lTlIIic MOil\(' (:.1110 ('slillla-
lor liW) ullkss there is pnfer! correlatioll, ix" p= I, Also, whil(' "'(' ha\'e
dOlliJll'd the 11I11Ilh(')" of replicatiolls, 1\'(' ha\'e dOlle so ill a ("(lInp"laliollally
Irivial wa)': dlallgillg siglls, Silln' Ihe cOlllp"latiolls illl'oll"!'d ill pselldo-
I"<lIIdolll II II III her gelllTalioll are Iypically lII(1rl' demandillg Ihall IIll'n' sigll
("hallges, this is allolhn adl'alliage of OIlIlilhelic-varial('s silllulaliolls,
t\ (Olll parisoll of Ihe lTude MOIlI!' ( :OIr\O esl imalor i'l (0) 10 II H' ;UII iI hel ic-
variales eslimator li(O) is prodded ill 'bilk \I.(i, For lIIosl or Ihl' "~illllda­
liollS, tlte ratio of lite slalld'lI"!l elTor of li(O) 10 Ihe slalldard error of i'1(O)
is O,OO(;G/O,()\(;;I=().'lOO, a reduclioll ofahonl (jOW" III comparisoll, a dOIl-
hlillg of Ihe Illllllhcr of r('plicaliolls 1'1'0111 11110211/ for Ih(' lTlld(' 1\\01111' (:arlo
eslimalor wOllld yield a ralio of 1/ ~=(),7()7, ollly a 2!)'J" r('(hlllioll, 1\1or('
1'""\II01l1y, OhSl~r\'l' 1'1'0111 (!I.,1.7) alld (!).-I, Ili) I\tOlII\t .. rOllio or IIII' slalld'lI"<l ('1'-
1'01' oui (0) to the slOIlIdOlnl,'rror olfl (0) is OIlIeslilllOltor of J( \ + I) It!, 11l'1I(T
lhe ratio O,OOGG/O,OIG!i=0.400 illlplies 01 COITe\OIlioll of -(iWJ" 1>('111'('('11 the
alltitltetic pairs of tlte SilllUI;lIiolls ill Tallie !l,(i, a suhslallti.II ,'ahl(' which is
rl'spollsihle Ii))" Ihe dr'lll1alic reduclioll ill l'ari;IIH,(, of li((}),

'y 9,-1,5 E>:I!'ll.Iiol/,\ f/I/d !.ill/iff/filil/.l ,

-tIll' MOille Carlo approach 10 pricillg palh-dl'\H'lIdl'lIt .opliolls is qllil!' gl'lI-

'1ral alld lila), he applied 10 virlll.III), all)' Ellrop('all dl'l"ivatil'l' sl'cllrily, For
'ixalllple, to price an'rage-rall' I(nl'igll nllTl'lH'y opliolls IVl' 1I'01lid sillllliale
drire paths as ahOle (pl'lhaJl~ IIsing a dilkn'llI stochastic PIOC(,SS lIlore ap-
'lropriiHe for exchallge ralt's), l"lllllpllie the 1I1I1'mp/' 1'01' each replicalioll,
1~'Pl'at this man)' limcs, and complltt' the al'nagc 111'101,1 Ihl' replit"'llions,
, hilS lhl' power or lhl' Cox-Ross rbk-IH'llIral pricing Illethod is consi(ier:
a l\c, However, Ih(',re are St','eral illlportallllilllil'llions 10 this appro'lI"h 111011
S \(lllitl he cllIphaslf.ed,

~
First, th(' MOllte Carlo approach 1\1.\\' (111)' hl' applied to FuroP"'11l op-
lOllS, opliolls Ihal (01111101 Ill' ,'xl'n"isl'd I'ad\', Th(' !'arly l'x('rci",' I{'ailln' of
I 1I1('("":all oplions inlrodllces Ih(' addnl (,(lIl1plicalioll of 1\('ll'rlllillillg ;111

o lIilllal ('x('I'Ciw polin', II'hidl 11111'1 Ill' d01l1' r('cllrsively IIsillg a ',,"II.lIl1ic-
p "ograllllllillg-like allal~'si" III slIch c.I.~('S, 1lIlIlH'I'icd SOllllioll (If II\(' corrl'-
~11)()ndillg PilE is nllTl'lIll1' Ihl' 01111' ;II'ailahle IIll'lhod for ohlailling pritTS,
! Second, to apply thl' (:ox-i{oss techlliqll(' 10 a gin'lI c\ni,"aliH' "~(,cllril)',
"~' mllsl lirsl prlll'(' Ihal Ihl' SlTllril" 1"11/1 1)(' priced hl' arhilrage (ollsidna-
li,ms alolle. Recall thai in Ihl' Black-Scho\(', rr;IIIH'\\'ork, 111(' Il<hllbilragc
condilion lVas slIl"Iil"i('nl 10 CO:llpkleh" d{'ll'nllill(, IIII' oplioll pric(' (111)' hl'-
caIlS(' liT were ah\e III conSlrllcl a <Il'n;lInic portfolio or stocks, hOllds, and
9, 'i, Cllllrlil.lioll

opliolls Ihal was riskless, lit effect, this illlplil"s that the optiolt is "spall lied"
hr stocks alld hOllds or, lIlore pre('isdy, the optioll's parolf ;It da((' T call
he perkctiy replicaled hy a parlinll;lr dY";lIl1ic Iradill)!; slr;II('h'Y illvolvill)!;
ollh" SIOCKs and hOllds, The lIo-arhilrage COllclilioll Irallslales illio Ihe re-
qllirellll'llllhallhe oplioll price mllsl eqllalllw cmt olllw clvlI;lInic Iradill)!;
slralq,,)'lhal n'plicall's Ihl' oplioll's parolr.
Bllt Ihere are sililatiolls where Ihl' derivative M'cllrit)' (';1111101 he ('('pli-
caleel hy allY dYllamic strateh')' illvolvillg l'xistillg securities, For example, if
we aSSllllle Ihal lite clilfllSioll parameln (7 ill (~l,:!,:!) is stochastic thell illllay
he showil Ihal wilhout further restrictiolls Oil r1 there exisls 110 1I0IHIc)!;l'lI'
nail' dYIl;lIllic tradillg stratl'h,), involving stocks, hond,. alld optiolls that is
riskkss. I kllrislically, hec,l\lse there are 1I0W t\\'o SlIIIIT('S or 1I1ll'l·r\ainty. the
oplion is \Ill IO\lgl'l' "spanned" hy a dynalllir pOr\lillio or slocks alld hOllds
(see Sectioll ~I,'U; alld Iluallg [ I !)!):ll fill' further disnlssioll),
Thcr!'i(.J'(·. hd'.re we (';111 apply IIw I'isk'lu'lItral pricillg IlIl'thod 10 a
pal'lintiar derivaliw security, we lIIust fil'st check that it is spalliled hyother
Irac:l.~d assets, Sillce Goldman, Sosin, and (:atlo (1!)7!)) delllonstrate thaI
the optioll to sell althe maxilllulII is illdeed spalllled, we call apply the Cox·
Ross method to thaI case with the assurallce Ihat til(' rcslIltillg pricc is ill ran
Ihe Ilo·arbilrage price alld that clevialiolls ('1'0111 Ihis pricc IH'('cssarily illlply
riskless prolil opporlllllitics, Bul il llIar 1)(' 11IOIl' cliliicllll 10 \'('1 ily spall IIi II)!;
('or ilIOn' COlllPicx path·clepellelellt e1l'l ivativcs, III Ihose C;IS(,S, \\'l' lIlay have
to emhl'll tIll' secllrity ill a mockl of l'colloll1ir eql1ilibril1m, \\'ith,sperilic
ass\ll1\ptiolls al>ol1l agellts' prereu~ul'l's auel their il\\'{'stllll'lIl opportullity
Sl'" CIS, rill' {'''ClIlll'k, in Ihl' slOeltastic,,,"I"Iilill' Illlldd .. rSl'l'Iioll !l,:\'(i,

9,5 ConcllLo;ion

Thl' pricing or dnil',lIil'l' s(,curities is lIue 0(' Iltl' ullqualiliec\ SUllTSSCS 0('
1110dlTil {,(,OIlOl1lics, It Itas cltangeeltltc \\'a)' e{'t'lloJlli~Is view d)'llamic mod-
cis o('securilics prin's, and itltas had all C'lHlI'IlIOllS ill1P;ICI 011 lite invest11lcllt
COllllllllllilY, TIll' ('('eatioll of' ever moJ'(' COlllPlcx lill;111l i;t\ illStl'l111ll'lItS has
I>e(,11 all iJ1lport;1I11 stim11l11s Ii.r a(,;1<lcl1lie I'cse;ll'elt ;111<1 f(l1' tlte estahlislt·
1I1l'IIt or a liolla fid(, "finallciall'n)!;iIH'('l'illg" disciplill(" Recl'lIt illnovalions
ill dnil';lIil'l' securities illcltlCil-: al'l'I'agl' rail' optiOIlS, IIIOJ'(' gell('l';t\ "look·
hack .. opliollS, h"rrier optiolls (also kllOWIl as "clOIl'Il alld 0111" or "hirlh alld
c1c;lIh" opliollS), ('OIlIPOUllcl opliollS, dual-(,1IIH'lIn' or du;t\-e'luit\' options,
s)'lIlhelic ('ol1l'l'l'lihk hOIlc\S, spre;1<I-I()( I.. il1t('l'esl (';lIe '''';lpS. rainhow op-
lioll', ;l11cl 111;111\' olher exotic secllrities, 111 e;\c1l 0(' 111l'-'<' rases, dosed·l'orm
pricing fllrnllibs are availahle ollly for a "lTV SII\;\II set "I' pro ... ·s'I's for IIIl'
underlyillg assl'l\ price. ,\lleI a gu'at e1l'al,,1' fllrlhlT !l'sl',11elt is IIl'l'lkel to
chl'C'k whether sllch process('s at'lually IiI th(' dau, t\ton'I)\('I, ill 111;111)' or
 'c/, IJI'IWIlIIlW J'l"Irill~ l\i(Jdd~

lIu'st, cast's, all~llrtiLII expn'ssiolls for hedging positions in these securities

do lIot cxist alld mllst .dso be dctt'nllilll~d ~lI\pirically,
Tht'l't' arc nl;IIII' IIlIsClllcd isslles ill t he statistical ill/(on:llcc OfCOlltillIlOllS-
tilJlc proct'sses willt dis('I'elelv sampled elata, Clirrently, tile llIost prcssillg
iSSlll' is tilt' !lifIin"l\' ill ohtailling tonsistelltcstilllaics of tlte parameters of
Itt, processes Ivith nonlincar dril't ;tIl<l/or diffllsioll rocrtiricnts, For lIlany
It(, processcs of inttTCSl, \1'(' do nOI It:t\'(' doscd-lill'lll exprcssions li,r thcir
transilioll Ikllsilit's ;md Itt'IIC(, maximullI likelihood estimation is 1I0t I'casi-
hit-, Thl' CMt\1 appmadl of I (:tIIS('1l alld SdH'inkm;l1l ((~l\l[i) IIlav hI' the
lIIost proltlising .tilt'l'lIativc, alld I'lIIpirit'al applicatiolls atld Monic Carlo
sltulit's ;tn' sllrc 10 follo\\"
Allot 1\('1' 'IlT~1 I If ~Irt ivc nllTCII I research involves dl'vdopillg heller Illod-
ds of flllldalllcnl;d ;Issel price dYII:tlllics, For example, casllal ('Illpirical oh-
servalioll sllggt'sts Iltl' prcs('II((' oljlllllp compollents in assct prices that are
rt'spollsihk fill' rd<llin'(y brge alld sllddell movelllents, hilt occllr rl'\;ttivdy
illfrt'qll('llIly alld art' Iherdill'c cotlsiderahly lIlore challenging to cstimatc
pn'cisd)',~N Indcl'd, Iherc is ('\'1'11 some t10llht as 10 whether sllch jllmp
pn;n'ssl's ran t'wr ht' it\t'ntilicd from discretely sampl('d price data sincc
thc very a('\ of dis(Tt'te-s'llIlplill~ destroys the onc clear distinction hctwcen
diffllsion PflU'('SSI'S 'lIlI\.jlllllP pnH'I'ss('s-the contillllity of sam pic p<lths,
The di/lindlil's ill t"tilllalillg paramctric models ofass('t price dyn'1I11ics
have I('d 10 sev('I';d attempts 10 captllre the dynamics 1U1I1/IIITlllIll'lri(((l/y, For
('xalllpl(', h)' pbcillg r('stril'lions 011 tlte drift coefficient of a diffllsion pro-
cess, Ait-Sahalia (I~l~l:~) proposes a nonparalllctric estimator of its dillllsioll
coefficicnt and applies lhis {'stinlator to the pricing or illt('l'{'st rat(' <'plions,
Longstafl' (I ~l~l:l) propOSI'S a tesl of option-pricing models hy fOClISill):\ 011
lhe risk-ncutral distributioll illlplicit ill option prices, And I hl!chinson, 1,0,
and I'og)!;io (II)!).!) atll'lIIl'l 10 I'rilT derivative securilies via 1lt'\Irallll'(\\'ork
mOllels, Ahholl)!;1t il is'lilll(Hlcarly 10 tell iftitcse nonparanH'lric <I lid higltly
data-il\tel\si",' 1IIl'thuds will offer illlprovcllwllts over their IMranH'tric COIIII-
t('l'P<lrlS, tIlt' prdilltinar), cvidence is qnite prolllisin)!;, In Chaptl'r 12, wc
n'\'il'w som(' of' tlll'se t('Chlli,!lIl's alld prescnt an application to Ih(' pricillg
alld hed)!;in).( 0(' dl'l'ivative senllitit's,
Clost'll' rl'lat('(1 10 the isslle or "tock pricc dynamics are sevl'!'al open
IJllt'slions rq~;lI<lillg tltt' prkillg of' oplions ill incol1lplete 11I;1I1('ts, markets
in whirh thl' SIlIIlTl'S of IlIH'l'ILlill\\' afft-cting lilt' fllnd;lHH'ntal aSSl't <Ire 1I0t
spalllled hy traded s(,(llIi(ies, For exalllple, il' tite volatility or the 1'1lI1<!.1-
lIIenlal asset's pritT is s(ochastil', it is ollly wilier the 1II0st rcstrinivc sct
of asslllllptions that Ihl' pricl' of all option on sl1ch an assct lllay 1)(' d('(er-
milled hy ,Irhitr<lgl' argllllll'lIts, Sillt'<, th('l'c is ahnost IIl1iv('l'sal agrct'IlH'lll
\
\ :""St'(', (nr (· .... \ll\pl,·. Itdl ,\\\<1 Totou" (1~1~·n. l~lK:~}. ~1t-nuu (1~17t}h}th'\Tlop, ~\l1 I)plil)I1'
I IHieing 101111111.1 lUI (Olithill('I~ dillll,itlll,'jllllll' PICHt',,,,,,,,,, abo Me'llolI (l~nli;l) for 11101('
Sc'('
I
gt'llt'l,ll eli.." tI,~ioli 01111{' illlp.1t I oj IIli, . . pc·( ih'illg .\leu J.. prin' dyn~Hllif\on 1111" pricing ufoplioll.'i.
l'rub/ellu 393

that volatilities do shift over time ill random fashion, it is clear that issues
regarding market incompleteness are central to the pricing of derivative
securities.
In this chapter we have only touched upon a small set of issues that
smrollnd derivatives research, those that have received the least attention
in the extant literature, with the hope that a wider group of academics and
investment professionals will be encouraged to join in the fray and quicken
the progress in this exciting area.

Problems-Chapter 9

9.1 Show that the continuous-time process /JII(t) of Section 9.1.1 converges
in distribution to a normally distributed continuous-time process PCt) by
calculating tile the moment-generating function of pn(t) and taking limits.
9.2 Derive (9.3.30) and (9.3.31) explicitly by evaluating and inverting ~e
Fisher information matrix in (9.3.7) for the maximum likelihood estimators
a
I'- and ~ of the parameters of a geometric Brownian motion based pn
regularly sampled data. !

a
9.3 Derive tile maximum likelhood estimators 1'-, 2 , and y of the parab-
eters of the trending Ornstein-Uhlenbeck process (9.3.46), and calculate
their asymptotic distribution explicitly using (9.3.7). How do these three
estimators differ in their asymptotic properties under standard asympLOtiCS
and under continuous-record asymptotics?
9.4 You are currently managing a large pension fund and have invested
most (lfit in IBM stock. Exactly onc year from now, you will have to liquidate
your elllire IHM holdings, and you are concerned that it may be an inauspi-
cious time to sell your position. eLM Financial Products Corporation has
come to you with the following proposal: For a fee to be negotiated, th!!y
will agree to buy your entire mM holdings exactly one year from now, but
at a price per share equal to the maximum of the daily closing prices o~r
the olle-year period. What fee should you expect in your negotiations with
eLM? Specifically:
9.4.1 Estimate the current (time 0) fair market price H(O) of the option
to sell OIl the maximum using Monte Carlo simulation. For simplicity,
assume that IBM's stock price P(t) follows a geometric Brownian motion
(9.2.2) so that
J>(l~) 2
log - - ~ N (ll(1~ - 'I), a (/2 - til), (9.5.1)
J>(lI)

and lise daily returns of IBM stock over the most recent five-year period to
estimate Ihe parameters 11 and a~ to calihrate your simulations. Assume
394 9. /)nivlltilll' ",icillg Model!.

lhalthere arc 2:)3 tradillg days in a ycar ancllhal market ptin's \1;I\'C 110
volatility when markets arc dosed, i.e., weekcnds. holidays.

9.4.2 Provide a !)!i% cOlllidclln: illlerval for ('(0) and alll'Slilll;Itl' oflhe
\lumber ofsilllulatiolls Ileeded 10 yield a price estimate Ihal is wilhin $.0[,
of the true price.

9.4.3 How does Ihis pricc co III pare wilh the price givcn hy Ill!' (;oldlllall-
Sosin·Gatto forl\lula? Can you explain the discrepancy? Which price
would you lise to decide whether to accept or reject el.M's propos;I!?

\
\
\
\

\
 1
1
Fixcd-
Iocool
c Secu
10\
rities 1
1
1
1
1
1
[:-.: T I (I 1
SC lL \I 'T
s tu d ) , b E Italld t 1
ht
a n ' 1'11 n d s Ih;1l hav\- ~ lII.'X! WI.' \I ll
o
11)' ~I'( ' nu ca 'l l 0 \1 1 1
., ...·III·ili ' dlil'd ll pnJV ' ,1 \l {
ill a<iv i~i"n ,I H io 1
l's th ,n a n c s or d Il IO I
I,,' h O ll
pily.1H is o h c l. '. S o dhlllt d lIIark 1
'Jlts a r l I u s e d l h O ll r is k , ~o l.'\!;, Wl
c ill ra d d s Ilt-S Ih ~
in c o ! lw
s l 'c u r i e! I I I lc
! lI O n '
lo o s e ly t'ITe th ;1I I lt e ir I"'Y 1
~('(tlri t k c r la il L III to d l' n a ll l( ' jix llll.'llts
li('s s il l' < ; iss t h e U.s ,' s c r il w h o f'd·ill("lJ
II Ii 1 k (, li e d b lI la r k t' n d s \\'/ uU'
Trl'aSll li x c d y th t' { s , ,,11 1001.' f
l,), ;1 lI 1 P;I)'IllL u s Tn 1 1 uture
are ilJ 1 0 1 ll 1 'IIIS ill 'a s H r y , COlI
0 ,'1 a ll trill.' fi
(kxnl (T d p la
ll s { o 1 I 0 il li ll \'{'lllioll xed-
( o in ll is s u e il a l {('/Ill ,11 T r
M 'l Il )' a ti o ll /r /, 'x n II S, b ll { e a s ll r y
il ln m l< o /" li ll ' id s o t h a J iJ II ,f , il l ('
ea t I h e ir p a y ",110:'(' ;I ll y l!l!ll
'i li l' S a s d i s n l s s c d
.' s e n u i (he
d ( 'v o lt ll H '\ ){
'; ;I r e
/lOlllill<
, s p < 'c s wdl a il l ( 'a ll f ix l1 p a y
marke ia l ;IIIClJ s to < ie r e ll e d il l re ll ll 'l I t"
t> h a n li O Il to tl ly o \i le r < a ! 'I ,, 'I S c a ll a l lt'rlll
IsseI. H ~,1
their o ' d
w n I I lS e v e l o p e d s e
li x c d - il
ln J ll J ( \lt t l t t 'n b e ,' p p l i c d
p a r 'l l d ' s c n lr il i{ ' a n ,' s c v ( 'r .t to f ix e d -
acadL'u li
Jic s t u w li o ll a l s t r l l r 's , F ir i \,('i\SO
ti lt ' !1Ia dy of c t u r e a f r o ll i IIU' l'i{ s l, Ill(
' f ix e d IlS tt l
rk('\~ f ix e d - in nd the tlily m ·i ll c o m
si/,l.' is Ii)!' TrL come ir own ,l I 'k e ls e
';\sury S s e c u .- il ,
tllc;
il K o ll le J~\lr('d h y q u L 'c u l' il ie s hilS le l' ll li ll o lo g ) ', They
have
k s ilS I .i k
a d it io n c w is t' t h e
sCCllrit a ll li ti e ,l iT c x
trcllld o w n tr
n o c ls ics h a v sO
lH lo \Y e a s p e H lS la ll d il lg o r y hir){<
' rq?;an s , Se(
'o ll ( l,
s lu d ) ,i I ln C l· n c ia l ph lI lt 'l ll ti lk-ss o f
ll g f i x n a il ll y ,
so Ihd \{ '( ' il l f in a n li t' s I raded. w h " ,t il
t:<>\111\ l ·i n c o r p r it T c e ll w o T c l'
( 'x ! ,, 'c
r a il '' ' w
it h o u t
lllc se
c u r il ie S vary
o
r y h e c a l l i r d , li x e d -
ta li o ll h'l\'il\ s w (' <"a ll ly <IS d is c u s e th e } '
(:urili. s of f ~ 10 b ll ('X p
ion' t h o ll ll t n have
,~ (" .t uture n : I lw " el1<-( il e s va
lT ), c a s h n H lI p ! 'I ry. By
or illde il lf ( 'r tn
O lt io ll
! lo w s .
'I'll<' p
iI ', ll io
ll S i l l l
-, " I ' ( '/
ta ll g in
x ,' d ~cn about r i n 's " rodlln g d is -
lI la J lY lrilie I ' ( 'o ll \' 'd hy ~
( ll h ( 'r s ( 'a n I lO m il
la 'k\llg
;l I ld l k ;I s s e ls y in li lr m l <fi.~(,( ( 'I I I ;o ll a l illg
l 'i q l i v f<lll h e a li o f \ HIJH ra T r e a s li
S l' C II " I m ll l lt'~, lT ~l'­
s e c u r it (' scnl a s r c w h il ,'
y kss a r l lics; a ( o ll lh il a I d is ( \l \I li r e pr
put 0P G \H a h la li ll lI l r<ll il - e s
lion, k h O ll ll ,\ o
f li \( '( t'~. F
d , lo r I·in{,!lI ilially.
(')(alllJ ll<' s (' ('
I StH:h lIl', i~ fI J "i fi l'
s
St.'" hUH{ b . li ;l H a lix n l· jJ
(~lIl1pl ! ,dn:.t(t ) ( o Il lC
",1i " " yh~'('u
'\ S h il " ' .. 'S~U('(1
(I \I !I !; ) h y lf lt '
1m" n (1 1\ ., (:
.t H .t d
'" it '\ \' , i, u \, ,\
u d . . ,·\(>
t.d (1111(
'1" f{.iU
,t'{ u tu (' n
ls .
 1(J. 1·IXI ·,,·ll/m lll,· S"(/l l'ilil'' \

Thc litcr atuH ' Oil fixe d-in com e

secu ritie s is vas!." Wc brea k it illto
main parts . First, in this chap ter two
we intro duce basi c conc epts and
elllp irica l work 011 lille ar tillie -seri disc uss
es mod els of hOlld yields. This
only loos ely lIIotivated hy theo ry work is
and has the r,rac tical aim of cxpl
fore cast ing pow er of the terll l stru orin g the
ctur e of inte rest rates . III Cha pter
tllrn to mor c alllh itiou s, fully spec II we
ified tcrll l-str uctu re lIIod els that
used to pric e illte rest- rate dniv ativ call he
e secu ritie s.

10.1 Basic Con cep ts

In prin cipl e a fixe d·in com e sccu

rity can prom ise a strca m orru lure
of any form , hut ther e arc tWO class pa)'I1H'llts
ic case s.
lIra-roll/iIIl/ /JOIli/S, also raile d diJ(V
lt1ll bonds, mak e a sing le paym ent
date ill the flllllre know n as (he at a
IIIl1lurily dalf. The size of this
the faa llalll f of the bon d. The paym ent is
leng th of tilllc to the matu rity
mail lrily of the hOlld. US Trea dalc is Ihe
sury hills (Trc asur y obli gatio lls
at issue of up to I ~ IIHlllths) take with Illat llrity
this li>rlll.
('.oll/}(III /HI//( /' mak e (1111/1/111
/HI,V lllrIl/ J of a give n fraC
equa lly spac ed dal," up to ;lIId lioll of facc \,,1111<' at
incl udin g the matu rilY datc , whcl
valu e is also IMid. US Trea sury I lile I.IC(,
no(e s alld hOllds (Tre asur y obli
matu rity at issuc abov e 12 lIIon gatio lls "'ith
ths) take this fOrtH. Cou pon pa),m
Trea sury Ilote s and bOllds arc mac cilts on
k ever y six mon ths, but the coup
for thes e illStrtlllH'lIts arc norm on rales
ally CJllotecl at an anlll lal r;\te;
Trea sury hOlld actllally pays :{.[','J thlls a 7%
" of face vallie ever y six mon ths up
incl udin g lIIatllril)'.:I I') alld
Cou pon boncls CIII he thou ght
of as pack ages of cliscollnt hond
corr espo ndin g to each COU pOIl paym s, olle
ellt and olle corr espo ndin g to the
COLI pOll paYlllent log( fIlial
:ther with the repa yme nt of prin
mere ly an acad cllli c conc ept, as cipa l. This is 1I0t
the prin cipa l and inte rest com poll
US Trea sury hon ds h;lve beel l tracl cnts of
ecl sepa r,ltc ly und er the Trea Sllry
(Sep arat e Trad illg or Rq~istered 's STR IPS
Inte rcst and Prin cipa l Secu ritie s)
sinc e 19H!i, alld Ihl' prin :s of such prog LlIll
Trea sury slri/l s at allll latu ritie s ha\'(
repo rtecl daily ill thl' \I'(/Il Slrl'l 'l jllltn ' heen
lfll sinc e HlH9.

2FIlrtlln;lld), il I"" illfl ,'a,,',1 ill '1"ali

ly silln' Ed 1\;11 It' '. jlld~t'lIlt'nt: "It
Ihat, r('lt'ris pari hilS, Ih .. knili lyoi'; is !;"II('rally ,'gree d
.Ii,·ld is roll!;"ly propo rtion al to Ih
h;l~ Il!'rn (hllll p".III "lIn il in .. 'I'I;llIlily O!'IIl;III1If'(' lital
tilt' /l'''l'lIll'aSI. Ill' Ihi. stand ard, th"te
h;l~ 1,,'wlIl" , .. ;11) "xlr'" l1tiin m) ~lfII"lurt' ofin" ,r".,l ra,,'s
arily (('nil t'Ii"ld ind"t 'd" (Kall!' 11!l7
Shille r «( !J\)O) Jill' cxrt'Il""1 ...·...·nt.'"r ()). S.·,· Mdin o (I~I~H) or
\·t·y~. and SlIIu lar".a n (I !/!/Ii)
'S,·t' a l!'Xli>ook s" .. 11 a.' F"holl.; ""ti for a hook·I"II!;lh In"\lI III'IIl .
F"hll lli (I\I\I;l) Ill' F:llltll.zi (t\I\lIi)
un 1h(" mark,'(:o, for lJS TI('~I'lIry for !'lInh er ti .. lails
St'fw ili('.\.
W.l. nalic Concl'pts

IO.l.l lJiS({)Ullt/JOlldl
We first define and illustrate basic hond market concepts for discount bonds.
The yidd to maturity on a bond is that discoullt rate which equates the present
value of the bond's payments to iL~ price. Thus if Pn , is the time t price of
a discollnt hond that makes a sin~1c paylllellt 0(" $1 0\\ timc 1+ n, and Y", is
the hond's yield to maturity, we have

(10.1.1)
1'", = (I + 1'",)",
so the yield can be found from the price as

( I+ V)
1,,( ::::
l'-U)
"f • ( 10.1.2)

It is COlllmon in the empirical finance literature to work with log or continu-

ously compounded variables. This has the usual adv:lIltage that it transforms
the nonlinear equation (10.1.2) into a linear olle. Using lowercase letters
(i)!' logs the relationship betweell log yield OIlHllog price is

(10.1.3)

The In7ll slmdure of ill tere.1 I mle5 is the set of yields to maturity, at a given
tilllC', Oil honds of different matnrities. The .'lirld JIJread S", == Y", - YI " orin
tog terllls .I", = y,,1 - YII, is the difference between the yield on an'n-period
bOlld and the yield on a one-period bond, a measure of the shape of the
tcrlll structure. The yield curve is a plot of the term structure, that is, a plot
of Y"I or y", against 11 on some particular date t. The solid line in Figure
10.1.1 shows the log zero-cou[>on yield curve for US Treasury securities at
the end of January 1987. 1 This particular yield curvc rises at first, then
falls at longer maturities so that it has a hUlllp shape. This is not unusual,
altholl~h the yield curve is most cOllllllonly upw;u!l-sloping .
over the whole I
rall~(, of maturities. Sometimes the yield curve is illver/ed, sloping down oVfr
tlte whole range of malurities.

l1o/tlillg-l'rriod Rrturns
The /w/tlillg1Jrriod return on a bond is the return over some holding peri~
less than the bond's maturity. In order to economize on notation,. we spe-
cialize at once to the case where the holding period is a single period:~ We

~Tllb rurvc is nOI hased on 'l"ott·d slrip pri(t·~, which M~ r~adily aV;lilable only for rnet
yea .. ,. hili is estilllaled frolll Ihe prices of cOIII'0J1-I)('arin~ Treas"ry lx,"ds. FiKure 10.1.\ is
clll<' 10 MrCllllorll ane! Kwo" (199:1) :1111111'<"' Mr< :lIl1ocll" (1'171, 1'17,,) estimation melh",\ "-,
c1i.,clI"'·cI ill ,t'clion 10.1.:1 helow.
\"ihillt'r (19~JO) gi\'t.".~ a milch mon' (olllprelil'Il . . i\'(· rrt',tllllt"IH, \\o'hich requires Inore (Oil)·
plil"a[cd JlOI:lliol1.
 /II, !-Ix,'d-IIIIII/II/' .'il'fllrilil',1
.c,r-_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ , _ _ ;_ _ ~-

.~
c:
t..
- r-
~(
;;
";;
C-

ol'
.;:

II
_.------------
III 1:,
---"-----~----
:!u ~', :\11
\1.lIl1l ily ill Y(';u,

Figltn· 111.1. 11'111 elll,/,I/ll l'IIM 1111/1 1';"11',,111-11111,' (:11' ...,.,\ in/IIIII/(I/)' 1')87

definc U.. ,,+I as Ihc olle-period holdillg-p,'riod rt'llIrn on all 11-l'niod hOlld
purchased al lillie 1 and sold;1I lillie 1 -I- I, Since the hond \\'illll!" an (II - 1)-
pniod hond wht'll il is sold. Ih,· sal" pricc is ",, __ 1.1 f I and Ihc hlliding-pniod
relllrn is

1'" I III (1 + 1'",)" ( 10,1.,1)

(I -\- U", .. d
I',I{ (I t- l'" I,/l I )" I'

The holdillg-pniod 1,'111111 ill (10,1,1) i, high irlhe hOlld has a high \icld
when il is plIn'h;IS\'d al lilll!' I. ,\lId il il 1",,;1 low yidd \\,(,CII il is ,old.II lilllt'
t + I (sint''' a lo\\' "it'ld n,I)'\"p"l11b III a high l'rin').
l\1'1\'ing III logs for ,ill'l,li.-il\', ,I,,· Illg h .. ldillg.pt'riod 1\'111111, ' .. I) I ,-
log( I -I- /{",I) 1 ). i,

III I )-".. I,ll I

\'1/1 1)(-"" 1.1)1 --,1'",), ( I 0, I.:,)

Th,' h"l \"plaliIY ill (111,1,:,) ,hll\\" ho\\' lilt, holtlill)!;-pl'l'iotin'lllrn is dl'l('\'-
lIlill",1 hy Ihe llt'gilll1illg-ol-pl'liod ~'it'I" (posili\'l'ly) all" Ihe !'hang!' ill Ihl'
yic-ld llyn Ih,' holdillg 1"'1 ioc\ (1l<",l~;lIi\'t'h-),
III, I 1111,';" (;""1'1,/111

[:''Illalioll (lll,l.:1) r:lll II\' 1":\lI:III~I'd so 111.11 il 1\'[;11\', I[H' lo~ 1111\111
1'11\'1' l"d:ll'llIlllI' IlIg pli ... · 101110110" ;"ulllll' 1\'1111'1 """ IIII' 11I'~ll'l'Iio,l:
/'", -'I" /I' I /'" I" I, 011,' .... 111 ,"I,,· Il1i, dilk,,'''''' "'III;lIillll 1011\,:11'\1.
"I1I1)'llllllillg (1111 1111111(" log hUlid p .. i((·, Illllii III(' 1I1.1I111il\ d.llc- i."I 11'~1«'lu'cI
(,lllel IHllill~ 111.11 til(' I()~ pric," ;11 11I.11i1i il\ ('1)11.11 ... /1'1(1) In ohl~,jl1 /Iflf =
- ~:' 1.1 /" ,II t I" tH ill h'l n" or t"t' ",,·hl

,Lit = (-;;I) L'"

"-!
/:.:0
11111/'
(I II. J.(i)

Tlii" "'I";lIill'l ,1I11"'S 111011 1I11'Iog ~idd 10 1I1:lllllil~'OIl a ~"nl-nllll'''" 110 ... 1
\"IILI!> :iI,' "\'\'Llg" ["!-\ 1<'lllIIlP''\' I'l'I'iod il II ... 11,,1111 is 111'11\ IIIII\:\lIlIil\',

h;.';"f/J(II~tlll'.\

1\, "It I" ,I' tiilkl "III III.lllll'ili,·s rail lit', ,""lIi",·d 10 gll;II "III,,\, :111 illl,·n·,1 1':111'
"\,,, li,,,d-illl 11111<' i111'CSlIllC1I111l It,· 11I:l<\c ill Ihc !'tlllll":!ill' i"len'sl raIl' 1111
Ihi, i,,\,"IIII\'11i is ",died :1'/IIIWIIHI 111/"."
!" ,C:II:II'.IIII',\,:l1 lilll" / 0111 illll'n'sl 1'011,' 011:1 0111'-1"'1 i"d ill\'('sllllt'1I110 h!'
IIl.Id,' .,1 lilll<' / -I- II. :III illH'slor rail Pl'o,,(,,'d:ls lilll'"I" 'I'll,' d('sil'('d 1'111111'1'
illl<"I""'III\\illl':lI'$! :lllillll'/+ II-!- I "lsh,'Ii"l hlll""III'(II+ I)-period
[""Id, :ilis (,,,,Is 1'''11,,;11 lilll" 1 alld 1':I)'s $1,'11 lilll<' (-1- ,,+ I. Th,' ill\'eslor
":1I1h I" 11.111,1,', lhl' ('osl ortllis ill\'('stllll'lli rrllllllilllt' (Itllillle I II; to d" +
Ih:, ,II" ,,('Ih "" 1 1.,/1'", 11-I'('riO(I hOllds, Thi, pl'o,III(,(,s" posilil'(' cash 1I0\\' or
i'", (I' .. , :"jI'",) = 1''''1.1011 lilll\' I, "xal'lll' elltlligh 1001'1:,,'1 the Il('galiv(' lillie
/ ',I,1t 1111'" 1'1'''"1 Ii ... lil'sl Irallsanioll, Tlte ,;111' or lI-pl'J'iod hOllds illlplies a
"":~;Il"" ,';"It II till' "I' 1'''IU/I'''I;l\ lill\(' 1 + II. This .... 111 [I(' IlltHlghl .or;ls th,'
('0'' 01 lill' olll'-pnilld illl'("lllll'1l1 10 Ill' lll;ltlt-;l\ lillH' ( + II, TIlt' cash IInws
1'\',,"llil.c: 11'11111 lilt'''' I1';1 11 S;t1'1 iOlls al'(' illllsll'al('d ill Figlll'" \()':2,
Tl,,' "/1'\\':11 d 1';1\,' is deli 11 ... 110 I... IIII' 1'('1111'11 oil III<' Ii III<' I j- II i\l\'('sllll(,111
I II i'". ~ ,/1',,/:

(I -1- 1'", I,,)" "I

II -I- 1'",) (10,1.7)
(I t- 1'",)"

11111", ",'l.lli'>11 1-;" III .. /ir,sl sllhsCl'ipl n'/iTs itl 111,' II II 11 t1){'r orp(,l'io<ls all('a<l
II",! II", tllI"-I"'lilld illl'I'SIIII(,1I1 is 10 h" 111:1<1<-. ;11111 tI,,· s,'('.oll<l stlilscripi
I\'k" III tI,,· d.lll· .1' "hi..!IIIH·!ilrwanl 1';11<' is scI. ,\1 lilt' I'osl ora<ldiliollal
(lI'ill,I,";II' ill 11I'1:llioll 11'1' ('oilld ;lIso ddill<' I'III'II':IIc1I'.II,·, 1'01' llllIliipl'l'iotl
illl,',II:WIII.\. 1>111 III' <1011111 PIII'SIl(, Illis 1111'111\'1' !IIT",

'II "\,11111'1" ,II I'll \\.11 d II ,u(iug j, Ih,' 1/'/"-,,1\\1/, d 111.11 kl'l III t ','1 II ",1'0111 \ ,,'I IIfili{'.' .. \I WI"

.111,:111111'" 111111'\\ 'I"~ III II it', I", ;IIIIIOIIIICTd 1.111 Iwloll' dlt, '(',lilliit" .111' i"llI'd. "it" '\C'c'llIilic"
.IIt' ,',Id,', i HI rlll' 1\ 11'·11·' ...... 111"11111.11 )"('1. hjlll ""111,'1111'111 II I III I III ,,111'11 dl!' ~I'I 1IlIIic'" .In' j .... ucci.
 ~ ..... J 1"\.1 14 "1/11 0111," • )/"11111(/1'"\

t i 111(' 1 1+ II 1+ 11+
'lbnsa('lic)ns
I I
BII)' 1
(1/ + 1l-ilC'riod -1'1111.1
hond

( ~'~)
J'II~ 1.1
Sdl/'II+I.I/ I '1I1
II-period honels
,,, I'
/' II/
/)",

1'111-1.1
Nel o
J'ui

Figure /0.2. ('iI.IIt NIII'" ill II "'J/WIII" '/i(II/If/l'lillll

Movill)!; to IIl)!;s (ill' simplicitl', tI\(, II-perio<i-ail('ad log fot ward rall' is

(II -\- I)YIII'\'/ - IIY",

=: ,)'111 -t- ('1 + 1)(Y,,+I,1 - .'Yllt), ( lO.l.H)

Equatioll (IO.I.H) shows Ihat Ihe lill'ward rate is positive whenever discount
hond 1)I'in's fall wilh malllrity. Also, Ihe forward raIl' is ahove bOlll the 7/-
pnioil and tile' (1/ + I )-pc'rind dis(,otHlI hond yields when !ht' (11 + I)-period
yield is ahm'(' Ihe' II-pcriod yidel. Ill;!! is. when th(' yielel clirve is upward-
sl()pitl~,7 This reb!ioll h('twt'e'n a yield to maturity and the installlalll'OIlS
forw,ml rale al 111;11 JII;II uri I)' is ;lIlalo)!;lltJs 10 th(' r('lation h('tweell marginal
and averagc' (osl. Thl' yield 10 malurily is the average ('ost orhorrowill~ for
II pnio<ls. whill' till' I',rwanl 1;\lc' is Iht, marginal ('osl of I'xt('nclin~ thl' time

pCTiod of tilt' loan.

Fi~lIr(' 10.1 illustratl's tilt' rdatioll hctw('('11 the lilrward-ralt' CIII\,(' (shown
as a clasht'l! litw) and the yit'ltl ("tlrv(' (a solid line), Th(' (()rwanI-ral(' curve
lit,S ahol'c' th(' ric'lei ('tlIV(' whell I h(' yidd clirve is lIplVard·sl()pin~. and below
il whl'lI the yidd Cllrl'e is do\\,I\WMd-slopin~, The IWo curves cross when
tht, yit'ld ("I\\"\"t' i, Ihl. These ;m' the standard propnti('s or Il\ar~inal and
al'cTagl' cost ('lIln's. \\'11t'1I tilt' (ost of a JIlarginal IInit exce(,ds lhe co,t of
all ;t\'CTa~,' IIl1it tlll'lI till' ;\\'c'lag" cost increases wilh ;\tIdition of" thl' ,I",
7 f\~ tht' lime \1"'\ . . I\lll)"~ \ d.H1\I' h t liw hculIllH,l1l1rily 11,111(' h""llIul;, ( IIl.I,X) appnl,u"ht,S
/'" ":.:. '"", -f tl ;i)'"djl n. Ill1' n pC! ioc\ ridd 1'111, II tillw", tIll" ",lop" 01 .It.,
yield ("111"\'(' al 111;11111 11\' II.
JO. J. Basic Concepts 401

marginal unit, so the average cost rises when the marginal cost is above the
average cost. Conversely, the average cost falls when the marginal cost is
below the average cost.
I

10.1.2 Coupon Bonds \

A~ we have already emphasized, a coupon bond can be viewed as a pa~kage
of discount bonds, one with face value equal to the coupon for each date at
which a coupon is paid, and one with the same face value and maturity as
the coupon bond itself. Figure 10.3 gives a time line to illustrate the time
pattern of payments on a coupon bond.
The price of a coupon bond depends not only on its maturity n and the
date t, but also on its coupon rate. To keep notation as simple as possible.
we define a period as the time interval between coupon payments and Cas
the coupon rate per period. In the case of US Treasury bonds a period ,is six
months, and C is one half the conventionally quoted annual coupon rate.
We write the price of a coupon bond as POll to show its dependence on the
coupon rate. .
The per-period yield to maturity on a coupon bond, Ycnto is defin~d as
that discount rate which equates the present value of the bond's payments
to its price, so we have

e e l+C
1""1 :::: + 2 + ... + . (10.1.9)
(I + Y ent ) (I + Y"'t) (I + yent)n
In the case of US Treasury bonds, where a period is six months, Yenl is the
six-month yield and the annual yield is conventionally quoted as twice Yen /.
Equation (10.1.9) cannot be inverted to get an analytical solution for
Y,"I' Instead it must be solved numerically, but the procedure is straightfor-
ward since all future payments are positive so there is a unique positive real
solution for Yenl •s Unlike the yield to maturity on a discount bond, the yield
to maturity on a coupon bond does not necessarily equal the per-period
return if the bond is held to maturity. That return is not even defined until
one specifies the reinvestment strategy for coupons received prior to matu-
rity. The yield to maturity equals the per-period return on the coupon bond
held to maturity only if coupons are reinvested at a rate equal to'the yield
to maturity.
The implicit yield formula (10.1.9) simplifies in two important special
cases. First, when POll = I, the bond is said to be selling at par. In this case
the yield just equals the coupon rate: Yrnl = C. Second, when maturity n

"Wilh Ilq:;lliv~ future paymenl'. there can be mllhipl .. positive real solUliol1S tn (10.1.9).
or a
III Ih,' oiliolly';s of ;Ilv..'tllleill projects. th" discolillt rat<· that equate. the pre",nt vdlue
projcn to il.~ cost is known as tht" i1Jin7lfJ/ mil' oluturn. Wlwil projec~ have some negative cash
flow, in rlie flllurt\ tht"rt· CUl hC' multiple ~ollitioll."i for the int~rnal rate of return.
_____ Jime.L_ _ _ _ _ --J.+l- _...--t+-2-W t +n- 1 t+ n
I I I I
(1) Maturi[)' 2 n- I n

(2) Face value C C C 1+ C

(3) Present
C C C (1 + C)
value discounted
at }~'"
(1 + Y,nt) (l + Y,n,)2 (I + Y,,,,)n-l (1 + Yrn,)n

(1) x (3)
C 2C (n -l)C nO + C)
(1 + You) (1 + Y,n,)2 (I + Yrn,)n-I (I + Yrn,)n
'L((I) x (3»)
Den' = 2:(3)

Figure 10.3. Calculation of Duration for a Coupon Bond

lO.l. iJll.)i( COIlrt'/lts 403

(mUIiI \)1' /1n1)f!tuily. In Ihi~ l:OIse the yicldjuSI

is infinile, the bond is called a
equab the ratio of the bond price to the coupon raIl': )~."" == C/I'rOiJl'

/Jllmlio/l 1I1/11l/lll/IIWizlltioll
Fordiscounl iJollds, malurity measures the kngth ol'tillle that a hondhulder
has invesled money. BUl for cuupon hOllds. malurilY is an illlpafecI mca-
sure or this Ienglh of lime because lIIuch of' a coupon hond's value comcs
frolll paymenls lh<ll are made before malurily. MIL('(Iu/a.v \ durati()II, dill' 10
Macaulay (l!):~H), is inlended lO be a beller measure; like maturily, iL~ IIlliL~
are lime periods. To undersland Macaulay's duration, lhink uf a COUpOIl
bond as a IMckage of discounl bUilds. Macaulay's dur;ltioll is a weigh led av-
erage of the malurities of the underlying discounl hond.~, whne the weight
Oil eadl lI\;llurily is the present value of the cO\Tespollding discounl hond
cilculated using the COUPOIl bond's yield as the discoullt rate:"
(. ,,(' (Ilel
1T+t;i-l-':'~+"'+I/~

CL::"I ~ -I- II"+b ( 10.1.10)

POll

The maturilY of the first cOlllponent dis('ounl hond is OIH' lll'riod and this
receives a weighl of C/( I -I- l'rlll), the present value of' this hOlld when 1'"" is
lhe discounl rale; the maturily of the second discount hond is lwu and lhis
rcceives a weighl of C/(I -I- 1'(nl)2; and so on unlil th .. Iasl discounl bund
or Il\;llttrily II gt:ts a weight of (I + C)/< I -j 1'",,)". To ('(\lIVer! this illlo ;\11
average. we divide by the sum of the weights C/ (I -j- l'",,) -I- C/ (I -I- r"a)2 -I-
... -I- (l -I- C)/(I -I- Y'"I)", which from (1O.1.!1) is just the bon(1 price I'"".
These calculalions are illustraled graphically in Figure 10.3.
When C = 0, the bond is a discounl bond and Macaulay's duralion
equals lIIaturity. When C > 0, Macaulay's duralion is kss lhan 1I\;llurity and
it declines wilh the coupon rate. For a given cuupon rate, duratiun declines
with the bond yield because a higher yield redllCl's the weighl Oil more
dislanl paYlllenls in the average (10.1.10). The duration finllluia simplifies
wi,en a coupon bond is selling al par or has an ill finite nl.lllirity. A par
bond has price 1'",/ = I and yield F,,,, = C, so dlll'alion becumes /),,,, =
(I - (I -I- j'",()-")/(i - (I -I- 1',,,,)-1). A consol bond with infinite maturilY
has yield Y'CVI = C/I',ool so duration hecomes /),,,,, = (I -I- l"OOI)/l"OOI'
NUlllerical examples thal illllstrate these properties are given in 'EI-
hlc 10.1. The tahle shows Mac,ltllay's dur'ltioll (and Inodiiied dur,lIion, de-
filled in (10.1.12) helow, in parenlheses) IiII' bonds with yields and coupon

~I~t;lfalll;ty abo sllgg('sl~ that Ollt' could usc.' yit'lds Oil di~("OIIlIt honds r.uil,,!" than th(~ }'idcl
011 lilt' ('0 11 pOll hOlld to rairul.ttc- the prt"St"JI ,";,dlu' of (,~lfh COUPOII l'aYIl1(,1I1. IloWl'\'('r Ihi.'\
:'lppro;\("h I('qllil('~ IIl;I' OI}('I11('i\slIre.1 cOlllpl(,l(" Jt'IIH'OtlIHHlIt'JIII.\III1( 1111(',
·HI·. /0. FiXl'll'/lInJlIIl' SI'I IIritin

Table 10.1. "'amlill/.~:' 1/111/ IIItH/illrt! dum/i'lll j"r .\f!fftn! !JIII/d,.

Malurily (yt'ars)
.J
10 :10 :xc
-. - ".- --~.- -----
(:OUI'01l rau- otY"
Yit'ld O(,~, 1.000 :!.OOO ',.(H)1l 11l.1l0() :IO.()OO
(1.000) (:!.()I)O) (:d)OO) (10.000) C!O.OOO)
rIll
,I", 1.000 :!.OOO :>.I)O{) \H.OOO :10.000
(O.~)7Ii) ( 1.%1) (·I.H7H) (~).7:,I') (:!'I.:!liH)

IO'X. I.OO() :!.()OO ".()OO IO.O()O :~().()()()

(O.~l":!) ( 1.~IO") (·1.762) (~J':':!4 ) (:!H571)

.. -"- -'--~-~'-"-'----. -- _.---- --".
( :IIl1pllll rail' r,JI(I
I'!

Vit'll! OfX. ll.tlHH I. ~ 1:1:! 1':',,0 HAI7 21.1 ,,0

(1l.!IHH) (I.\J:I:!) (·I.:.r,O) (HAI7) (:! l.l :,0)

:.'~J O.~IHH l.tl~H ·I.-IW, 7.!lH!1 I',.H·II :!o."oo

(O.~Hi·1 ) (I.HHI) (·1.:171\) (7.7 t l:,) ( I r •. ·I:,·I) (:.!().()IJlI)

I o 'X, O.!IHH 1.!I:!·1 -1.'1 J.I 7AH~) IO.!I:,7 10.:,00

(O.tl·to) (I.!';:!:!) (-I.:W·\ ) (7.1:~:!) ( 10.·1:\1,) (10.0011)
--.--- - - -_.._.-
.. -- .. _-_.-----.--._----------
(:0111'011 ralt' I f )t}~1

Yield O'y" O.~)77 I.H7', ,1.2,,0 7.1,2:, IH.'I~H

(O.~I77) ( I.H;:,) ('1.2:'0) 0.62:,) ( IH.!l:~H)
:,(Ycl O.~I77 I.HliH 1.1:,li 7.107 1·1.02" :!0500
(O.!I',:I) (I.H:!:I) ('LO,d) (li.~I:I:1) ( l:tliH:~) (:!O.OOO)

lOry" O,~J7(i I,Hli:! ,1.0;'4 6.',4~ ~I,!I:~H 10."O()

«(),~):~O) (1.77:\) (:I,HIiI) (1i.2:-11) (!)AIi;,) (IO.()OO)
_.. ------------------.--
TIlt' I.. hlt- It'IUIII'' ~l;tLlIIl.ly's dill ;11;011 alld, lit pall'ntlu:s(.·s. l1\odili"tl dur,uinn fur honds \dth
st'lt·'"h.'cI yi(·ld . . ,lIul lUallltiti"", Dllration, \'it'1d, ;llItllllalurity an' Mau'd ill ;tlHllIallillics Inll Ihe
uudt" lying t·~,h \lbt1tHl'o i\"'~\lIH(' 111;11 hcm<i paVIII('UIS an' macie 01' six·lIlolith illt". val.".

r;ltes ofO'X" :,'1.., ;III\! 10'1." ;\11I! \Il;\tlll ities ranging frolll one ycar to inlinity.
Duraliou is givt' II ill \'(';US 1)(11 is r;tinti;ltt'd using six-lI\onth pniods as wOllld
he approprial(' fi'r I IS Tn';\slIry hOIHk
II W(' lake Ihe d('Ji\'ali\'t, of (10. f .II) with rcsp('('( 10 r"", or equivalelltly
with respect 10 (I -)- };"tl, WI' filld 11\;11 I-.fa('aulay's duralioll has allolhN \Try
10. l. llasic COIlCrflls 405

illlponant property. It is the negative of the elasticity of a coupon bond's

price with respect to its gross yield (I + Y(I//):10

D _ _ dP"" (I + Y,",) (10.1.11)

",I - d( I + Y"II) P'"I
III illdustry applications, Macaulay's duration is often divided by the
gross yield (I + Yrll/ ) to get what is calkd modified dura/ion:

°n.1 dl""1
(lO.l.l2)

Modified duration meaSllres the proportional sensitivity of a bond's Ii rice

(0 a sillall absolute change in iL~ yield. Thus if modified duration is 10, an

increase in the yield of I basis point (say from 3.00% to 3.01 %) will cause a
10 basis point or 0.10% drop in the bond price. ll I

Macaulay's duration and modified duration are sometimes used t~ an-

swer the following question: What single coupon bond best approximates
the return on a zero-<:oupon bond with a given maturity? This question is
of practical interest because many financial intermediaries have long-term
zero-<:oupon liabilities, such as pension obligations, and they may wish to
malch or immuniu these Iiabililies with coupon-bearing Treasury bondsP
Although today stripped zero-<:oupon Treasury bonds are available, they
lIlay be unattractive because of tax clientele and liquidity effects, so the im-
munization problem remains relevant. If there is a parallel shift in the yield
curve so that bond yields of all maturities move by the same amount, then
a change in the zero-<:oupon yield is accompanied by an equal change in
the coupon bond yield. In this case equation (10.1.11) shows that a coupon
bond whose Macaulay duratioll equals the malUrity of the zero-<:oup~l li-
ability (equivalently, a coupon bond whose modified duration equals the
modifIed duration of the zero-<:oupon liability) has, to a first-order approx-
imation, the same return as the zero-<:oupon liability. This bond--or any
portfolio of bonds with the same duration-solves the immunization prob-
lem for small, parallel shifts in the term structure.
Although this approach is attractively simple, there are several reasons
why it mllst be lIsed with caution. First, it assumes that yields of all maturi-
ties move hy the same amount, in a parallel shift of the term structure. We

I"Th .... bSlicity of a variable /l with r"'pen [0 a variahle A is defined 10 be the derivative of
il with r.. ,p,.(\ to A, lim,.s AI il: (dill dA)(AIIl). ECjllivalemly, il is Ihe derivalive oflo&(B) with
rt"p,.n to I()~(A).
I' Not,· Ihat if duration is lIleasur,.c1 in six-Illonth time unil-'. then yields should be measurtd
Oil a ,iX'1l10Ilth ba,i~. Olle (all ftlllWrl 10 all allllllal basis hy halving dunllion and doubling
yield,. Th .. IIl1mb,.rs in T.. blt" 10.1 hav,. h,.en annllali,,.,1 ill Ihis Wdy.
l~hllll""lil.ali()l1 was orillinally d .. filled hy R,.c1din~lOn (1952) as "the investment of the
",-,,'Is ill s"ch OJ. WJ.i lhallhe ("XiSlill~ hl"ine" is immllne 10 a ~eneral change in Ihe rdle of
i"lt·rn!". FahOl.l.i ami Fahoni (I!l!l:.). Chap"'r 42. ~ives a (olllprehensiYe !lisenssion.
406 10. Fixed-Income Sewri/ifs

show in Section 10.2.1 that historically, movemen15 in shorl-lenn interest

rates have tended to be larger than movelllen15 in longer-ternl bond yields.
Some modified approaches have been developed to handle the lIlore real-
istic case where short yields move more than long yields, so that there arc
nonparallel shiflS in the term structure (sec I3ierwag, Kaufman, and Toevs
[1983], GraniLO [1984], Ingersoll, SkelLOn, and Weil lI9781).
Second, (10.1.11) and (10.1.12) give first-<>rder derivatives so they apply
only to infinitesimally small changes in yields. Figure lOA illustrates the
fact that the relationship between the log price and the yield on a bond is
convex rather than linear. The slope of this relationship, modified duration,
increases as yields fall (a fact shown also in Table 10.1). This lIlay he taken
illlo account by using a second-order derivative. The convexity of a bond is
defined as
C ",n ,(i+I) + II(n+l)
~L-i=l ~ (l+)'F",)·"t
Convexity _
]'",1

qnd convexity can be used in a seeond'<lrder Taylor series approxilllation of

Ihe price impact of a change in yield:

\ dP,n( Y,") dP,,, I , I IF 1'0' I 2

\ ::::: - - - d}," +- --2- - - (dY,,,)
! P,,, Ii Y,,, P,,, 2 d Y," P,"
(- lnotiiii.ed duration) tl Y,"
I
I

+"21 convexity (dY,,,) 2 . (10.1.14)

\

\Finally, both Macaulay's duration and Illodified duration aSSlIllle that

~
Sh
nows are fixed and do not change when interest rates change. This
a. ~umplion is appropriate for Treasury securities but not for callahle seclll'i-
ti s such as corporate bonds or mortgage-backed securilies, or for secmities
th default risk if the prohability of default varies with the level of interest
r' tes. By'modelling the way in which cash flows vary with interest rates, it is
P1Jssible to calculate the sensitivity of prices to interest rates for these lIlore
cTnplicated se(:lIritil'S; this sensitivity is known <IS rJJrrlilic dumtioll. J:I

A 'I.oglinear Modd for COli/lOll /JowLI

The idea of duration has also bel'1l used in the academic literature to lind
approximate linear relationships hetween log cOllpon bOlld yields, holding-
period returns, and forward rates that arc analogous to the exact rehltion-
ships for zero-colI\lon bonds. To understand this approach, start from the

I'See Foibul.li and Fabul.I.i (I\l~):», Chapll'''' '.!!I-:IIl. ami F"lmui (\\J\lti) ('ur a .Ii.n",;,,)) of
\'aIiI)U~ methods u5ed hy fix("(\·iIlCOll1e al)~I'y~ts II) ralculatt." t"lfl'ctive duration.
/0. J. fj(lJir. Conrrl)Lr 407

/
Slop" = Modilied [)uration

Yield

Figure 10.4. '/1"'!',itf-l'i"''' III'/flli(lI/,hi/,

loglinear approximate return formula (7.l.19) dnivcd in Chapter 7. and

apply it to the one-period return r' .... 111 on an II-period conpon bond:

Here the log nominal coupon r. plays the role of the dividt'I\(1 Oil stock.
bUl of course it is fixed rather than random. The par,lIneters p and k arc
given by p == lie I + exp(r. -I)) and II == - log(p) -- (I - p) log(ll fl - I).
Whcn the bond is selling at par, the II its price is SI so its log prilT is J.ero
and p =-= III I + C) = (1 + Yrlll ) - ' . It is standard to use this value for p.
which gives a good approximation for rctllnts 011 honds selling dose to
par.
Onc CIII treat (10.1.1;». like Ihe '1Il<tlOgollS I('w-coupon expression
(10.1.:;). as a dilli.'rence equation illl\te log bond pricc. Solving !(II'wanllO
the maturity datc one obtains

11-1

LP'[h+(I-p)r- r, ... _,.III"I· (10.1.16)

;=0

This eqll,llion relates the price ofa cOIlj>onlrond 10 its slrcam of co lip on pay-
mCllIs ,lilt! the flllllre returns Oil Ihe IlOlId. 1\ similar 'lpproxim'llion of the
 ,101{ 10, FiXfd·/llftllllf S,'('Il,-;I;".1

IIII-( yidd 10 \I lal lII'i Iv.)', ,,' shows Ih;\l i I sal isli('s all ('<"Illatiol\ of II\(' salll(' lim 11:

II""

L p'lhf' (I - pic - .1'111/]

1=-0

(t - 1''')
---- -' I h +-
(I ", ()
(I - fI)r - ),,,,/ I,
,
(10.1.17)

Eqllatiolls (10,1,1 Ii) alld (I D,I,17) log('11II'r imply Illal IIl(' lI'period COllPOI1
hond vield salislit,s y,,,, ~ (I _. p)/(I - flll)} 2:;::,:
pi r'.II_I,Iil+,' Thus al-
Ihough 11I('rt, is 110 ('x:"'1 rt'I;llioll,hip Illne is all approxinlale ('qllalilY hl'-
IW(,(,II IIII' log vidd III 1II;\llIril~' Oil a COli pOll bond and it weigh led an'r;lg('
or Ihe r('llII'llS 011 lI\e hOlld Wh('ll il is h('ld 10 malurilY,
Equalioll (J 0, J,I J) lells liS Illal Macalllay's dural ion fill' a cOIIPon bond is
tI\(, (it-rivalivt, orils log prin' wilh n'sp('('llo ils 101-( yidd, EtI'I:llioll (10,1.17)
gives I II is dt'li ,,;) Iin' as

(I - fl") 1 - (J + 1',",)'"
n, " -':;
(1 - p) I - (I +- 1', ",) -I '
(1 0,1. IS)

wh('It, lilt' Sf 'COIlt! elf";"i IV II\t'S I' == ( 1 -I 1', ",) - I , As 1I0I('d ;\bo\,(', Ih is rda t illn
1)('1\\'('('11 dllralion alld vield holds ('x a 1'1 I)' li)r a bond s(,lIillg al par,
SlIbslillllillg (1O.1.17) and (IO,I.IH) illlo (10,1.1:), W(' oblaill a loglin-
('ar I('blioll IWI\\,(,('II holding-period r('lul'lls and yields [Ill' COUpOIl bonds:

' .. ",'ll ~ IJ,nl,n,-(/),,,-I)Yr,n--I,I-II' (I n, i 19)

This t"llIaliol1 "'as lirsl tlt'l i\'t'd hy Shillt'r, Camph('lI, anti Schot'nholtl:
1 (19~t\),11 It is allalogolls III (10,1.:,) for zero-coupon bon(\s; maturity in
(
I Ihal (''Illalion is rt-pla('('d h)' dllralion IUTC, and o/'('ollrs(' 111(' IWo ('qual ions
I
I an' consisll'llI wilh 011(' ,II1011ll'r I'llI' a IITO-COUpOIl bOlld whose duration
I (,quais ils IlIallllil),.
t\ similal an;i1l'sis 1'01' I'ol'\\'anl ral('S sllows Ihal Ih(' II-period-ahead 1-
Ilt'riot\ forward ralt' implicil in Iht' cOllpon-i>earing lerlll slrllCllln' is
I
I
I /111 :~
1},,1I11 ' ',111.,1 - [),'I .,I,",
---.-.:..-.-- ( I (). I.:!()
- n,,,
\ /I, '<\ I

Tllis rorlllllla, \\'lIich is also dill' 10 Slrilln, Campbell, al1d SrlIOCI1\tO\t1.

\
I (I!H'\:\), )'('dllct·s 10 1111' (\i'(01l111 hond 10\'11111'" (IO.I.H) whell dll1'alioll ('<J";lIs
lIIalurilY·

IISIIilln, ( .. uHphdt ..1Ih\ S, Il\u'l\!\ult, " . . ,. ' ... / ''''It'"tl 01 y, ,," hut thcst· ~\IC.' t'llui\\tlc:nt tu lht'
~afllC' 1i',I-olCkr .IPIIIU-..;illl;Ilioli 11'<o('cl If) ""1 in' t I O.I.I~.). They ;,1:-.,,, ,"'rin' tl)lln"la~ I t'latillg
IIIlIltipcrioci huldil1g 1('lunl' lit "i,'leI,.
, II. I. Basic Concepts

10.1.3 Estimating the bra-Coupon Term Structure

The classic immunization problem is that of finding a coupon bond or

portfolio of coupon bonds whose return has the same sensitivity to s~all
interest-rate movements as the return on a given zero-coupon bond. Alter-
natively, one can try to find a portfolio of coupon bonds whose I:ash flows
exactly match those of a given zero-coupon bond. In general, this portfolio
will involve shortselling some bonds. This procedure has academic interest
as well; one can extract an implied zero-coupon term structure from the
coupon term structure.
If the complete zero-coupon term structure-that is, the prices of dis-
COUllt bonds PI ... P" maturing at each coupon elate-is known, then it is
easy to find the price of a coupon bond as

(lO.1.2l)

Time subscripts are omitted here and throughout this section to economize
on notation.
Similarly, if a complete coupon term structure-the prices of coupon
bonds Pel ... P," maturing at each coupon date-is available, then (10.1.21)
can be llsed to back out the implied zero-coupon term structure. Starting
with a oue-period coupon bond, Pel = PI (l + C) so PI = PcI/(1 + C). We
can then proceed iteratively. Given discount bond prices Pi, ... , Pn - t , we
can find P" as
P _ PC7I-P7I-IC-···-PtC
II - 1+ C (10.1.22)

Sometimes the coupon term structure may be more-than-complete in

the sense lhal at least one coupon bond matures on each coupon date
anel several coupon bonds mature on some coupon dates. In this case
(10.1.21) restricts the prices of some coupon bonds to be exact functions
of the prices of other coupon bonds. Such restrictions are unlikely to hold
in practice because of tax effects and other market frictions. To handle this
Carleton and Cooper (1976) suggest adding a bond-specific error term to
( 10.1.21) and estimating it as a cross-sectional regression with all the bonds
outstanding at a particular date. If these bonds are indexed i = 1 '" I, then
,itt' regression is

1"'''' = 1', C; + PtC; + ... + p".(1 + C;) + Uj. j ::::: I . .. I, (10.1.23)

witer(' (:. is the coupon on the ith bond and 1Ij is the maturity of the ith bond.
Thl' regressors are coupon payments at different dates. and the coefficients
art' ,ite discount hond prices Ij. j = I ... N. where N == maXj 1Ij is the longest
coupon bonrlmaturity. The system can be estimated by au; provided th~l
the coupon term structure is complete and that I ::: N. "
410 10. Fixed-lnfOmI'SI'fwitiel

'~'l}line Estimation
In practice the term structure of coupon bonds is usually incomplete, and
this means that the coefficients in (10.1.23) are not identified without im-
posing further restrictions. It seems natural to impose that the prices of dis-
count bonds should vary smoothly with maturity. McCulloch (1!171, 197:,)
suggests·that a convenient way to do this is to write POI' regarded as a function
of maturity P(n), as a linear combination of certain pres(Jecified functions:

J
1'(11) I +L ;;(n). (10.1.24)
1
(lJ
J=I
I
McCulloch calls 1'( n) the di.lfOll1lt fu II ftioll. The jj(lI) in (10.1.24) are known
functions of maturity n, and the fl,
are coefficiellL~ to be estimated. Since
~)«(}) = I, we must have jj(O) = () for all j.
i Substituting (10.1.24) into (10.1.23) and rearranging. we obtain a rc-
1resSion equation

\
I
ni = t
J=I
(lj Xij + ui. i = I ... 1. ( 10.1.25)

,.there n; == Pr.... - I - C,II" the difference between the coupon bond price
at" the undiscounleu value of iL~ future payments, and X" == jj( II,) +
<:\; L;:;'I ;;(1). Like equation (10.1.23), this equation can be estimated by
QIS, hut there are now ollly J coefliciellL~ rather than NY'
i A key question is how to specify the functions ;;(11) ill (10.1.24). One
si,mple possibility is to make 1'( II), the discount function, a polynolllial. To do
this one sets ;;(11) = IIi. Although a sufficiently high-order polynolllial Gill
approximate any function. ill practice one may want to use more parameters
to fit the discount function at some maturities rather than others. For
example one may want a more flexible approximation in maturity ranges
where many bonds are traded.
To meet this need McCulloch suggesL~ that I'(n) should be a .II/lille
fllnction. l6 An rth-order spline. defllled over sOllie fmile illt(~rvai. is a piece-
wise rth-oruer polynomial with r- I cOl1linuous derivalives; its nh dnivalive
is a step function. The poinL~ where the rth derivative changes discontin-
lIously (including the poinls al lhe hq~inllillg and end of the inlerval over
which the spline is defined) arc known as IWIII /Joints. If there arc K knot

"The hond pricing errors al<' unlikely 10 he hOlnmked"..'lic. McCllllorh .... K'u·.' lhal lhl'
Mar"lanl deviation of II, is proportiollal to II,,· hid·ask spread lor bond i. ami 111I1S wl'ights
('arh observdlion by the reciproral of il, sprl'ad. This is not required for ron.,isleney. hili 1Il;'y
i'nprnve tl\~ efficiency or the e~timales.
I~S\lil'. Mason. amt eh;1\I (1!17H) giV<' ;\n aen'"ihk illlwdllniollio splill(, IIlt'lhoduloKY.
/(). 1. nt/sir COl/rrlll.\ 'III

points, there are K - I subintervals ill each of which the spline is a polYllo-
Illiai. The splint' has K - 2 + r free paramcters, r 1<11' the first suhint('l"val
and I (that determines the L1l1festril"lt'd nit derivative) «)r each of the K - 2
followillg subintervals. McCulloch suggest.s that the kllot poillts should he
chos(,11 so thaI each subinterval contains an cqualllllllllH"r ofholld 1Jl,I!IHity
datc~.
If j"orward rates arc to be contiuuous, the discoullt fUIH"tion must have at
least olle continuous derivative. llellce a quadrati! spliIH·. estimated by Mc-
Culluch (1~171). is the lowesl-onler spline that c;lIIlit the discount function.
lfwe reC]lIire that the forward-rate curve should ,IIsD 1)(" continuously difler-
(~Illiahlc. thell we lIeed to lise a cubic spline. t'stimall'(lb), McCullodl (197:»)
and olhers. McCulloch's papers p;ivt' lhe ralhn complicated limllulas for
tht' fUllctions .//11) lhalmakc 1'(11) a qll,lIlLltic or l"Ilhic splille. 17

'1fl.\" lj(I'I/I
OI.S eSlilllatioll of (10.1.25) chooses tIl!" parallH'tns ", so t1latthc bond pric-
i:lg errors 11/ arc ullcorrclatcd with the variahles XiI lhat ddille the discount
fUI!rlioll. If a sufficiently lIexihle splille is lIsed, thl'lI the pricillg e/Tors will
he ullcolTclated with matllrity or any Ilolllinear fUllctioll ofillaturity. Pricing
errors may, however. he corrclatnl with the COUpOl1 r;uc which is the other
(\elillillg characteristic ofa hone!. IlItlt't'd rvkCIIII"t1l (1~17I) found that his
model ll'nded to underprice bone!s tltat IV("I"(' selling below pal' bt'callse of
their low coupon rates.
McCulloch (I D75) allribules this to ,I lax dkn. US Treasury bOlld
COli pOliS arc taxed ,IS ordinary illcollle while priet, apprt'ci~tliol\ 011 a COli POll-
he;lring bond purchased al a discollnt is taxed as capital gains. If thc capital
gains lax rate T~ is less than lhl' ordinary incolnc tax rate T (as has oftcn
been the case historically). then this Gill explain a price prellliulll 011 honds
selling below par. For an inveslor who holds a bond 10 maturity the pricing
f<>nullia (10.1.21) should be mOllified to

I',,, == [I - TgO -1'".»)1'(11) + (I - riC L "(i). ( IO.1.2li)

1=1

The splillc approach call be modified to handle lax dlLTts like lhal in
(I ().l.~(;), at the cost of some additiollal complexity ill t'stil1latio\l. Oll(e
tax crfects arc included. coupon bond prices lIlust be uscd to construct the
variables XI) Olt thc righI-hand side of (I ().I.~:)). This mcalts lhat the bond
pricing errors are correlated with lhl' rl'gll'sSOIS so tit!" !"qll;llion Itlllsi hl'

1";:\d;lIllS and \';111 De\'elltcr (1~~J4) argile.' 101 tht' 11.'1(' of .1 101ll11l"0Id('1 "iplillt,. with tltt'
cuhic 1('1'111 omilH'd, ill order to JIIaximil(' tilt· ...'iIllOolhllt·:-. ...... of III(' for"';lId-l.ttt" nllV(', wh('u'
!\l1loolhllt''iS i;-, ddill('tilo he milltl."i Ih(' ;'I\'('rag" .'iCfllart'd ,\('( oud <1('1 i\';I.i",' 01 IIH' 101 \\,aul-I.Uf'
rur\'(,' with n,':-'IH,'('t to m~\tHr'1y.
 J (), J'/Xt't!-JIlt'()/l/t'St't'llrillt'J

estimated bl' illSlnllllC'lIla\ variables ralher than simple OIX l.ilzenberger

alld Rol/il (I ~IHI) 'Ippl)' a lax-adjllsled splille modc'l of this sort to hOlld
lIIarket data fro II I sc\'('\'.11 different c(lllIItri('s,
Thl' t,lx-adjnslnl splillt' IIlluh-1 aSSllIllt'S that the samt' tax ratt's art' rd-
evalll fill' all hOllds, Thl' model call1lol halldle "c1ieJltele" efreets, ill which
difkrclltl), (;Ixc'd illl'cslClrs spccialill' ill differelll honds, Schaefer (I !lH I,
I~IH~) sllggc'sts Ih"t c1iclllcle dkl'ts call Ill" halldled hy first fillding a set of
tax-dlicil'llt hOllds for ,111 invl'Slor in a particular tax hracket,thl'lI estimating
an implil'dlCT'H'olllHHI vit'ld Cllrvl' from Ihose honels alone,

Nlllllillmr /11m/I'll
Despite Ihe f1exihilil)' of Ihc splille "pproach, spline fllnctiolls haw sOllie
IIl1appealillg propcrlics, First. sillce splilles are polynomials Iht'y ifllply a
discollnt fllllnion whil'h diverges as 1II.llllrity increases r"ther thall goillg
to lITO ;IS r('ljllin'll hy Illt'ory, Implied forward ratt's also diverge rathl'l'
thall cOllvc'rgillg 10 all)' lixcdlilllit. Second, there is 110 sifllple way to ellsure
Ihal the discollllt flilinioll alwa)'s declines with maturity (i,e" that all forw,lrd
rates are positive), Thc' fill'ward curve illustrated ill Figllre 10,1 gilt's I\egative
al a maturity of '.!.7 YI"lrs. and this hl'havior is not IIIlC0I1111lllll (sc'l' SllI'a
11~IH'11l, Thes,' probkills art' rl'l"tt'" 10 the facl Ihat a lIal Z<'I'O-coupon
yield curl'(' illlplic's ,III ,'xpOlll'lllially declining discollnt fllllction. which is
not e"sil), approximat('d Ill';I polmOlllial fllnction, Since allY plausihll' yield
cllrve lIattcns 0111 at thl' long en<l. splines are likely to ha\'e difticllities with
longer-malllrily hOllds,
These dillicultil's havl' II'd sOllie authors 10 suggest nonlillear alli'ma-
lives to the lilll'ar specilication (10,1.24), Oll(, alternative, sllggesteCl h)'
Vasicek alld FOllg (1I)H2). is 10 IIS(' all fx/wl/t'Illitll.I/,lilll'. a spline applied 10
a nl'gativ(' ('XPOIH'lIlial Irallsl('l'Il1ation of maturity, The I'xpollelltial splillt:
has thl' <ksirahk property lh,lt «H'ward rates and 7.ero-collpon yidds con-
\'I'rge to a fixc'd limil as lll;lllllit)' inneases, More gennally. a lIat yield cun'l'
is l'as), 10 lit with ,III eXIHHll'lIli,t1 SplillC,
Althollgh III<' ('XPOIII'lItial spline isappl'aling in theory. il is not dear that
il pnf(lI'IlIs hl'ttl'r th,1I1 thl' standard spline in practice (Sl't' She;1 [E1Wi]),
The ('XPOlIl'llli,t1 splint' dOt'S nol make it easier to restrin forward rates to
he positive, As 1'01' its Illllg'lIlalurit)' hl'havior, it is important 10 l'CIl\(,llIbl'l'
Ihal fill'ward r,II"s (,;111111,1 h .. din'cll), ('stilllated hl'yond Ihe maturity of thc
longesl cOII)lon I>olld; th(,), call on I)' he identified hy restricting thc' relation
h .. tw('('11 IOllg-horill'lI lill'w<ln! .. <I(('S <I lid shorter-hori7.on forward rates, The
('x)loIH'nlial sp!inl',lik(' the standard splint', fits the ohs!'r\'c'd maturity rangc
f\('xihl),. ll'aving III .. lilllilillg 1'01'11';1111 ratl' and speed or conv('rgl'n('(' 10 this
rail' to hI' dC'lt'I'mill('d lIIorl' hy IIII' reslrictions of the splille than hy all)'
,lIar,\('tc'l istics or lilt' IlllIg-hori,oll dOlt", Sincl' the expollI'lllial splint' in-
1'0l\'t'S 1I0ulin(',I!' ('Stilll<llillll of'" par,IIIH'\('r used to transform maturity. it is
 ,
141

more difllcultto use than the standard spline and this cost mayoutweig~'the
exponential spline's desirable long-horizon properties. In any case, forward
rate and yield cUl\fes should be treated with caution if they are extrapolated
beyond the maturity of the longest traded bond. i ';
Some other authors have solved the problem of negative forward:rates
by restricting the shape of thc zero-coupoll yield CIII\fC. Nelson and Siegel
(I !lH7), for example, model the instantancous forward rate at maturity n
a
as thc solution to second-order differcntial equation with cqual ~oots:
fen) = flo + fll exp( -a n) + an {J2 exp( -an). This implies that the dis~ount
function is doublc-exponential:
,
!'(n) = exp[-flo n + (fll + {J~)(l - exp(-a1l»/a - nfl2exp(-a1l)].

This specification generates forward-rate and yield cul\fes with a desirblc

range of shapes, including upward-sloping, inverted, and humIHhaped.
Svensson (1994) has developed this specification further. Other recent work
has generated bond-price formulas from fully specified general-equilibrium
models of the term structurc, which wc discuss in Chapter 11.

10.2 Interpreting the Term Structure of Interest Rates

There is a largc empirical literature which tests statements about expected-

return relati9nships among bonds without deriving these statements from
a fully specified eqUilibrium model. For simplicity we discuss this literature
assuming that zero-coupon bond prices arc obsel\fcd or can be estimated
from coupon bond prices.

10.2.1 The Expectatio1ls HypDthesu

The most popular simple model of the term structure is known as the expec-
tlltiom hY/JOthesis. We distinguish the /Jure expectati01ls hypothesis (PEH) (PEH),
which says that expccted excess returns on long-term over short-term bonds
are zero, from the expeclati01l5 hypothesu (EH). which says that expected ex-
c('ss returns are constant over time. This terminology is due to Lutz (1940).

J)iffmnl J'imns of the Pure EX/Jerlatio1l5 Hypothesis

We also distinguish different forms of the PEH, according to the time hori-
zon over which 'expected cxcess returns are zero. A first form of the PEH
equates the one-period expected returns on one-period and n-period bonds.
The olle-p('riod rcturn on a one-period honel is known in advance to be
(I + rill. so this form of the PEH implies
414 10. Fixnl-II/((JIIII' SI'(IlIili"J

whle the second equality f()llows from the dC/inition of holdillg-period

ret~rn and the fact that (I + YIII) is knowll at time I.
jA second form of the I'EH equates the II-period expected returlls Oil
on I-period and II-period bonds:
I
I (I + Y == E,[(I + YII)(I + YI.t+d ... (1 + }'1.1+1I-1)1·
II , ) · (10.\!.\!)

Heje (I -+ Yn,)" is the n-period return on an II-period bond, which equals

the expected return frolll rolling over olle-period bonds for 11 periods. It is
str,lIghtforward to show that if (I O.\!.\!) holds for all n, it implies

(I + l' )"
1 + 1';,_1 I == ", I = Ed 1+ l'1 14-11-11. (lO.\!.:~)
. (1 + YII-l.t)"- .

Un ler this form of the PEl I, the (II - I )-pcriod-ahead one-period forward
ratd equals the expccted (11 - I )-period-ahead spot rate.
lit is also straighlli.)fwanllo show Ihat if (I O.\!.2) holds for all II, il illlplies
!
. . (I + }'1I1)" = (I + I'll) 1-:, [(I + }',,-I.'ld,,-I]. (1O.\!.4)

But (10.2.4) is inconsistent with (10.2.1) whenever interest rates arc random.
The problem is that byJcnsen's Inequality, the expectation of the reciprocal
of a random variable is llotthe reciprocal of the expectation of that random
variablc. Thus thc pure expectations hypothesis cannot hold in both its
one-period form and its II-period form. IX
One can understand this problellllllore clearly by assuming thaI illterest
rates are lognormal and hOlllos\<.edastic and taking logs of the one-period
PEH equation (10.2.1) and the II-period PEH equation (1 O.\!.4). Notillg
lhat from cquation (10.1.5) the exccss olle-period log relUI'Il Oil all II-period
bond is

T•. t+t - YII = (YIII - YII) - (/1- I)(Y,,-I.t+1 - YIII),

cquation (10.2.1) implies that

E[TII.t+1 - )'11] -(1/2)\'al'[,.".I+1 - )'11], (IO.2.(j)

while (10.2.4) implies that

E[TII.I+I - )'111 = (1/2)Var["".I+1 - Y111. (10.2.7)

The dif1('ren('(~ betw('en the right-hancl sides of (10.2.6) and (10.2.7) is

I"COX, III).:l·ISOII, alld Ross (1!11l1 .. ) ", .. ke Ihis poilll VCI)' dc .. r1y. They also .. r).:IIC Ih .. 1 ill
rontin\1(}\t~ thue, only expected ('quality of iWilantallt'olls n'lurllS (it model rOlTt'~pontiing to
(10.:.1.1» i, cn ... i<lCnl wilh thc ahselln' of arhitra~(·. ""1 MrC"lIoch (1\19:\) ha., showlI th,"
Ihill; .. t"~lIh (It'pt.·lIth Of1lt.'~ldrli\'(' ~1.'i~lIIl1plioIJS alld doc'!\ not hold in g'(·ntra1.
10.2. Infl'Ilm'finK till' '/I'rmSlnu'llIIl' 1I/IIIfl'/l'.lf Ullfl'.1 415

·((dlf,. [().2. ,\In/II.\ ulJI/.\/lIl1dflnl d,.I'lllliOIl\ (If (1'1111.\/111(/1111' I'1I/;aM,..\.

(.III/.i.! bUild lIIal"lfl" (111

\',Iri,d,h- ., :1 Ii Ie :!·1 IH 1'l0

Exn::-. . . I ('IUI"II II.:\W. O.,.li·, O.IW~ 0.\)\7 0.711\1 IUiI·1 -O.IHH

'"./11 - .1'11 (O.liH) (I.n'l) ('l.(I,.·I) IIi.:! I H) (11.:1:11 11\1.·10) CI7.0H)

(;1"",);<" ill yi<"ld 0.010 0.010 0.010 0.0111 11.1)\1 0.011 11.I11'l
'il/.Ill - ,.111 10.,.'.I'l) (0':'71;) (0570) \0.:\ \71 10.·IH:-\1 \11..1(0) (\1:\\11)

<:II.llIgC· 111 yield -0.11111 -lUI!) -0.0:.1; -0.01·\ 0.011 0.01 I 0.01'l
-,",,-1.1+1 - Yilt 10.liOIl) 10.,.111.) (0':'7:1) (O.:):~I:l) (0.·111:-\1 111.-110) (0.:110)

\,i"I" "1'1'<,,111 0.1\17 0.:1'l" 0.,.70 0.7Ii'. O.!F',)-\ I.t:.:t 1.:lli7

)'/11 - .1'lt 10.'l1'l) W.:IiI:I) (004:111) 10.,.\I·\) (().7~17) 11.01'l) IU:I7)

1.llIlg hOlld IlIiilllritit's ale.' lII('il~lII ('d ill mouths. For ("it( Ii \',11 i.lhll' tite t.thlt' 1('pOI h lhl.' ~alllpit'
lIU',\\\ autl :-'I\mph' ~1.,,\daH\ dc.'vi"\tion (in p.\lt.·lHh\·:-,\·~) W,\1\~ '''t'Hlhty (LH,\ o\t'r the.' pt.-lim.'
I~J:-):':'I~ I q~11 ::l. Tilt, UOiL" .11"(' anllualized pt'l( ('IHagl' pOilll~. Tht' tllldl"llyil1g dala "I(' It'IO·
rOllpo:1 hOlld )'il'ld~ hUIll MrCulloril and K",ol1 (I~J~J:\).

Val'[ 1".,+1 - .vld, whirh lIlea~un:s the quailliialive illlporlallCt' oflheJellscll's

Illequalily effect ill a lognormal hOllloskeda~lir model.
Table I ().~ reports unconditional sample IllCallS alld standard deviations
Ii)!' several terlll-structure variables OVl'\' Ihe period I ~':I~: I to I ~)~II :2.1!' All
dala arc 1ll0111llly, bill arc measured ill allllllali/.l'd IH'I('Clllagl' Jloilll~; Ilial
is, the r,l\V variables arc multiplied by 12()(). Th(' lilsl 111\\' ~holVs Ihe ml'all
and st,\I\danl deviation or excess rdurns Oil II-",ollth I.l'ro-Glupon bonds
over olle-Illonth bills. The mean excess retllrn is posili\'l' anti rising with
malurity at lirst, bllt it starl!; to rail at a matlllilY of Olle ycar allli b cvell
slightly lIegalivc li)r lell-year zero-coupoll bOllds.
This pallerll rail be underslOot\ by breakillg excess retul'lls inlo Ihe two
l'tJllIJ)onenls on Ihl' right-hand side of l'qllalion (J().2':'): the yidd spread
(y", - ),1') bl'lWel'lI II-period and olle-period hOllds, and - (II - 1) times the
ch'lnge in yield CV,,--I.'+I - y",) on the II-period bond. Intnesl rates of all
lixl'd lIIatllrities rise during the sample pl'l'iod, as shown in the second row
ofTablc 10.2 and illllstrated 1()rol1('·monlh alld H'II-Yl'ar ralt's in Figure 105.
At the short end of the terlll structurc Ihis dkn is OnSl'l by Ihl' declinc in
1II'lllll'ity frolll II to 11- 1 as the bond is hdd lill' 01\(' 1\\""lh; thlls the r\tallW'

1"·1:II>It· IO.:,! i~ ,11Il'Xp'IIUIt'd "e.'lsioli ofa lahle.' shoWIl III <:;11111'1)('11 (I~)~I:-)), Tilt' IHll1Ih('r~
gin'lI h('Il' .1Il' ~Iighll)" dilh'J"('nt from tht' 11I1I1lj,('I"' ill liIal papt'l 1)1"( .111.... (· Iltt' ~"III"It· pt'liod
o.,,,'d ill Ih,lI P''1H"1" \,',is 1~):J1:1 10 19HO::l. _Ihhollgh it W;t~ (,llnllt'oll"'''" Iq)orlC'd 10 ht' I~I:)~: I 10
I\I\II::!.
'tlll Ill. h.v<i-I//((/II/I'Snllll./f.I

xr-----r-----r-----r-----r-----T-----~----~----._----,

l-lIumlhyit'''I

" ,

0'1

1~ II ill 1~170 I\)KO 11)\11) 1\)%

Figllre 10.5. Shill /- 1/1/11 1./lI/~-·li·'1I/ Il/lrwII Ul/lr,l 1952 III I'NI

ill yil'ld (Y,,-l.tt I - )I",), shoWII ill thl' third row of Tahk 10.2, is lIegal:vc for
short hOllds, cOlltribllting positively to tht'ir return.~u Al tht' long t'lIrl or th('
t('rlll structure, how('\'('r, the decline ill maturity fmm 11 to 1/ - I is negligible,
allel so Ih(' chang(, ill richl (.'1',,-1.11,1 - .v",) is POSiliv(', callsillg capilalloss('s 011
10llg zero-coli pOll bOllds which outweigh Iht' high!'r yields orkn'd hy these
hOllds, showlI ill Ihe l(lImh ro\\' ol"I;i1I!e 10.2,
The slalldard d('viatioll or ex('('ss retul'lls rises rapiclly with maturity. If
('X("('ss hOllcl r('IIII"IIS an' whitt' IlOis(', Ih('11 Ilw slallclarderroJ" of the sa!llple
!IIean is the stallclard (it-Vi;llioll diviclt'cI by the square roOl of the sample si/e
(-Hi!llIlOlIlhs). The sianclard ('ITOI' lill" 1/ =: 2 is ollly O,O~(}\" whereas the
st;\Ildanl enor (ill' 1/ "'" I:.!O is 1,71 'Xo. Thlls Iht' p;lIlcm or l\I('all retlll'llS is
illlpre<"isl'iy t'slilllal('(1 al long 1Il;\Ill1iti('s.
Till' slandard (\t-vi;lIitlil of ('x!"t'ss rl'llIrllS also delermines tll(' sizl' of'the
w('elge het\\'('('11 Ih(' olH'-p('I'iod allell/-period forms of Ih(' pure exp('natiol1s
hypOlll<'sis, 'I'll<' dilf('l'('II("(' l>et\\'('('11 IIl<'ali allllualizC'cll'xcess n'tuflls ullcler
(10,2,(,) alld (IO.:.!.7) is (111)' (1.000:\';:, lill" 1/ = 2. It is still olily 0.11 IX, IiII'

'.!\lhl\"('~It,. ~ \dlll ,t"'''' 10 pfohl" 11111 !IIi, 1t'llth'I)e'\' of hlln<l \'i,'I,l\ to I;IH ,,~ 1Il;lIlIril\' shrink,
an- ",~,i(\ 'n ht, "1 illin)!. "u' "it'l,' ('" \T."
W.2. I7Itnpretillg the 1erlll Structure oj Interest Uates 417

11 = 24. But it rises to 1.15% for 71 = 120. This calculation shows that

the differences between different forms of the PEH are small except for
very long-maturity zer<H:oupon bonds. Since these bonds have the most
imprecisely estil'1ated mean returns, the data reject all forms of the PEH
at the short end of the term structure, but reject no fonns of the PEH at
the long end of the terlll structure. In this sense the distinction between
different forms of the PEH is not critical for evaluating this hypothesis.
Most empirical research uses neither the one-period fonn of the PEH
(10.2.6), nor the n-period form (10.2.7), but a log form of the PEH that
equates the expected log returns on bonds of all maturities:

E[rn.t+l - YIt] = o. (10.2.8)

This model is halfway between equations (10.2.6) and (10.2.7) and can be
justified as an approximation to either of them when variance terms are
small. Alternatively, it can be derived directly as in McCulloch (1993).

IJIIlllimtiom oj the Log Pure Extleetations Hypothesis

Once the PEl! is formulated in logs, it is comparatively easy to state its
implications for longer-term bonds. The log PEH implies, first, that the
one-period log yield (which is the same as the one-period return on a one-
period bond) should equal the expected log holding return on a longer
II-period bond held for one period: .

(10.2.9)

Second, a long-term n-period log yield should equal the expected sumi of
71 sllccessive log yields on one-period bonds which are rolled over forl n
periods: :
n-1
Ynt = (l/n) LEt[YI.t+;]. {IO.2.1O)
i=O

Finally, the (11 - I )-period-ahead one-period log forward rate should equal
the expected one-period spot rate (n - I) periods ahead:

(10.2.11)

This implies that the log forward rate for a one-period investment to be
made at a particular date in the future should follow a martingale:

00.2.12)

[I' allY of equations (10.2.9), (10.2.10). and (l 0.2.11) hold for all n and I,
thell the other equations also hold for all n and I. Also, if any of these
 /0. FiX I't/- /lIO JII/ I' ,'i/f
lllil iI'S
C Illations hold for 1/
== 2 <Jl sol lie elate t,
the n the oth er equ ati
h )Id for n ::::: :1 <llld the on s als o
sal lie dal e I. No le how
ill C Ilo t gen era lly eve r tha t (10 .2. 9)- ( 1O.
equ iva len t for p;u ,tk ula ~.II)
r II and I.
A Il'matives to the l'l,re I~XI)
/'{t(t!iu/l.I I {ylmtltl·
T Ie exp ect ati ons hyp .lis
oth esi s (EH ) is mo re
it allows the exp ect ed gen el'a l tha n the PE
retlll'lIS 011 bo nd s or dif l I III tha t

.... C( IIst<llllS, wh
ich can de pe nd on ma
h11 we en exp ect ed ret
fer ent ma l1u itic s 10 clif
tur ity hll tllo t on tim e. fer by
Th e dif fer enc es

...•.
urn s 011 bo nd s or dif
Gil led lel1 l1jJ l'fm ia. Th fer enl ma tur ilie s arc
e PEI·I says tha t ter m sOJ lH'\ iJl) cS

.-...
~ays tha t the y arc con pre mi a arc "Lero, wh ile

-• sta nt thr ou! ;h tim e. 21 the Ell

for mu lat ed for on e-p I.ike the I'E H, the Ell
eri od sim ple relllJ'llS, ('all he
for log ret urn s. If bO for ll-p eri od sim ple ret
lld ret llrl ls arc log nol urn s, or
Sin gle ton (1990), the 'lll al an d hOllloskc!las
ll the se for mu lat iol ls ti(', as ill
arc COIl.~isLelJl with on
..-. beGlllSe the Jen sen 's
Ine qua lity eff ect s arc e an olh er

...:.a;.. pir ica J res ear ch typica

tha t ter m pre mi a mi gh

Hic ks (1946) an d Lu
lly con cen tra tes on the
b\r\X dis cus sio ns of the
tCl'm MruclUre ten ded
t vary ov er till le, con ccn
con sta nt ove r tillle. Re
log for m of the EI I.
ccl ltl' lII-

to ign ore the po~sih

tra tin g ins te,l d 011 the
ility
tz (1940) arg ued tha ir sig n.
wh ile hor row crs pre fcr t len der s pre fer sho rt
IOIlg- ma tur itie s, so tha ma tur itie s
hig her ave rag e ret urn t long- bo nd s sho uld
s tlrall sho rt hon ds. hav e
ar~\led tha t dif fer Mo dig lial li and Su tch
ent len der s and bor row (I !)(;(»
}/(lb ilal s, so tha t ter ers IlIi!{ht hav e dilTere
lll pre mi a mi gh t be nC! ll1 /JlrJi'nni
am hQ fS dis pu ted the {;ltiv(' as well as pos itiv
PE H hu t did 1I0t exp e. Al lth cse
rec ell t wo rk has use d lici tly que stio ll lite Ell
illt ert ell lpo ral ass et pri . Mo re
avc rdg e sig n an d the cin g the ory 10 der'ive
lim e-v ari atio n of ter m bo th tlte
Ch apt er II. pre llli a; we dis cus s tlti
s wo rk in

/0. 2,2 Yield Spreads allr

llnt l'l'l 'st Hate ForcrtL
lts
We now con sid er empir
ic;)1 evi del lce 011 the
Sil\ce the El tal low s CO exp ect ati on s hypothe~b (El l),
llstillll differences ill the
an d lon g-t erm bo nd s, it exp ect ed ret urn s 01\ sho
cloes /lot rcs tric t COllst< rt-
we dro p cOllstaJl\.~ fro lllt ter ms so for con ven
m all eql lal ion s in thi~ ien ce
So far we hav e sta led sec tio n.

..:....
the i/llplicati()/I.~ or the
for the levels of lIo mi exp en< ltio ns hyp oth esi
nal iJltere~t ra\('~. In s
ina l int ere st rat es see pos i-W orl d Wa r II US
m to fol low a hig hly per dat a, nO Ill-
clo se to IInity. so IIIl1ch siS len t pro ces s willi a
l~l\Ipirkal wo rk liSt roo t very
1e1.J'ls.~~ 'S yid l! sprCilds
iIlS\(',HI of yie ld
i
....: .
..•...
11·rhi~
,,,,'/:t' i., Ih,' l rOIll 1I I 11111' ill Ill!'
FoWl" amI Bli.~' (19117). lIlos lilt
hOl.ever, "'I' "1(''111
1i1'· I,II1 1U'. Failla (lm H). FoUll" (I~)~)I), ;Iud
t·Xf\·~\ rt·lurn~ pn'l lIi,, " 10 It''' 'r I"
nil louR-tenn hond!\., r .... li/l' d. rall lN l\)a ll"'
% '~S"r Cha pIN ' 2 alit!
!)I' ot'l l •
, 7 f"r a eli, e"" jo" 01 (I"il mOl.'.
Th,' 1'(''''';,</1'111"'' or Ih,· ,ho
/l-,,,,,,
JO.2. /1I/1'I/1l"l'Ii1l,( Ihl' '1'1'7111 :'i/l1lrlllrr '!f JIII"II'I/I!II1r'.1 11!1

Recall th;ll lhc yield spread hctW('('1I lhl' 1I-pniod yield alld Ih(~ OIlC-
period yidd is .1", == _~,,' - .~I" E<l'lalioll (1Il.1.li) illlplics Ih;1I

S", (~)E/[t[(:VI.III-YI/)+(I"'1
1/ i~1
1./1, YI.II')]]

(~) E, [t [(11- i)6)·\.II" -\- (1",1 I/H- )I.IH)]]' (10.2.1:'.)

The secolld equalily ill cquatioll ( I 0.2.1:~) replan's IIlltllipniod i IIten~st r,IIC
challges by Sillns of sillgle-period interest rate challges. Thc e«IIation says
Ihal the yield spread equals a weigh led average of ('Xp(~clcd 1IIIIII'e i\llen~SI
ratc changes, plus all IIllwcighled aver;lg(' of exp('('tcd IlIlure cxcess relurns
011 IOllg bonds. If changes in inlerest rales arc slaliollary (thaI is, if illlerest
rates thelllselves have onc ullit rool hilI 1101 IWO), and il excess relurns
are slationary (as wOllld be implied by any Illodel ill which risk aversion
and honds' risk characteristics are stationary), lhell the yield spread is also
static,nary. This means thaI yields of diffcrellt maturities are willll'gm/l'd. 23
The expectations hypothesis says that the s('('olld term on the right-
halld side of (10.2.13) is constanl. This has illq>ortalll implicalions fur the
relalioll between the yield spread alld lulure inl('I'esl.r;III'S. It Illeans that lhe
yield spread is (lip to a const,lIlt) the ol'tilllall()rn:ast(')' of the challge ill the
IOllg-bond yield over the life of the short hUlld, alld the optilllal f(H'CcaSler
of changes ill shOrl rates over the lil'c of the long hondo \tecilling that we
h,l\'(' dropped all nlllstallt terlllS, the rdaliolls alt'

(n~I)S"1 = i':lly,,-I,I+t-Yllrl. (10.2.14)

and
S", := E, [
L(I - i/Il)6,YI.t+i
"-1 ]
' (10.2.15)
I~t

Efjllalioll (10.2.14) can be obtained hy sllhstitutill!-: the ddillilion of r".'1- I,

(lO.!'!,,», illto (10.2.9) alld rearrangillg. It shows thaI whell the yield spread
is hi!-:h, the 10llg rate is expected to risl'. This is hecalls.. a high yield ~jlr('ad
gives Ihe IOllg hOlld a yield advalltage whirh IIIlIst he ollset hy an anticipatccl
Gtpital loss. Surh a capital loss call only COIllC ahout through all ill('f'ease
ill lhe long-bolld yield. Equatioll (10.2.1:1) lilllow~ dir(,ctly 110111 (10.2.1:\)
with constant expected excess returns. 1\ shows Ih;ll whell the yicld spread is

pro{"('ss i:-. clisfll.'ist'(\ 11I111u.'r ill <:h''1H('" 11.

:!\~l'c.' (:.IIuph<:ll awl Shitll'r (l!tH7) It)r a di.'i( tI'!'Iioll III (Oilllq!,l.tliclll ill llie h',lII .'itlll( HII('
of illll'n'.\1 ral('$,
 J tI. J'I,\t'(/'JII(OIlU' ~.'W( UlliU'."

'1I,b/.' 10,], 1I"gll'\\;1I1I I'II"/litint/l~ .. 1/11// Y. ,

1)"1"'11<1"111 1.1I11/!. hOlltlmlltlllity (II)

Llli.,I.1<- :1 Ii I:! :!·I ·IX 1:10

l.""g·Vll'ld
rilallg('s IHun ·0.11'. OX\'. --I..I:\'. -I..J.JX -~.~():! -·J.~:!(i
( 10.~.11i) I II. I ~ II ) (O.:!K:!) lli.·I·I:.!) 10.,.')!/) (1.00·1) ( I..,.H) (:!.1I71;)

SIUJlI'Llh'
d'~tI,g(':-, o.!"',o:! 1I.·lii7 II,:I:.!II II.:!?:! O,:IIi:1 II.·I·I:! I,·III:!
( 1Il.:.!,IH) (O.O!Jli) III.IIK) (O.I,lii) 10.~OH) (O.:!:.!:l) III.:IHI) (O.I·li)

I.ong hOllclm;1111I ili"';11 (' 1Il,';I;o..1II (,.I ill 111011111,. Tilt' first row r('port" thl' (':-.limait'd r('gressioll
(udliriC'llI ~" b tlllI (I o.'2.lfi), with .111 ;lWlllplolir stanci,li'd ('nor (ill I);U (")lhl':-'(''''') ctlt'tllatt'd 10
allow Ilu hCh'ro.,l..,ccl."tit'ily ill III(' malllH'!' dl',n ilwd ill the APpt'lIdi:<, TIle' S('cOJul row fCPOI f."
Iht" Iht' (':-.Iilllalt,d n'~n'.,:-,ioll codlit'i"llt VII 110m (IO.~.IH). with all .asymptotic M~lIldaJd ('ITOI'
cllrulah'c1 ill lilt" ;o..;lInc II1;UlIU' ... all(lwillj!, also for J ('siciual otlltO(,(HTt"i.uion, The c'xpc'('(;ltioll."i
I"'p"lh"si",",h,' \l'III\ '\1'"·111 ...· illll'li," (hal hOlh~ .. ami Y.. "hOllhl,·II,uloll'·. Th,' 1I1I<lI'rlyill);
tl.\la a'n- m01\\hly 1\'1u·nUlpon bond y't'ld:-. U\'l'1' \Iw pt'lind 1~':)':l:1 to \~".n :2, fnun MrCul10ch
aliI I ,,"WOll (I!I\I:I),

high. shOll Lllt·S .IIT ('''I)(,("ll'd to rise so Ihal Ihe average short raIl' over Ihe
lifi' of Ihl' long hond I'lJlIals IIII' initial long-hond yield. Nl'ar-ll'rlll increases
ill shorl rates an' given grl'aln weighl Ihan furlher-off illcreIS('s. because
Ihe), alli'n t hI' 1('\'1'1 of short rates dming a greall'r pan of Ihl' life of Ih-:: IOllg
hond,

l'idd S/,mllh 1/11// Fllturf I.ol)g UI/II"

Equation (I ().~.I·I). which sars Ihal high yield sprl'ads should forl'cast in-
1T1'a.~('.~ ill 10llg ralC.~. f;\rI's poorly in Ihl' dala, Macaulay (I!):~H) firsl nOled
Ihl' (;\fl Ihal high yield spreads ;Irtltally lelld 10 precede decreases in long
rail'S. Ill' \\'!"OII': "Thl' yidds of bonds of Ihe highesl grade should jflll during
a pniod in wllidl shOri-tlTlll rall's arl' highn than Ihe yields of Ihe honds
and ril" durillg a pniotl ill which shOIl-Ien\l rales arc lower. Now experience
is lllon' Iwarl), tIll' opposill''' (M;lclIII"y jl!):\H. p. :~:~I).
'Elhll' 10.:1 rl'pol Is ('stilllal('s of the cOl'fficil'nt fJ" and ils standard error
ill the regrl'ssioll

-"" \.1" - ."//.1 == O'lI"'~" ( .\",

---I
/1-
)+ € 11,1- (I(),2.Ui)

Thl' malurill' II \,;11 i(" h 11\\1 :1 IlIllIlllts 10 120 1110111 hs ( 10 years) .~'I According

:.' I Fur 111;11111 iii"" ,11,11\" II lit· \(',11 tilt, 1.1"1" Ihe., til(' approxilllation .",,,_1.'1 I =:::: ."'H,H I. Note
LU.~. 11I1t'ltJldlllg lite Ii-nil SllIulllle II} 11I1t'I"fJI Ualt'J 421

10 the expectations hypothesis, we should find f3n = 1. In fact altthe

estimates in Table 10.3 are negative; all are significantly less than one, and
sOllle arc significantly less than zero. When the long-short yield spread is
high the long yield tends to fall, amplifying the yield differential between
long and short bonds, rather than rising to offset the yield differential as
required by the expectations hypothesis.
The regression equation (I 0.2.1 G) contains the same information as a
regression of the excess one-period return on an n-period bond onto the
yield spread s",. Equation (10.2.5) relating excess relUrns to yields implies
Ihat Ihe excess-return regression would have a coefficient of (I - f3n). Thus
the IIcgatiw estimates of f3n in Table 10.3 correspond to a strong positive
relationship between yield spreads and excess returns on long bonds. This is
similar to the positive relationship between dividend yields and stock returns
disclIssed in Chapter 7.~~)
One difficulty with the regression (l 0.2.16) is that it is particularly sen-
sitive to measurement error in the long-term interest rate (see Stambaugh
[ I ~lHH]). Since the long rate appears both in the regressor with a positive
sign and in the dependent variable with a negative sign, measurement error
wOllld tend to produce the negative signs found in Table 10.3. Campbell
and Shiller (1991) point Ollt that this can be handled by using instrumen-
t;\1 variahles regression where the instruments are correlated with the yield
spread bllt not with the bond yield measurement error. They try a variety
of instruments and find that the negative regression coefficients are quite
rob\lst.

YiPld Spreads and Future Shorl Ralps

There is mllch more truth in proposition (10.2.15), that high yield spreads
should forecast long-term increases in short rates. This can be tested either
directly or indirectly. The direct approach is to form the ex post value of the
short-rate changes that appear 011 the right-hand side of (10.2.15) and to
regress this on the yield spread. We define

n-I
s;', - L(I - i/n)6.Yl.t+i. (10.2.17)
j~l

i
)
I
that this is lIot the same as approximatinf( p._I.I+1 by p•. 1+ I. The numbers given differ slighlly
from th"", ill Campbell (I!J!J!'J) because that I"per IIses the sample period 19!i1:1 to 19')0:2.
t'rrollt"ollsly r<,()()ned as 19:'2: I to I !J!JI :2.
~
iI
-"Calllpbell and Ammer (199:1). Fama and French (I9R9). and Keirn and Stambaugh (I9~6)
show that yit"ld spreads help to forecast eXces., returns on bonds as well as on other long-ttlnn

i
ass,·ts. (:;lInpb"1l and Shiller (I \191) alld Shiller. Campbell. and Schoenholtz (19R3"> show tllal
yield spH'ads tend lO forecast declines ill long·bond yields.
 10. FiXI'tl-/II('(IIIII' .vm,.itir,~

1"
~J1d rim the regression
J:', = J1." + y" .';", + fill' (IO,\!,IH)
tH
The expectations hypothesis implies that y" == I for all /I.
Table 10.3 reporlS estimated y" coemcienL~ with standard errors, cor-
recting for heteroskedasticity and overlap in the equation errors ill the man-
ner discussed in the Appendix. The estimated coef[jcienL~ have a U shape:
For small n they arc smaller th;11I one bllt significantly positivt'; lip to a
year or so they decline with 11, becoming insignificantly dilferent fl'Om zero;
beyond one year the coellicienlS increase and at ten years the coefficient
is even significantly greater than olle. Thus Table 10.3 shows that yield
spreads have forecasting power ror short-rate 1ll0vemenlS over a horiwn of
two or three months, anel again over horizolls of several ye'II's. Around one
yt';lr, however, yield-spread variation sn~l1Is almost lin related to suhseqllent
JIIovemenlS in short rates.
The regression equation (I O.:!.I H) cOlllaills Ihe same infill'lnalioll as a
regression of (1/11) times the excess II-period return Oil :III II-period hond
onto the yield spread s",. The relation hetween excess [etunls and yields
implies that the excess-relllrn regl'essiolJ would h;lve a coefficient of (I - y,,),
Table 10.3 implies that yield spreads forecast excess returns olltlO horizons
of several years, but the forecasting power diminishes towards ten years,
There arc several econometric difficulties with the direct approachjust
descrihed. First, one los('s II p('riods or dala at the (~IJ(I of the salllpk period,
This can be quite serious: For example, the len-year regression in 'Iitble
10.3 ends in 1981, whereas the three-mollth rq;ression ends in 1991. This
makes a substantial difference to the reslIllS, as discussed hy Camphell alld
Shiller (1991). Second, the error term {IO' is a movillg average of order
(n - 1), so standard errors must he conected in lhe mallller descrih(~d in
the App\:ndix, This can lead to IInite-sample problems when (II - I) is not
small relative to the sample size. Thinl, the regressor is serially correlated
ai'll correlated with lags of the dependellt variahle, and lhis too call ('allse
fil/ite-sample prohlems (see M,lIlkiw and Shapiro [1~8fiJ. Rkhanlsoll alld
St6ck [1990], ;lI\d Stambaugh 11!)H{ij).
i Although these econollletric prohklllS are imj)onallt, they do lIot seem
to laccount lor the U-shaped lJ<\tlern of coefliciellls. Campbell and Shiller
(1 ~191) find similar results \lsillg a vector alltoregressive (VAR) met hoe!ology
likf that described in Section 7,2,:l of Chapter 7, They rind Ihat the IOllg-
11'1\111 yicid spI'I'ad is higltiy ("lInci;Ited with all IIl1l'estrirt('d VAR (U'('Clsl of
1111'111"(' ,~hon-ral(' IIIOV(,III('lIts, while the illtenllediate-lenll yide! spread is
IIIltch IIlOre weakly correlated with the VAR f()I,(,Gls!.

t';Fallla (19H4) and 5l1il1<-r, Calli 1'1,..11 , and ScllO('lIh"hl. (l\IH:\) "'" Ihis approadl alllo",lo"n
("(1<, of Ihe (("rm ~lnl('Clln·. while Fall1;l anti Bliss (1 ~lH7) ('xtt'lld it lO Ih(' long ('lIti. (:;IIBphdl
;lll(, ShiUt'r (J!ml) pnwiclc .a ("(Jlll()rt'ht'IlSi\'(' U'\'it'w.
10.1. (;Olldll.\iO/l 4\13

To illlerprel ·r.lblc IO.:~, it is helpful \0 relurn to \·(lll.lIioll (I O.:!.I :~) and

rewrilc il as
( to.:!. I!))

"YH' - E,[<"I (-;;I) E, [.'!~(1/

..... - ;)6'\'1./1, ] .

and

.11", == (D [t E, (/,,11_1.11, - )'114 ,)].

III ~cllcrallhe yield spread is the SlIlIl oftlVo (,OlllpOIlCIIL~, olle Ihatlilrecasts
interesl r~lll' changes (.~y",) and Olll' thaI rorl'c~lsls cxcess 1'l'lllrllS Oll long
honds (.,r",). This means that the regrcssion ('()('flicicnl y" in ('cluation
(I O.:!.I H) is

COV('\·~f' .f",]
VH
Var[s"tJ
Var[.ry",] + COV[.I.~"I' .\r"ll
(IO.\1.:!O)
Var!"Y"ll + Var!.lr,,11 + :! CoV!-'.'~""II.. ,!·

For any givl'n variance of excess-rcturn filrecasls .\1,,,, as lhc variance

of in\erest rale !ill'CGISlS .\y", goes to ~.('ro the cocfJid('lll y .. gO\~S 10 ~,cro,
hUI as Ihe variallce of .IY,,1 increases the coeflicienl y" goes to onc. The U-
shaped pallel'll of regression cod'licicnL~ in -Lillie I o,:~ lIlay be explained hy
redu('cd forccastabililY of interesl ral(' movemcllts at \loril.ons around onc
ycar. There lIlay he somc short-run forecaslahilily 'lrising from Federal Re-
servc operaling procedures, <1l1cl some long-run forecastahililY arising from
husinl'ss-cycle effects on interest rates, hUI al a one-yeai' hori~.on Ihe Federal
Res('\ve lIlay slIlooth interest raIl'S so Ihatlhe vari<lhililY of ,IY,,1 is slllall. nal-
duai, lknola, and Foresi (1993), Rudehus('\l (199:,), and Roherds, Runkle,
and Whileillan (l!)!)(i) argue ror Ihis in\f'rprl'lalion or Ihe evicic-Ilcc. COIl-
sistl'lItwilh lhis c"planation, Mankiw alld Miron (1!)H(i) show Iha( Ihe pre-
dinilllls of the l:xpeClations hypothesis !il till' d,lla heller ill J>niods whell
illlCl'esl ratc Illovcments have been highly rorecaslahlc, slIch as Ihe perioc\
illllll<'C\ialdy Iwfi,re Ihe roullC\illg or Ihe Fednal I{cs('\'ve System.

10.3 Conclusion

Thc results ill Table I ().:~ illlply thatnaivc inveslOrs, whojlldge honc\s by their
yield., 10 lllatlll'ilY alld buy IOllg honds when Iheir yields al'l' rcl;llivdy high.
havl' Il'lldec\lo ('arn superior relurns ill III<' poslwar period ill Ih(' Iinill'd
 III. hxnl-IIIWI/II' .'''"1"11 ullr.\

Slal(·s. This findillg is n'llIillisc('nt of III<' filldillg disCIIss('d ill Chapt<T 7, Ihal
slock rclllnls IClld 10 Iw higher 11'111'11 dividelld ridds ar(' high al Ihe starr of
Ih(' holdillg pnio<l. As ill lhc slOck llIark!,t case, it is not clear whethl'r this
res It It r<'llens a billll<' of ratiollalily Oil the part ofinvcslors Of Ih(' presellce
ortinw-varyillg risk prelllia. Froot (1~IK!I) has IIsed slIrve)' dat,lto argue lhat
hOlld lIIarkct ill\'('slors h;l\'c irralional expectalions, hill lll<'rc is also llIuch
tlworetical work, dis(lIssn\ ill Ih(' lIext chapin, that explores the impact of
lime-varyillg risk on Ihe lerm struclure or illterest rates.
This chapter has cOllcenlrat('d onlhe fon'clslillg (lower ofyit'ld sprc;t(1s
for huure 1110\'('111<'111\ ill lIol\lill.d illl('l"('st rales. Yield spreads are ,iiso llsd\1I
ill forecasling olher \";II iahles. For ('xampk, onc ran decompose Ilolllillal
rat('s into ill{J;ltioll rail'S alld real illl<Test rates; lhe evidence is Ihal most of
Ihe long-run IOI('clsling )lower of Ihe lcrlll slmclure is fil!" illllation ralher
Ihall 1"\',11 ill!t'I"\'SI LIlt'S (S(T Llllla 11~17!\ 1!1901 and MishkinI19!Hl:J, 1~)90hJ),
We IIl<'lItiollCd ill Chapler H Ihal Ihc slop!' or Ihe lerlll slructllre has Stlllt!'
ahility to forecast ('X("('ss rctltrJIs Oil stocks as wdl as bonds, Olher r('celll
studies h\' (:111'11 (I ~l~ll h) ;tlld Estr('lla ,lIId llardonVl'lis (I !l!ll) haw shoWIl
Ihattlll' terlll ,trllClilrt' I'.n'ca'is rcal ecollomic activily, sillce illv(,rtl"C1 ~'iclcl
Cllrvl'S 1(,lId 10 prl'("('d(' rcccssiolls alld sl('eply lIpwanl-slopill!!; )'i('ld nUT('S
11'11(110 IlI'('('('d(' l"p,lIl,i. '11'.

Problems-Chapter 10

10.1 YOII an' lold Iilal all H-year lIolllillalll'rO-<"OllPOII hOlld has a lo~ yield
to maturilY of~),1 'Y... alld a ~)-\,<,ar nOlllillall('r<>-<"OIl)lOIl hOlld has a 10;; yield
of H,W!."
10,1.1 Call Ihl' plll"l' ('xpcctaliolls Iheory o/"th!' t(,!'I1l slructure d,'\crihl'
IllI's(' tlala?

10.1.2 ,\ )"(',Ir gO('S hI'. alld IiiI' hOllds ill !l;1rI (a) slill hal'(' IIi(' S;III1('
yil'lds to llIalllril\', Callthl' plll"l' expectaliolls theory o/"Ih(' It'rlll strllllllrc
dl'snii>e 1111's(' 11('", .Ltla~

IO.I.:l I lllw wlluld VilliI' allsw('rs dlang(' ifY(lIl \\1('1'1' told thai the h()uds
ha\'(' all H';;, COli pOll I;lle pn I'('ar. raliler thall zero COUpOIlS?

10,2 SUP)lOS(' th,ll lit" 1IIIlIH'(;UY aUlhorilY «lIIlro\s sl\orHcI"I\I illtl'J"('sl

ral('s hy sclling
\"11 _00 .\'1 I I -\- A\.\'.!I - )'11) + f"
with A > O. 1IIIIIili\('II'. IIII' 111011<'1,11'), alilhority Iries III S\llIlIllh interest
ral('s hili 1;lises 111<'111 \111<'11 Ihe ,i,'ld CIIII'(' is Sl('('p, SIIPpO~(, also Ihal Ih('
tl""-pl'riod hout! "it'ld ';l1i,li('\

I'll = 1.1'11 I F,I.I'IIIII)/~+xl'

I'roblrms 425:"
'
~
-:.-t\
where Xl is a term premium that represents the deviation of the two-period ;,'...:: i
yield from the log pure expectations hypothesis, equation (10.2.10). T h e ' '.'
variahle Xl follows an AR( I) process

Xl = r/lxI-l + TI/·
The error terms fl and '1/ are serially uncorrelated and uncorrelated with
each other.
10.2.1 Show that this model can be solved. for an in terest-rate proc~ of
the form ;
YI/ = YI.I-I + yXI + fl'

Express the coefficient y as a function of the other parameters in l the

lIIo(k!. i
10.2.2 The expectations hypothesis of the term structure is often te~ted
in the manner of equation (10.2.17) by regressing the scaled chanie in
the short rate onto the yield spread,

I
and tc~tillg thc hypothesis that the coeflicient f3 = 1. If the m6del
described above holds, what is the population value of the regression
coefficient fJ?

10.2.3 Now consider a version of the problem involving n-period bOllds.

The monetary authority scts short-term interest rates as .

•
and lhe n·period bond yield is determincd by

y.. 1 - YII = (n - l)EIlY ... ttl - y,l/) + x"

where XI now measures the deviation of the n-period yield from the log
pure expectations hypothesis (10.2.14). (This formulation ignores the
distinction between y.. 1 and y.. _I,I.) As before, XI follows an AR( 1) process.
What is the coefficient y in this case? What is the regression coefficient
fJ ill a regression of the form (l 0.2.16),
(y"./+I - Y.. ,) = ex + t3(y", - YI/)/(n - I) + U,+I ?
10.2.4 Do you find the model you have studied in this problem to be a
plausible explanation of empirical findings on the term structure? Why
or why not?
Note: This problem is based 011 McCallum (1994}.
 11
Term-Structure Models

Tills ClIAI'TER EXPLORES the large lIIo(\cm lilcrallllT Oil hIlly spn'ilie(\ gell-
eral-eCJuilihrium models of the term structure or illtercst rates. Much of
this litl'r,rture is set in continuous tillie, which simplilies sUllie of the theo-
retical analysis but complicates empirical implementation. Since we fucus
011 the econollletric testing of tire models ,\lui their I'lIIpirical implications,
W(' adopt a discrete-time approach; however we tak(~ care to relate all our

results to tlreir continuuus-time equiv'llents. We follow the literalllre by lirst

developing models lur real bonds, but we discllss in SOIlIC detail how these
lllodels Clll he IlsC'd to price nOlllinal honds.
All the lIlodels in this chapter start from the gt'neral assct pricing COII-
dilioll introduced as (8.1.3) in Chapter H: I = E,[ (l + ({,.II dM1+ I J. whcn~
R,.I+ I is the rcal relllrll on sOllle asset i and M,t I is the .I/(}cil(l.llir tiiJ({) 11II I }f,r-
lUI. A, we explaincd in Scction H.I or Chapter H, this cOlldition implics that

thc cxp~ctcd return on any asset is ncgatively related to its covariance with
thc s(()chastic discount factor. III models with utility-maximizing investors,
the stochastic discount factor measures tire margin,lllltility or investors. As-
scts whose returns covary positively with tht: slochastic disco\lnll~lctor lend
to payoff when marginal utilily is high-they deliver wealth at linles when
wealth is most valuable lO investors. Investors are willin).( to pay high prit-es
aIHI accept low ret lirns on such assets.
Fixcd-illcollle securities arc particularly easy to pritT lisill).( this rrallle-
work. When (<lsh Ilows are random, the stochastic properties or the cash
flows help to determine the covariallce or all assel 's return wilh Ihe stochas-
lie discoullt EI('lor. But a fixetl-im:omc security has delerminislic clsh flows,
so it (ovaries with the stochastic dis(olllll Ltctor ollly Iwcallse ther!' is timc-
~<lriati()11 ill discount ratcs. This variation ill dis('oullt r,lIe~ is drivcn by the
ti 1I1(~-scries be havior of the stochastic discolIll t betor, so te rlll-st rllclllrc lIIod-
cis arc equivalent to lime-series models fI)r the sto('\lastic discounl factor.
Frolll (10.1.4) in Chapter 10, we kllow that returns on II-period real
l.eI'O-COlipon bonds arc related to real bund prices in ;1 particlll<trly simple
 II. li'IIII-Slrudllll' ,\(/ltldl

way: (I + 11".1 t I) =:: I'" __ 1.11 1/ I '"I, Suhstitutillg- this illto (H.I.:~), we lind that
the r('al pri!"t' 01' all II-pniod r('al hOlld, {',i/, satisfies

( I I. 0.1 )

This "'1,,;11 iOIl kIlt Is itsr! rto;\ I t'cursivt, ;Ipproach. WI' model }'''I as a funCl ion
01' Ihose slale variahl,'s Ihat an' rd('valll fOl" fill"eCaslillg- Ihe A'i'+1 prtln:ss.
Civl'n that prtlct'Ss ~\nd till' fllllClitln rt'latin~ [',,-1.1 to state variables, \\'l' can
C\!culat<, Ih(' I'Ullctioll relalillg ['''I Itl stale variahles. We slart Ihe calndalioll
hy nllting Ihal 1\" = I.
Equalioll (II.D.I) (';111 also ht, solved forwartl 10 express Ihe II-period
hond price as Ihl' ('xl't'l'led prodllrt 01' II stochastic dis(,Olllll bclors:

( 11.0.2)

Althollgh w,' l'lIlphasilt' tilt' It'cursive approach, in some lIlodels it is more

ronvenit'llt to work dircctly witlt (Il.(),~).
Section 11.1 explores a class of simple models in which all releyant
variables are cOlldilioll.dly log-normal and log hUlld yields arc lillear in stal<'
variables, These II/Ii Itf-yiPlrllllodd.1 include all the Illost cOllllllonly used terlll-
sl 1'1I1'1ure IllOdds. Se('1 iOIl I I.!! shows how Ihesc 1I10dds ('all he fit to 110m i nal
interest r;\\(' <Ial.I, alld r<,\'iews Iheir slrenglhs ;\\ld weakncsst's. One ollht'
main USt'S or Il'I"m-slrllclurt· lJlo<lels is ill pricing interesl-ratt' clerivati\'(' st'-
curities; we discllss this applicllion in Section 11,:1. We show how standard
It'l'IlI-stnlt'lllrt' II10dds (';111 1)(' lIIo<iilied so lhat they lit the Cllrrcllt Icrlll
StntClllrt' exactly. \,,'e thell usc the llwdds \0 price I()rwards, futlll CS, and
opliollS Oil lixed-illcolllt' securilil's.

11,1 Affine-Yield Models

To kl'('p lIIall('rs simpie-, 1,'(' aSSllUll' Ihrougholll this st,rtion Ihat the dislri-
hution of the slocha,tic discoulll EKlor Mit I is contlilion;t1ly lognormal. We
sJll'dl)' IIlodel, ill which bond prices an' jointly lognorlllal \Vilh M I + J. We
call Ihcn take !o~s of (11.n.l) to ohlain

1',,1 = FIIIIIIIII/'" 1.1//1 i-(I/!!)Varllllllfl +I',,-I.ltll, (11.1.1)

",htTt· as lIsn.t! IOI,'t'lelse kll('rs tlt'llott' II\{' logs of t!\{' COlTl'spollding IIP-
Jlercase kilns so 101' t'xalllpk 1111\ I =' log-(Mlt I). This is Ihl' hasic eqllalioll
Wt' shall liSt'.
WI' hegin wilh I\\'o Inodds in which a singlt' statl' vari;lh!e fOI'I'C<ISls lhe
stochastic t1iSt'<1l1l1l btlo\. S('nion 11.1.1 discusses til<' first modd, in which
IIIlt I is IHllllmkl'<iaslic, wltil(' S('nioll 11.1.2 discllsses Ihe secolld 1II0ckl,
in whit-h Ihl' COII"iliollal I'ariallcl' of 111ft I challgl's over lime, Tht'st, arc
11.1. AfJilll'-Yil'ld Modl'ls

discrete-time versions of the well-known models of Vasicek (1977) and Cox,

Ingersoll, and Ross (1985a), respectively. Section 11.l.3 then considers a
more general model with two state variables, a discrete-time version of the
model of Longstaff and Schwartz (1992). All of these models have the
property that log bond prices, and hence log bond yields, are linear or
afftllf in the state variables. This ensures the desired joint lognormality of
bond prices with the stochastic discount factor. Section ILIA describes the
general properties of these affine-yield modfiJ, and discusses some alternative
modelling approaches. I

11.1.1 A llomoskrdaslic Singll'-Faclor Model

It is convenient to work with the negative of the log stochastic discollnt
factor, -11l1+1. Without loss of generality, this can be expressed as the sum
of its one-period-ahead conditional expectation x/ and an innovation tl+l:

-m,+I==Xt+tHI. (11.1.2)

We assume that f/+1 is normally distributed wilh constanl variance.

Next we assume that Xt+1 follows the simplest interesting time-series
process, a univariate AR( 1) process wilh mean J1. and persistence cpo The
shock to Xt+1 is written ~/+l:

(11'.1.3)

The innovations to 11l1+1 and XI+I may be correlated. To capture this, we

write Et+1 as
1'1+1 == fJ~1+1 + 1]1+1, (11j1.4)
where ~t+1 and 1]/+1 are normally distributed with constant variances and are
uncorrdated with each other.
The presence of the uncorrclated shock 1]/+1 only affects the average
level ofthe term structure and not its average slope or its time-series behavior.
To simplify notation, we accordingly drop it and assume that fl+l = j3~'+I'
Eqllation (11.1.2) can then be rewritten as

•
(11.1.5)

Tlw innovation ~I+I is now the only shock in the system; accordingly we can
write its variance simply as (}2 without causing confusion.
Eqllations (11.1.5) and (I!. 1.:\) imply that -m,+1 can be written as an
ARMA( 1,1) process since it is the slim of an AR( 1) process and white noise.

10111' di"frt·l<··tilll~ I'r~"t,"tation {(,llow" Singleton (I!J!IO), Sun (1992), and especially
1I.u·kll' (I \1\1:\). SlIn (1\1\12) t'xplor~s the r.. lation h .. tw.. en discrete·time and (onlinuom·tim ..
II1lHh·ls in more' detail.
 430 J J. 'Jinl/·S/mr/1II1'Mlld"LI'

In fact, -m'+1 has the same strllctllre as asset retllrns did ill the (·x.uIIJllc of
Chapter 7, Section 7.1.4. As in tl1<lt example, it is important to realize that
-1II,+t is not a univariate prot:ess evcn tholl!{h its conditional expectation X,
is IIni-.lariate. Thlls the IInivariolle alitocolTclatiolls of -111,+1 dn \lot tdllls
all we need to know l'or assct pricing; different sets of parameter values. with
dillcrent implications (tJl' asset pricing, cOlild he consislenl wilh Ih(' same
sct of univariatc alllocorrcialions (tll' - /11,+ I. For example, Ihese alilOcorr('-
lalions could all bc zcro heGllISe a 2 = 0, which would make illleresl rales
constalll, but thcy could also bc 1.cro lor a~ i- 0 if fJ takcs on a panirlli<u'
valuc, and in this case interest rates would vary over time.
Wc can dctcrmine the price of a one·period bond by notinf,( thaI whell
II = I, /1"-1.1+1 = /~).I+I = 0, so the terlllS involvin~ /1,,_1.1+1 ill eqllatioll
y (11.1 ..1) drop out. Substituting ( 11.15) and (11.1.3) into (11.1.1 ), we have

1 JII' = Ellllll+il+(1/2)Var,llll,+il = -X, +/32a 2/'2. (1I.I.li)

I
IThe one-period bond yield )'11 = -/'1" so
i
),1' = X, - /3 2 a 2 /'2. (11.1.7)

IThe short rate eqllals the state variahle less a constant tcrlll, so it inherils
thc AR( I) dynamics of the Slate variable. Indeed, wc can think of the short
\ rale as mcasllring the state of the ecollomy ill this modcl. Note that thnt:
'liS nothing in cquation (11.1.7) lhat rules out a negative short rate.
is Wc now guess thai the f01'1II of the price funclion for an It-period bond

-/1"1 = A"+B"x,, (II.I.H)

ISince thc n-period bond yield y", =
-11"ti II, we arc guessing thal the yield on
a bond of any maturity is linear or affine in the state variahle XI (Brown and
!Schacfcr [1991). We alrcad), know that bond prices for 11 = 0 and 11 = I
!satisfy cCJuation (11.1.8), with Au = Bo = 0, A, = -/32a~/'2, and III = I. We
Iprocccd to verify our gucss by showing Ihal il is consistent with Ihe pricing
'relation (1 I. 1.1). At the salll(, time we can derive recursive fornlllias (t)r Ihe
coellicients A" alld Il".
Our guess for Ihe price function (II.I.H) implies Ihal the two It'II\IS Oil
Ihe right·hand sidc of (11.1.1) arc

( 11.1.9)

Substituting (II.I.H) alld (11.1.9) illto (11.1.1), we gc~

A. + U"x,-x,-A"._,-II,,_dl-eJil/L-/J,,_,eJix,
+ (fl + /I/I-Jl~(T~ /'2 = O. (11.1.10)
11.1. AJIIIII~ l'id" Morldf

Thi, IIlIISI hold for allY x" so Ihe (,O('lfu'icllls Oil x, 11111,1 SIIIII 10 I.(~nl alld the
relll;lillillg coefficiellts IIIlISI also Sllill to /.(TO. This illiplics

II" 1+<1>11"-1 == (I </)")/(1 -</».

( II. 1.11 )

We ha\'(' now verilied Ihe g"ess (11. U\), sillce willi the codf'lcienL~ ill
(11.1.11) Ihe price functioll (II.I.H) satislies the asset pricing equation
(11.1.1) alld ils aSSllmptiol1 that hOlld rclul"lls arc cOllditiol\;tlly logllorm;tI.

IIIIIJlimtioll.1 oj thf I [omoshetill.llir Mudd

The hOllloskedastic bond pricing lIIodel has several interesting illlplicatiolls.
First, the cod'licient iJ" measures the bll ill the log price of an II-period
iJolid when there is an illCl'Case in the state variahle x, or e'luivillelltly ill
Ihe ()lIe-period illterest r<lte YI/. It therefore lIIeasures the sensitivity of the
"-period bond return to the one-period in terest r;i!e. Equation (II. 1.11)
sh,)ws that the coefficient Btl li)lIows a simple univariate linear difference
eqllation in II, with solution (I - rj>")/( 1 - <1». As II increases, /J" approaches
a limit /J = I/( 1- cp). Thus hond prices bl! whell shOlt rates rise, and till'
semitivity ofhond returns to short rates increases with maturity.
NOll.' that iJ tI is different from duration, ddined ill Sectioll 10.1.2 of
Chapter 10. Duration measures the sellSitivity of the II-period bond retulII
to the ll-period bond yield. and for zero-coupon honds duration nJuals
1Jl'ltlll'ity. iJ" lJleasures the scmitivity or the lI-peri()(1 bond retllJ'n to the
olJe-period interest rate; it is alwap less than matlirilY hera lise the II-!,('['iod
bond yield moves less than one-/i)r-olle with the one-period ilJterest rate.
A second implication of the model is tllat the expe('\('d log excess return
011 all II-period bond over a one-period bond. E, l r".ll-1 J -),1' = E/ [IJ"-I./~ll­
I'", + jll,. is given by
E,l /'".I-j-11 - }II -COV/l'·"./+I,III,j-IJ -V;II-,!r"./fI1/2

13,,_1 Co\', (x" I. II/Il I I- Ii;' 1\'.11, (x, H 1/2

(11.1.12)

The first equality in (11.1.12) is a general result, disl'lIssed ill Chapter H.

th,lt holds for the excess log return OIJ any asset over the riskfree interest
rate. It ran he obtained by taking' logs of tile fnlJdallll'ntal rdatioll I ==
E,l(1 + U,.,+IlM,+d for the 11-period hond and the short interest rate. and
then taking the difl'erence between Ihe two eqnations. It says that the ex-
pected excess log return is the sum of a risk premillm 1('1'111 and a./ensen's
Inequality t(,),111 in the own variance which appcars I)('callse we arc working
in I()~s.
 II, (n II/-Slnll 1111<' ,1,,,,11'1.\

TIll" "'(1111(1 I'qll;dill' ill (II,I,I:!) IIS(,S Ille /;11'1 Illal III(' 1lIlt'Xpe('(eci (0111-
POIII"III 011111' log 1('111111 Oil .III II-pnioci hOlld isjllsi -11,,_1 lilllt's Ih(' ill-
III "';11 i011 ill IIII' ,1;111' \,;lIi.lJ,I .. , Th .. Ihird "l(lIalily ill (I I.I.I~) IIS(,S IIII' LI(I
I h;11 IIII' (olld i I iOIl;i\ 1;1 I i;IIII'" "I ,I, I I a lid i Is ('olldi liolla I cOI'alia 11('(' lI'i III III, \ I
;11 (' (Ollsl;lIlts 10 ,hOI,' 111.11 11ll' ("p(Tled IOf!; ('xcess n'llIl'II Oil ;\111' bOlld is
cOlIsl;tll1 ol'n liltl(', so Ih.IIIIll' log ('\p,'dalions h\'pollll'sis-blllllOllh(' IOf{
p"l'e e\l)('cl;\liO\lS l"pOll!l'sis-holds,
- II" I i, lht, t'lH'IIil'i"1l1 1'1'0111 .I j'('gr('ssioll of 1I-1)(,liod 10f{ hOlld ITIIIIIIS
IlII ,1;111' \';lli;lhll' illllo";llillIlS, 'I' I\'(' "all illl('rplt'l -1/" I as Iltt' hOlld's 111;1(1-
illg Oil IIII' sillgle '0111('1' oil is!.. alld lin'! as IliC r(,ward Ii,r i>e;lrillg a IIlIil of
ris!... ,\111'1'1 lal i\'('h', ronll"'illg \';Isin').. (1!177) alld Ollll'lS, 11'(' Illiglll (';IIclllal<'
Ill(' pri .. e orli,k as Ill<' r;lIio 01'1111' ('\p('('«('d ('xcess log 1'('1 Ill'll Oil a hlllld, pillS
OIl!' h;df its IIII'll 1·;lriall .... III adjtlsi /ilr ./(,IIS(,II 's 11I(,«lIalil\', 10 Ihe sialldanl
d(,l'ialioll of 1111" "XI ",s log 1'<'1111'11 1111 ill(' hOlld, IlI-/ill('d Ihis lI'a)" Iht' prin'
0/ risk isjltsl ,fin i II I h is IIwcI .. 1.
The hottlmkedaslit' hond pricing IIICHIc! ;1!sO has illlplir;lliolis for lilt,
pall<'t'li of /ill'\\';11'11 I';II"S, ;Ind 111'11\ ... lor IIII' shapl' of Ih(' l'ic'lt! 1'111'1'(,. 'Ii)
,It-ril',, lllt'sl' illiplit'aliolls, ,,',' 110'" IIt;11 ill all)' 1(,I'II1-slJ'tlClIll'e IIlodl'l Ih,' 11-

IH'riod';IIll';ltI 101 11,11 d I al(' /'" s;lIisli,'s

/'" /'", /'" , I.'

\'11 + (1-:'/,." I I., I I I - \'1') - (I,:, [/1".1 f I [ - /1",). ( I I. I. 1:1)

III Ihis Illodel F,I /1".'1 I 1..- /1", = - 1/" 1-:, [ t,..I', ~I I. alld 1-:, r""'11.'1 I 1- .1'1' is gin'lI
hI' (II.I.I~), SlIhslilitlittg illio (11.1.1:1) alld IIsillg II" = (I - CP")/( I - CP),
\l'C gCI

/'"
/1 -, [/il (.!.. - (f>")]~ n~ + CP"l.\', -
I - l' :!
/1)

( If" 1
/1"
[ ---I -;- + [(I', -
)~n~] /1) + ('+fin-4») ., n- "J cP /I

- (i' .! (' - CP)-

(11.1.11)

Tllt'lilSl ,'cl'l;tlill ill (11,1,11) sltol\" ilI;1I lilt' challg" illil ... II-p('riod ((,rwanl
1';11,' i~ (/." lillit's IIii' 1'1t;lIlgi' ill ,\, Till" 11I00'CII1<'lIls ill lite I"r\\'anl 1';11,' <ii,'
0111 g('olll<'lril';tlh ;11 1';111' </•. Tllis ,;lIl 1)(' lIlldcrsloot\ I." Ilolillg Ih,ll lit"
log "\llI'(,(;llillll' Illpolltl'sis Itolds itlillis IlIodd,.so lil .. wanl-ral\' 1ll0\','11II'\lls
n'Ih-, I 11III\"'IIIt'III.' ill lilt' ("1)(,(,(,'<1 IUIII('(' short ral,' w\tidl ;1('(' givt'tI Il\' </>"
lilllt',~ IIIOI·(,IIt<'1I1.s ill lit .. 1'1I1T"lll s\torl LII",
11.1. AJjilLe-rield Mudels

As malllrity n incre,l~es, the forward rate approaches

a constant that does not depend on the current value or the state variable X,.
Equation (1 Ll.7-) implies that the average short rate is J1 - fj 2a 2 /2. Thus
the difTerellce between the limiting fonvard rate and the average short ~ate
is I

-(1/(1 - if;))2a 2/2 - (,8/(1 - if;))a 2.

This is the same as the limiting expected log excess return on a long-t~nn
bond. Because of the Jensen's Inequality effect, the log forward-rate curve
tends to slope downwards towards its limit unless fj is sufficienuy negative,
fJ < -1/2(1 -I/J). •
A~ XI varies, the forward-rate curve may take on different shapes. The
seconct equality in (11.1.14) shows that the forward-rate curve can be written
as the sum of a component that does not vary with n, a component that dies
out with n at rate if;, and a component that dies out with n at rate if;2. The
third component has a constant coefficient with a negative sign; thus there
is always a steeply rising component of the forward-rate curve. The second
component has a coefficient that varies with x" so this component may
be slowly rising, slowly falling, or flat. Hence the forward-rate curve may be
rising throughout, falling throughout (inverted), or may be rising at first and
then falling (hump-shaped) if the third component initially dominates and
then is dominated by the second component further out along the curve.
These are the most common shapes for nominal fonvard-rate curves. Thus,
if one is willing to apply the model to nominal interest rates, disregarding
the fact that it allows interest rates to go negative, one can fit most observed
nominal term structures. However the model cannot generate a forward-
rate curve which is falling at first and then rising (inverted hump-shaped), as
occasionally seen in the data.
It is worth noting that when if; :::: I, the one-period interest rate follows
a random walk. In this case the coefficients An and Bn never converge as n
increases. We have Bn :::: n and An - An-I :::: -(fj + n - 1)2a 2 /2. The
forward rate becomes Inl = XI - (fJ + n)2a 2/2, which may increase with
matllrity at first if fJ is negative but eventually decreases with maturity forever.
Thlls the homoskedastic bond pricing model does not aIlow the limiting
forward rate to be both finite and time-varying; either if; < I, in which case
the liJlliting forward rate is constant over time, or I/J = I, in which case
there is liD finite limiting forward ratc. This restriction may seem rather
countcriIltllitivc; in fact it follows from the very general result-derived
by Dybvig, IngersoIl, and Ross (1996)-that the limiting fonvard rate, if it
exists, ran lIever fall. In the hO!l1oskcdastic model with if; < I the limiting
forward rate never falls because it is COllstallt; in the homoskedastic model
with tP :::: I the limiting forward rate does not cxist.
434 11. 1er1ll-S/ruflur" Mot/I'l{

Thc discrctc-timc model developed in this scction is closely relaled 10

the continilolls-tillle model of Vasicek (1977). Vasicek specifies a continll-
olls-timc AR( I) or Ornstcin-Uhlcnhcck proccss for thc short inteJ"('sl rate r.
givcn by the following stochastic differential eqnation:
y Ilr = K(IJ-r)d/+adlJ.
I
~here K, 0, and a arc constants,~ Also, Vasicck assumes that the /)/1(1' of
In/errst m/e rish--the ratio of thc cxpectcd excess return on a bond to the
standard deviatioll of the excess return on the honcl-is a constant that docs
\lot depend on the Icvel of the short interest rate, The model of this section
~Ierives an AR( I) proccss for the short ratc and a constant price of risk from
,)rimitive assumptions on the stochastic discount factor.

~::qui[jbrjum Interpretation oj the Mot/el

G)ur analysis has shown that the sign of the coefficient f3 determines the

~
. gn of a\l bond risk premia. To understand this, cOllsider the effects of
. positive shock ~'+I which increases the state variable X,+I and lowers all
I ond prices. When f3 is positive the shock also drives down 1111-11. so I>ond
turns are positively correlatcd with the stochastic discount factor. This
orrclation has hedge vallie, so risk premia on bonds arc negative. When fJ
i~ negative, on the other hand, bond retllrns arc negatively correlated with
the stochastic discount factor, and risk premia arc positive.
We can gct Illore intuition by considering the case where the stochastic
discount factor reflects the power utility fllllctioll of a represelltative agent.
asinChapter8.lllthiscaseMt+1 = li(CI+J/C,)-Y.whereliisthediscollllt
factor and y is the risk-aversioll coefficient or the representative agenJ. Tak-
ing logs, we have
(11.1.\(i)

It follows that X, :E E,[-m,+il = -log(c5) + yEI[tH,+tl, and (HI ==

-mt+1 - E,[-ml+tl =
y(tH,+1 - E, [L':>.(I+ I J). X, is a linear fUllclioll of
expected consumption growth, aud E/+I is proportional to the innovation
in consumption growth. The terlll-structure model of this senioJl then
implies that expected consumption growth is an AR( 1) process. so that
realized consumption growth is an ARMA( 1,1 i process. The ('odlirielll
~ governs the covariance hetween consumption innov<ltions and revisions
ill expected future cOllsumption growth. If fJ is positive. then a positive
cOlISulllption shock today drives lip expected future consulIlplioll growth
and increases illlerest r<ltes; the resulting fall ill bond prices makes honds
covary Jlegatively with consumptioJl and gives them negative risk prcmia. If

'lA... in Chapter 9. dB in (11. L' :) dt'HOh";-; till' hlt"rctlWllt to;,l nrnwnlan 11lt)tlo11~ it ~hn\lh'
11111 h" (Ullr",,,<I wilh 11ll' hUIIllp,i"" "udti"i"Il\.' II" ullhis ,,'Clioll.
11.1. AJJi1/e-YiddMode~ 435

Ii is negative. a positive shock to COIISUllIptioll lowns illtncst rates so honds

have positive risk premia.
Campbell (19HG) explores the relatioll betweell boml risk premia and
the time-series properties of COIISlllllptioll ill a related model. Camphell's
model is similar to the one here ill that cOllslImptioll .lIld <lsset returns arc
cOllditiollally lognormal and hOlJloskedaslic. It is 1ll01T reslfictive titan the
model here hecause it makes consllmptioll growth (r<lther than expected
consumption growth) a univariate slOchaslic process, hUI it is 1II0re gelleral
ill thaI it docs lIot rcquirc expected cOllslImption growth to follow an AR( I)
process. Camphell shows that the sign or tlte risk prelllilllll for all II-period
hond depellds Oil whether a conslllllptioll inllovatioll raises or lowers COIl-
sllmption growth expected over (" - I) periods. n'ld.IIS ,\1111 Zill (I ~194)
explore this model ill greater detail. Uacklls. (;regoJ)', alld Zin (I ~IH~I) also
relate hUlld risk premia to thc timc-snies properties ofcollsllmption growth
and intercst rates.
Cox, Ingersoll, and Ross (19H:)a) show how to derive a continuous-
t;mc term-structure Illodcllikc the one ill this sectioll from an underlying
productioll model. SlIn (1992) and Backus (1!l!l:1) restatc thcir results in
discrcte tilllt'. A~slll1\c that therc is a represelltative agcllt with discollnt
factor I) alld time-separable log utility. Suppose tlt,lIthe agellt !'accs a hUdget
cOllstrailll of tlte fimll

(11.1.17)

whae K, i~ capital at the start of the pniod, (1\, -- (;,) is invested capital,
and X, V,+I is the return on capital. Thi~ budget C<Hlslr'lint has constant
relurns to scale hecause the return on capital does not depcnd Oil the level
of capital. X, is the anticipated component of the relllrn and Vt+t is an
unallticipated technoloh'Y shock. With log utility it is well-known that the
agent chooscs C,; 1\, = (I - .5). Suhstituting this illto (11.1.17) and taking
logs we find that
( II.I.lH)

wherev,+1 == log(V,+I)..\lld-1II1\1 = -Iog(o)-!-(',(I\I x,-l-(HI.This

derivation allows x, to follow any process, including the AR( I) assllllled hy
thl' tcrill-structure 1II0dei.

11.1.2 A Sqllflrl'-/{oo/ Sillgl,'-hlr/"I' MildI'!

The hOllloskedas(ic model uf tlte previous sectioll is appealing becallse of'

iL~ simplicity. but it has sevcral IIlIattrarti\'e features. First, it assullles that
interest rate changes have cOllstant variance. Secolld, Ihe model allows in-
terest rates to go negative. This lIIakes it applicahle to real interest rates. hut
less appropriate for nominal interest ratt's. Third, it implies that risk premia
 II. '/i'r/I/-Sll"llrlwl' Alorlfll

are COllstalll Ol'("f lillI!", cOlllrary 10 Iht' evidellce presented in Section 10.2.1
of ChapIn 10. ()Ile CUI alter Ihe llIodel (0 handle these prohlems, while
rel;linin~ 11111<"11 of Ill<' silliplicily of lht' hasic Slrllf\lIre, h)' allowill~ the slale
l'ariaIJh·.\', 10 1()IIol\' a (ondilionally IO~I\Orlllallllll hel('\'Os\:.cdaslir .H{lIIlH'-mo/
process. Tl1is (11;lng(' is (,lIlird), cOllsislenl Wilh III(' t'quilihriullI foundalions
I(Hlll(' modd gi\'('n ill Ill!" prcviolls scclion.
Tht' sqllan'-root IIIO(h-I, whid! is a disITetl,-tinll' version or tlil' blllOllS
Cox, IIIf,!;crsoll, alld Hoss (I ~)H!'Ja) contilluouS-lilllc lIIodel, replan's (II. ! .:-»)
alld (11.1.:\) willi

-. 111,,1 (11.1.1 ~J)

(II.I.~O)

Thc new clelllellt herc is lhal lhc shock ~'+I is lIlultiplied hy x,t/~. To
IIll<lcrsl;lllIlthl' iniportalll'l' or this, n'ralllhal ill the hOlllos\:.l'daSlic lIHHkl
XH I and /11'1, arc Ilormal condilimlal on Xl ror all i ::: I. This nealls \11;1\
onc can anal}'/(' lit!' Itolnoskecbslic nlOdell'ilhcr hy lakin~ lof,?;s of (11.0.1)
to f,?;t'l tht' rt'l'\lrsi\'c' c'llllatioll (11.1.1). or hy takillg logs of (11.0.2) 10 get ;1/1
II·period IOf,!;lill(,;lr equ;ttion:

/'", == E,IIII"I' ·'·'lll""I+(I/~)Var.l/lllll+···+IIII1·"J. (II.I.:!I)

Calculations h:ls('(1 11I1 (11.1.21) ;\H' IHOIT t'llIlIhcrsOllll' thall lhl' <lilah-sis
p)'('senled in lht' pn'\'iolls section, hUl they f,?;ive lhe sallie rl'sllil. In Ihe
SCjIl;lrt'-root JlIodel, hI' conlrasl, X,tt and 11/'+1 are norlllal condilioll;d Oil
x, hilt x" .• alld 1/1'1' an' nOllllorlilalcollditional on x, for all i > I. ',his
IIIt';IIIS that 011(' can 0111, allalyl.t' lit(' s'lllar('-roollllodelusill)!; III(' rt'('llrsi\~
t'cl'lalion (11.1.1); IIII' lI-pl'l'ioel Illglilll'ar relatioll (11.1.21) docs not holel
ill the s<)llart'-root lIIodel.
Procl'cding wilh Ihe rccursiw analysis as he/iJre, we call delermine the
prict' of a olle-pt'l'iod bond hy suhstiluling ( 11.1.1 !) illlO (11.1.1) 10 g('l

(11.1.~2)

The olH'-pnio<l hOlld yit,ld 1'1, = - hI is 1I0W proportional 10 the Sl,tle

varial>le x,. ()lIn' ,Igaill Ihe shOll rail' nlt',lsUrt·S Ihl' SIal!' or Ihc CCOIiOlln' ill
the IIl1ldd.
Si 11(,1' Ilit' sh or! 1<1 lI' is prllport iOIl:tl \(l Ihe stall' vari;lhle, i I in heri IS the
property Ihal its cOlldilional v;lrianc!' is proportional 10 its lew!. Many
,\lIt hoI'S have lillII'd Ihat illtl'l'l'st I<llc volalility tends to II(' hif,!;hn wli('n
illleresl raIl'S art' high; ill Sectioll 11.~.2 we discuss the elllpiricall'vidt'llce
on lhis point. This property ;also make's il hard IiII' Ihe inll'rl'sl raIl' 10 go
nl')!;ati\'l', sillce Ihl' IIl'warel drifl ill lilt' stall' variable lcnds 10 dOlllillale Ihe
randolll shorks as x, d<'dill(,s 100~anls ll·lO. Cox, I ngt'rsoll , ;1I1l1 Ross (1!IW)a)
11.1. Ajjine-YieldMoaels

show that negative interest rates are ruled out ill the cOlltinuous-time version:
of this model, where the instantaneous interest rate follows the process
elr == K((J - r)dt+crr l / 2 dlfl Tilllc-variation in voIatiIityalso produces time-
variation in term premia, so that the log expectations hypothesis no longer
holds ill this model.
,.n
We now guess that the price fUJlClion for all II-period bond has the same
linear form as before, - POll = A" + fIll X" equation (11.1.8). In this model
Au == l~, ;::: 0, AI == 0, and BI == 1 - fJ 2 a 2 /2. It is straightforwarclto
verify the guess and to show that All and BII obey

,
l

Comparing (11.1.23) with (11.1.11), we see that the term in (J2 has been
mowd from the equation describing An La tbe equation describing Bn. this
is because the v;riance is now proportional to the Slate variable, so it affects
the slope coefficient rather than the illtercept coefficient for the bond price.
TIl(' lilllitin~ value of B", which we write as B, is now the solution to a
CJuadratic equation, bllt for realistic parameter values this solution is c1.se
to the limit 1/(1 - </» from the previous model. Thus BII is positive and
increasing in n.
The expected excess log bond return in the square-root model is given
by

Etlr".,+il- YII == -Covl[r".I+I. mt+d -Var,[Tn .,+d/2

B,,_I COV,[X1+I. mt+d - R!_I Var.[x/+I1/2
(11.1.24 )

Thc first two equalities here are the same as in the previous model. The
third equality is the formula from the previolls model, (11.1.12), multiplied
hy the state variable XI' ThllS the expected log excess return is proportional
to tlw state variable X, or, equivalently, to the short interest rate YI/. This is
the expected result since the conditional variance of interest rates is pro-
portional to XI' Once again the sign of f3 determines the sign of the risk
premium term in (J 1.1.24). Since the standard deviation of excess bond
returns is proportional to the square root of XI> the price of interest rate
risk-the ratio of the expected excess log return on a bond, plus one half its
own variance to acljust for Jensen's IneC]uality, to the standard de\iation of

:Itkpending on the par-.unett'rvailles. it lIlay be possible forthe interest rate \0 be zero in the
"omin\\\""-tin\t' ""l<Itot. l~lIIgstalf (1992) <li",",-,,'s alternative WdYS to model thi. po~ibility.
}'
438 11. 'limn-Structure Mot/ell

,the excess log return 011 the bond-is also proportional to the square root
lof x,.
I The forward rate in the square-root lIlodel is given by

/." = YI, + B,,(E,(t.X'+I) - COV/(X/+I. 111/+1 J) - n~Var/[x'l-ll/2

== (l-/Fa 2 /2)x,-IJ,,(I-1>)(x,-tl)+x,{ja 2 )
( 11.1.2!i)

"he first equality in (11.1.25) is the sallie as in the hOllloskedastic lIIodel.

vhile the second equality lIIultiplies variance terms by X, where appropri-
\le. It can be shown that the square-root model permits the sallie range of

l
hares for the yield curve-upward-sloping, inverted, alld humped-as thl'
IOmoskedastic model.
. Pearson and SUIl (1994) have shown that the square-root model can I}(:
generalized to allow the variance of the state variable to be linear in the level
of the state variable, rather than proportional to it. One simply replaces the
x,1/2 terms, multiplying the shocks in (11.1.19) and (11.1.20) with terms of
the form (ao + al x,) 1/2. The resulting model is tractable because it relllaillS
in the affine-yield class, and it nests both the homoskedastic model (the
case ao == I, al == 0) and the basic square-root model (the case a" = 0,
al :::: I).

11.1.3A 11u()-Fac/orMotiel

So far we have only considered single-factor models. Such models illlply

lhat all bond returns are perfectly correlated. While bond returns do tend
to be highly correlated, their correlations are certainly not one and so it is
natural 10 ask how this implication can be avoided.
We now present a simple model in which there are two factors rather
than one, so lhal bond returns are no longer perfectly correlated." The
model is a discrete-lime version of the model of Longstall and Schwartz
(1992). It replaces (11.1.19) with

(11.1.2G)

and replaces (11.1.20) wilh a pair of equations for the st,\te varia hies:
I/~
Xu+ 1 (1-1>1)/11 +1>l x l,+X" ~I.t+" ( 11.1(27)

xv+, (I - 1>~)IL~ + 1/1'2 X~I + '>:'21/2

1 ~2.H-I. (11.1.'2H)

~AhhulIKh hond relllfllS are "," I'<'r I<-r II)' rorrd;ol"d ill Ihis IIlt)(I"I, III<" fovari,,"n' ",ald.
(,rhuncl rt'l1lfn~ h.u rtf.llk tW() alull11'11f(' i~ sillglllar WIIC."IIl'V('r W(' (,hsl"lv(' m(,n'lllilil Iwe, IUJllcls.
,.
We disc,,'" Ihi. poilll rllrlll<"l' ill Senioll 11.1.·1.
/ /. 1. Afji Ilr- Yirlel M Oelfts 439

Finally, Ille rdalion IWlw~~el\ the shod.s is

ftll == fl~I.III' (11.1.29)

alld Ihe shocks ~I.I+I al1(l ~V+I an' uncoITt'iale<i wilh c;lch olher. We will
I'Til<' (J ~ «1I' Ihe varia lice or ~I.I+ I alld rr} "'I' Ihe val iall"" or t;v I I.
III Ihis IllOdd, minus Ihe lo~ slochaslic discouill (';IC\or is (c,n'casl hy lwo
Sl'lle vari'lhles, XII and X~/' The variallcc o('the illllovatiolJ to the lo~ slochas-
li(' discollllt faClor is proportional 10 Ihe level of XII, as ill Ihe square-rool
modd; all(1 each or lhe lwo slale variahlcs follows a square-rool aUlore-
gressive pron'ss. Filially, Ihe lo~ slochaslic discoullt Ltdor is cOlldiliollally
corrdaled with XI hut not wilh x~. This lasl assumplioll is required 10 kcep
Ihl' nlO(\<'I in Ill(' Irarlahlc afline-yid<I dass. Noll' lhallhc Iwo-farlor IllOdd
Iwsls Ihe sillglc-bclOr squarc-rool lJIodel, whit'h GUI he ohlaillc(\ hy sellill~
X~I = 0, hUl docs not ncst lhe single-(;\Uor hOllloskedaslic l1Iodd.
Prm:eedillg illlhe usual way. we filld Ihal Ihe price ora oIH'-pniod hond
I~

The ollc-period bOlld yield YII == -Jill is 110 IOllg('\' proportional 10 lltc
slalC variable XII, bccause it depellds also OIJ X~/' The shorl ilileresl rale
is 110 1()Il~cr sufficienl to IIIcasure lhe slale or Ihe ('COIlOIll), ill Ihis model.
l.ongsla{f alld Schwartz (l992) poillt olll, however, Ihal lhe condiliollal
variancl' or Ihl' ,hort raIl' is a di ffl'l'e II \ linear function of Ihe Iwo SI<I\('
variabks:

(11.1.:11 )

Thus Ihe s!lort raIl' and its condilional volalilily slIlIlllIarize lhe slale or lhe
economy, <lnel one can always state Ihe IIImlcl in terllls or lhese lWO varia hies.
We guess Ihat the price funclion for all II-pl'l'iod hond is lincar in Ihe
IhO Slate variahles: -11"1 = A" + 8 1" XII + J~2u X~/' V.'e already kllow lhal
Ao = 11'0 = Hlo = O,AI = 0,1111 = l-rr,'l/'2,andnll = I,lti.~
slrai~hll<)rwarel 10 show lhal A'l> /JIll> alld H2u ohey

(11. U~?)
 J I, Irllll-,\Innlllll' .II{)(/,'I,I'

Th(' dilf('f('lIc(' ('/(II.lIioll lill" III" is Ih(' saJlle as in Ihe singlc-hlclol" square-
rool Jllod('l, (II,I,~:\), hUI 11t(' dilf('I'('II('(' equation I(lr H!" includes only a
\('rlll ill Ihe own v;lri;II\(,(, of x~ I)('caus(' X~ is IIIlCOIT('\atecI wilh 111 anel clc)('s
1101 alf('cl 11)(' v;II'i;IIH,(, of III, Thc dilkrcllcc ('qllatioll ((II' A" isjllslthe Stlill
of IWo lenllS, each of which has Ih(' bmiliar I(ll'lll from lite sillglc-bclor
sqllare-fOOI II10de!,
The exp,'('I('d (')\('"SS log hOlld r('llim ill Ihe Iwo-I;telor IIwdcl is gil'ell
Ill'

Ed ".. ", II - ,\'1' -- (:0",11'"", I, 1II1t" I - V'lI',1 1'",1+1 I/~

II\." I <:OI',hUII, 1I/1t11 - /t~,"_1 Vard,"1.1+11/2

- n~"1 V;lr'!~·!.Ild/'!.
! -HI." Ifln~ - U~,"_'la~ /'!.JXI/
I n.;_.11
( I 1.1.:1:1)

This is III<' S'III1" ;1\ ill III<' s'l";lr(,-lOol Ili0dd, wilh Ihe addilioll of .11' exlla
1('\'111, arisillg I'rolll.lI'IISI'II\ i\lI'')II;IIil)', illihe varian\'(' of X~,ltl'
'1'11(' r"I"'OInl r;II(' ill III<' 111'0-1'01<'101 III"dd is givell hy

/;" .\'1, ~, /II" (E,! 1\ 1"1.11 I I - <:01'1\"'1.1 I I, 111/\ I Il + H!" Ed LI. X~,lf-I I
- Ii;" \'OIr,1 1"1,/1 II/~ - Iii" \'arl\x~,It_ll/2
(1-/1~(J~/'2)I"I'+.\'~'- 1I1,,(l-c/>I)(XIt-III)

-- /i~" (I -, tjl~) ( ,\-~ I -- II ~) - /II" ,\'1/ fJ (1 ~

(11.1.:\,1 )

This is III<' oill'iOll' g(,lIer;IIil.;lIioll of Ihe square-rool Jllodel. IlIlponalltl~',

il ran gelll'LII(' 1\\01'1' (,(lIlIplicl\('d shapcs for 11\1' yield rllr\,l', illcllldillg
illl'l'I'lt'd hllilip sllapl", ;IS III<' illdqH'llIlclll 1II01'1'II\elliS of hOlh XI, aile! -"2,
.IIkCI Ihe 11'1'111 slrllclllrl',
Tire all;t1ysis of Ilris III"dd iIlIlSII;II('s all illlportanl prillciplt-, I\s Cox,
!lIgI'lsoll, alld Ross (I~IW>;,) alld Dybvig (19K~)) haw ('lllphasi'l.I't\, un(\1'1
,'('naill .. i),"'"I1SIOI""('S 0111' (';Ill (,,,"Slfll.-t IIulltif;lClor 1I'J'lII-sIJ'lICllliT lIIodels
silllpl)' Ill' "addillg lip" sillglt'-bnor llrodds, Whl'lIc\'('I' Ihe siorhastic dis-
('OUIII fartol /II" I ".11'
1)(' ",rilll'n as Ih .. Slllll of Iwo indepl'ndl'lIl procl'sseS,
Ihl'lIlll1' rl'sulting 11'1'111 stru('IUlt' is IIII' SUIII of IIII' 11'11Il sl1'\l('\un's Ihal wO\lld
('xisl ulldn ('"d, III' tll<'SI' III "(,('SSI'S, III Ihl' I,ollgstalf alld Srhwartl (I !)!)~)
1lI0del lilt' slo('h"Sli(' dis("11I11 farlo)' is lite SIIIIl of -XII - x~:2fi~I,1t I and
'-x~" ;md Ihese (,""IPOIII'III>; ;tIl' illt\I'(lCllt\I'llI of each ollteL IlIspe('(ioll or
(II.I.:H) shows Ihatlh" resultillg tl'l'IIl SlfllCllll'(' i,sjusllhc Slllll ofa gl'lH'ral
J I. I. Affine-Yield Modds

square-root term structure driven by the XII process and a special

term structure with parameter restriction fJ = 0 driven by the X2, process, ' .

I I. 1.4 Beyond Affine-Yield Modell

We have considered a sequence or models, each or which turns out to have
the property that log bond yields are linear or affine in the underlying state
variables. Brown and Schaefer (1991) and Duffle and Ran 0.993) have
clarified the primitive assumptions necessary to get an affine-yield model.
In the discrete-time rramework used here, these conditions are most easily
stated by defining a vector XI which contains the log stochastic discount
factor ml and the time t values or the state variables relevant ror forecasting
ruture ml+i, i = 1 ... n. Ir the conditional rorecast of x one period ahead,
EI [XI+ I], is affine in the state variables, and ir the conditional distribution or
x one period ahead is normal with a variance-covariance matrix Varl[xl+d
which is afflOe in the state variables, then the resulting term-structure model
is an arfine-yield model.
To see this, consider the steps we lIsed to derive the implications of
each sllccessive term-structure model. We first calculated the'log short-
terlll imerest rate; this is affine in the underlying state variables if mt+l is
conditionally normal and E/ [m/+ tl and Varl [ml+tl are affine in the state
vari'lbles. We next guessed that log bond yields were affine and proceeded
to verify the guess. If yields are affine, and if X is conditionally normal with
affIne variance-covariance matrix, then the risk premium on any bond is
affIne. Finally we derived log forward rates; these are affine if the short rate,
risk premium, and the expected change in the state variable are all affine,
Affll1e forward rates imply affine yields, verifying that the model is in the
arrme-yield class.
Brown and Schaerer (1991) and Durfie and Kan (1993) state conditions
on the short rate which deliver an affine-yield model in a continuous-time
setting. They show that the risk-adjusted drift in the short rate-the ex-
pected change in the short rate less the covariance of the short rate with
the stochastic discount ractor-and the variance of the short rate must boch
be affine to get an affine-yield model. The models of Vasicek (1977), Cox,
I ngersoll, and Ross (1985a), and Pcarson and Sun (1994) satisfy these re-
quiremcnts, butsornc other continuous-time models such as that orBrenna,n
and Schwartz (1979) do not. .
Arline-yield models have a number or desirable properties which help to
cxplain their appeal. First, log bond yields inherit the conditional normality
asslimed ror the underlying state variables. Second, because log bond yields
are linear runctions or the state variables we can renormaIize the model
so that the yields themselves arc the state variables. This is obvious in a
onc-factor model whcrc the short ratc is thc statc variable, but it is equaIly
 442 11. 1mll-Slruclltrf Modrls

possible in a model with any Illllllher of factors. Longstaff and Schwanz

(1992) present their two-factor model as one in which the volatility of the
short rate and the level of the short rate are the factors; the moe!e1 coule!
be written equally well in terms of any two bond yields of fixed maturities.
I Third, affine-yield models with K state variables imply that the terlll structme
, of interest rates can bc summarized by the levels of K bond yields at each
: point in timc and the constant coefficients relating other bond yields to the
K basis yields. In this sense affme-yield lIlodels arc lin car; their nonlinearity
is confined to the process governing the intertemporal evolution of the K
basis yields and the relation betwecn the cross-sectional coefficients and the
underlying parameters of the model.
Affine-yield models also have sOllle disadvantages. The lincar relations
among bond yields llIean that the covariance matrix of hond returns has
rank K--cquivalently, we can perfectly Ilt the return on any bOlld using a
regression on K other contemporaneous bond returns. This implication
will always he rejected hy a data set containing lIIore than K homb, unless
we add extra error terms to the model. Affine-yield models also limit the wa),
in which interest rate volatility can change with the level of interest rates;
for example a model in which volatility is proportional to the square of the
interest rate is not afline. Finally, as COlIStantinides (1992) emplwsizes,
single-factor affine-yield models imply that risk premia on long-term honds
always have the salTle sign.
If we move outside the affine-yield class of models, we can no longer
work with equation (11.1.1) but must return to the underlying nonlinear
difference equation (11.0.1) or its n-period representation (11.0.2). In gen-
eral these equations must be solved numerically. One common method is to
set up a binomial tree for the short-term interest rate. lllack, Derman, and
Toy (1990) and Black and K;lrasinski (1991), for example, assllme that the
simple one-period yield YII is conditionally lognormal (as opposed to the
assumption ofafITne-yicld models that (I + YII ) is conditionally lognormal).
They use a binomial tree to solve their models for the implied term struc-
ture of interest rates. Constantinides (1992), however, presents a model
that can be solved in closed form. His model makes the log stochastic dis-
count factor a SIIIlI of nOllcentral c.hi-sqllared randolll variahles rather than
a normal randolll variable, and Constantinides is thell ahle to ('akulaIC 11)('
'txpeCl~tiollS in ( 11.0.2) analytically,
I
I 11.2 Fitting Term-Structure Models to the Data

11,2.1 ]{eal/Jolll[.I, NOl1lill(lllJolld.{, (lnrl1njl{(lioll

I
the term-structure models descrihnl so f~lr apply to bonds whose payol1s arc
'liskless in real terms. Almost all aCllIal honds insteacl have payofh that an~
11.2. filli/l~ '1n-III-Slruclul"f' M()drLI I() lilt" /)flla

riskless in llolllinallCnlJs.~> We 1I0W discuss how llic models call he adapted

to deal with this fact.
To study nominal bonds we need 10 inlroduce slime lIew nolatioll. We
write the nomill·.\1 price index at til\lt~ I ",IS ClJ. ;\Ill! tht" gros~ ralc of inll,lIioll
frolll I 10 1+ 1 'IS n,; I == {2,; 1/{2,. We have ;Ilre;uly ddined 1'", to he
the rcal pritT of all n-period n'al bond whidl P;IYS Ollt' goods unil OIL lillie
I + II; we now ddille I>!I to he Ihe nominal price of ;111 n-pcriod nominal
bond whirh pays $1 at Ii III(' I + II. Frolllthcsl' IkfinitiollS il follows Ihallhe
IlOlllinal price o/" an II-pcriod real hOlld is I'", (~, and the real price of all
II-period nominal bond is I~'; (li. We do nol adopl allY spccialllotatioll /CU"
Ihese last two (on(cpts.
If we now apply the gelleral asset pricing condilioll.

10 lile real relul'll on all II-p('riod nominal bond. WI' filld Ilwl

:0
1,$1
= E,
[I'S'~I~'I\-I Mit I
] . (11.2.1)

Multiplying through by Q,. we have

( 11.'.!.2)

where M:+I == M'+I/ n l + 1 can he thought of as a nOll/illal s\ochaslic dis(Ollllt

t;lctor that pri(es nominal returns.
The clllpiricalli\eralUre onllolllillal honds uses Ihis result in aile of two
ways. Thc firsl approa(h is to take lile primiliV!" assllllll'liollS Ihal W(' made
abollt M,+ 1 ill Sec lion ILl ami 10 apply Ihem ill'le'IlI \0 M~+ I' The real
lerlll-SlrllrLlIre JIlodels of the lasl scclion aJ"(~ l!Jen n'inll"rpreled as numinal
tnll\-stnIC[IlrC JIlodels. Brown and Dyhvig ( I ~IK()). tor exalllple. do this when

~'SOIIH' gOVCTIIIIH"It,"i, lIot;lhly 1110.\(' "I (:.III.tcl.l. b"wl, .11111111" \ lh.. h,l\"(' 1.'~IIt'd hOlld., \\1111\('
lIominall'ayofls arc linked to a nomillal prill' index. III I!J9ti IIi(' US TIC'astlry is considerillg-
isstling- ,'\imiiar securities. These judex-Ii liked hOllds approximate I('al hOTlch hilt an' nU('ly
('x~lClly e{\llivalelll t() rca I bonds. Un,wI\ ~lIld Sc:il,l(.'lc:r (l~I~H) gi\t';' 1\l("l(( (ti~nlssi(Jll (,I Ilu,'
impl·rt(·niot\s in the UK il1dl'xin~ ~ysh·lU. anet ~'pply tht' (:I)X, l1\g('I~ml1, anti R()~, (I'JH:M)
1I\{)dl'\ III UK illdt"X-link"t\ hllml •. S'T "Iso II"". .IIHI \:;11111'1 ... 11 (I~I\I:» ",HI \:""'l'bell "lid
Slrilln (I~I%)"
 I I, 'J'nlll-S/rUr/url! ,'vlodels

11i('}, appl}' IiiI' (:0:\, Ingnsoll, alld Ross (I !IH!'ia) sCjllare-root lIlodel directly
10 dara 011 liS III Hllillal hOlld prices, Thl' sqllare-root model restricts interest
rales 10 he POSilil'l', and in Ihis n'slH'n il is JIlore approprial(' for nominal
inlen'sl r.II('s Ihall f(H' 1'('.11 illll'rl'si rail'S,
The secolld ''IlplOarh is 10 ;ISSllnlt' Ihat Ihe two COIIIJlOI1('nts of Ihe
nOlninal slodl;I~lil' disl'ounl bl'lor, 1\11/ I and II n H I, art' independent of
each otht'r. 'IiI SC(' hllw Ihis .ISSlllllptioll f;u'ilitates empirical work, take lo~s
()f tht' llol1linal slodl'lstic discollnt fade))' t() get

(11.2,3)

\Vh(,11 tilt' COIIIIHlJlt'lliS ,It,) I ,llld IT/II ;tr(' illdq)(,lldent, we ran price nominal
honds hy IIsing Ihl' illsights of Cox, lngt'rsoll, alld Ross (I!lH!'ia) and Dybvig
(1 !IH!I), R('call fronl St'nion 1I,I,:~ Ihdr r('snlt that the log hond price in a
l1l()del with two illd('p('Il(\cllt ('OmpOll('llts of the stochastic discount factor
is the Slim ()f Ihl' log hOlld prices illlplicd hy each compont'nt. We can, for
example, ''1lpl}' I he l.ollgslaff alld Schwartz (1 !)!)2) JIIodd to nOJllin.l1 bonds
hy assllmillg Ihal lilt) I is desnilll'd hy a sqllare-root single-factor model,
-1/11/ I = .l'Jr + XIII/:! 11~1.t) I, alld Ihat IT,) 1
,
IS known at I and ('qllal to a state
\'al'iahk,\'~I.v\'I'lhl'lIgl,t 111;)1 = "I11I1I+rr"11 .'(Jr+x:;:!fl~l.lt,+x:!1>
=
and Ihe l.ollgslan~S('hl\';11'I1 IIllldl'l (ksl"rihl's lIoJl1illal bonds.
Mort' )!;(,IIt'J'al/)" 11)(' asslIllIplioll I hal M, f I alld 1/ n 11,1 art' ill(kpcnde~tl
iJl1pli\'s thaI prin's Ill' 1I011lill<l1 hOllds "reinst prices of real hOllds mllltiplied
hy Ihe ('x/l('('I;JliolJ 01'11)(' (III lire rl'all'.thlt' ol'1Il01Jt'Y, alld thaI expccled real
rctuntS Oil lIolllillal hOlltis <Ire tIlt, sa1llc as expectcd real relllrns on real
/JOlltiS, To S('(' Ihis, ('onsider I'qualioll (11,2.2) wilh maturilY 1/ I, al.d =
lIole Ihal Ih\' illdt'I'('lltll'Jl('e of' M'll alld 1/ nal al/ows liS 10 repbcc the
exp('ctatioll (\1' t1l<'il' )ll'odttl'l hy Ih" pI'Ot!IIl'l of their exp('naliolls:

I'~, = Elli\I~)11 = FIIMIl11E/[--I-] = 1'11f.!.JF'/[_I_], (11,2.4)

nil I f.!.J+l

sillc\' I'll = E,l M'II' alld I/n l l l ::;;: f.!.JIGt-I' Tltlls Ihc 1I0minai price of
a hotld whirh pal's $1 IOl\lorrow is Iht' lIominal price of a hond which pays
0111' ullit 01' good~ IOlllorrow, liJl1es Iltt' ('xp('elalioll of Ih(' rcal vallie of $1
IOllloITOW,
WI' 1I0W glll'SS Ih'l1 a sillliLlr l('bliollShip holds for a\l JIIalurilies n, and
W(' pro\'1' I his Ill' i 1)(11\('1 iolt, I I' 1111' (1/- I )-I'nioc/ relalionship holds, r:-I.t ==
I'" u(hF"II/<!/I" l/.tlH'1I

I)~
"I
Jo:
I
[/'~
1/
1.,) 1 /\1'11 _(h
(6 \ l ]

1':1["" 1,')I(!;"EI)I[_I_]!ltlll-~]
(h (h I " I I
11.2. Filling 'lmn-Struclure Models to tlU'Data

= Q, EI [1',,-1.1+1 M I+ 1 E I+ 1 [(LJ]
= J>"I Qs E, [_I_J
(b+"
.
where the last equality uses both the independence of real variables from
the price level (which enables us to replace the expectation of a p r o d u f t ' i
by the product of expectations). and the fact that POI == E/[P._ 1•1+ 1 MI+I~'
Equation (11.2.5) is the desired result that the nominal price of a bond
which pays $1 at time t + n is the nominal price of a bond which pays one
unit of goods at time 1+ n, times the expected real value ofS1 at time 1+ n.
Dividing (11.2.5) by 0. we can see that the same relationship holds between
the real prices of nominal bonds and the real prices of real bonds. Further,
(11.2.5) implies that the expected real return on a nominal bond equals the
expected real return on a real bond:

EI [1~_~I+l ~]
J "I Qs+1

(11.2.6)

Gibbons and Ramaswamy (1993) usc these results to test the implications
of real term-structure models for econometric forecasts of real returns on
nominal bonds.
Although it is extremely convenient to assume that inflation is indepen-
dent of the real stochastic discount factor, this assumption may be unreal-
istic. Ibrr and Campbell (1995), Campbell and Ammer (1993), and Pen-
nacchi (1991), using respectively UK data on indexed and nominal bonds,
rational-expectations methodology applied to US data, and survey data, all
find that innovations to expected inflation are negatively correlated in the
short nm with innovations to expected future real interest rates. More
directly, Campbell and Shiller (1996) fwd that inflation innovations are
correlated with stock returns and real consumption growth, proxies for the
stochastic discount factor suggested by the traditional CAPM of Chapter 5
and the consumption CAPM of Chapter 8.

11.2.2 Em/)ineal Evidmre on Affine-Yield Models

All the models we have discllssed so far need additional error terms if they
are to fit the data. To see why. consider a model in which the real stochastic'
discount factor is driven by a single state variable. In such a model, returns
on all real bonds are perfectly correlated because the model has only a single
shock. Similarly, ret urns on all nominal bonds are perfectly correlated in any'
 I

44() I I. 'Irnll-SlruriIll1' !IIm/t'll

model where a sin!!;lc slat(' variahle drives the nOlllinal stochastic discount
IiI(' \I 1/'. In reality there are 110 d(,terlllinistic Iincar relationships alllOn!!;
returns Oil dillcrent honds, so these implications are bound to he n:i('Ctcd
hy the data, Adding extra state variables increases the rank of the variallcc-
covariance matrix of bon <I returns from one 10 K, where K is the IIIl1l1hn
of state v-Jriables, but whenever there arc more than K bonds the lIlatrix
remains singular--cquivalcntly, there arc deterministic linear relatiollships
among bond returns. So these models, too, arc trivially rejected hy the data.
To handle this problem empirical researchers allow additional error
terms to a/Tect bond prices. These errors may be thought of as measurement
errors in bond prices, errors in calculating implied zero-coupon prices from
an observed coupon-uearin!!; term structure, or model specification errors
arising from tax eflects or trallSactions COSL~. Alternatively. if Ollc uses a
model for the real stochastic discount f;lClOr al\(ltesL~ it on nominal honds
in the manner of Gibhons and Ramaswamy (1993). the errors Illay arise
from unexpected inflation.
Whatever the source of the additional errors, auxiliary assulllJltions
about their behavior are needed to keep the model testable. One comlllon
assumption is that bond-price errors are serially uncorrelated, although they
may be correlated across honds. This assumption makes it easy to examine
the tillle-series implications of term-structure models, Other authors as-
sume that bond-price errors arc uncorrclated across bonds. although they
may be correlated over time. .

AJjine-Yitld Models as I,alenl-Variablr M/)dfl~

Stambaugh (1988) and Heston (1992) show that undcr fairly weak assulllp-
tiOl~ about the additional bone! price errors, an affine-yield model illlplies
a I tmt-variable structure for bond relllrns. Variables that forecast I>olld
relt rns can do so only as proxies 1(11' the underlying statc variables of the
lllo~c1; if there are fewer state variables than forecasting variables. this pUL~

I
-/)",
testable restrictions on I()recasting equations for bond returns.
'A general anine-yield model with K state variables takes the f(mll

= + Ill" XII + ... + Ill\" XI\"

I
A" (11.'2.7)
whe 'e Xk" k == I ... K, arc the state l"ariahJes, and A" alld lJ.". /1 = I ... K,
arc :onstants. The model also illlpl.ies that expected exn'ss returlls Oil long
hOIl Is over thc short interest ratc (an he wrillclI as

E,l r".H I - ,vI,) A;, + n;" XII + ... + Il~" XI\" (ll.'2.H)

1
whe e A~ and B;". k = I ... K, are constants. The model puts n \lSS-
sect ollal restricliolls 011 these constants which arc related to the tillie-series
prm\css driving the state variahles. hut we ignore this aspect of the lIIodd
hen"
11.2. Filling '/i'flll-S/rurlll;l' M(I(It-/.1 /(/111/' /)1//1/

Now ~IIPpO~C that we do not ohscrn' thc 11'111' I'XI'I'SS rcturns on lOll!!;
hOllds, hili illsl!';ul ohsl'rvl' a lIoi~y IIl1'aSllrc

1'".1+1 = 1'".1.1 - .\'11 !·II".I.I, (II.:!.!/)

\Vh I' rc 'I ",1+ I is a II ClTor tcrill. Wc aSSlllliC Ikll // ",II I i~ 01'1 hogolla I loa VI'I'lo.'
h, conlainillg.l inslnlllll'lliS "/" j = I ... .1:

(I U.IO)

Till: \'cclor h, lIli!!;ht contain la~~l'(1 variahlc~, for I'xal1lpk, if the rcturtl
error '/.../+1 is serially 1Il1corrclated. We further aSSIIIIle Ihat iiII' ea('h statc
vari;lhlc XI .. " = I .. , K, the cxpl'ctation or the statl' \',11 iahk conditiollal
011 Ihl' illSll'IllIlClliS is linear in the illSlnlllll'IIIS:

I
E IXk' I h,] LOk/hjl (\ 1.2.11)
/=1

for ~ollle cOllstallt coe/Iiciellls (l.)'

These ;tsSlllllptions imply that the expectatioll of I'",tt I conditional on
the illstruiliellts, which from (I I.:!. 10) is thc sallic as Ihl' expcctatioll orthe
true ex('c~s rCIUI'Il 1'",'1 1 - YI, condiliollal 011 Illc illSll'llllll'lItS, is lillcar in the
illstrlllllellts:

EI"",'+I I h,l = E[I'".'~I-.\'II I h,l =

,...
" I
II:. -I- L JJ;"E lx., h,l := ,1:.+ LJJZ . LOI,hjt. (11.:.1.1:.1)
k=1 .=1 ,=1

defille C'II to he the vector [/'1.111 .. , ",V.,. 11101' asselS

11'11'1' 11 I .. ,N.
thcli (II,:!, I:!) call he rcwritten in veftor ()l'J1I as

C,+I = A' -I- Ch, -I- 1/ 11,1' (\ 1.2.1:\)

where A' is a vt'('(or whos(' IIlh dl'lIll' II I is II;, alld C is a 11I'lIrix of('ocnicicllls
whose (II, jl dClllellt is

(.',,/ = L'" 1I;"lI k/. ( I I.:!. 14 )

k=1

Equatiolls (II.:!,I:{) alld (I I.:!. H) dl'lillc a lalclll-varialllt- IIlode! ((,..

n,p(Ttnl cX('css hOlld returns with K lalclIl variahles. E<lualioll (I1.:!.(4)
sa~'s Ihat thc (N x J) matrix or codIicicllts of N asscls 011 .I illstnllllellLs has
rallk at 11I0st K. whcre K is the 1IIIIIIher of state variahles ill Ihl' IIl1dcrlyill!!;
terl1l-stnlcturl' lIIodel. The instrtllll('lIts (lnT,ISI ('XITSS hOlld rcturns only
IIIJ'Ough their ability to proxy (II' till' sl;II(' v;lIiahlt-s (1111';ISIIII'II hy IIII' Ii!/
 II. ir,Il/·Slrllt"{Wi'M(}(idl

("o!'fli("iellls) ;lIltllhc 10k ofllw sial!' variahles ill d!'II'nllining l'X("!'ss hond
n'lUrlls (llH'aslIll'd hI' IIJ(' II;" coefficil'llIS). Thc systCtll is particlllariv easy
10 1Il11lnslalld in Ihl' singll'-faClor cas!', IItTt' K == I, WI' CIII drop tht' It
sllhsnipls. aud (II.:.!.I·I) 1ll'("Ollll'S

(.',,/

1-:,\\1;\1 ion ( 1 I. ~. I:») SOl\"' ,11;\, <';Ie II row or 11\1' III 011 rix C is pl"Opor\ iOlla 1 '() cae h
01 hn row, and" w ("oef"ficieilis of pJ"OpOri ionality are ratios oflj~ coeflirien ts.
Note that the r;\llk of Ihe 1ll<lIrix C could 1)(' less than K; for example. it i~
lero ill a hOllJoskedaslic Illodd wilh K statc variables IlCcause in such a
modd the ("(ll'rficil'nts II;" are ICI"O for all Ie and 11.
l.atl'lIt-variable models of Ihl' f(mn (11.2,14) or (11.2.1!i) have been
applied to lillal\l"ial l\at" hI' (:;lIl1plwll (1~IH7), Gihhons and Fnson (19W»,
and I LUlst'1I alld Ilwlrick (I !1H:I). They call h(' estilllated hy (;ell('J"alilt~d
Melhod of MOll\('lltS applied to the systelll ofrq\"ression equations (11.2.1 ~).
Ill'ston (I !1!12) poinls oul Ih"l OIH' call l'qllivalently ('stilllate a syst('1\l 0(" ill-
stnnll(,lllal I'ariables rl'grl'ssions of I'X("I'SS returns 011 K hasis I'XCI'SS rl'turllS,
whl'I"(' tIll.' ('\enH'lIls of h, an' IIIl' illslnlllll'nis.
A key iss\\(' is how 10 ("hoose instnlllll'l\IS hi th;1l satisfy (11.2.10) (or-
thogonality of inSlnlllJ('nis and hOlld pricing errors) and (11.2.11) (state
variahles liIlI'ar ill the iIlSlnlIlH'IIIS). III all affine-yield model wilhout bond
pricing (.'l"rors, hond )'il'lds alld forward rail'S arc linear ill till' stall' I'ariahlt-s;
hencc the state variahll's arl' lillear ill yit'ltls alld forward ratl'S, This propt:rly
survives the ,uldilioll of 1I01"lnall), dislrihuled hond pricing errors, TilliS it b
lIatllral to choose yit'lds or forward rail'S as illstfllll\CIIlS satisfying (I ! .2.11 ),
To s,llisfy (II,~,I 0), Olle lIIlIst he Illore specific about the natllre of the
hond pricillg nrors. The error ill a hond price !\wasllrl'd at lillie 1 affecls
hoth the lilll!' I hOlld yidd alld Ihe exCl'SS relurn 011 the hOlld from I 10
1 + I, I kiln' )'idds alld fill'ward rat!'s JlI!'asured at tillle 1 are not likt'ly 10
hI' orthogollallo nrors in ('xn'ss hOlld n'llIrJlS from 110 I + I. If Ihe hOlld
price elTors arc 11lll"lllTdated across tilll!', however, thell yields and forward
rail'S llll';ISlIrl'd al lilll!' 1- I will hl' ort1rogollallo cxcess bOlld retllrn errors
frolll 1 to I -I I; ;\IId if Ihe hOlld pritT nrOl"!1 arc Ilncorre\;\ll'd across hOllds,
Iliell 011(' call dll'o,,' a SI'I of )'il'lds or forward rates llleasllred al differelll
maillrilies Ihall Ihos!' IIsl'd Ii,,' excess returns. St,\lllhallgil (1!IHH) applies
.} hOlh Ihes(' strall'gil's to monthl\" data Oil lIS Treasury hills of lllatllrilil's 111"0
\ to six lllOllIhs o\"n III(' lH'riod I 1):;!)::llo I I)H!i: II. III' /inds strollg evidl'nn'
I
I. agaillSt a nllHld wit 11 Ill\(' sl<lIl' \";lriahlt, alld w!'aker el'idell("t' agaillst a nlOtkl
I with two slate I'ari;thl,'s, I kstoll (I !1!12) silldies a llIort' r('celll pniod, I ~170:2
to 1~IHH::), alld a ,LiLt sci illdllding 10llger lIIatllrities ((i, 12, :I(i, alltl tiO
, months) alld lillds Ii II I<- ('I"idl'lI("c againsl a modd with (Jill' Slate variahlt-.
11.2. Fitting Term-SITUcture Models to the Data 449

Evidence on the Short-Rate Process

If one is willing to assume that there is negligible measurement error in
the short-term nominal interest rate, then time-series analysis of short-rate
behavior may be a useful first step in building a nominal term-slructure
model. Chan, Karolyi, LongstalT, and Sanders (1992) estimate a discrete·
time model for the short rate of the form

YI.I+I - Ylt ex + /3YII + f,+I. 01.2.16)

where
(11.2.17)
This specification nests the single-factor models we discllssed in Section 11.1;
thc hOlTloskeoastic model has y = 0, while the square-root model has
y = 0.5. It also approximates a continuous-time difrusion process for the
ins tan taneous short rate r(t) of the form liT = (flo + /31 r)dt + a rY dB. Such
a diffusion process nests the major single-factor continuous-time models for
lhe short rale. The Vasicek (1977) model, for example, has y :::; 0; the
Cox, Ingersoll, and Ross (19B5a) model has y = 0.5, and the Brennan and
Schwartz (1979) model has y == 1. 6
Chan et al. (1992) estimate (11.2.16) and (11.2.17) by Generalized
Method of Moments. Theydefine an error vector with two elements, the first
being YI.I+I - (l + ,B)Ytl-a and the second being (YI.t+1 - (1 + ,B)YII - ex)2 7"'
a~y;;. These errors are orthogonal to any instruments known at time t; it.
constant and the level of the short rate YII arc used as the instruments. If!
monthly data on a one-month Treasury bill rate over the period 1964:6 t~
19R9: 12, Chan et a!. find that ex and fl are small and often statistically iri·
significant. The short-term interest rate is highly persistent so it is hard t6
reject the hypothesis that it follows a random walk. They also find that y
is large and precisely estimated. They can reject all models which make
y < I, and their unrestricted estimate of y is about 1.5 and almost two
standard errors above I.
To understand these results, consider the case where ex = fJ = 0, so
the short rate is a random walk without drift. Then the error term €'+I ill
(11.2.16) isjust the change in the short rate YI.I+I -YII, and (11.2.17) says that
the (~xpectation of the squared change in the short rate, E,[(YI.I+I - YII)21 =
.) 2y F . I 1
iT"YII' .qlllva ent y,

(11.2.18)

SO whclI the change in the short rate is scaled by the appropriate power of
the short rate, it hecomes hOlfloskeclastic. Figllf(~s 11.1a through d illustrate

"NOI(' how("'('" Ihat (11.2.1 Ii) and (11.2.17) do nol nest th., Pearson-Sun m(~lel.
 I
J i
.".,.
r
I
-
I
r
t
,.
Ir:
-II
\ :>..
{ ~ -0

{ ;

j
=f
--=:s:::-
?' 4- -
~~~--~~--~~--~~--~-
~JI rol Mil til 1111 I 0- ~tt..... (rI- 'I I- ,- -
I
I

·... 0
':: II
;:. -.
::'2.

\." ,.-
11,2, FilljllK '/i,,./II-Slntrlitrf MfI/(rL\ In II,,· (Jt/la

Ihe resulls of Chan et al. by plOl\illg challgl's ill shOl'l raIl'S sl'alcd by various
powers or shorl rales, The figures show (YLIt I - .1'I,l/(yi,l for y := 0,05,
I, and l.!i, usillg the dala of McCulloch alld Kwoll (I ~'~I:\) OVl'!' IIIl' period
I ~1:):2: I to I ~I~ll :~, Over the period sinc!' I ~l(i'l slll<iin\ hy (:klll dOlI.. il is
stri\;'ill,l; how Ihl' variallce or Ihe series appl';\rS 10 slahili/.I' as Oil" illcreases
y from () 10 15,
Thcse rcsults raisc two problcllls (ill' sillgk-I~\r\Or allille-yield models of
thl' nominal term structure, First, when there is 110 IIIl'an-n~version ill the
short r,lll', forward rates and bond yields mOl)' rise wilh maturity initially, but
Ihe), c\,l'lIlually lkrlille with maturity and cOlllillUl' 10 do so forl'ver, SeulIId,
sillgk-EI(,(or aflilll~-yieid lI\odd~ n''1uirc Ihal y = () or ().!"> ill (1I,~,17), The
l'slilllaled value of l.!i lakcs one outside Ihl' Iran;lhll' rLlss or alline-yidd
lI\o<lcb alill forces olle to solve lilt' lel'lll-slrll('\lIn' lIIodel Illllllerically,
There is as yet 110 cUllsensus ahollt how 10 resolve Ihesl' prublems, Ait-
Sa!t;\li.1 (I ~'~)(ib) aq.;ues that existing paramctric models are too restrictivc;
he proposcs a nonparamctric IIIcthod I'llI' cSI imating Ihc drift and vobtilily o\'
thc short intl'rcst rate, Hc al-gues that the short ratc is wry dose 10 a ralldolll
wal~ whcn it is in the lIIiddle of its historical range (roughly, between 4% and
177,,), bllt that it lIIean-rcverts strongly whell it geL~ olltside this range, Chan
et .d. miss this bccause their linear model docs Ilot allow mean-rcversion to
lil:Pl'IHI olllhc level of the illterest rate, Ait-Sahalia .tlso argiles thai interest-
ratl' volatility is related to the level of the intercst rate ill a more cOlllplicated
w<ly th;1l\ is allowed by any stalldard lIIodel. lIis 1I\0sl general parametric
llIodel, alldthe ulIly olle he docs not n:je('\ sialistically. has the short interest
ratl' followillg Ihe dilfusion ilr := (flu + fill + II~I~ +- fI'\/ I)d, + (ou + 01' +
a~ r Y lilli, I Ie estimates y to be abollt ~, bllt the othcr parameters of the
vol.\1ility fUllnion also play an import<1nt role in (\et\'rll\ining volatility,
Followillg Hamilton (I ~lH!)), an alternalive vil'w is Ihat Iht' short rate
ralidOlllly swilchcs among different rl'giml's, each of which has ils OWIIIIIC,II1
alld volatility parameters, Such a model m<1y have 1l\l:<IIl-rI'VerSiOIl within
each regime, hilt the short rate llIay appear 10 be highl), persistcllt whell olle
averages data from difTcrent regimes, lfregimes with high IIIl'all parametcrs
art' also regillles with high volatility paralllctns, thell sllch a model lIIay also
explaill lhe apparcllt semitivily of inlnl'st ratc vo!;\tilily 1'\) Ihe level of Ihe
illieresl rail' wilholl\ illvoking a high vallie of y, Figllres II, LI-II show that
110 single vailic of y lIIakes scaled illtl'resl ral .. Ch<1l1l-\l'S homoskl'daSlic o\'er
til(' whole period sillce 195~; the choke of y := 15 works vcry well for
1%,1 to 1\l\J1 Inti worsens heteroskec\aslicil), ill till' 1~):)Os 'lIlc\carly I%Os,7
Thlls at Ieasl SO II l(' regime challges arc Ill'l'<ll'd 10 til Ih .. dal'l. alld it lIIay
he tll.1l a model with y := 0 or y = O.!i is ade'!ll;\1(' olin' rq.;iIlH' changes

';Althollgh llli ... i~ 1101 ~ItO\\,11 ill the: liglllt'~. IIIf' Y 1.:1 lIIodd .11 ... 0 III {".II...:\ dowlI ill lilt"
1!1!lIh,
 II. '[;'1"111-.\"1,.,,(/'111' Mlldd\'

a ..e allowt'd. (; .. al' (I ~)~Hi) ('"plon's Ihis possihility hilt ('stilllal("s only slightly
lower val lit'S "I y Ihall (:h;lI\ ('1 aI., whil,' Naik and 1.('(' (I~)~\<I) solvl' lilr bOlld
and hond-oplion prict's in a regillle-shift model with y = n,
Bn·'I1'(· ... Ifaries. and Kron("r (I ~J~l(i) Illove in a sOlllewhat dilli~rent di-
H't'tion, Thn' allow for eARCl I cfkrts Oil interest rate volatility, as dc-
snilwc\ ill S('(lioli I ~.~ of (:hapl('/' I~, as well as the IeI'd ef/'('ct on volalility
desnilwd hy (11.~,17), They repi<lc(' (11.2,17) by E,[f;i"11 = alld a/)';;
a/ = W -+- (/f;f- r/>n/_ I • a standard (;ARCII(I,f) l1Iodel. Tht'y lind thai a
1II0dd with y = 05 lits the short rate s(· .. ies '1llite well once GARCI-I t'frccts
'\IT inclllded in Ihe 1Il001d; h()\~eve .. they do nol explore Ihe illlplications or

this Ii, .. hond 0"

hond-oplion pricing.

Cmu-Snlilllud UI',\lri,.lilll/.\ (11/ Ihl' '/lnl/ Slmrl/lll'

So br Wl' ha\'(' (,lIIpha~ill'd tilt' tilllt'-snil's implications of aflilll'-yidd lIIod-
ds and hav(' ignored Iheir cross-secliollal implicalions. HrowlI alld Dyhvig
(19Hli) and Brown and Schadi'r (I !19'1) lake tltt' opposite approach, ignor-
ing tI\(' IIwdcls' tillle-sl'\'ics implicatiolls and eSlimating all tht' pal'alllt'\('rs
frollllhe Icrlll Sll'llCllllt' ofin\(T('sl raIl'S observcd al a poilll in lilll(", If Ihis
procedll .. c is repealed 0\'('1' I!lany lilllC periods, il g('n('ralcs a scqllCIIC(" or
parameter estilllates whi.h shollid ill theory hl' idl'ntit',,1 for all tillll' \ll'l'iods
hilI which ill practi( (. varies 0\'('1' lilliI', Thl' procedllre is analogolls 10 rhe
COlIIlIHlIl practice or calculating illlplicd volalility hy ill\'('rting the Black-
Scho\('s t<JrI\\l\la \lsillg tradcd optioll pric('s; tllne 100 thl' model rcq\\ires
Ihal volalilil), 1)(' con~lallr ov('/' Ii 111('. hilI illlplied volatililY tellds to ,\lOVl' OVl'I'
ti IIIC,
Of ('()\\rSl', hOlld pricillg e!Tors I\\ight calise ('still\al<'d parall\Ctn~ to
shift O\'lT Iilll(, ('\'l'1I if rnl<' IIl1dcrl)'i ng paraillerers are COI\S!a1l I. Bllt ill silnl'ie
1I'rIIl-stnlctllre IIIIHids lill'r(' also appear to he SOllll' syslelllalic diffe!'l'I\('('s
hI'IW('ell thl' p"rallll·tcr \';!Il1('s Ill'l'lled to lit cross-sectional t''\'III-strllnllre
data ali<I the paralllell'l' v<lhl<'s illlplied h)' Ihe tillie-series hehaviorofilltlTest
rau's, TilesI' s),stclnalic dilkrclI(,cs arc illdicative or llIisspecificarion in the
1II(I(Ids, 'IiI IIIHlcrstalld the prohleill. WI' will choosl' parameters in the
sillgle-faclor hOlllosk('dasli(' alld squar('-rool n\Odds 10 Iii variolls simple
1I101l\('lIls or Ill(' data alld will sho\\' 11,,1t rhe rcsultilll4 1I10del docs lIot lI\a(eh
SOli\(, IIlhn ch;lrOlflnistif~ or
II\(' <lOlIOl.
III Ihe irOllloskcdaslic singl('-Eleror 1Il/)(ld, Ihe illlporlallr paralll('lers or
rlre lIIodd ('all II(' i(kllrifi('d Ill' ('omilkrillg till' /()liowing fillll' II\OIllCllts or
Ihl' <lala:

.)
a-
J J.2. FillillK Tmll-S/rllr/lIl'f' Mudd, /0 II" 1)11/11

: : _(_I )~ a~/2 _ (_fI )(J~

l-rp I-I/l

(11.2. 19)

The first-order autocorrelation of the short rate identifies the autoregressive

parametcr I/l. Given I/l. the variance of the short rate then identifies the
ill!lo\"ation variance a~. Givell I/l and a~. the average excess return 011 a
vcr)' long-term bond. or equivalently the ;lVerage difference between a very
long-tcrmfc)rwarcl rate and the short rate. identify the parameter fl. Finally.
givell CPo a~. and fl. the mean short rate identifi(~s J1..
III the zero·coupon yield data of McCulloch and Kwon (1993) over the
period I ~)52 to 1991. the monthly fir.~t-order autocorrelation of the short
ratc is O.9H. implying I/l :::: 0.9H. The stand~\rd deviation of the short rate is
:~.(Hi4% at all anllual rate or 0.00255 in natural \lniL~. implying a == 0.00051
ill n<llllraillniis or O.(i\O% at an annllal rate.
III the d;Il<l there is sOllie discrepancy betweellthe average excess return
Oil IOllg bOllds. which from l~lbk 10.2 is negative at -0.048% at an annual

rate for II :::: 120. and the average slope of the forward-rate curve. which
is positive at 1.507% at an annual r;lle when measured by the difference
hetweeIl a (jO-120 month I()rwani rate and the I-month short rate. The
differcllce occurs because interest rates rose over the period 1952 to 1991;
statioll;)ry terlll-structure Illodels force the true mean change in interest
I·ales 10 he zcro. hut an increase in inlerest rales ill a particular sample can
lIIake the sample mean excess return on long hands negative even when
tlte sal\lpl(~ lIIe;UI slope of the forward-rate curve is positive. The vallie, of
!l required to lit the average slope' or the forward-rate curve is -122. The
illlplicd valuc for II - a 'I. /2. expressed at an annual rate. is 7.(i32%.
The difIiculty with the homoskec!astic single-factor model is that with
these parameters the average forward-ratc terlll-structure curves very grad-
lIally ("mill its initial value to its asymptote, as shown by the dashed line: in
Figure 11.2. The sample average forward-rate curve over the 1952 to 1991
period. sh(Mn hy the solicl line in Figure 11.2. rises much more steeply, at
first and thell flattens out at ahout five years maturity.
This problem arises IwcallSe the theoretical average forward-rate curve
approaches its asymptote approximately at geometric rate I/l. One could
tIIatch the sample average forw;lrcl-rate curve more closely by choosinR, a
,\lllallcr vallie of 1/1. Unfortunately this would be inconsistent not only Wi~l
Ihe obsern-d persistence of lite short rail', but also with the observed pattern
of" \'oi;ttility in f<')I·w;lrd rates. Equation (11.1.14) shows that the standard
454 II. 1imll-Slmrllll1' M{I(/c·ll

,~' , ...... "',- TIH'OITlkal ;l\'l'r;.tg:t' f(HWarci·...H(· (,lIIV("

"

Sample i;n'cr.lg:e fon"ard-rall' (Urn'

2 4 f. I:!
MalurilY in years

I
Figure 11.2. Smnpll' (1/1(/ Ti'fol1'Ii<(I/ Avrmgr [o'OIwcur/·U"lr CWW\

de iatioll of the forward rate declines at rale <1>. In the 1952 to I ~l~ll lwrio<i
th standard deviation of the n-period forward rate barely declines at all
with maturity n. and this feature of the data can only be fit by an extrcmely
pe~siSlenl short-rale process. Backus and Zin (1994) discuss lhis problem
in <ietail and suggestlhal a highcr-order lIlodel which allows bOlh transilOlI'
and persistent movements in the short rate can fit the lerm slruclure more
successrully.
Parameter idemilication is somewhat more dil1icult in the square-rool
lIIodel. Here the moments given iu equatioll (11.2.19) become

Corr[YII' )'1.1_1 J = tjJ

2
2 2 2 a It
Var{Yltl = (l - fl a 1'2) I _ (P

(11.2.20)
11.3. l'rjl'il'K Fix/'c!-I"('(Jllu' I krill/llitlt' Sl'fur;I;f'.\

wh('re IJ is th(' limitinl-; vallie 01' iJ" frolll ('qllatioll (11.1.:.t\). As helill'e, we
Gill identilyc,/> = O.!lH from the estimated lirst-ordn alltocorrelatioll ofthc
shorl rate, but now lhe olher pOIl'allldel's of the llIudd arc simllltalleously
detCl'mined. One call of course eSli1llOlIe Ihe1ll by Ccnerali/.cd Melhod or
MOJllenls. The s(luare-ruol model, like lhe homosknlaslic 1II0del, produces
an av('ra!-:c forward-rale curvc IhOlI approaches ils aSYlllplO!(' vCI),slowlywhell
Ih(' shoJ'l rale is highly persislelll; Ihlls Ihl' lIIodel hOI, lIlany 01' Ihe sallie
elllpiriral lilllilations as lhe homoskedaslic IIlOdl'!.
III sllllllllary, lhe Sill~lc-racl()r aflille-yidd llIodds WI' haw dl'sl'rihc,1 ill
Ihis ch;ljllcr arc 100 restrictive 10 IiI Ih(' hl'hOlvior of nOlllinal interest rates.
Th(' Ialelll-variahk struClllre of Ill<' data, Ihe lIalllre of Ihe shOl'l ralc pro-
cess, aile! the shape of Ihc avera~e lerlll slrllClllrc ar(' all hanl 10 Iii wilh
Ih('se models. III responsc to this rcsearchers are "xplorill~ IIlore I-;ell('ral
III(Hlels, illrludilll-; aHille-yield models ill whi('h Ihe sill~le slale variahle lill-
lows a hil-;her-order ARMA process (Backus alld Zill [I !194j), alline-yield
models Wilh several state variables (l.olll-;st.d'f a III I Schwan/. [ I!1!l2)), regime-
s\\:t,hing lIIodels (Gray [19961, Naik and l.ee [1994)), and GARClllllodcls
of il!terest rate volatilily (Brcnner, Haljes, and Kroner [199G)), No one
1II0dl'l has yCI emerged as lhe consensus choile liJi' 1Il0delin~ Ihe nominal
IeI'm slructure. We nole however lhal Brown and Schadi'r (I !l94) ,lIld Gil>-
hOlls alld Ramaswamy (199:1) haY<' ;lchiewd SOllIe SUl'U'SS in (ittill~ simple
II10dcls 10 prices of UK index-linkcd bonds alld l'conollll'lril' I(,recasts of
real retlll'llS on US nOlllinal bonds, Thus sillgle-Ctnor alline-yield lIIodels
ilia\, be 1II0re appropriale for lIIodelilll-; r('al illterest ral,'s thanl(II'lIIodelilll-;
Illlillinal interest rail'S.

11.3 Pricing Fixed-Income Derivative Securities

One of lhe main reasons for the explosioll of interesl in terlll-siruclure

models is the practical need to price alld hedge lixed-illcollle derivative se-
curities, In Ihis section we show how terlll-strlll'lllrl' lIIodl'ls call bc used in
this context. Section 11.3,1 begins by dis(lissinl-; ways to .IlJl-;lIlelll standard
terlll-structure models so that thcy lit the current yield curve exactly. Deriva-
lives traders llsually wanl to take this yield curve as ~ivell, alld so lhey wallt
to llSl' a pricing model lhal is fully cOllsis\{'nt wilh all (,lII'renl bond prices.
We explain lhe popular approaches of 110 alld Let: (I !IHG), Black, Derlllan,
and Toy (1990). and lIeath,.Jarrow, and Molton (1!I!l2). Sectioll 113.2
shows how lerlll-slrlll'lure 1II0dels (';UI he 1IS1'd til pricl' li"ward and IlItllr('s
COli tracts 011 fixed-incollle securitics, while Sl'l'lion 11.:1.:1 e)'plon's option

pricing ill the context of a lel'ln-SIl'lulIlll' 1110<\1'1.

1.'"

II, J. I Fillillg 1111' (,'II/Trlll '/i'rlll Slru(/l/If /':,\'(/(11\,

III g('II('Ld a IlIod,') girl's all ('xact (it to as IIlany data POilllS as it has parallw-
t('lS, TI\(' hOIlI",I,,('d,lstic sillgk-(;I('(or mod('1 pn'st'llIed ill S('ctioll ILl, (Ill'
('x;lJlJpl(', has 1'0111 P;ILIJII('I('rS, cp, fl. a~, alld II. IlIcvitahly this model does
1I0t fil tI\(' whol(' 1('1111 ,tlll('(I1/(' ('xactly, To allow 1'01' this th(' I'Il1piricalwork
of Ih(' pn'\'iou\ s('('(ioJl ad,lt-d ('rror I('1'1 liS, refleclillg Illode! sp('('ili(,;lIioll
I'ITor alld 1I\(';\Sun'1I1I'111 I'ITO), ill hOlld pric('s,
III pricillg (ixl'd-iIlCOIIIl' dnivative securities it ilia), bl' dl'sir;lhlt- 10 h,l\'('
a IIlodeilital dol'S Iii Ill(' t'\1IT1'llt lel'lll structurl' l'xanly, 'IiI achil'vl' Ihi", I,'l'
(,;UI USt' Iltt' /('Slilt or Cox, I 11 gl' rsoll , alld Ross (l9Wla) alld Dybl'i!!; (I~)~~))
that Ollt' ('all add illdq)('IHll'lit tl'rllI-structure lIIodels logelher, A silllplt,
approach, dul' ori!!;illally to 110 alld I.ee (IDHIi), is to break oi>s('J'\'cd /'orwald
r;llt's '/;" illto Iwo (,OIlIPOII('IIIS:

( 11.:\,1 )

wilt'll' I,;;is Ihl' 1'<11 ward ralt' illlpli('d hy a slalldard Ira('lahle IIlOdd alld /,~', is
Ihl' rl'sidll;11. Thl' r('sidllall'IIIll»III11'1I1 is Ihell attributed to a dl'terminislic
1t'I'III-strtICIU\'(' Inodl'l. Sillc\' ;\ dl'ltTllIillistic proc('ss is illdl'Jlt'lldetll II!' allY
slocliaslic IIJ'Oc('s" IiiI' dl'nlllll'"silioll (11.:1.1) is always kgililllat(', '('itnt'
is a ('orrespllllding d(,(,Olllposilioll of Ihl' siochastic discolillt b(')or,

(I t,:~,:n

III a del('l'IlIillislic 1l10llt-1. Ih(' ahselll't' or arhi I rage r(''1"in's 1h;'1

h h
== YI.lt II = WIllI'

Tllus IV<' aI'\' l'o'lllbliJlg Ihal I'tlllll'l' slodlastic disCOllll! (~I('\O\'S cOlltaill a
tit-Iel'lllillislic COIIlP(I/H'1l1 lital is rell('(')et! ill future SilOrl-lt'l'lli illle\'esl )'alcs
alld CilITt'II1 (iI/ward r;tles,
Allholl!!;h Illis proc('d II II' \VOl ks w('11 ill allY Ollt' period, IIi ere is nOlhillg
10 (,IlSIl/'(' tltat il will 1)(' (,OIiSiSII'IlI frolll pcriod to p('riod, A typical applica-
tioll ()r Iitt' a)lpro;)( h S('IS vi, = 0, so Iltal IIt(' CIllTt'll1 short ratt' is Ils('d as
.111 illplll illio lilt, st<,,'h'lSlic \('rtll-slrllrllll't' \llodel withoul allY adjllstlllcill
(ill' a tll'll'lllIillbli(' (,OIIiPOlH'1l1. Ikll'l'lllillislic ('olll»ollcnis or flltllrl' ~hort
rail'S l;,II" ;11'1' 11)('11 'I'I 10 11<1/11<'1'0 I'alll(,s to iii till' tillle I t('rlll SI),IlC\lI)'l',
\\'h('1l lilll(, I -I- 1/ ;Ini,'('s, h(l\\'l'I'('\', this pro('('dllrl' is r('pealcd; 1l0'" )";,1+,, is
~('Ilo 1('1'0 alld d(,lt'!'lIlillisti(' ('olllpOnl'lllS oflllore dislallt {'utlln' shon r;lI(,s
a\'(' llIad(' 1I01l1<'!'O 10 Iii III(' lilll(' I + 1/ /('1'111 stnH'llIrl', As [)yhl'i~ (1~IH~I)
('llIpltasi/('s, Ihis lillI(' illltlllSisl('lln' is lI'OIIhil'sOIlH' althollgh lite procedure
IIlal' work \VI'II ror SOl Ill' pllrpOSI'S,
It is ;Ilso illlpoll;11I1 10 1II1c1e)'sl'lIullh;1l lilling onl' sci ofassel prices ('x-
<lnly dOl'S 1101 ).\II',lr;lIl11'l' 111.11 a lIlo(11'! will lit otllt'l' asst't pric('s accuratdy,
 J J. 3. l'riring Fixl'd-Inromr DPTilinJilJf Sr(unlies

Backus, Faresi, and Zin (1996) illustrat e this problem as follows.

They
SlIllle that the homosk edastic single-f actor model of subsect ion 11.1.1
with a mean-re verting short rate so if! <: 1. They show that one can
exactly ,,'
lit the current term structur e with a homosk edastic random walk
model, a "
lognorm al version ofHo and Lee ( 19R6). The model uses equatio
n (11.1.5),
hili replaces equatio n (11.1.:~) with

\
(11.3.4)
,
where 1';'-1,j is a determi nistic drift term that is specifie d at time
~, for all
fUllIre dates 1+ i in order to fIt the time I term structur e of imerest
rates.
and as before ~I+j is a normall y distribu ted shock with constan t variance 2
0 •
Hackus, Foresi, and Zin (1996) show that this model does not capture
the
conditio nal means or variance s of future interest rates, and so it
mi~prices
options on bonds. Problem 11.1 works this out in detail.
A somewh at more sophisti cated procedu re for fitting the term
struc·
ture of interest rates specifies future determi nistic volatilities of
short rate
tnovem ents, as well as future determi nistic drifts. Black, Derman
, and Toy
(1990) do this in a lognorm al model for the short rate. In the
present
morlel one can replace the constan t variance of ~t+j, 0 2 , wilh a
det~rmin·
i~lic<llly lime-var ying one-per iod-ahe ad conditio nal varianc
e (]I~j' Backus.
Foresi, 'and Zin (1996) show that if the true model is the mean-re verting
ho-
Illoskedaslic model, the misspec ified random walk model with determi
nistic
volatilities and drifts can fit any two of the current term stmctur e,
the con-
ditional means of future short rates, and the conditio nal variance
s offutur e
short rates. Howeve r it still cannot fIt all three of these simultan eously.
and
so it cannot correctl y price a comple te set of bond options . The
lesson of
this exampl e is that fixed-in come derivative security prices depend
on the
dynamic behavio r of interest rates, so it is importa nt to model interest
rate
dynamic s as aCCllrately as possible even if one is interest ed only
in pricing
derivative securitie s today.
A related approac h that has hecome very popular is due to Heath,J
ar-
rol\', and Mortoll (1992). These authors start from the current forward
-rate
curve discusse d in Chapte r 10, and they suggest that one should
specify a
IeI'm structur e of forward volatilities to determi ne the movem ents
of future
risk-adjusted forward rales. To IInderst and this approac h as simply
as possi·
ble, suppose that interest -rate risk is unprice d. so there are no risk
premia
in bond markets and the objectiv e process for forward rales coincid
es with
the risk-adjusted process. In this case bonds of all maturiti es must
have
the same expecte d instanta neous return in a continu ous-tim e setting.
and
the same expecte d one-per iod return in a discrete -time setting. That
is, the
one-per ioo version of the pure expecta tions hypothe sis of the term
stmctur e
(PEII) holds, so from (l0.2.6) of Chapter 10 we have

EI[rn.l+1 - YIIl == -(l/2)V ar,[rn.t+1 - YII1. (11.3.5)

458 l I. -limn-Structure MculeLf

1
1e expected log excess return on a bond of any maturity over the one-
p riod interest rate is minus one-half the variance of the log excess return.
Now recall the relation between an n-period-ahead I-period lo~ (lI"\vard
r~te f., and log bond prices, ~iven as (10.1.8) in Chapter 10: fll' = 1)",-
fJ:.+l.t. This implics that thc chan~c from timc t to time t + I ill ,I forward
rate for an investment to be made attimc t + 11 is
II f.-1.1+1 - fn, (1),,-1.1+1 -1)1I.,+Il- (I)", -1)"+l.tl
r".,+1 - rll+I.lfI
( 11.3.6)

T1ki~g expectations of (ll.:~.(j) and using (ll.:t!i), wc find that

Et[J.-I.I+1 - /..,] = (2) (Var/[r,,+I.t+1 - )1,1 - Var/[r"./+I - )I,l).

(I I.:l.7)
The conditional varianccs of futurc cxcess bond rcturns determine the ex-
pJcLcd changes in fonvard rates, and these cxpectcd changcs together with
tHe current forward-rate curvc dctcrminc thc forward-ratc curvcs and yield
curvcs that are cxpected to prevail at every date in the future. Similar prop-
erties hold for the risk-adjusted forw<lnl-rale process even whcn interest-rate
risk is priccd.
Hcath,Jarrow, and Monon (1992)cxploit this insight in ;1 continllollS-
time selling and show how it can be used to price lixed;incollle derivative
securitics. It is still important to model interest-ratc dynamics a(Tllraldy
in this framcwork, but now the parametcrs of thc model arc exprcssed as
volatilities; many participants in the markets for lixcd-incomc sccurities lind
it easier to work with thcse parametcrs than with the paramcters that ~overn
short-rate dynamics and intcrcst-ratc risk prices in traditional models. A
drawback of this approach, howcver, is that thc implied process for thc
short-term interest rate is gencrally cxtrcmely complicatcd.

11.3.2 Fonvllrds alld Futures

A particularly simplc kind of derivative securilY is a forward COlllracl. Au
n-period forward contract, ncgotiatcd at timc t on an undcrlyin~ secmilY
with price SI+" at tilllc I + 11, specilies a pricc at which the secmity will hc
purchased at time t + n. Thus the forward price, which wc writl' C"" is
determilled allillle t but 110 money chan~es hands ulltiltillle 1+ II.N
Cox, Ingersoll, and Ross (I ~H 1b) show that thc forward price (;"1 is the
tillle t price ofa claim to a payoffof S,+,,/ 1'111 at time t+1!. Equivalently, (;"1 1'''1

"The II-period forward ral,' ddillcd ill S"rlioll 10.1. t o("Chaplcr 10 is Ihe yield 011 a f," w.. ,,1
«IIlIrao 10 huy a 1.ern",0Ilpon hond wilh lIlalllrily dal,· I + /I + I ;1\ lin", I + II.
II,}, I'ririllK Fixf'lI-IIIWilll' I)nillalilll' Snllrilil'" 45!I

is the price 01' a claim to a payorI' or -"/+/1' Intuitively, the 1'111 terms appear
because no llIoney need be paid until time 1 + II; thus th(' purchaser of a
lonvard contr;lCt has the lise of mOIH'Y (,ctwC\'n I and I + II, (:OX, Inl-:('rsoll,
and Ross establish this proposition using a simple arhitragl' argument. They
ronsider the fi)lIowing investment strategy: At tilll!' I, take a long positioll
in 1/1'", fi)l'ward contracts and put (;", into II-period hOllds. lIy doing this
olle can purchase G"t! 1'", bonds. The payoff from this stratch')' at tillle 1+ 1/
IS

( II.:tH)

\Vhere the first terlll is the profit or loss on the f()I'wanl contracts alld the
se(olld terlll is the payofl'on the honds. Sill!'e this illvestlll('lll strateh')' costs
(;", at time I alld pays ,,"1+11/1'111 at time 1 + II, the proposition is estahlished,
It ('all also he stated using stochastic-dis!'oullt-factor 11Otatioll as

G", = Et!M""~"S,~,,/I',,,I, (11.3,9)

wl.cre the n-pl'l'iod stochastic discount f;lctor M",'+II is the product 01' 11
successive olle-pcriod stochastic discoullt ractors: MII,I\II 0= M'+I'.' M'+1I'
A futlln's contra(( differs frolll a ((lrward (,Olltr;lLt in one illlportant re-
s]leo: It is I1wrimilo marh/'Ieach period during the Jill' orlhe flllltraCl, so th,lI
the (lurchaser ofa futurcs contract receives the rUllIITS pi ire illCl'ease or pays
the futures price deCl'C<lsc each period, Because ofthes<' Illargill payments,
rutmes pricing-unlike forward pricillg-gl'lH'rall), illvol\,('s lIIore thaujust
th!' two periods I alld 1+ IlY If we wril(' II", price or all lI-pI'liod IUllJr('s
(outran as 11,,1, the II wc have

(11.:1.10)

This call he established using a similar argumelll tu thai of Cox, Ingersoll,

and Ross. Consider the following investmcnt stratchT At time I, take a long
positioll in 1/1'11 fultlres contracts and put /I", into one-period honds, By
doing [his one can purchase 11",/1'11 honds, At time I + I. liquidate the
flllllrcs COil tracts. The payofffroJII Ihis strateh,)' at tilllC 1 -1- I is

I II", 11,,_1.1 I,'

-I' f /1,,-1,1+1 - /I tl + -- --- (11.:\.1 I)
tl " Plt 1'1,

!'Ttw Tn·;,:-.ury·holltl.\lul Tn'asury-nuh,' 1,,\\11"\':-' fDIHI,\rh lLH\t',\ nil tht' {:hirilgn l\u.1I"1I01
Tradl' al:-.o han' a tlluuher of spedal option fe.tHlI(':-' tkH ,\((('rt tlwir prlc.:c.'s. A uader with a
shOll position can ('hoo~(' 10 c1divcr Oil allY day ,\·ithill thc M'It!(,IIU'1I1 lIloluh and Gill dUH)s('
to delin'!" a Humhl',. of "ltl'rll.Hive hOlUb. Tht' shOll tradt· .. ..tI~o h...'\ a "wild card option" 10
.1I111011lH"t' delivery al ;1 paniflilar day's sclIl('lIIt'lIl I" in' ,IllY lilllt' ill th ...\jx 1111111." alfel" fh~tt
pi ict' is d('('rl1lill('d. Tht, c1i.Ii(II~si()n IU'l"c ah.'HI";l{"l,'i frolll liu'st, oplioll k'HIlIt's; sec' Ilull ( I!'9~t.
Chaplt·1' '\) for an illtroduftioJl 10 111('111,
 11. 'l;"III /-.)/, ."rl"r " /lJlld"['~

whe n' till" lirst 11'1111 is till" IIlar

k-to- III;lr ket payl llell t 011 the flit
(lurd lase cl at till\(" I ;111<1 the II res cOll tract s
SITOlld tcrll l is the payo ff 011
caus e the hllll n's cOll lract s arc the hOll ds. Be-
IIlar kl'd to Illar ket, the 1~lIlire
he liqu idat ed;\ I lillI<' I + I wilh posi tioll can
oul g-en erati ng- any flllt her cash
I + II. Sillc e Ihis illl'I'Stllll'lIt stral< 1I00,'S at tillle
'!W cost s H", at time I alld pays
+
allil lie I I, WI' hal'l ' show n Ihal 11,,-1.1,1/1'11
(11. :\.10 ) hold s. Furt herm ore,
(113 .10) (())'w ard to tillll ' I + we call solv e
II, IIsillg- thl' fac,t that
H II . I +" =
.'\,+", to obta in

( 11.:1,12)

COlllparill)!; 1''111atiolls (11.: I.!l)

alld (11. :\.12 ), we call S(T Ihat
sOllie Cirl"lllllsl'IIll'!'S whe rl' forw ther l' are
ard conl racl s alld rUIUrl's COll
011 Ihc' salll l' untll 'll}'i llg- ;lsS!'1 lract s wrilt l'lI
witll Ihe sam e llIat urilY hal'!
First , ifho nclp rilT s are 1101 ralld ' l"lua l pric es.
ollli hell ahse ncl' ofar hilra g-e
rl'ql lires thai
1'", == n:'~-III/)I,'I" so (;", = If""
This lIlea ns that forw ard and
pril' es ;Irl' eqll al in allY Illod flllll res
cl with a cOll stan t intCJ'est rate
ther e is only Ollt' pni od 10 lIIal . SCl' olld, if
lll'ily Ihl'n I'", == I'll anel ag-ai
Silln ' flliu res COlllral'lS arl' lIlar ll (;", :=: II",.
kl'ti 10 llIar ket daily Ihl' peri
hI' 0111' <la)', so Ihis Il'slIlI is oilil od hl'rl ' 1I1IIst
llile d illlt' rt'st. Thir d, ilill t'
IIIIClerlyill)!; asst' l is HOI ralld olll, pric t' oj' lilt'
Iht'l l ((,I'\varcl and l'lIll1n's pric
the IIl1derlyillg- assl' l prilT .. /!) t's hoth eqll al
S(T Ihis, note that if
thell (113 .9) h('co lIIl's
S,+" == 1', a cons tant ,

sillce 1'111 = E, ( ,,1 11 ,1 f II I. l j nc\cr Ihe saille fouciilioJls

show Ihat II", = III r ::::: V, alld w(' ,.. an
I' if 11,,_ 1,'/1 \' bl'Cl IlSe (11.:1.10) hl'l'Olll('S

(11.:1,14)
Thll s /I", == \' lor all II, so !(II'w
ard ;lIld flllll r('s pric ('s ar(' cqlla
Mor e gC'I)('1 allv, It/M cITr , forw \.
ard alld fllltl iTS pric cs may dille
case wllC'rl' Ihe lInde rlyin g- assc r. III the
t is all 1/ + T-pe riod zero -cot lpon
I, whic h will hc a r-l'( 'Jiod hon hon d at Ii Ill«'
d al lilll! ' 1+ 11, we can wril( ' Ih('
as (;, "I alld lh(' fllill res pric t' ()rw are! pric ('
as 1/"" , The forw ard pric (' is
ill Ihis case : easy 10 calc ulal e

Whe ll r = I IIII' I'iell! OIl Ihis

for"';1J'(1 COlllraCI is Ihc I()\,w anl
in Scct ion 10,1. I of Cha pin rate defi n('d
10: [':,, == II (;1 ",,
The fllltl res pri, I' IIIIISI hc
calc llial eci r(,l"llrsil'c1y froll l
(I I .:1.10). III a l'arli cliLI I I('I'III- t''1I1;lIioll
SI 1'11('\ 11)(' lIlOc ld OliC (';111 do
t'xpl icill y alld sol\' (' 1'01' I\)t' n·\;t Ihe calc lllal ioll
lioll ht'lw l'('n !(,rw ard alld fillll
res pric es.
II. J. I'ri(illg Fixnl-I"«l/II~ IJn;vlllivt' .'il"l"/lr;tit'.~

Problem 11.2 is to do this filr the hOllloskedastic single-factor model

opec! in Section 11.1.1. The problem is to show that the ratio of ~
to futures prices is constant in that Illodel. and that it exceeds one so lhal
forward prices are always greater than futures prices.

11.3.3 Oll/ioll 1'n"riIlK ill 1/ Tmll-S/niC/IlTI' Modf'l

Suppme one wants to price a European call option written on an underlying

se("\lrity with pdce S,.IH Irthe option has II periods to expiration and exercise
price X. then its terlllinal payoff is Max(S,+ II-X. 0). It can be priced like any
other II-period ,lsset !Ising the T/-perioo stochastic discount factor Mil.,+," -
A'I'TI ... M'+II' Writing the option price as C'",(X). we have i
(;,,,(.'<) E,[MII.'+II Max('\;+11 - X.O») I
== E,[M".,+"S,+" S'h > X) \

-X E,[MII .,+" .11,+" > X). (I 1.,.16)

III general equation (11.3.16) lIIust be evaluated using numerical rrieth-

oels. bllt it simplifies dramatically in one special case. Suppose that M~.I+II
aile! S,+" art' jointly lognormal conditional on time I information, with ~on­
elitionalexpectations of their logs /lm and /l" and conditional variances~nd
covariance of their logs am"" a". and am" All these moments may depFnd
on I and II, hut we suppress this for notational simplicity. Then we have

E,[M".,tll S'tll I S'+II > X) I

exp ( 11", + /1. +
allllll + a"2 + 2a,.,) I

x <I> (
/l.+a ,,-x +a, ) .
ll
(11.3.17)
•
a.

alld

E,IMnl+ n I S,+" ~ XJ == exp(ll",+a~II/)<I>(Jl'+:~"-X). (11.3.18)

when' <1>(.) is the cUlllulative elistriblltioll function of a standard normal

ralldoJll variahk. anel x == log(X). I I
EqlJations (11.3.17) and (113.1 Il) hold for any lognormal random vari-
ahles M and S and do nol derencI 011 any otllt'r rroperties ofth('se varia hIes.

1"'1'1. .. "ol;o,i"" lin,' di/l'·I.< 1'1'0"1 'til' l"I';llioll ",,'<1 ill (:hal'l .. r ~J. Tlrrn' /', i, list·" for II",
IIlld(,II~'illg !'Ic'nll ily prirt', hili IIl'r" we 1"( .... (.1"\"(. /' rill' 1('&"fH:ollpon hond prin's ~lIHllI~(·.\ fur a
J..:,C'IIC" if' '''("(,lIdly pdn"
t tTl ....,,· ... ·'''Ih w.. r",,,"';,,,,,, It\' R"himi<"i" ( I!Iili): "',' also 11,,;0"1( allli l.il/ .. "I>'·I'I(,·r (J 'JXlI).
I
'4'i2 II. ·1i'I'II/·SlnHIIIIl'M"dd,

nut W(' kllow frolll asset jlril-in):: 1IIl'IIry 111011 11ll' ulHkrlying s'Tllrily pri, (" S,
I"IIISI salisfy

I Sf . , (
== ('xp /1",+/1,+ rr""" + a"2 + 2a",,) '

~
== 1,·tlt\llf,f-I"·\f~,,1 (11.:~,I'I)

We also kilo\\, Ihal Ille pi ice of an II-pel iod lero-coupon hond, I'"f. III1ISI
';lIisIY

I I'''f = EtlM".f+,,1 == eXP(ll",+ a~",). (11.:~.20)

I

Usillg (11.3.1 !)) alld (11.:t20) losilllplify (11.:\.17) alld (11.:U H), ;1\111 slIhSli-
IlIlillg inlo (11.:~.!(i), we gel all expression for Ihe price ofa call ol'lioll whell
Ihe IInderlyillg securily isjoilll\Y \ogllol'lna\ wilh Ille Illllhipniod stochaslic
dis(,Ollllt I;IClor:

, (/I,+a",,-.\'+a,,)
.'i,<!J
"
- XI",<!J
(Il,+a",.-x)
~
,fiT:. " a \\
. (s, - .\'-/1", +a,,/'2)
'\f <!J r;:y-
yaH

- XI
,
Ifl <!J
("f - X-/1",
r;:y-
- 0,,/2) . (11.:1.21 )
" (1"

To get Ihe sialldard oplioll pricillg IClI'IlIu\a of Hlack and Sci" lieS ( I !17:1),
we lIe(~d two fllnhel' asslIlI'IlIions. Firsl, assl\lII"lhallhe cOlldilion;" \,;lri;I\\('('
of Ihe ullderlying securilY price /I periwis ahead, a,,, is prop"rtioll,,1 III II:
au = lIa~ for sOllie COllslall1 a~. Secolld, assullle Ihal Ihe lerll1 slruclure
is lIal so Ihat I'lff =
1'-111 Ie)!' sOllie conslalll inleresl rail' I'. Wilh tllese
,l<lclitiona\ asslllllpliollS, (11.3,21) yields Ille Bbd.-Schoks 1(I\"III\1la,l~

.,
<'",( X) == .\, <!J
. (\,-x+(/'+a~/2)1I)
r::
ylla

-
""I"A (,,-x+(/,-rr 1/ 2)1I)
.,,\(' ,,>
.J/i rr . ( /1.:1.22)

For fixed-illcollle deri\'alives, however, Ihl' extra asslIillpliollS 1I('('deli 10

I{el the UhlCk-SdlO\cS IC)l'Inula (11.:1.22) arc nol reasonahle. SIIPPOs(' lltal
Ihe asset 011 which Ihe call oplioll is wrillcil is a I.ero-coupoll I>olld II'hicl,
cUlTelltly has 1/+ r p('riods 10 malurily. IfillI' oplioll has ext'l'cis(' prin' X alld
l~jl)('riOtiS 10 expir.1I iOll, III,' Opl ion's 11OI),o1LIl "X piral ion willII(' ~101 x( I'r.' I 1 / -

I:!Of f(}I1I'~(". for allY gi\('11 " we rail ~11\\';,y., cldillt' n:! ::::::; n,./ II alld I ::::: - {,,,,/,, '" Ih.1I
II (' l\1~IC·k·SdlOlt's lonl1111;aOlpplit·s lor Iha, II. Tht, ;l~.'lIl11lJ(i()lI~ gi\'('u ;11(' IU'nll'fllor,lit' HI.,d.. ~
S; I!O!c',1Iii 101'1II111a tu apply 10 all II wilh 111(' 'i..III)(, , ;1IIc1 n:!.
I
II.J. 1'l'il'illJ; Fbml-III((I/IU' Dmlllllil". Sl'l'lIl'ilil',l 41i~

.\,0). TII{' r{'\evant hOlld prin' at expiLII inll is Ihl' T -p,'1 iot! bont! prin' sillt'(,
Ihl' Ill<llllrity of Ihl' bond shrinks over lilllt'. In a tenll- stl'llcture 1lI0del Ihe
cOllditional volatility of the r-pniod bond prict' 1/ pniods ahl'ad is 1101
I!;l'lllTally II tillles the cOllditional vol,lIility of iiI<' (1/ + T - I )-pcriod hOlld
prke one period ahead. Abo. of rOllrSl', Ihl' t!'l'lIl sll'llrtllll' is gl'lll'r<llly nol
flat ill a Icrlll-structure lIIodel.
To get closed-form solutions fill' interest-ratl' dnivativI's prices we need
a tl'rlll-structure llIodel in which hond prices alld stodl;\stk discoUIII (~lClors
are conditionally lognormal at all hori/,ons; Ihal is, wI'need Ihl' hOlllosketlas-
tic sillglc-fartor lIIodel of Section 11.1,1 or SO III I' IllultiEIl'lor gClleralil<lIioll
of it. III the single-ractor lIIodd WI' CIII liS!' til<' optioll pricillg '(II'IIIlIla
(11.:'L:!I)withlhefollowinginpllls: S, = 1',,\1.' = l'XP(-A"H-I!"trX,),
}'", == exp(-!\"-!J,,x,),and

CT" Var,[-A, -Ii, x,\,,1

. (1-t/>')~CT~(I-tP~")
/J~ Var, [x, f,,1 = ., l' (11.3.23)
(I-¢)-(I-,p')

This expression for a" docs not grow linearly with II. I knte if one uses the
Black-Scholes j(mllula (11.3,22) and cairlllatl's illlj)licd volatility. the illl-
plied vol'ltility will depend 011 the lIl;lllll'ity uflhe option; therl' willlw a trIm
,Iimrlllrp oj im/)iil'li VOilllilii.~ Ihal will depend 011 Ihl' parameters of Ihe IIndl'r-
Iving Il'rlll- structllre llIodl'l. JallIshidian (1 !lH!l) prl'scllts a cOlltinuous-limc
versioll of Ihis result, and Turnhllll alld Milnc (I !1!H) <JeriV<' it in disCTctl'
tillle alollf,?; wilh nUlllcrous rcsults I<JI' <JtitCI' typl'S of' l!cri"ativl' securilies,
Oplioll pricill~ is cOllsiderahly 1II0Il' dillintll ill ;\ ~;q\larl'-ro()1 model. hlll
Cux, Ingersoll. and Ross (1985a) present sOllie lISdll1 rl'sllIL~.
Invl'stml'nl professionals orten wallt to pricr optiolls in a way that is ex-
actly consistent with the CllrrCllttenll strllrlllre of interest rates. Tt) do this.
we can hreak Ihe II-pcriod stochastic disCOlltll {;Irtor illtu tWI) cOlllpollenL~:

(I U.24)

where. as ill Sectiol\ 11.3,1. the ll-nll\\pOI\I'11I i, sll)('h<lstic while the i~

compOnl'lIl is deterministic. There is a corresponding decompositioll of
bond priccs ror any malllrity j: lj, == I;; }'/;. Then it is easy 10 show that

(;",(:\) == E,[M;:.I+ft M::. II " Max(/';~" " 1';',1+ >I - X, 0) 1

M::.I+>I p;.,+)·:/l 1'.1;:,/+11 M,IX (/';', 1+ " - XI I':',ff ",0) J

1'"n+r.1 ('"
'",
(XII'"r./t-n ). (I1.:t2!i)
where {.''' is the cdl optioll pricc that would prevail ifthe stochastic discount
brlor weI"!' M". III othn words optiolls c;ln he priced using the stochas-
lic lertll-slnll'tlll"!' IIIOd..!, using Ihe delermillistic model only to a(Ullst Ihe
exercise pritT alld 1111" filial solulion ((II' the oplion price, This approach
was firsl IIsed hy 110 ;llId Lee (I (IH(i); however as nyhvig (19WI) POilllS OUI,
110 ;uull.(T (hoOSI' ;1' t1wif II-IIIOdd Ilrl' Sillgk-f;\l"lOf 1r00\Ioskedaslic 1II0del
wilh t/> = I, \"lrich Ira, 1I1111}('IOIIS unappealillg properties, Black, lklmall,
alld Toy (1~1!IO), Ilealh, .larrow, and Morton (1992), and 111111 and \\'hile
(I!l!/Oa) IIS(, similar ;lpplOaciws wilh differenl choice.~ fill' Ihe a-lIIodel.

I 1.4 Conclusion

In Ihis chapler liT ha\'(' thorollghly I'xplorcd a Iraclahle class of illttTest-

rale models, Ihl' so-called affine-yield models. In Ihes(' models log hond
yidds arc lincar in slate variables, which simplifies Ihe .nlalysis of Ihe term
slructure ofilllcresl raIl'S and offix(,d-illcoll\e derivalive securilies. We have
als"o S('('II Ihat affilw-yil'ld IlIo(ld, have SOUl(' limilaliollS, particlliarly in de-
snihing thl' dynamics or the short-term nominal interesl rate. Th('l"(' is
'Iccordillgll' I-(reat int('l'esl ill del'dopilll-( more f1exihle models Ihal allo\\' for
slich pheIlOI\\('II;1 as 1I11111ipic 1'('l-(illll'S, nonlinear nwan-n'l'ersioll, and seri-
ally corrd;tled illl('l'esl-rale l'olatililY, and thaI fully exploil IIII' informatioll
ill Ihe yidd 1'1Ir\'('.
A~ Ihe lel'lll-slrll(llire lill'rallllT \IIoves forward, il will he imporlanl 10
intel-(r.\I(' il with Ihe I'esl or the asset pricilll-( lileralllrc. WI' have secn thaI
lenll-sll'll('\IIJ'(' lIIodds can 1)(' dewed as lilllc-series models filr the sl')chastic
discollllt bctol', The research on stock retllrns discllsscd ill Chaplel H also
sl'('k.~ (0 chara('\('ri/e Ihe hehavior of Ihe slochastic disco\lnl f;lclor. Ry COlll-
hining lilt' inlimll;!tioll in til(' prices of stocks and lixed-illcolI\e securities
it sholllcll)(' possihle 10 I-(aill a hel\er IInderstanding of Ihe economic forces
that d('tennil\(' Ihe prices of financial assets,

Problems-Chapter J 1

11.1 AsslllIll' Ihallhe hOllloskl'(bstic IOl-(nol'lnal I>ond pricing llIodel giV('1I

h)' eqllatioJ\s (I I. I.:\) alld (11.1.:») holds wilh rp < I.
11.1.1 SIiPPOSI' VOlllillhc C\ll'rl'lIllerlll structure of ill (t'res( rates Il~illl-(
a randolll w;rlk lIIodd ;\lIgllll'lIted by I\t-terrllillis(ir drift ('\'IllS, clju;lIioll
( 11.:~.4). Ileri\'(' all ex pn'ssioll rdat illl-( the drift terllls 10 Ihe stale \'ariahle
.\', and the paranlt'll'Is pf lilt' trill' I>olld pricing Iliodd.

11.1.2 (:OIIlP;III' Ill<' 1"'1)('CII'<1 1'111111'1' 101-( short raIl'S illlplil'd hy tl\(' Il'It('
hOlld pricillg Iliodd ,,"e1111t' ""ldwnwalk luodel wilh detel'lllillislic drifts.
 465

11.1.3 Compare the time I conditional variances of log bond pryces al

limc I + I implied by the true bOlld priciIlI{ model and the random walk
l1lodel with deterministic drifts. '
I
1l.1.4 Compare the prices of bond optiollS illlplierl hy the true! bond
I
pricillg Illodel and the random walk lIlodel with deterministic drifis.
Note: This questioll is based 011 fiackus and Zin (1994). ,
11.2 Define (;'"1 to be the price at tilllc I of all II-period forward contract
on a zero-coupon bond which matures at time 1+ n + r. Define H'"1 to he
the price at time I of all n-period futures contract on the same zero-coupon
hond. AsslIlIle that the hOIll()skedastic single-factor term-structure model
of Sec t iOIl I 1.1.1 holds.
11.2.1 Show that both the log forward price g'"1 and the log futures
price It, ", are affine in the state variable x,. Solve for the coefficients
determining these prices as functions of the term-structllre coefficients
All and Jill'

11.2.2 Show that the ratio of forward to futures prices is constant and
gn'atcr thall one. Give some economic intuition for this result.

11.2.3 For the parameter values in Section 11.2.2, plot the ratio of for-
ward prices 10 futures prices as a function of maturity n.
Note: This question is based on fiackus, Foresi, and Zin (\996).
 Nonlinearities in Financial Data
12

TilE ECONOMETRIC METHODS we discuss ill this tt~xt an~ allllost all designed
to detcct linrar structure in finam:ial data. In Chapter 2, for example, we
develop lime-series tests for predictability of asset relllrllS that use weighted
ccmbin,lliuns of return autocorrclations-linear predictability is the fucus.
The event study uf Chapter 4, and the (,APM and APT uf Chapters 5 and
6, arc based on linear models of expected returns. And even when we
broaden our foclls inlaler chapters to include other economic variables slIch
as consumption, dividends, and interest rates, the lIlodcls remain linear.
This emphasis on linearity should not be too surprising since many of the
economic models lhal drive financial econometrics are linear models.
However, many aspects of economic hehavior llIay not he linear. Exper-
imental evidence and casual introspection suggest that investor's' alii tudes
towards risk and expected return are nonlinear. The lenns of many lill<ln-
cial contracts sHch as options and other derivative secllrities are nonlinear.
And the strategic interactions among market partit'ipants, the process by
which information is incorporated into security prices, and the dynamics
of ecollomy-wide IIUClU<ltiolls are all inherently nOldinear. Therefore, a
natural frontier for financial econometrics is the 1II0deling of nonlinear
phenomena.
This is quite a challenge, since the collectioll of nonlinear models is
much "larger" than the collection of linear models-after all, everything
which is not linear is nonlinear. Moreover, Ilonlinear IllOdels arc generally
more difficult to analyze than linear ones, rarely producing closed-form ex-
pressions which can he casily manipulated and empirically implemcnted.
In sOllie cases, the only mode of analysis is computational, a1ld this is lIl1\:I-
miliar territory to those of us who ,liT accustollled to thillking analytically,
illtuitively. and linearly.
nut cconoJ\lists of a new generatioll arc ('I'cating Il!'W models and tools
tll<lt CUI ClpllllT nonlincarities in econoillic phenorr,crra, anel sOllie of these
models arrd tools arc the focus of this chapler. Excitillg advanccs in dynalll-
 12, NOI/ /iI/t'l /rilit' J il/ Fil/I /I/ril
/II ),1/1/

ical systc llls Ihco ry. lIoll lille ar

lillH"-s('ries allal ysis, stoc hast ic-\'o
els, lIon para lllel ric slali slics , aile! latili lY mod -
artil ieial ncu ral netw orks have
1'('(,(' 111 illl(' r('sl ill lIoll fu('l ed lhl'
lill(' arili ('s ill fina ncia l dala , alld
of Ih('s (' topi cs ill th(' follo wing
wc shal l expl oce each
sedi ollS ,
Sect ioll I ~,I r!'l'i ,its SOIll!' of
lhc isslI('s raisc d in Cha pler ~
pr('diclOlhilil\,. hill hOlIl ;1 lill!'; rcga rdin g
II-\'t"rSIiS-lIolllill('ar pnsp ('cti \'(',
laxOIIOIII)' of IllO dds Ihal dislill)!;l \Vl' pr('s cill a
Iisli('s h('lw eell mod els llial arc
ill III ('a II alld 11<'111'(' d('pa l'l froll Ilon lill(' ar
llli( ' lIlal 'ling ai!' hypO lh!'s is. alld
arc lIoli lilic ar in "OIriOlIl(,(' alld mod els Ihal
II<'IICC depa l'l froll l indq H'lI dl'IH
froll l lh!' llIal'lill)!;ait- h\'POllI('s T hili nol
is,
S('('( ioll I~,~ ('xp lm(' s ill gr('
aln d(,ta il IIlOd('ls thaI arc Iloll
\'ari ancl '. incl ildil lg IIl1i\'arial(' lilic ar ill
and Illui tivar iat(' C(,l lcra lilcd
COl lditi ollal ly IlclcJ'()skedOlstie AIIlOJ'(')!;rc\sil'('
( ;ARCII) and stoc hast ic-v olati
In S('ct iolls I :!,:I alld I~..I wc nIOl lity lIlod els,
'(' beyo nd para lJl(, tric tillle -s('ri
e1s to ('xp lor(' nOli para lll!'l ric cs llIod -
lIl('t hods for fittin g non lille ar
1)('IW('('1I \'aria lll!'s , illdu dillg r('la tioll ship s
Sillo othi llg tech lliqu es and artif
lI!'tw orks , Alth ou)! ;h Ih('s(' t('ch icial IlI'lI lal
lliqu !'s arc able [0 llllCOI'('r a \'ari
lin!' arili !'s, thn' ;rr<' IIl'OI"ill' dOll ety of nOIl-
a-d!'(l!,lId!'nt alld com puta tioll
'Ii) illlls lralc th!' POIl'('I' oftll ('S!' ally illll'IISil'!',
l!'ch lliql l!'S, we pres !'lIt all appl
(llicill)!; .111(1 h(,d ging of dnil'OIlil icati oll 10 lhe
'!' sl'cl lrilie s OIlId 10 eSlil llali llg
dell sili! ", Slal!'-pi ic('
W!' .!lso disc llss SOIlI(' of III<'
lilllilOiliolls of Ihes e lech lliqu
lioll I ':2,:1. The IlIosl illl!, ollal il l's ill S!'c-
lilllilOiliolls al(, the lwill proh lem
tillg alld data -sllo opil lg. whic h s of ol'er fil-
plagll<' line ar mod els too but
the salll !' c\eg n'e, Ullfill'lIIl1atc 1I0t lIear ly 10
ly, 11'(' have I'cry lillie to say abo
lI'ith thcs c issue s exce pt ill vel')' ut holl' te deal
sp!'c ial case s, hCll ce this is all area
ope n rese arch qU(, Slio m to 1)(' with 1l1:11lY
allswl'!'I'C\.

12.1 Non linc ar Stru ctur c in Uni vari

ate Tim e Seri es
A lypi ct\li lllt'- snie s lIlod d relat
es all obse rvcd tilll(, serie s x,IO
S('II'II'II('(' of shoc ks f" III lilll'f all ulld erly ing
lr tillll '-ser ies allal ysis
1(1) (' IIIH'OITdall'ci hili
the shoc ks an' assu lIled
arl' 1101 1Il'I,(,~"II'ily aSSllllll'd 10
i{epn'sl'IlIOIlioll TIH'Of('1I1 all\, Iw lID, By lh(' \Vol d
tilll!' snil 's call he writ tcn as all
linl' ar IIlOl'ill)!; 'lI'I'!'a)!;1' of slIch infil lile- orde r
shoc ks, alld Ihis lilll' al' mov illg-
res! 'nlal ion SllllllllOlri/c's tilt' llllc av('r age r('p-
olHl ilion al vari ance and auto cova
th(' snic s, riall C<'s of
III IIOlll il/l'I1 I tilll! '-sni ('s all;i1vsis
tIl!' IlIll krly ing ,~hocks ar(' typic
SllllH'd to hc 111>,11111 W(' s('ck a pms ;i1ly as-
illly non line ar fUllc tioll r(,la ting
XI to tlie histo ry of
tile scri(',~
lire shoc ks, ,\ gl'lH'rOlI r(,pr esen
tatio n is

(I ~,I.I)
 I

I'
J2. J. Nonlinf(lr Structure in Ullillflrillif Time SflifS

where the shocks are assumed to have mean zero and unit variance, an~ f(·)
is some unknown function. The generality of this representation makes it .;~;:~~.
very hard to work with-most models used in practice fall into a somewhat
lllore restricted c\a~s that can be written as i
(12.1.2)

The function g(.) represents the mean of XI conditional on past information,

since E'_I [x, 1 = g(E '-I. f,_~ •... ). The innovation in XI is proportionallo the
shock fl' where the coefficient of proportionality is the functiQn h(·). The
sCJlIare of this function is the variance of X, conditional on past information,
since r.1_1 (xI-Et-I [X,])2) = h(fl_l. f l-2 •. ' .)2. Models with nonlinear gO
are said to be nonlinear in mf(ln, whereas models with nonlinear h(.)2 arc
said to be nonlinear in variance.
To t.lIlder~tand t~e restrictions ~mposed by (12.1.2) on.( 12.1.1), coryider
expandlllg (I 2. l.l ) III a Taylor senes around fl =
0 for given (I-I. (1-'2' ••• :
XI = /(O,ft-l .... )+flji(O.f/_I .... )

(12.1.3)
where Ji is lh~ derivative of J with respect to fl' its first argument; iii is the
second derivatiw of / with respect to f,; and so forth. To obtain (12.1.2), we
drop the higher-order terms in the Taylor expansion and set g(fl_I •... ) =
/(0. EI_I .... ) and h(f/_I .... ) = ji(O, (I-I>' .. ). By dropping higher-order
tenllS we link the time-variation in the higher conditional moments of XI
inflexibly with the time-variation in the second conditional moment of x"
since for all powers p~2, E/_I[(XI - E/_I(x,])PJ :::: h(.)PE[€fJ. Those who
arc interested primarily in the first two conditional moments of XI regard
this restriction as a price worth paying for the greater tractability of (12.1.2).
ECJuation (12.1.2) leads to a natural division in the nonlinear time-
series literature between models of the conditional mean gO and models
of the conditional variance h(-)2. Most time-series models concentrate on
one form of nonlinearity or the other. A simple nonlinear moving-average
model, for example, takes the form
(12.1.4)

Here f.{(') = cui_I and hO = 1. This model is nonlinear in mean but not
in variance. The first-order Autoregressive Conditionally Heteroskedastic
(ARCH) model of Engle (19R2), on the other hand, takes the form

(12.1.5)

Here g(.) = 0 and h(·) = j(U;_I' This model is nonlinear in variance but
not in Illean.
470 J2. NOlllinearitieJ ill Fil/flllrifl/IJtl/1l

Onc way to understand thc distinction bctwecn nonlincarity in lIlean

and nonlinearity in variancc is to considcr thc moments of thc x, proccss.
A~ we havc cmphasizcd, nonlinear Jllodels can be constructed so that sec-
ond moments (autocovarianccs) E[x, x,_;] arc all zero for i>O. III the
two cxamplcs abovc it is easy to conlirm that this is thc casc provided
that f., is symmetrically distributcd, i.c., its third momcnt is zen>. For
thc nonlincar moving averagc (12.1.4), for examplc. we have Elx, X,_I] ==
E[ Cf.,+af.;_1 )(15,-1 +af.;_2) J == aE[f!.:-ll = 0 whcn EI f.~_1 J=O.
Now considcr thc bchavior of highcr momcnts of thc form

Models that arc nonlincar in the mcan allow these higher 1ll0mCIllS to he
nonlcro whcn i, j. k, ... >0. Models that arc nonlincar in variance bllt obey
thc martingalc propcrty havc E(x, I X,-I •.. . J=O, so their highcr momcills
arc lCro whcn i. j. k • ... >0. These models Gill only havc nonzero higher
momcnts if at Icast onc timc lag indcx i. j. h• ... is 1.Cro. In thc nonlinear-
moving-avcragc cxamplc, (\ 2.1.4). the third momcnt with i= j= I,

E[ (f,+af ;_I)(f,-I +af;_t)2 J

2
aEk/_ 11+2a E[f~2J Elf;_11 i' O.
tc nrst-o~dcr ~CH cxample. (12.1.5); the same third momellt [[x, x;_11
In}
== ·(f.,Jafi_l)fi_Iaf.~21 = o. fillt for this model the fOllrth IIlOlllent with
i= ,j=k=l, E(x; x;_.1 = Elf; at f.:_ 1f;_21 i' O.
I
Wc discuss ARCH and other models of changing variance in Sectioll 12.2;
for ;the remainder of this scction we concentratc on nonlinear models or
thc Iconditional mean. In Section 12.1.1 we explore scveral alternative ways
to ~arametrize nonlinear models, and in Section 12.1.2 wc usc thcse para-
me ric models to motivate and explain somc COllllTlonly IIsed tests for non-
lin arity in univariatc time series, including thc test of Brock, Dechert, and
Sch inkman (1987).

J2. J. I S011lr I'llram~tri(: /I1otidl

impossible to provide an exhaustive aCCOllill of all nonlinear specili-
cati ns, cven when we restrict ollr alleillioll to the slIbset of parametric
1II01.els. Priestlcy (1988), Ter;isvirta, 'lj0stheilll, and Granger (\ 9!14). and
Tong (1990) provide excellcnt coveragc of mailY of thc lIIost poplllar 11011-
Iinellr time-series lIIodels, including IllOre-speciali/.ed lIIodels with sOllie very
intrigUing names, c .g., .v/frxritillg Ihrr.~/lOltllllltort'gTr.\.\i(m (SETAl{) , flm/J/ill/tir-
drJJmcll'1li I'x/Jonential a utoTrwe.uio 11 (EXPAR), and Jttltr-dr/Jenlil'1lt "'f}(lrll (SDM).
To provide a sense of the hreadth of this area, we discllss fOllr examples in
12. I. NtmJil/i'l/r S/rurllHl' in (/lIil>lIIill/1' Timl' Sl'ril'.1 .17\

this sectioll: polYIIOIlliallllodels, pic(Twisc-lillear lII(xlds, Mark()v-llwitchill~

Illodels, alld deterministic rhaotir lllOllels.

['o/)'Ill/millt Mor/pLf
Om' way to reprcselll the fUllction g(.) is cxp.\l\d it ill .1 'bylor scrics arollnd
(/_I=(/_~='" =0, which yields a <liscn·te-timc \'"IIITm .\I'ril'.< (see Vollerra
L1D:)!l)):
no "-' '"X.;

LII/(-1 1+ LL",,(I"('I',
,;::::1 I I r'l
"-' '"X..: .......,

+LLL("kf/.,fl ,(I k+· ... (1~.l.Ii)

1=1 F' k=,

TIl(' sill~le
SUIllIll.ltioll in (12.I.G) is a slalldanl lillcar Illovill~ average, the
dO~lble sUllllllatioll captllres thc cITects oflag~ed cross-prodllcts ortwo inno-
vatiolls, the triple slllllmatioll capturcs the eCkels of la~~ed cross-products
of (hree innovations, and so 011. The sUllllllatiolls indexe(1 by j st.art at i,
the SlIllllllatiollS indexed by k start at j, and so on to avoid cOllntill~ a ~iven
cross-product of innovatiolls /IIore thall OIHT. The idea is (0 represcllt the
tnit' nonlinear function of past innovations as a weighted SUIII of polyno-
mial runnions of (he innovations. Eqllatioll (I ~.I.1) is a Silllple example of
a 1I'lOdei of this fonll. Robinson (1979) and Priestley (I~)HH) m,lke o:tensive
II,,' of this specification.
Polynomial models lIIay also hc writ tell in autoregressive «»"III. The
fUllction g-(fl_l, <I_~"") rclatill~ the (ollditionallll('all to past shocks Illay
be rewritten as a function g*(XI_I' XI_~"") rdatin~ the cOllditionalmelll
to b~s of XI' The alltorc~rtssive version of (I '2.I.li) is th(,11

0V "- '>.!

LIl~XI-I+ LLI';,xl-,xl._,
1;;:;1 1=1 j:.-:/

no ro ro
+L LL (~k X,_, XI_, X'-k + .... ( 1~.1.7)
;=1 ,=, k~)

It is also possible to ohtailllllixed autore~ressive/ll1()villfi-avna~e repre-

sentatiolls, the nonlinear equivalent of ARM/\ iIlodds. Thl' hili\lear lIloclel,
for example. IIses la~g('d vailles of XI. I.. g~ed v;t1ll(,S of f " and (Toss·products
or illl' 111'0:

""" "'v "-

La,E /_;+ Lfi,xl

"'-
-t- L Lv" XI_,f /·
,=I ,= I
l• (1~.l.H)
1=1 1=1
 } 2, NOI/!iI/t'l/rilil'v il/ Fil/tll/ritll })1I111

This lIlodel call capt 111'1' lIolllilll'arities parsillloniously (with a fillite, short
lal-( 1{'lIl-(th) II'hl'lI PUI'(' lIolllille;II' lIlovilll-(-;\Vcral-(' or Ilonlinl'ar alltor('~rl's­
siVl' lIlodds f;lillo 110 so, (;rangl'l' ant! Andersen (197H) anti Suhha K;'o ;mel
Cabr (1!IH'I) ex pIon' bilillear lIIodels ill delail.

l'il't'l7l1i.wl.i 111'11,. II/oddl

Allothn popllLlr \\';\\' to lit tlotllitlt'<lr slnl(llll'(' is 10 US(' pieCl'wisl'-lint'ar
fllnl'liotls, as ill the lirsl-onln 1!tIl',lltll/d tll/lmt'/,TJ'fuilll/ (TAR):

if XI-l < Ir
(l ~,1.9)
if X,_I > Ie.

lien' the illtenqll <llId slope col'iIici{'nt ill a l'l'l-(rcssioll of x, Oil its lag XI_ (
{il-p{,tld Otl the \'<lllIe of .'(,_1 in rdalion 10 lhe threshold /(. This lJIOlklc\l\ he
gellt ...ali/{'{l to higher ordns ancllllllltiplt, Ihrcsholds, as explaillcd ill del ail
ill '1(lIlg (I !)H:I, I !)!IO),
l'ieITWisl'-lilll'<lr mlllkis <llsn inr\lule dlll1lJ;f-/lIlill/lllotll'ls or, as Ihey art'
known in tI\(' C{'ollolilics Ii Il'I'at lII'e, lIlodcls with ,l/mrlll/(/I/i/mlrl. In Iht'st'
lIlodds, Ihe P;II;IIIII'Il'l's arc aSSUlllcd to shifl-Iypi('ally ollt'l'-during a Ii xed
salllpk pl'l'iod, and IIll' go;}l is to I'slimale Ihe two sets ofparallH'ters as well as
the challgc (loint or stl'llctllr;ti hrcak, I'crron (1!IH9) appli{'s this tcchniquc
to llIal'l'OI'('OIlOltlil' till\(' sni{'s, ;\I\d grodsky (I !1!1:~) atlt! C;1r!slein, MIIller,
and Siq{lllUIUI ( I!)!J.l) pn's('ntlllorc n'n'nt melhods for dealing with cll;tng{'
POiIlIS, illcluding IIOllp<lralllClric I'slilllators and Bayesian ill fe l'l'II('(' ,
Ch;lIIge-poillt 1\\('lhoc!s arc \'''''y wdl-l'stahlishl'd ill the statistics all{! ()P-
1'laliol1s n's(';IITh litcratlln', bill lheir application 10 (,COllOIJlic Illodels is
1101 wilhollt (,OlltrovcrW, UlIlikl' the typical engill{'l'l-ing applicalion wilerI'
a structural break is klloll'lI to ('xist ill a ~iV<'n datasct, we can Ilt'wr say \Vith
I'tTI<lillt)' Ihal ',I ~lrtlt'I\lI"al bn'ak !'Xisls in ,Ill ccollomic tillll' snit's, AII(1 if
I\'{' think a sll'llctlll;rI br('ak has ()(Tllrrcel hccause of so III l' major ('collolllic
evelll, l',g" a stO( k lllarkel cLlSh, this {hlta-drivcn spl~l'ifiraliotl search rail
bias 0111' illi'crctl<TS dr;lI11atirally tOI\';mls lineling hreaks whcre nOllt' ('xist
(scc, fill' ('X;lIl1pk, 1.(';1111('1" 1II17HI alld 1.0 alit! MarKinlay 119!IO]),

II Irllilllll-SII'ilr hil/g' ;\ '{lrld,

The Mat kU\'-'lI'il( bing IlIo<l..t or I bl1li\tol\ (I !IH!I, I (I!HI, I!1!l:I) alld Sl'l()\'(~
(\!)l'tI~I, \!Il'tll» is do",l)' rdaln\ to thl' TAR, Tltl' key dilfl ... l'lIc(' is that
('hallges ill rq{illll' ;In' dCll'nllilled 1I0t hy the Icvd oftit(' proc('ss, bill 1)\, all
ttlwits{'f\'('d sUte \';lIi;dllc which is t"piedl), Illoddl'd as a tI.\;lrkov rhaitl, For
I'X-,lIl1pk,

{ tt I -I /ll_\, _ -t- fir it' .\,

,\'/ (1~,I.I()}
lr,~ + fl~ x, + f~, if v, =0
12.1. Nonlinear Structure in Univariate Time Series 473

where 5, is an unobservable two-state Markov chain with some transition

probability matrix P. Note the slightly different timing convention in
(12.1.10): 5, determines the regime at time t, not 5,_1. In both regimes, x,
is all AR( I), but the parameters (including the variance of the error term)
differ across regimes, and the change in regime is stochastic and possibly
serially correlated.
This model has obvious appeal from an economic perspective. Changes
ill regime are caused by factors other than the series we are currently mod-
eling (5, determines the regime, not x,), rarely do we know which regime
we are in (5, is unobservable), but after the fact we can often identify which
regime we were in with some degree of confidence (5, can be estimated,
via lIamilton's [1989] filtering process). Moreover, the Markov-switching
model does not suffer from some of the statistical biases that models of
structural breaks do; the regime shifL~ are "identified" by the interaction be-
tween the data and the Markov chain, not by a priori inspection of the data.
Hamilton's (1989) application to business cycles is an excellent illustration
of the power and scope of this technique.

iMrnllilli-ltir Nonlinear Dynamical.'>~Y5terllJ

Thnt' have been many exciting recenl advances in modeling deterministic
noniiTll'{lrtiynamicaisysterns, and these have motivated a number of techniques
for estimating nonlinear relationships. Relatively simple systems of ordinary
(Iifferential and difference equations have been shown to exhibit extremely
complex dynamics. The popular term for such complexity is the Butterfly
FJFrt, the notion that "a flap ofa butterfly's wings in Brazil sets offa tornado
in Texas".1 This refers, only halfjokingly, to the following simple system
of deterministic ordinary diflerential equations proposed by Lorenz (1963)
for modeling weather patterns:

X 10(y - x) (12.1.11)
y = xz + 28x - y (l2.Q2)
8 i
i: = xy + '3z. (12.1.13)

I.orenz (1963) observed that even the slightest change in the starting values
of this system-in the fourth decimal place, for example-produces dra-
matically different sample paths, even after only a short time. This sensitivity
to initial conditions is a hallmark of the emerging field of chaos theory.

•
IThis b adaplrd from Iht' lilk of Edward l.orellz's addr..", to the American Association
for Ihe Advancement of Science in Washilll{ton, D.C., December 1979. See Gleick (191l7) for
a livl'ly and t'ntertaining layman's account of the emerging science of nonlinear dynamical
systellls. or chaos theory.
474 12. Nonlinearities ill Hlumrial Data

C!

co
o·

<0
0
><
...
0

""0

~I 0 0.2 U.4 0,(; O.H 1.11

!
1
I Figure 12.1. 'O,e Ten/ Mal'

An even simpler example ofa chaotic system is the well-known telllmap:

if X,_I < ~
X, = if X,_I > ~
-,\, E (0, I). (1~.1.11)

Th' tent map can be viewed as a first-order thrcshold autoregression with

no shock f, and with parameters (11=0, f31=2, (12=2, and f32= -~. If X,_I
Iie~ between 0 and I, X, also lics in this intcrval; thus thc telll map maps thc
unIt interval back into itself as illustrated in Figure 12.1. Data generated
by k12.1.14) appear random in that they are uniformly distributed on the
unit interval and arc serially uncorrclated. Moreover, the data also exhibit
selisitive dependcncc to initial conditions, which will bc vcrificd in Prohlcm
12.1. Hsieh (1991) prcsents several other leading examples, while Brock
(1986), Holdcn (1986), and Thompson and Stewart (1986) provide lI10re
formal di.~cussions of the mathematics of chaotic systems.
Although thc JIIany important breakthroughs in nonlinear dynamical
systems do have immediate implications for physics, biology, aIHI other
"hard" scienccs, the impact 011 econoJllics and finance has been less dra-
matic. While a number of economic applicatiollS have bcen cOIISiliercd,2
nonc arc especially compelling, particularly fmm an empirical pnspenivc.

2&e, for example, Boldrill alld WoodlOld (1990), lI,ork alld Sayers (19HH), (:raig. I\ohl.lw.
and Papdl (1991). Day (19H:I). (;',111(11110111 alld Mal!(,allt(· (19M!;). Ihidl (199:1). 1\('11"""
12.1. NOlllilll'llr Sirtlrillll' iii Ultillllli(//t' Tilllt, Snit'.1

There are two serious problems ill IlH)(ldillg I'COIlOlllic plu'lloml'lla as de-
tennillistic Ilolllillear dynamical systems. First, unlike the theory that is
available in mallY natural sciences, ecolloillic theory is gt'lllTally Ilot spe-
cific about fUllctional forms. Thus ecollomists rarely have theoreticil rea-
sons for expectillg to find one form of nOll linearity r;llhlT thall allother.
Second, economists arc rarely ahle to t:onduct controlled experiments, and
this Inakes it almost impossihle to deduce the par;lIlH'tlTS or a deterministic
dynamical system governing econolllic phenomena. eve II ifsuch a system ex-
ists and is low-dimellsional. When controllnl expniml'nts are kasible, e.g.,
in p;micle physics, it is possible to recover the dynaillics with great precision
hy taking many "snapshots" of the system ;It r1osl'iy spaced tillle intervals.
This technique, knowll as ,I .Iim/}(}.IIO/Iit lilli/lora I'"illl'lllt; I/'rlioll, has given
elllpirical content to even the llIost ahstral'lnotions of nonlinear dynamit:al
systems. hut unlilrtunatdy cannot he applied to non-expnimental data.
The possihility that a rdatively simpit' set of nonlinear deterministic
equations can generate the kind of complexities we see in finallciallllarkelS
is tantalizing. hut it is of lillie interest if we C<lIlllot recover these cquations
witL any degree of precision. Moreover. the impart of statisticil sampling
errors 011 a system with sensitive dependellce to illitial cOllditions makes
dvnamical systems theory even less practical. Of course, given the rapid
p,lce at which this field is .. dvancing, these resl'Ivaliolls 11l;IY he lIIuch less
serious ill a few years.

12.1.2 l/lIill(lnllit' ·li·.I!.1 Jor NOlllilll'r/r '\/1'1/('/111/'

Despite the clveat.~ of thc previous section, the mathelnalit:s of chaos theory
has motivated several ncw statistical tests liJr indcpcndence and nonlincar
structure which arc valuablc in their own right, and WI' now discuss thcse
tests.

'/I'.Ii.1 /Ifl.\rd Oil Higher Momenis

Our earlier discllssion of higher mOlllenl.~ of nonlinear lIlodeis can scrve
as the basis lill' a statistical test of nonlinearity. Iisieh (I !IH!I), Ii)!' cxample,
ddines a selinl titirumolllent:

E I X, .\'/-/ X, J I
<p(i, j) - (1~.I.Ei)
E[ x/ 1:1/ 2
ane! observes that <p(i, j)=O for all i, j>O firr liD data, or data generated hy a
m;lrlin)!;;11c modclthat is nonlillear only ill variall!'l'. I Ie suggests estimatin)!;

and O'Brien (I\I~I:I). I'c""',,,, ,lIul 1'011('" (l(r~I:!). SdH'inkmall .11111 l.ell.lIlJll (I~IH~I). alld
Schelllkmall alld Woodlord (1\.194).
 /2. NllfI/illl'tltilil'.1 il/ l-'illfl1ll'illl /)11111

(p(i, j) ill IIII' olll'io\ls way:

+- LI X, X,_; X'_j
.p(i, jl - (I ~,l. Iti)
[ .L"
r
'l]:If'!
'--I X,
•

l 'lI(kr Ihe IIIIIlII\')\OII\('sis Ihal <p( i, j)=O, and with sufficielll n'gularity cOlltii-
lions impos('d Oil x, so that higher 1Il01llt'I\ts exist, fl(jJ(i, j\ is aSYlllplOtirally
normal alld ils I'ariallct' Call ill' consisll'lIlly eslilllal('d hy

\' -- (12.1.17)

Ilsi('h \ lesl IIS('S 011(' parrindar third 1I\0ll1CIII or Ihl' data, but it is also
possible 10 look at Sel'crallilollll'lIts silllullallt'ously. The alltoregressiVl' poly-
lIollliallllocll'l ( I:!.1.7), lill' I'Xalllplt·, suggl'sts that a simpll' lI'st of nOli Ii Ill' ar-
it)' ill the mea II is to rq-\n'ss x, Ollto its OlVlllagS alld crOSS-PI oducts of its 0\\,11
lags, ;1111110 \('SI for Ihe joilll sigllilicllI(,(' ofthl' 1l0nlillCar I.-nilS. Tsay (l!lH())
proposl's a \t'SI of Illb son using S('eOllll-oHler lerlllS alld ,\1 lags for a lolal
of M (M + I )/'2 lIonlilH'ar regressors. ()nc call ca!rulale hdnoskt't!;ISlicilY-
cOllsiSlt'll1 slandarcll'ITOI'S so Ihal Ihl' lesl becolllcs robusl to the prcsence
or Ilolllillcarity in variancl'.

'1111' Cllndlllillll IlIltgml II lid /111' Cllndl//illll J)illlfn.lillll

To distinguish a I\t-tel'lllinistic, chaotic process rrom a lruly ralldom process,
it is esselltial to view the data in a sllllirielldy high-dimellsiollallimll. In lhe
case of Ihe t('111 Illap, for l'xalllpl(', lhl' data appear randolll if one plots x,
Oil lhl' IInil inlerval sillc(' x, has" IlIIifonll dislriblliioll. If Olll' ploLs X, all(l
-"'_1011 the ullit squarl', howl'vl'r, lhl' data will all fall 011 tit I' tellt-shapccllilll'
showlI ill Figure I ~.I.
This straiglillill'wanl approach call yil'id surprising insights, as \\'1' saw in
allal)'l.illg slork pric(' dis(TI'I('IIt'ss ill (:hapll'r~. Howevl'r it becollles diHiclIlt
10 illlplcllH'lIllVlu'1I high('r dilliellsiolls or more cOlJlplicate<inonlilll'arilics
an'involved, (:rassl)('rgn alld 1'1Ot';lccia (I!lH3) have suggested a lonllal
approach to capt III'(' Ihis hasic icka, Their approach \)l'gins by organizing
lhl' llata (pn'lillt'red, if desired, 10 l'CIllOV(' lilll'ar struelllre) into lI-hi.l/oriPJ
-,,;', ddilll'd hI'
x;' = !x, n\ I,···, XII. (I :!.I.IH)

Th(' parallll'l('r II is kllo\\,11 as Ihe "IIt/mldilll; dillll'lHioll.

Thl' lIext ~t('1' is 10 Lrinlbll' tl\(' i'raclioll of pairs of II-histories that arc
"do,,'" to OIl(' ;11 11>1 hIT. 'I'll III1'<lSIII(' clOS('III'SS, WI' pick a 11I1I1I\)l'r II and call
a pair of II-historil's ,<' ;\IId x;' rlose 10 Oil(' anotill'f if Ihl' greatl'st ',liJSo\tlll'
dilIc:n'lIn' IIl't\\'('('1I llt.- l'orn'sp'lIldillg 11I1'11I\)('rs or the pair is smalln than
 ..~ ...

k: /lIaxi=o ..... II~ I IX.-i-Xt-il < k. We define a closeness indicator K" that
one if the two n-histories are close to one another and zero otherwise: ,

K,t = {I if maxi=O ..... n-1 \X'-i - xt-il < k (12.1.19)

o otherwise.

We define CII,'r(k) to be the fraction of pairs that arc close in this sense, in
a sample of n-histories of size T:

(12.1.20)

The coTTe/alion integral Cn(k) is the limit of this fraction as the sample size
increases:
02.1.21)

Equivalently, it is the probability that a randomly selected pair of n-histories

is close.
Obviously the correlation integral will depend on both the embedding
dimension n and the parameter k. To see how k can matter, set the embed-
din!!; dimension n= 1 so that n-histories consist of single data points, and
consider the case where the data are lID and uniformly distributed on the
unit inten-al (0, 1). In this case the fraction of data points that are within a
distance k ofa benchmark data point is 2k when the benchmark data point
is in the middle of the unit inten-al (between k and I-k), but it is smaller
when the benchmark data point lies ncar the edge of the unit interval. In
the extreme case where the benchmark data point is zero or one, only a
fraction k of the other data points arc within k of the benchmark. The gen-
eral formula for the fraction of data points that are close to a benchmark
point b is min(k+b, 2k, k+l-b). As k shrinks, however, the complications
caused by this "edge problem" become negligible and the correlation inte-
gral approaches 2k.
Grassberger and Procaccia (1983) investigate the behavior of the cor-
relation integral as the distance measure k shrinks. They calculate the ratio
of log CII(k) to log k for small k: '

. log CliCk)
v" = hm ----"'----
k~() log k
(12.1.22)

which measures the proportional decrease in the fraction of points that a~e
close to one another as we decrease the parameter that defines closeness.
In the lID uniform case with n= I, the ratio log CI (k)/ log k approaches
log 2k/ log k=(log 2+ log k)/ log k= I as k shrinks. Thus VI =1 for lID lIlli-
limll data; for small k, the fraction of points that arc close to one anothpr
shrinks at the same rate as k. I
478 12. NonlillPflTilip.l il/ Fil/(/I/ri(/l /)(/((/

Now consider the behavior of the correlatioll integral with highn ("111-
bedding dimensions II. When 1/==2, we are plotting 2-histories of till' ll~\ta
011 a 2-dimensional diagram such as Figure 12.1 and asking what fraclion
of the 2-histories lie within a square whose center is a benchmark 2-history
and whose sides are of length '211. With unifi>nnly distributed IlL> data, a
fra(r.ion 4k2 of the data points lie within such .1 square when the hendllllark
2-hi tory is sulliciently far away rrom the edges or the ullit sqllilre. Again
we landle the edge problem by letting II shrillk, and we lind tl ... t the ratio
log Pl(k)/ log k approaches log 4kt / log k = (log 4+21og Ii)/ log Ii == '2 as
k sh!rinks. Thus 11'1==2 for IlD unifOl"Ill data; for slIIall k, the fraction of p~'irs
of I~oillts 'that are close to one another shrinks twice as fast as k. In general
v"9n for lID uniform data; for small k, the fraction of Tl-histories that are
clo* to one another shrinks 71 times as f~lst as k.
\The correlation integral behaves very differently when the data an' gen-
eraied by a nonlinear deterministic prucess. Tu see this, consider data
geJl~rated hy the tent map. III olle dimcusioll, such data rail Ulli(()\"fllly Oil
the IlIIit lille so we again get VI:::: I. But in two dimensions, all the data points
faIltn the tent-shaped line shown in Figure 1'2.4. For slIIall k, the fraction
of I irs ofpoinL~ that are close to one .mother shrinks at the same I"ilte as k
=
so 1 I. In higher dimensions a similar argulllent applies, and V,,= I lilr all
1/ wF,len data are generated hy the tent map.

r
he correlation dimension is ddined to he the limit of v" ,IS /I illlleasl's,
whe 1 this limit exists:
v:::: linl 11". (12.1.~~')
11-00

Nonlinear deterministic proccsses arc char'lCterized by linite v.

The contrast between nun linear deterministic data and lID uniform
data generalizes to lID d<lta with other distributions, since V,,== 11 for Ill>
data regardless of the distrihlltioll. The dfed or the distribution averages
out because we take each lI-history in tlll"n as a benchmark n-history whell
c<llcnlating the correlatioll illtegral. Thus Grassberger <I lid Proca(cia (I 9H:~)
suggest that one can distinguish lion linear deterministic data frolll III> ran-
dom data by calculating V" ror different 11 and seeing whether it grows wilh
II or converges to SUIIIC lixed limit. This approach requires l<lq.;e .\IllOl\lIts
of data since one mnst use very slJlall Ii \0 ("akulate V" and 110 distrihution
theory is available for v".

The Ilro(h-Decherl-Schrinhlllllll '/"51

Brock, Dechert, and Scheillklllall (19H7) have developed all altemative ap-
proach that is better suited to thc Iilllited allloullts uf data typically availahle
ill economics and finance. They show that evell when k is fillite, ir the data
arc Ill) then for any n
( 1'2.1.24)
/2.2. 1\1111"".1 n/CllIlIIgil/g i't,/alilily 47!1

'Ii. IInderstand this result, note that III<' ralio (:"I.(/I)(C,,(k) call he illln-
preted as a conditional probability:

C"II(l1)
ItI;l)~ Ix. ,- x, ,I
C,,(h) 1-::.1 •..• 11

lIIax Ix.-, -- x, . ,I
1=1..,.,11

That i~, C,,+I (h)/ C,,(h) is the prohahility Ih'lI Iwo data poillts are dose, givell
that the previolls II data poillts are close. Ir till' <lala are liD, this Illllst equal
Ihe \llll'oIHliliotl;li probability that two data points all' clOSt" <:1 (II). Selling
C,,+ 1 (II) / C" (11)= Cdh) for all positive II, we oi>laill (12.1.2'1).
Brock, Dechert, and Scheinkmall (1!IH7) plOpose Ihe /WS lest slalislic,

~J' C"./(II.) - CII(h!~, (I '2.1.'21;)

.I", r(ll) = " I
(1 ". / (/1)

whITe C", /,(11) ;'IHI (;1. rUt) arc the s'lIl1ple correlatioll illtegrals ddilled ill
( 12. ; .20), alld n", r(k) is an estimator of the aSYllIptotic standard deviation
of C".r(ll)- (:1./ (h)". The nDS statist'l(, is aSYIlIJ>lot'lcdly standard normal
under the liD Ilull hypothesis; it is applied ;lIld n;plail\t'd by I !sid I (1~IH9)
alld Scheinklll'1I1 alld LeBaroll (1!IH!l), who provide t'xplicitexpressiolls lor
a".r(/i). Iisieh (I !lH!I) and Iisieh (I !l!ll) report Monte Calio lesults on the
si/,e an(1 power of the BDS statistic ill linite sampks.
'A'hill' thele are sOllie pathologicaillolllillear Itwdds fOI which C,,(k)=
(;1 (h)" as in liD dala, the BDS statistic apJ>('ars to ha\'(' good power againsl
Ihl' IIIOSI cOllllnonly \lsed nonlinear IllOdels. It is importallt to understand
th.1l it has power against models that are IHllllinear ill \',\rian('(~ hut not in
mean, as well "s models that arc nonlinear in meall, Titus" liDS Icjeuion
docs not necessarily imply that a time-series has a tillle-v.Il'ring conditional
mean; it could simply he evidellu' 1(.1' a time-var),illg conditiollal variance.
IIsieh (1901), 1'01' example, strongly n:jnb the hypot hl'sis that (0111111011
stock returns arc liD using the liDS test. I Ie tltcn estimates models or the
tiIlH:-v;lr)'illg conditional variallcc of returlls and g(,ts 11 11K It weaker e\'idencc
ag;lillsl the hypothesis that tlte r('siduals 1'10111 such IIlOdcls ;1)(' III>.

12.2 Models of Changing Volatility

III this sn:tiol\ W(' cOl\sider alterllati\,t' ways to IlI<Hld tltt· challging volatil-
ity of a timc-snit's '''~I. Sectioll 1'2.'2.1 presellts Illli\'''li;lIe Alltoregressiv('
COlldilionall), Ilctel'Oskedastic (ARCI I) "nd stocha~li('·\'oLllilit)' lIIodels, ;llId
Sectioll 1'2.'2.'l sholVs huw these may be gen('l';lli/nllo a 1IllIltiv;lri"te sellillg.
Sectioll 12,~.:\ co\'(,rs models ill which tillle·\"lIialioll ill thl' cOllditiOIt;t1I1Il'all
 j.<.. "'J1JiJlJt'IJfJ/J/'.1 JIj "Jlj{Jlfj wi /)((/1/

is lillkt'd (0 tilllt'-\';Iriatioll illtht' cOllditiollal variallce; tht'se models art' 11011-

lillear in holll Ine;lll alld varialll'l'.
III ordn to (,(lIIlTlltrall' Oil volatility, we asslIme Ihal lilt I is all illn(),,;\-
lioll, lhal is, il has lIIt'an/el'O condilional 011 time / information. III a finance
application, /11/ I lIIight 1)(' the illnovatioll ill all assct rt'lul'll. Wt' defille 0/
to hI' tht' time' I conditioll;11 \,;II'i;ItH'C of 1111 I or I'CJuivalcntly thc conditional
expcctatioll of //;'1 I' W(' assltllll' that cOllditiollaloll lillie I illforlllatioll, lhe
illllOV;lIioll is lIorlllall\' distrillllt('d:

'iltl ~ N(o, 0/). (I:!.~.I )

2
The I\IICOIlIliliultal variance oflh(' iltllovatiolt, 0 • isjllst the IInconditiollal
eXllI'ctatioll of 0/::1

Thlls variahility of a/
arolltHI its lIIt'all does 1I0t changt' the IIIICOllditiol1al
.
vanalHT a- .
"

. The variahility or al~ do('s, how('v('r, affect higher l1J(llllCl1ts or tht' 1111-
(,(lIl1litiollal distrihltlioll or 'ilt I, III particlllar, with time-varyillg the 1111- a/
COllditiollal distJihlltioll 01'111 I I has (;\lter t<tils thall a Ilonnal distrihlliion.
To show this, \1'(' (irst writ(,:

(I~.~.~)

wltl'n' fit I is an liD randolll vari;lhle \.itll /.l'I'O \\lean aJld IInit vari:ln('(' (as
ill Ihe pre\'iolls s('('tioll) that is lIorlllally distrihllled (all aSSlllllptiol 1 we did
lIot lIIake ill till' pre\'iolls senioll),
As WI' Ilisnlsse(\ ill (:hapIl'f I, a IIsefltllllt'asllrt' of tail thicklll'sS for lht'
distrihlltioll or a ralldolll I'ariahk V is tht' Ilortllalized fOllrth 1lI01l1t'IlI, or
kurtosis, defillet! hy I\(y) '" E[/liEI/F, It is well kllown that the kurtosis
ora Illlllllal ralldolll variahle is :1; hell(,c K(~/+t) Bllt for innovations = :\.
'I/~I, WI' ha\,('

Ela;t I E[ f:+1 1
1\ (III I I)
Wla/])2

:11-:10/1
(Elo,~ l)~

:\<E[an)~
:~.
(Elo/IJ~

:tThb I ('!\lIh Iwleh 11111\ }we .111 .... '· \\'(' .1It" h"tlll..illg with all inltor.llioll ~('I i,':"o Ih~u hil~;1 ("oll'.. l;lIll
(II'IH) (ullclilion;d 1I1t',tll. hJl ,I "',ic·,wilh a lillH'-".lryilig-foll<iilioll.d I1It'OlIl.ilH' 1I11ffilulillilflal
\;\li:IIH(' j, IItJlllu' ";11111' .1' IIIC" IIIIt"CHlclilinll.d ,·.xpc·n.lIioll 01111" rOlldiliuUOII \'ari;lIln',
12.2. Mod.els oj Changing Volatility

where the first equality follows from the independence of a, and €t+I. and the
ineCJuality is implied by Jensen's Inequality. InlUitively. the unconditional
distribution is a mixture of normal distributions. some with small variances
that concentrate mass around the mean and some with large variances that
put mass in the tails of the distribution. Thus the mixed distribution has
fatter tails than the normal.
We now consider alternative ways of modeling and estimating the al
process. The literalUre on this subject is enormous. and so our review is
inevitably selective. Bollerslev. Chou, and Kroner (1992), Bollerslev, Engle,
and Nelson (1994), Hamilton (1994) provide much more comprehensive
slIrveys.

12.2.1 Univariate Models

Early research on time-varying volatility extracted volatility estimates from

asset return data before specitying a parametric time-series model forv9latil-
ity. Officer (1973), for example, used a rolling standard deviation-the~stan­
darel deviation of returns measured over a subsample which moves forward
through time-to estimate volatility ateach point in time. Other researchers
have IIscd the difference between the high and low prices on a given day to
estimate volatility for that day (Garman and Klass [1980), Parkinson [1980)).
Such methods implicitly assume that volatility is constant over some inierval
of tillle.
These methods are often CJuite accurate if the objective is simply to
measure volatility at a point in time; as Merton (1980) observed, if an ,asset
price follows a diffusion with constant volatility, e.g., a geometric Brownian
Illotion, volatility can be estimated arbitrarily accurately with an arbitrarily
short sample period if one measures prices sufficiently frequently."- Nilson
(19!12) has shown that a similar argument can be made even when volatility
changes through time, provided that the conditional distribution of returns
is not too fat-tailed and that volatility changes are sufficiently gradual.
It is, however. both logically inconsistent and statistically inefficient to
lise volatility measures that are based on the assumption of constant volatility
over some period when the resulting series moves through time. To handle
this. more recent work specifies a parametric model for volatility first, and
then IIses the model to extract volatility estimates from the data?n returns.

AHCf{ Models
A basic observation about asset return data is that large returns (of either
sign) tend to be followed by more large returns (of either sign). In other

~ S"t' Sectioll 9.3.2 of Chapt~r 9. Note however that high-frequency price data are often
'~v~r~ly affected by microstructure problems of the sort discussed in Chapter 3. This has
Iill\it~d the ll,~fllllles., of Ihe hil\h.luw IlI"lhlld of Carman and Klass (\980) and Parkinson
(I\IHO).
 12. NOlllillmrilips ill Fillflllfi,,{ /)(11"

f
J?,
Ii
I
I
bII'":
,)

o L-____~______~____~______~____~__~__~____~______~
,. 1920 1930 1940 I !ISO I9fiO 1970 I!lMO 1!190 ~WOO
Year

Figure 12.2. Monthly EXWJ l,0t: US S/(}rk lle/llmJ. /926 /() 1 <)<)4

words. the volatility of asset returns appears to be serially correlated. This

can be seen visually in Figure 12.2, which plots monthly excess relllrns on
the CRSP value-weighted stock index over the period from Inti to I !I!I1.
The individual monthly returns vary wildly. but they do so within a range
which itself changes slowly over time. The range for returns is very wide in
the 1930s, for example, and lIluch narrower in the 1950s and I<JGOs.
An alternative way to understand this is to calculate serial correlation
coefficients for squared excess returns or absolute excess returns. At 0.2:1
and 0.21. respectively, the first-urder serial correlation coclliciell IS for these
series are about twice as large as the first-order serial correlation coefIiciellt
for returns themselves. 0.11, and arc highly statistically significant since the
standard error under the Ilull of no serial corrt"iation is 1/ fl = O.O:\().
The dilTerence is evell more dramatic in the average uf the first 12 auto-
correlation coefTicienL~: 0.20 fill' squared excess returns. 0.21 fur ahsolute
excess returns. and 0.02 for excess returns themselves. This rcilecL~ the l;tCl
that the autocurrelations of squared and absolute returns die out only vcr}'
slowly.
To capture the serial correlation or volatility, Engle (I !lH2) proposed
Ihe class or Autoregn'ssiv(' COlulitionally Ilctcl'Oskedastic, or ARCll, Inod-
9
12.2. Mc)(JeL\ ()rClUIll~illi V(){lIlilil.~

cis: TileS!' writ(' ('ollditiollal variall(,(, as a dislrihlll('(liag or pasl s'llian'd

inllov'llions:
(1\1.\1.1)
where a(l.) is a polynomial in the 100g Op(T.llor. To k('('p the conditional
variallce posilive, wand the coeflil'i(,llts in aU.) mllsl hI' nOllllegative.
As a way to model persistelll movements in volatility without eslimat-
ing a very large IIIlmber of coeflkients il\ a high-unler polYI\\)lllial a(/.).
Bollerslcv (I ~IH(i) sllggested the (;cnerali1.ed AIIIOI('gl('ssiw (:onditionally
I-lcteroskedastic, or GARCH, lI\odd:

o,~ = lJ.) -+- fJ(I.)a/ 1 f- a(/.)IJ7, (I~.~.!i)

wilerI' fJ(l.) is also a polynomial in Ihe lag operator. By allalogy with ARMA
Illodels, Ihis is called a GARCH(/), '/) llIodd whel\ the onit-r of the polyno-
mial fJ(l.) is /' and the order oflhe polY\lol\li.1I a(!.) is 'I. TIlt' I\lOst ('o\ll\llonly
IIsed model ill Ihe CARCI1 class is the silllple CARCII (t ,I) which can be
w,illcn as

( 12.2.G)

In the sccond equality in (12.2.6), Ihe terlll (11; -0,1. 1) has IIIC<ln zero, ('on-
ditional on tillle /-1 information, and can be Ihoughl or as Ihe shock 10
volalilily. The cocfllcicnl rt measures the eXlenl to whirh a volatility shock
loday feeds throllgh inlo nexl period's volalility, while (a+/J) IIwasures lhe
rale al which lhis effecl dics OUI over lime. Tlte third eq\lality in (12.2.(j)
rewrites tltc volatility shock as o'~I(Ei-l), lite sqllare ofa standard normal
Ic.~s ils mean-tltat is, a dCllle<lned x2 (1) random variable-mliitiplied hy
p.lst volatility 0,2_ 1,
The CARe:! 1( 1,1) model can also he wrilll'lI ill tl'lIlIS of its implirations
for sfJlIarcd illllovations '7;+1' We have

(\ ~.~.7)

This representatioll makes it clear that the CARel I (1,1) model is an

AR:vtA(I,I) model for squared innovatiolls; but a standanl ARMJ\(I,I)
model has homosked'l.~tic .~hocks, while hel'l' thl' shocks (II;!. 1 -0/) arc them-
selves hcteroskedastic.

1"'1 li.ltl'llt/' lint! Stlltionarity

In the CARCH( 1,1) model it is easy 10 construct lIlultipniod I<JI'('casts or
volatility, When a +fJ < I, the unconditional variall<'l' or '/,+1, or equiv<llcntly
thl' UIl(,Olldiliollal expectation or (1/, is (1)/( I-a-/l). R,'cllr.,i"clv'illl'liIUI-
 J L. NOIl/illl'llri/iI'J ill Fill{/I/ri(/l /)(//(/

illg ill (I ~.~.ti), alld IIsing Ihe law of ileraled expectations, the fondi lional
expectalioll 0(' ml;lIilil)' j pl'riods ahead is

(I~.~.H)

Thl' IIIl1lripcriod \'o!alility lim'Clst r('verts 10 its III1COIHliliollallll(';ln ,II ral("

(ll' + Ill, This rl'Lilioll 1)1'(\\"('(,11 sill~k-Jleriod and IIIl1hipcriod forecasls is
(hI' S,III1,' as ill a lill('ar ARMA( 1,1) model wilh alllor(,gr(,ssive cod!ici('nl
(a + Ill. l\Itlitipl'fiod (im'c"sls (";\11 Ill' ,'ollslnICl('d ill a similar bshioll «Ir
hi~l\l'r-onlcr (;J\IU :11 IIHHI,.}s.

When a -I- Il= I, I hI' condil iOllal I'xIll'Clal ion or volatili I)' j periods alll'ad
is insll'ad
(12.2.9)
Thc GARCI I (1,1) Illodd wil h a + Il = I has a IIl1il allllllTgrcssive root so
Ihat IOdav's VoblililY affl'Cls lim'casls ofvoialililY inlo Ihe itHh'finilc fllt\ll"l'.
II is t\lI'I"I'('orl' kllo\"11 a~ an inll'grall'd CARel I, or ICARCI I (1,1), lIJodl'\.
«
. Th(' :AR(:I I (1,1) process ror (J;
looks very 1I1\ll:h lik" a lilH'ar randolll
walk wilh drift w. Ilo\\'('\'('r Ndsoll (19!H») shows Ihal Ihis allalo!-,'Y lIlust he
trl'all'e1 wilh caulioll. :\ lillcar ralldolll walk is lIollstalionar), in IWO S(,II'1'S.
Firsl, it has Ill) sialiollary dislrihulioll, h(,lIcl' Ih,' pro(('ss is IlI)I ,,/ridly ,1/f/liOI/-
(/1"\', Sl'colld, il has 110 IIIll"olHliliollal first or s('cond IIJOlllelllS, h(,lIce it is
111'11 rOlI(/rial/rn/f/liol/(/fY. flllh(' I(:ARCll( 1,1) lIloelel, olllh(' olher halld, (J/
is strictly staliollary ('\'('11 Ihollgh ils sialiollary <lislrihlliioll gl'lIl"rally bcks
IlI1CO/Hlitioll;tillloIlH'lItS, Thlls Ihl' I< :ARCII (),)) model is strictly st;lliOllal)'
hut 1101 gl'lll'lally ('o\'arian('(' stationary.
It is paninl!arly ('asy 10 show that the ICARel1 (1,1) JlIodel has ;. sta-
liollary distrihlltioll ill Ihl' casl' wher(' (u=O. l!erc (12.2.~) simplifies to
E,la,~~ ,I =0;, so volatility is a \liar! illgal<-, At the salllc lilliI', volatility r(,IILlillS
hOIlIH\e(\\ll'CIIIS(' it CHIIlOI go nl'!,(aliVl'. nllt the m<lrtillgalc cOllvergcnce
th('or(,l1\ st<lt('s thaI a hOllllllcd marlingale mllst cOllv,'rgl'; ill this case, th('
ollly valul' to which it call cOllv('rw' is 1(,1'0. The statiollary distriblltion for
a/ is Ih(,11 a clq~('I\(Ta,,' dislrihlltioll with POillllll;tsS at Zl'ro, alld this illlplies
that II\(' slaliollary ciislrihlliioll lill' '//11 is also (kgl'lIl'rall' al Zl'ro. III Ihis
case Ihe staliollan disirillllliolls Ii,r n,~ alld '/" t have IIIOlllellts, hut tlH'Y arc
all lrivially /ero,
'O\'ht'll 10-,0, N('I"," (I!)!)()) shows that Ih('rl' ('xists a 1I()IIlI('gl'll<'ratl'
slaliollary distrihulion lor (J/,
BUI Ihis dislrihutioll dol'S lIot ha\'(' a finile
IlIl'all or highn IIIOII\('llIs. Thl' illllovatioll '1,+1 Ihen has a slatiollary distri-
hnlioll ",ilh a /('ro lIH'all, hili wilh lails thaI arc so thick thai 110 Sl'('oIHI- or
hi)!;lll'r-ord('1 1IIIIIllt'IIIS ('xi,'I,~'

~lN('I."on show, Ih.11 Iii",,' III (lV'" Iii" hllid ilion- g('lIeraJly for (;:\JH :11 ( 1.1) Illo<icb \,"jlll
,,+ Ii ., I hilI \\'illo FII"~lfi 'j 1t1;11 .- 0,
12.2. Modfis ofCha7lgi1lg Volatility
• 485
AltmlfltiTlf FU7lctio7lal Fonns
In the standard GARCH model, forecasts of future variance are linear in
current and past variances and squared returns drive revisions in the fore-
casts. An alternative model, sometimes known as the absolute value GARCH
Jllodel, makes forecasts of future standard deviation linear in current and
past standard deviations and has absolute values of returns driving revisions
in the forecasts. An absolute value GARCH (1,1) model, for example, would
be
(12.2.10)

Schwert (19R9) and Taylor (1986) estimate absolute value ARCf"I models,
while Nelson and Foster (1994) discuss the absolute value GARCH(I ,l).
The models we have considered so far are symmetric in that negative and
positive shocks ft+t have the same effect on volatility. However Black (1976)
and many others have pointed out that there appears to be an asymmetry
in stock market data: Negative innovations to stock returns tend to increase
volatility more than positive innovations of the same magnitude. Possible
explanations for this asymmetry are discussed in Section 12.2.3. To handle
this, one can generalize the absolute value GARCH model to

(\2.2.11)

where
f(f / ) = If, - bl - r(fl - b). (12.2.12)

Here the shift parameter b and the tilt parameter c measure two different
types of asymmetry. b is unrestricted but we need lei ~ I to ensure that
!(f I)"~O. When c=O but b=/=O, the effect of a shock on volatility depends on
its distance from b, so that volatility increases more when there is no shock
than when there is a shock of size b. When b=O but c=/=O, a zero shock. has
the smallest impact on volatility but there is a distinction between positive
ane! negative shocks; a shock of given size may have a larger effect when it is
negative than when it is positive, orvice versa. Following Hentschel (1995), a
nice way to understand (12.2.12) is to plot !(f/) against flo as in Figure 12.3.6
Panel (a) of the figure shows the absolute-value function (b=O, c=0); this is
plotted again as a dashed line in each of the other panels. Panel (b) sliows
the shiftee! absolute-value fUlIction (b=0.5, c=O), panel (c) shows the ti'lted
absolute-value function (b=O, c=0.25), ami panel (d) shows a shifted ~nd
tiltee! absolute-value function (b=0.5, c= - 0.25).
Hentschel (1995) further generalizes (12.2.11) to allow a power of f(f,),
rarhn than j(f / ) itself, to affect volatility, and to allow a power of a" rather

IThis is silllilar 10 Ihe "Ilews illlparl fll,,'t·" or Pagan and Schwert (1990) and Engle:and
a/
Ng (I !1!1:1). ,,·hid. pIOL' againsl ry,. holdillg any olher relcvaIll state vdriables at their lI~con­
diliollallllt"alls.

•
4 Ii 12. NOlllinearitif.l;1I Fil/al/rial /)ata

...,r----:---...,...--~--.., ....
,i
eN ,, I
"i ,, I I /
/

,
"; I
/
/

S.

0
1"""
I I
,./

2 -2 -I 2
'. '.
(a) (b)

'" I
~ I
~CN, .1
, /

'"C'l I
/
/
/
+ : /
/

"1- ;/[
/
/
~
/
/

0
2 -2 -I 0 2
£.

(e) (d)

Figure 12.3. Shifl,,1 allIl nUnl Ab.lllh,lr-Valllf fo/lII(lilJl/

than a, itself, to be the variable that follows a linear difference equation.

The resulting equation is

(!~.~.13)

Equation (12.2.13) defines a !;lIllily of models that incllldes most of the pop-
ular GARCII-type models ill thc lilcraturc. 7 Thc standard GARCII model
seL'I A=v=2, and b=c=O. GlostClI, .Jagannalhan, and Runkle (19!13) have
g('lerali1.ecllhe slanclarcl GARCII lIIodei to allow non1.ero (. Engh: and Ng
(I! 93) have instcad allowcd nOll7.cro b. Thc absolute valuc GARel1 model
set A::::: \l = I with frec /1 and f. Anolhl'r partirularly illlpoftanlllll'lnl>n or Ihl'
rall~ily (12.2.12) is the expollclltial (;ARCII or ECARCH model of Nelson
(I!~~>O), which is uhlained hy selling 1.=0, 1'= I, al1(1 b=() to gel

I
I
log(a,) = lti + Ii !og(a,_1 ) + a [If II - (f I) . (l~.:!.l ,I)

rs. . "I", l>i"l\. (;'''''1\'''' .• ,,<1 E,,~I.- (I~I~':\) I ...... ..t .• lnl !;olllil)' .. flllo,"-'"
J2.2. M(lIlrLl ol Cllllllgillg V()latility 4H7

This modcl i, appealing hec;ltlse it docs not leqllilc any paralileter re~tric­
tions 10 cnSlire Ihat the conditional valiallce ofllw letllill is always positive.
Also it becolllcs hoth strictly nonstatiollary ;md covariallce l\(lIl~tationary
whell a + fJ= I, so il docs Illll share lhe 11l1l1Sllai Sl<lliSlical properties of the
lCARel1 (1,1) lIlodel. On the otlin halld, lllllilipniod f'llTcIsts of fllture
variances ar<~ harder 10 Gllculate ill Ihe ECA\{Cll \\Iodd; 110 dosed·form
expressions like (I 2.2.H) are availahk.

b/illlUlioll
We have introduced an almost bewildninl-( varicty of mbtility llIodels. Til
discover which katllfes of these models arc importallt ill fillinl-( financial
data, OIlC must he able to estimate the Illodeb' parallll'tcrs. Fortllllately
this is bidy strail-(Illforward f(lf (;ARCII lIIodels alld olher lI10deis in the
class defined hy ( 12.2.1:~). Conditiollal Oil the paraflleler~ of lile llIodel alld
all illitial vafiallce e~tilllate. the data are norlllally distribllted and we call
C()(1stl'lIct a likelihood functioll recursively. We write the vecto!' of model
pal,ulleters as (). define <r/«(}) to he the conditional standard deviation at
lime! implied by lhe panllncters and th{~ history of returns. and define
E/+I«(}I == JI,+!/a/«(}). When () contains Ihe true parameters of the model,
E,+I «(}) is liD with density [unction g(EIlI (0» which we have asslllned 10 he
sland,tr(llIonll;ll:
(12.2.15)

The cOIl<iilionallog likelihood of I/'~J is litcrcii>r('

log(g(J/,+I/a,(O)) -log(a,~(O»/2

- log(J2rr) - II; t I /'2a,~ (0)

-log(a/<B))/2. (12.2.1 G)

where the laM term is aJacobian tCfm thal appears hecause we ooserve 1/1+1
and not 1/,+1 /a,(8). The log likelihood or Ihe whole data sell/I •... , tiT is

r
L(I/I.·· .• 1/T) L f,(IJr.I; 0). (12.'2.17)
'~I

The maximulIl likelihood c~tilllator is the choice or paramell'rs () th,ltmax-

imizes (I '2.'2.17).~

lilll pr;.Klln: OUl' lH.'('(h. an initial a,; to hq~ill c.lkul.ltillg lhe (ollciitioll.d likt·lihood ... ill
(1!!.:!.IIl). Tlu.' infhu'lHT of lhe: initial condilion clilllilli~h(" .. on', filiI(' .111(1 h('fOIlH'~ 1Iq.~ligi.
hit· .\,"\'IIII)(Olic ally; Ihlls Ill(" choice of jllifi~" (fllldirioll do('.\ 11111 all("(, the t ollshlt'llf), 01 III("
(·~tilll.lloi.
 J1. Nlllllilll'(/I';t;I'.\;1I "'lIlwollI {Jllt(/

Allhollgh il is (,'IS), 10 sholl' Ihal Ihe maximum likdihoodeslilllalor is

l"<lIlsisl('III, il is h'lI lin 10 pro\'(' Ihal il is asymplolically !lorllla!. The dillirll!t"
is Ihallhis J"('qllin's r('glllarilv (,()luliliollS which are hard \0 vl'rify fill' (;:\R( :11
proc('ss('s, 1,('(' alld I "'IIS('II (I !)!H) giVl' sOllie resulls fill' till' (;AR( :11 ( 1,1 )
lIIodel hili /i-w olhn rl'sults arl' avaihlhle, Empirir'll rl'Sl'ar(/l('rs typical Iv
i~lIon' IIlis (llohklll .IIH! aSSIIIIlt' Ihal Ihl' usn,,1 regularilY cOllditiollS hold.
SOIllC sillllllalio/l 1'\'idl'lln' (Bollnsll'v "lid Wooldridgl' II!)!'~J alld I.III11S-
dailll'II!)!':)I) SlIpports Ihis pranicl',
1II'II1sdll'I (I (,!,:)) providl's lIIaxillllllll likelihood ('slilllall'S lill' a greal
varil'ly of Illodds ill IItl' falllily ( I ~.'2.1 ~) IIsing daily and Illonlhly siork rl'lurn
clata oVl'r Ih(' (lniod frolll 1!J2ti 10 1!,!IO, To estimate thl' paraml'ters A allei
I' with all)' pr('cisioll, 11(,lIlsdld lillds Ihat he lIel'ds IIII' vcry IOIrge 1I111111wr
of ohsl'rvOItiolls providl'd hy dOlily data. These data Sllggt'St th.1t }.. is clost' 10
(llll' (as illt!te ahsollltl' VOl IIll' (;ARClllllOcld), bUllhal1' is grealer ,hOlll 0111"
in fan close 10 I,:), III hoth daily .IIId 1II0nthly dala, llellischel linds thai
asymll\('try is helt('r Inodekd with Ihe shifl paralllell'r " Ihan wilh Ihe lill
parallll'ln (, Thlls liS slock r('lurlls arc well-descrihed hy 01 CARel-! Illodel
fill' Ihe condilional siandard (\l-vialioll, drivl'lI hy Ihe shilh-d ahsolute \'allll'
of SIHll"ks rOliset! tl> Ihe po\\,tT thr('(' halvl's. The volatilily proCI'SS is highly
pcrSiSll'll1 ill ;rllll ... Illockis eSlilll;II('d, ;rllhollgh ,he degn'(' ol"pI'rsis'('IIIT is
st'llsilin' Itl SI)('( ili,',lIioll ill IIII' p,,,I-Wodd War \I period,

Additillllllll'.Ox/df/III1/III\' \ 'f/rillh"',
lip 10 Ihis pOill1 \1'(' kll'(' 1110111'1("(1 volalilily IIsillg ollly Illl' pasl hislorl' of
n'lIlrns tlll'lllScll'cs, II is slr;Jighll()rward 10 add olher cxplanalory \"Iriahles:
For l'xalllpk, (llll' LIB II'riw all allgllH'llled CARel I (1,1) Illodd as

( I:.!:.!,IKI

whe\"(' X, is ;111\" ,'ari"hl(' kl\m"l\ al tillle /. Provided thaI X,::,,:O alld )' :::0, Ihis
Illodd still ("ol"lr"ills ,'o!alilill' 10 1)(' positiVI'. Altel"llalivdy, OIlC rail add
ex pl'lI 1;1 101"\' vari;rhl('.~ 10 Ill(' H:i\R( :llllIodel Wilholll allY sigll reslriniolls,
(;loSII'Il,J;lg'III1lalhall, alld RUllkle (I !)!):I) aclcl a shorl-Ierlllllolllinal intl'l"esl
rail' 10 various (;.-\\{( :'1 I\lodds alld show Ihal il has a sigllilical\1 posiliVl'
clll'!"1 1>11 slmk Ill~nk(', "oLililitl',

(:/IIl/litilllllll.'VlIlIl/ll/lllldity
The CARel I llltl(I..t~ 1\'1' hOI\"(' (ollsid(')cd imply ,hal Ihc dislrii>ution or rc-
lurus, ("(llldilioll;rl Oil til(' 1';'" hislOIY or rellll'llS, is lIonlla!. Eqllivalelltly,
Ihl' sl'lIuLrnli,,'d r('siduals 01 IheS(' 1I10dds, f ' l .c0I=I/H ,In,(O), should Ill'
IlOnlla\. l '1I",rlll\l;lleh', ill I'r;\clin' Iherl' is ('XCI'SS kllrtosis ill Ih(' slall(brd-
i/nl \"('sidllals 01 (::\\{( :11 Illllllds, ;1I1)('il kss Ih.uI ill thl' raw relllrllS (SCI',
lor ('x;\lIlph-,1\011("J,I('\'II~)H71 .11111 Nelsoll 11\'\)( I),
12.2. ModeLl oj Changing Volatility !489

Onc way to handlc this problcm is to continue to work with the condi-
tiollal normal likelihood function defincd by (12.2.16) and (12.2.17); but
to iuterpret the estimator as a quasi-maximum likelihood estimator (White
[ 19H2]). Standard errors for parametcr estimates can then be calculated
using a robust covariance matrix estimator as discllssed by Bollerslelanrl
Wooldridge (1992).
Alternatively, one can explicitly 1lI0dclthe fat-tailed distribution of the
shocks driving a GAReH process. Bollerslev (1987), for example, suggests
a Stll(\t-nH distribution with k dcgrees of frcedom:

K(E/+I(O»=f (
k; 1) f
(k)-I
2 (k-2)-1/2
( l+f~+~2
(O»)-(A+I)/2 '
. (12.2.19)
where fO is the gamma function. The t distribUlion converges to the
normal distribution as k increases, but has excess kurtosis; indeed its fourth
moment is infinite when k :s 4. In a similar spirit Nelson (1991) uses
a Gcneralized Error Distribution, while Engle and Gonzalez-Rivera (1991)
estimate the error density non parametrically.
GARCH models can also be estimated by Generalized Method of Mo-
mellts (GMM). This is appealing when the conditional volatility a?
can be
wrillen as a fairly simple function of obsel\led past variables (past squared
retllrtlS and additional variables sllch as interest rates). Then the model
implies that squarcd returns, less thc appropriate function of th~ observed
variables, are orthogonal to the obsel\led variables. GMM estimation has the
usual attraction that one need not specify a density for shocks to returns.

Slor/wslie-Volatility Models
Another respollse to the lIunllorlllality of relUrns conditional upon past re-
turns is to assume that therc is a random variable conditional upon which
returns are normal, but that this variable-which we may call stochastic volati/-
ity-is not directly observed. This kind of assumption is often made in
continuous-time theorcticalmodels, where asset prices follow diffusions with
volatility parameters that also follow diffusions. Melino and Turnbull (1990)
and Wiggins () 987) argue that discrete-time stochastic-volatility models are
natural approximations to such processes. If we parametrize the discrete-
time process for stochastic volatililY, we then have a filtering problem: to pro-
cess the ohsel\led data to estimate the parameters driving stochastic volatility
and to estimate the level of volatility at each point in time.
A simple example of a stochastic-volatility model is the following:

where €/~N((). a,2), ~/~N(O. a/), and we assume thal f, and ~, are seri~lly
uncorre\ated and independent of each other. Here a, measures the dif-
 I
4~0 /2. NOlllinearities in Final/rial /)(/t(l
I

ference between the conditional lo~ standard deviation of returns and its
mean; it follows a zcro-Illean AR( I) process.
We can rewrite this system hy squaring the return equation and taking
logs to get

10g(IJ~) ::= a, + log(E;), a, = cpa,-l + ~,. (12.2.21 )

This is in linear state-space form except that the first equation of ( 12.2.21 )
has an error with a log X2 distribution instead of a normal distrihution. To
appreciate the importance of the nonnormality. one need only consider thl'
fact that when f., is very dose to zero (an "inlier")' log(E~) is a very large
negative outlier.
The system can be estimated in a variety of ways. Melino and Turnhull
(1990) and Wiggins (1987) use GMM estimators. While this is straigillfor-
ward. it is not emdent. Harvey. Ruiz. and Shephard (1994) suggest a (Iuasi-
maximum-likelihood estimator which ignores the non normality of 10g(E;>
and proceeds as if both equations in (12.2.21) had normal error tenlls.
More recentlY,Jacquier, Polson, and Rossi (1994) have suggested a Bayesian
approach and Shephard and Kim (1994) have proposed a simulation-hased
exact maximum-likelihood estimator.

12.2.2 Multivariate ModeLl

So far we have considered only the volatility of a single asset return. More
generally, we may have a vector of asset retuJ'llS whose conditional covari-
ance matrix evolves through time. Suppose we have N asseL~ with re-
turn innovations l)i.,+I, i= I . " N. We stack these innovations into a'

~
ctor '71+1 =[ 1)1.1+1 ... I)N.l+tl' and dc/Inc aii,,= Var,(T/i.,+d and a'j.'=
V,(l)i.I+I.l)j,I+I); hence l:,=[a,j.,] is the conditional covariance matrix of
a I the returns. It is often convenient to stack the nonreliun<1ant clements
o E,-those on alld below the main diagonal-into a vector. The operator
which performs this stacking is kllown as the verI! operator: vech(E,) is a
vector with N (N + I) /2 clcmen ts.
I
A-fultivariate GAllCI I Models
Many of the ideas we have considered in a univariate context translate n<lt-
uj.allY to Ihe multivariate setlin~. The sil\\jllest gencrali1:ation or Ihe lllli-
v; riate GARCII( 1,1) model (i2.2.!i) rdales vech(E,) to VCCh(T/,T/;> and to
v<jch(E,_tl:

vech(E,) =w+ IJ! vcch(E,_d + A vech('7,'7;). (12.2.22)

JH re w is a vector with N(N+i)/2c1emenls, and IJ! and A are N(N+I)/2 x

(N + 1)/2 matrices; hence the total number of parameters in this model
J2.2. Milt/I'll IIf (.'IulI/gillg Vola/ili/.r 4!1I

is N~(N+I)~/'2 + N(N+I)/'2 which /-:I'OWS Wilh lhe /illlillt pow('/' of N. II

is dear lltal lhis llIodei becollIcs IInlll.lIlag(·OIhl(· wry qllickly; III1ICIl 01'111('
Ii ler.ilur(' Oil 1I11111iv<lriale (;ARCllllIodds 11\('ll'lc,/(' s('('ks 10 plac(, pl<lllsible
reslrirt iOlls on (I '2.'2.'2'2) 10 red lice lh(' 1IIIIIIhl'l" oi" I'OIrall\(·I('l"s. Another illl-
portant /-:0.11 of the literature is to lind restrirliolls whit-h /-:Ilaraillee that the
covariallce malrix~, is posilive ddinil!'. Sud I n'sl1 iniolls .\1(' comparalively
slraighlforwOInl ill a ullivariate sellillg-for example, alllhe pOIrallleters ill a
univariale GARel1 (I, I) 1lI0dellllliSt II(' posilive-hlll arc Inllch less ohviolls
in a IlIliltivariale 1lI0dei.
Kron('r and Ng (1993) provide 01 lIice survey of IiiI' leadill).;' lIIultivari-
all' CARClI models. A lirsl spedlicOllioll. lhc VECII lIIodd of l\ollnsicv,
EIl).;'k, alld Wooldrid/-:e (I !iSH) (nallled al'tl'l" Ihe wrh operator), writes the
covariOl/l(;c 1lI011rix as a set of llllivOIrial!' CARel I models. Eadl dement of
~, follows a ullivariale GARCH model driven by lhe CO/T('SI'OIHlillg eleJllenl
of til(' IToss-l'l"(ldllCI Illalrix 7/,1/;. The (i, j) d('JIl('llI of:E, is /-:ivcn hy

(12,'2.23)

Til i.' lIIodd is ohlained frolll (12.2.2'2) by llIakin).;' lhe lIIalrices A and W diag-
onal. The impliecl cOllditiollal covarianc(, nl<llrix is always positive d('finile if
lhe 1l1,llrires of paramelers [w,;], Ifl,) 1. and [a" 1arc all posit ive <ldinite. The
II lOde I has three paramelers for t'ach ('k~mcllt of l::, allllthlls :IN(N+ 1)/2
paramclers ill all.
A sccolld specificalioll, lhe IIEKK lIIodd of Engle alld Kroller (I !I!I:')
(named after all earlier working paper by Bollers/ev, Engle, Kraft, and
Kroner), /-:"arantees positive dclinileness by working Wilh quadralic forms
rather thall the individ\\al clements of l:,. The \llOdel is

( 1'2.2.24)

where C is a [ower lriangular malrix wilh N(N + 1)/'2 paramcters, anti Band
A arc squarc IIlatrices with N 2 parameters each, Ii II' a IOlal parameler COUllt
of (:'N 2 +N)/'2. Weak reslrictiolls Oil n and A ).;'11 a r<l II 1('(' lhal }:, is always
posilive defillilC.
A special case oflhc BEKK modd is Ih(' sillglc-I;I((or (;ARCII ( 1,1) lIIodd
of Engle, N/-:. alld Rothschild (1990). In this model W(' delille N-vcctors .x
and wand sellars ex alld fl, alld tlll'lI haw

1:, = etc + .xX[flw'l::,.(W + u(W'll,)~ \.

Here Cis reslricted as ill lhe previous equal ion. We call illlpos(' one nor-
malizing reslrictiOIi Oil this model; il is ('ollv(,lIielll (0 scI t'w= I, where t is
 /2. NOII/iIlNIIl/i/'{ ill FiIlI/II(ill/ /)010

a v('clor of Olles. Th(' v('Clor w call IhclI he Ih()lI~hl of as a v('cwr of port-

")fio \Vci~hls. W(' til-fill(' 11",==w'1J, alld (T/'J,.,==w'"E,w. The modd call IIUI\" he
reslaled as

(I,/., ... w'l /' A, A/ (TN','

liJl'/' t- /1(1"".,_1 + (OIf,.I'

Th(' covari.III ... ·S of .11 I\' 1\\'1l as,,·t retllrns II IUI'{' throlll-\h tilll(' only \\'ilil the
varianc(' of the portf(llio retllrll. which follows a univariate (;AR(:I I ( I .1)
llIudd. The sill~le-t;lrtor CAR( :11 ( 1.1) 1Il()<1r1 is a special else of tht' \I EKK
model when' Ih(' lllairin's A ,lIld l\ haw rank OIlC: A == fowX alld B ==
JiiwX. It has (N~+:IN+'!.)/'!. rret· paramelers. The lIlodel call h(' ext('lIded
strai~htrorwanll\' to allow ror llIultiple filC!ors or a hi~htT-order C;AI~ClI
strlll'lure.
Filially, BIIII(,lsl('\' (I~)')()) has propost'd a constaut-corr(,lation IIlOtl<-: ill
which each ,!Sst"! r('tlll'll varialHT f()llows ,I univariate CARCII( I ,I) modd
aud the covarian ... · h.. tw .... 11 ally two ,IsseiS is ~iven hy a constani-corrcblillll
cot'rticielll lIIultiplyill).; Ih(' conditional siandard dcviatiolls or Ihe 1('1\11'11<

(1/1.1 (0Il + fi,; (1;l.I-1 + (ill lJ~/

{l'1 J(lII,' (IIi.' .

This model lias IV (IV +:1 )/!! par,lllletl'l'S, I t ~i"es a positive defill ite c()"a;'iallce
malrix provided tilat IiiI' corr.. latiolls (l"lllake up a w(,ll-defined cOlrda'ion
matrix alld Ih(' P"I,Ull<'tl'l" (V". «II' aud fill an: all posiliv{·.
'1'(1 ulldnstalld the din"'II'IHTS hetwecll these Illodds, it is inslJ'lluivc
10 consider whal happells to 111(' cOlldilional covariance helween Iwo <Issei
),('III1'IIS ,Irler larg(, shocks or opposih' signs hil Ihe Iwo assels. III Ihe VEel1
IlIOlkl \Vilh a posili\'(' ex" coeffi<'il·lIl. Ill(' lIegaliv(' cross-prodlJct 11,,1111 100\'('rs
Ihe cOlltlitioll,11 ('0\',11.'1,111(,1'. III lIlt' COllstallt corrclar'loll JJlodel, (III Ihl' orlH'r
halld, th(' sigll orlll!' noss-produCI'I,11111 is irrelevanl; allY I'v('lIttllal illtTeases
lil(' vari,lIu'(,s ortwo positiv('ly cOITd;I\(·d assets rais(,s Ihe co"ariallce betwe('11
IIH'II1. III tll(' bClor AR( :llllIodd (1'1,1 only 1ll00'{'S wilh (TN"I' so 111(' dfeci or
a IIl'gative tTosS-prodlllt '1"11,, dqH'lIds Oil tllc weigh IS ill portf(llio fl.
As ill Ihe 1I11ivariate casl', It'tllJ'Jl volatilities may he persistelll ill mlllti-
varia\(' (;,\IH :11 Illodds. Mllitivariate lJJodels allow for Ih(' possibililY Ihal
SIUIII' assel \'(d.llilities Illav skill' CotlllllOIl persisl(,lll COJlt}l0J\I'nls; fill' ex-
;lIl1pl(', 1111'1(' Illighl 1)(' IIIit' jlt't sisll'lIt COIIl}lolH'nl ill a sci or volalililies, so
111<11 <III dl<tllgl's ill ollt' \,olalilil\' ,dali\'(' 10 anolher an·lr,tIlsilor),. !lollersl('\'
alld Engk (1~I~n) esplore litis i,k;I, which is allalogolls to th(' cOllcepl of
coilllq.:ralioll ill til<' litn,IIIJrt· olililH'ar Jlllit-rool processes.
12.2. Moddl O/,CllIlIIgillg \'11111 I iJit)' 493

MII/til/I/ria//' S/or//{/.\tir-Vol(//ili/y M(}{M.I'

'I'll(' uni\'ariate stochastic-volatility model V;ivclI III (I2.2~) i& also easily
n;\l'lIded III a IIIllhivariale sCllinv;. Wc ha\'('

02.2.2R)

II'h('l'(, 11t, ('t, Qt, and ~t arc now (N x I) vectors and <I> is all (N x N) matrix.
This lIlo(kl has N~ paralllt'tl'l's ill th(' matrix <I> , N(N+I)/2 parameters in
lil(' co\'arianc(' lIlatrix or ('" and N(N+ I )/'2 parameters in the covariance
1lIatrix of'7J" so the totalnl1lllber ofparallleters is N(2N+l). There is no
IIc('d to rcstrin 0., to lw positive and it is straiv;htrorwarcl to estimate the (',
and 7]t covariancc parameters ill sql1are-root forlllio ensure Ihat Ihe implied
('()v;lriallcc matrix is positive definite. Ilarvey. Ruiz, and Shephard (1994)
sU!2;!2;('st restrit'l('d versiolls of th is model in which <I> is diagonal (reducing the
Iltl1IJilt'r of paramelers to N(N+'2» or is evell the identity matrix (further
reducing the !\lImber or parameters to N(N+I».
Ev('n without such extra restrictions, it is important to understand that
the sp(,cification (12.2.2H) imposes constant conditional correlations or a!iset
re!lII'lls. Itl this respect it is as restrictive as Bollerskv's (1990) const~nt­
corrdalion CARel-! Illodel, and it has lllore parameters than that model
whelll'vl'r N>?.

A CO/ldi/iolllll A/arli/'t MOIlPl

E\'en the lIlost restrictive of the models we have discussed so rar are hard to
apply to a large cross-sectional data set because the lIumber or their param-
eters grows with the square orthe number of assets N. The problem is that
thest' lIlodl'b take the whole conditional covariance matrix or returns as the
ohject 10 he studied. An alternative approach, paralleling the much earlier
development of static mean-variance analysis, is to work with a conditional
lI\arkl~1 lIlo(kl. Continuing to ignore llonzero mean returns, we write !

'1i.I+1 == fill l1m.ttl + (i.t+I,

•
(12.2.29)

whnc {J,t == ai",.t/a"",,.1 is the conditional heta of asset iwith the market, and
(,.1+ I is an idiosyncratic shock which is assumed to be uneorrelated across as-
sets. Within this framework we Illightlllodel 0 11"0.1, the conditional variance
of thc lIIarket rctul'll as a univariate GARCH (I, I) process; we might model
{Jim .• or equiv;t1cntly ai,".t as depending on amlll.1> fJim.l-h and the retllrns 1/i/
alld '111"; and we might nlodd till' cOllditional variance or the idiosyncratic
shock III \'l'tlll'll as ;\lIothl'l' IInivariate CARCI-I( 1,1) process. The covariance
matrix implied by a \1Iodl'l of this sort is guaranteed 10 he positive definite,
alld the 1I111lli>('r of parameters ill thl' lIlodel grows at rate N rather than N'l ,
whit'h lIIakes Ihe lIIodd applicable to Illuch larger 1\lImbers orasscts. BraulI,
 494 12. NUllii1lfaritil'.1 ill Fi,ul/u'i(// /)(/1(/

Nelson, and Sunicr (1995) take this approach, using EGARCII fUllctional
forms for the individual componenL~ of the model.

12.2.] Links between First 01/(1 Second MUlllenls

We have reviewed some extremely sophisticated models of tillie-varying sec-
ond moments in time series whose first moments are assumed to be cunstant
and zero. But the essellce of finance theory is that it relatcs the first alld
second moments of asset returns. Accordingly we now discuss models in
which conditional mean returns may change with the conditional variances
and covariances.

The GARClI-M Modd

Engle, Lilien, and Robins (I 9S7) suggest adding a time-varying intercept to
the basic univariate model (12.2.2). Writing r,+1 for a continuously nllll-
pounded asset return which is the tillle series of interest (since we no longer
work with a mean-zero innovation), we have

( 12.2,:~()
'rI
I where 1+ t is an lID random variable as befure, and a; can follow any (;AR( :11
€
I process. This GARCi/-in-mean or GARCH-M model makes the conditional
; mcan of thc return linear in the conditional variance. It can be straiglllfor-
I wardly estimated by maximum likelihood, although it is not known whethn
thc model satisfies the regularity conditions for asymptotic normality of the
maximum likelihood estimator.
I
'
The GARCH-M model can also bc specified so that the condition'llmean
is linear in the conditional standard deviation rather than the conditional
variance. It has been generali7xd to a multivariate selling hy Bollerslev,
Englc, and Wooldridge (1988) and others, but the number of paralllet('\'s
increases rapidly with the numher of relums and the model is typically
applied to only a few assets.

The Instrummtai V(/ri(/bles ANm)(lch

As an alternative to the GARCII-M model, Campbell (1987) ali(I Ilarvcy
(1989,1991) have suggested that one call estimate the parameters linking
; first and second moments by GMM. These authors stan with a lIIodel fi)I'
'the "market" return that makes the expected markct retunt linear in its
OWII variance, conditional Oil sOllie vector HI cOlltaining I. inslnlllH'lIts or
forccasting variablcs:

E[ r,.,I+ dH, J (I~.:DI)

12.2. Motif/I t!/ OWlIgi IIIi Voill/iiil.v

CaJllphell alld l/arvey assullle that cOIl<iiliollal (~XP(Th'd n'llIl"IIs are lillt'ar
ill Ih(' illstnlJllelll.~ alld (\Clillc ('ITOrS

r"'.1f I - lI,b",.

1"111,1+1 ( 12.2.32)

Here bIll is a vector of regressioll codlicicl\L~ of Ihe market relurn on the

illslrlllllenL~. The error lim.ltl is the dilfnellce betwe('11 the market retllrll
and a linear comhination of the instrIlJllenL~, while Ihe error em.ltl is the
dilference betweell the market retllrn alld a lillear fllllriiOIl of ,tl' The 1I;•.
JIlodel (12.2.:{ I) implies that the errors IL",.'II alld P'".H I ~IIT both orlhogo-
n;lI to the instrulllenL~ H" With I. instrumellts, Ihne air 2/. orthogonality
condilions aV;lilable to estimate I.·t-2 paralncters (Yo, YI, ali<I Ihe I. coeffi-
cielllS in b",). Thus CMM delivers both parallieler ('slilnatcs and a test for
Ihe overidentifying restrictions of the IlImld.
This approach can easily be gClleralil.ed 10 include other assets whose
expected rei urns arc given by

E[r,.II_1 1 H,] = Yu + YI COV['i,I,I' I'''',lfl I H,l. (12.2.:tl)

IIthcre arc N such asseL~, we ddilli' ;, wctor T'II eo' l'l,ll I ..... IN,If I J'.
The cOllditiollal expectatioll OfTH I is given by Elr", 11,1 = II,B, where
B is ;l matrix with NI. coefficiellts. We dcfille ('!Tors

u," , r,t' - H,B,

([2.2.31)

and we geL 2NI. extra orthogonality conditions to identily NI. + I eXlra

paraJlleters. The tOlalnlllHber of orthogon;lIity cOllditions in (12.2.33) and
( 12.2.34) is 2(N + 1)1. and the total number of parameters is N (I. + I) +
I. + 2. Thus the model is identified whenever two or lIIore instruments are
available.
Harvey (I !IH9) further gcncralizes lhe 1II0del to allow for a time-varying
price of risk. lie replaces (12.2.:\:1) hy

where Y" varies through tillle but is COIlIIlIOIl ID all assets. Sillce (12.2.35)
holds f(JI' lhe market portfolio itself,

E[r,,, 1-11 I 11,1- y"

YI, = Var\ 1'",,1 t' I 11,1 .
(I2.2.3G)

alld Harwy uses lhis tu eSlimate the IIwdcl. I Ie substitutes (/2.2.311) into
(l:!.:!.:I:',). lHultiplies through hy Var\ I'm, I f I I H,I. ;lIl1lllsl's E[ 1'",,11 till,} =
 12. NOII/iIlNllili,.., ill FiI/({lIrial lJi111l

II,h", ;11)(1 FI", I ! 11,1 "" II,B 10 COllslruct a new eITor vector

V,II (11I1.'t I

(r" I . II,U)(f"'./l1 - H{h,,.)(ll,b,,, .• )'11). (I ~.~.:\7)

I Ltl"\"('\" I .. pLIi·(·' ,'" I ill (I ~.~.:l-I) \\'illl

V'I I ill (I ~.2.:\7), alld drops 111(' error

,'",./11 ill (I~.~.:\~). Tlli-;giv"-;;I s)'SIt'1Il willi I. fcwt'l'orlilogollalilycolldiliolls

alld Ol\(' I,'" p;lr,III1('11T 10 (·"illl;II" (sill(,(' YI drops (HII of lite lIlodel). Tlte
1I11111hl'l 01 o\('rid""lil\'ill~~ 1I',"i<lioll' d .. dilH's hy I. - I. llar\'('v (I '1H~))
lill<1, SOli\(' .. \'id(·I",(, llial II\(' prin' 01 I is}.. varies whell a US slock illdex is
IIse<1 a' lite 11),1 r}.. .. I portfolio; Itow('\,el h .. also rejecls Ihe overiclelllil\'ing
rl'slrinions 01 I Ill' Iliodei. I bl'\'('\' (1')')1) IIS('S a world Siock illdex as liIl'
111;11'1.. .. 1 port/illio dllli ohuill' SillliLlr n'slrlls.

nil' (:lIlldiliOIllt! (.',1/',\/ ({lIrllh" {'l/mll1li/illll'" (;AI'M

Fqll;lliOIl' (I ~.~.:VJ) alld (I ~.~.:\(i) (';111 Ill' I'e\\'rillell as

( 12~.1H)

\,)\('1(' 11" . Co\I'",I.r,,,.I<1 11,1/\'.111,.",.141 II,!, liIe cOlldilional

h"L1O!',""·li"itl'I!t""I.lk,·I"·III"I,;,"dA, '''' Fir",."I 1II,I"'Yo,lhl'
"'1'('('\ .. <1 "S(l'SS ,,'111,11 oil Ill<' 111;11 }.. .. I OV('I .1 risklt-ss relllrll.
J;lg;IIlIl;IIh.1I1 ;111<1 W,lllg (I ()()(;) eillpila,i/{' 111<11 Ihis cOlldiliollal v('I'sioll
ollil(' (:,\I'r-.ll1el'd 1101 ill'lll\' liIe IIllcolldili"llal CAPM Ihal was disCllSs('d ill
Chapin :1. If I,',· 1;lk,· III)(Olidiliollalexpenaliolls of (12.2.:\H), we get

( 12.2,19)

I "'IT FlAIl i., lilt' IIIICOlidilioll;1I t'xp(,(,I,'d ,'x('('ss relllrll Oil lile mark("t.
F.\fJ"1 is II\(' III1COIUliliollal expectalioll or Ihe condilional bela, which need
llill 1)(' llie ';1111(';" liI(' IlIlCOlldiliollal hela. althollgh Ihe dilli'renee is likely
10 he slIlall, Mo,1 ill'l,ollalll, tI\(' covariance helwecn the conditional beta
alld Ill<' e"pl'lll'(1 (',,!,S' IlIark .. 1 rellint AI appears ill (I ~,~.;l~l), Ass('ls whose
!>"Ias alt' itigit wlll'lI till' IIlark!'1 risk I'lelllillll1 is itigh will have hir.;her 1111·
('olldilioll;t1 IIl1'all n'llints Ihall wOlild he predicled hy lite ullcondiliollal
C\PM,Jlg;IIII1:1Ili;1I1 ;111<1 \V:lllg (I!)')(i) argile thai Ihe high av(,rage r('llirns
Oil siliall sllltk, Illighl Ilt'l'''plaill('d hI' Ihis ('ffeet ifsllIall,slock bctas 1("lId 10
rise al lillie, wll<'11 1111' ('''IIt'( 1('<1 ('x(,(',s r('llIrll Oil Ihl' slock IIlark('1 is high,
Thcy l' I'CS(, II I Slllll(' illdin'('\ "\'i<l(,IICl' for this storr althollgh Ihey do litH
din'cII\' II1<Hlt-1 I hI' I illw'\';lri;1I iOIl of slIlall·stock hl'las,

"dfllilil\' 11/1/1II'fll/1I11I ,/I,t! /1,'111111 /III//Il"tliol/\

Flllpil i(.11 11"1',11 ( 111'1 S 11:11'(' I< ,II lid lill'" ('vid('llCl' tilal periods o[,high \'ol;llil-
il\' ill sl," I.. "'1111 lis ,II'<' periods or high ""p('(,led stock n'IIII'IIS, SOIlI(' pa·
pers rl'l'llri \\'!';d.. ('\'iel"11i (' 1<>1 litis rd:lliollship (SC(' \lollel'sl,'\', Ellgle, and
J2.2. Mudels uf Changing Volatility 497

Wooldridge (1988), French, Schwert, and Stambaugh [1987], and Harvey

[ 19R9]), hut other papers which use the shon-term nominal interest rate as
an instrument find a negative relationship between the mean and volatility
of rellIrns (see Campbell [19R7] ami Glosten, Jagannathan, and Runkle
[ 1993}).
A~ French. Schwert. and Stamhaugh (19R7) emphasize, there is much
stronger eviden'ce that positive innovations to volatility are correlated with
negative innovations to returns. We have already discussed how asymmetric
(;ARClllllodeis can fit this correlation. At a deeper level, it can be explained
in one of two ways. One possibility is that negative shocks to returns drive
up volatility. The lroerage hypothesis, due originally to Black (1976), says that
when the total value of a levered firm falls, the value of its equity becomes
a smaller share of the total. Since equity bears the full risk of the firm. the
percentage volatility of equity should rise. Even if a firm is not financially
levered with debt, this may occur if the firm has fixed commitments to
workers or suppliers. Although there is surely some truth to this story, it is
hard to account for the magnitude of the return-volatility correlation using
realistic leverage estimates (see Christie [19R2] and Schwerl [1989]).
An alternative explanation is that causality runs the other way: Positive
shocks to volatility drive down returns. Campbell and Hentschel (1992) call
this the lIultitilityjeedback hypothesis. If expected stock returns increase when
volatility increases. and if expected dividends are unchanged, then stock
prices should fall when volatility increases. Campbell and Hentschel build
this into a formal model by using the loglinear approximation for returns
(7.2.2tl):
(12.2.40)
where

I)d.I+1 == E/+1 [fpitJ.dl+l+j] - EI

}=o
[fpj.tJ.dHl+i]
}=o
is the change in expectations of future dividends in (7.2.25), and

I)r.I+1 == E/+1 [f}=I

piT1+1+i] - EI [f}=l
piTHl+i]

is lhe change in expectations of future returns.

Campbell and Hentschel model the dividend news variable I)d,,+1 as
a GARCII(l.I) process with a zero mean: TJd.HI-N(O, (//> , where 0,2 =
(tJ +/ll1;:
1 + aTJ~/Y They model the expected return as linear in the variance

"111 !;,n Ihry """ a morr I:ell"rdl asymmelric Illodel. Ihe quadrdlic GARCH or QGARCH
IIln,It·, nf Srnlan:, (1991). Thi, i. 10 allow Ihe moclrl 10 fil asymmelry in retllrns even in
Ihr "hsrllcr (If volalililY ferclback. However Ih" h",ic iclea is more simply illlIslQled using a
SI'll"\:mll:ARClllllod,,l.
 498 }2. NOlllilleanlin ill Fillflllrilli })lIlf/

of dividcnd ncws: E, [ rltl J = Yo + YIO? Thcsc assumptiolls illlply that the

revision in cxpectatiolls ofa11 futllrc returns is a multiple oftoday's volatility
2 2 •
, shock (1/".1+1 - a l ).

11 •. HI E'+I [t, pJr,t i] - E, [tPJrHI+J]

J~I
It
J=I

(I :1.:1.41)

where O=Ylpa/(I-p(ex -\- Il)). The codTlcieut 0 is large when YI is large

(for then expected returns move strongly with volatility), whcn ex is large

l(for then shocks feed strongly into future volatility), and whell ex + Ii is
large (for then volatility shocks have persistcnt c!fecLs on expccted returns).
PSubstilliting into (12.2.-10), tlH" implied process for returns is
I
(I ~.~.1~)

,This is .not a CARel I process, but a quadratic function ofa CARel I process.
'I'It implies that returns arc negatively skewed because a large negative realiza-
,tion of I/d,l+l will be amplified by the quadratic term whereas a large positive
,I realization will he damped by the Cjlladratic term. The intuition is that any
\large shock of either sign raises expected future volatility and required re-
Iturns, driving down the stock rellirn today. Conversely, "no news is good
i news"; if IJd,I+I=O this lowers expectcd future volatility and raises the stock

I\return today. Campbell and Hentschel lind lllllCh stronger evidence for a
positive price of risk YI when they estilll;IlC the model (I ~.2.12) than whcn
ithey simply estilllate a standard GARCII-M model. Their results suggest that
!hoth the volatility feellback effect and the leverage clfect contribute to the
iasvlllllletric
, '
behavior or stock market volatility.

12.:{ Nonparametric Estimation

III somc financial applicatiolls we Illay be led to a functiollal relation between

two variahles Y and X witll<,ut the bCllcfit ora structural model to restrict the
parametric form of the relatioll. III these situations, we call use llVll/mrtllllel-
ric estimation techniqucs to capture a wide varicty ofnonlillcaritics without
recoursc 10 anyone particular specification of the nonlinear relation. In
contrast to the relatively highly strtlctllred or /wTameln'c approach to esti-
mating nonlinearities described in Sections 12. I and 12.2, lIonparaml'tric
(·stim.llion requires few assulllptions ahoutthe nature of the nonlinearities.
However, this is not without cost-non parametric estimation is highly <lata-
intensive alld is generally not effective fiJr smaller sample sizes. Moreover,
nonpar'lIlletric estimation is espt'ci,lIly prollt' to overfilling. a prohlem that
ClIlnOI he easily ovcrcollle hy statistical lIIethods (sec S~~ctioll 12.:) helow).
J2. J. NOII/){Irt/lIll'/lir b/illlOliol/ 4!1!I

I'crllap~ tll(' lIlost COllllllOllly tiSI'd nonparalll!'tric !'stilllators ilre SlnIHJ'''-

il/K estimators, in whkh ohservational CJ"rors are n'dlln~d hy aver,lging the
data in sophisticated ways. Kernel regression, orthogonal series expansion,
pr<~jl'Clion ptlrsuit, nearest-neigh hoI' estimators. average derivative estima-
tors, splines, and artificial neural networks arc al\ examples of smoothing.
To understand the motivation for stich ilvcraging, sllppose that we wish to
estimate the relation he tween two variahles 1', and X, which s;llisfy

l'1 = m(X/) + fl' 1= I ..... T. (12.3.1)

whert' m(·) is an arhitrary fixed btll tlnkllown nonlinear fllJlction and If,) is
a zero-mean 1/ n process.
COllsidn eSlil\laling 111(.) al a parlit-Illar dal(' In (ill' which X4,=')'(/, and
suppose thilt li,r this one observation XI", WI' can ohtain 11'/II'flifli indepen-
dt'nt ohservations of the variahle YI " say yl l,=YI .. , .. l',::=.v". Then a natural
eSlimator of 11\1' fllndion 111(') atthl' point X(, is

-I I>
"
n ;=1
I"
= -L
II ;=1
[III(X(,) + E; J ( 12.3.2)

= ( 12.3.3)

and by the Law or Large NUJllbers, the second tcrlll in (12.3.3) becomes
Jl(,gligible for large II.
Of ('ourS!', if I I',l is a til\le series, WI' do not haY(' II\(' Iuxllry of n'pl~al('d
observations for a given XI' However, if we assnllle Ihatthe Iilllction m(·) is
slIfflciently smooth, then for tillie-series ohservations X, Ilear thc vallie Xth
Ih!' corresponding values of YI shollid be close to m(.),(/). In other words, if
III ( .) is Sllf/iciclltly smooth, then in a smallneighhorhood around .),(" m(~/)

will be nearly COllstant and may be estimated by takillg an average of the Y,'s
that correspond 10 those XI'S ncar .),(,. The closer the X,'s are to the value
.),(,. the doser all averagc of corresponding Y,'s will he to m(xo). This argues
for " lIJriKfltrd "wrage of Ihe Y/s, where Ihe weigh Is dedint' as Ihe X/s get
farther away from .),(/. This weigh led averagt' procedllre of estimating m(x)
is lhe essell!'e ofsllloolhing. More formally, (()r allY arhitrary x, a slIIoothing
estimalor of lIl(x) llIolY be expressed as
T
.
lIl(x) == T ""' (UI. r!x) r,.
I L... ( 12.3.4)
I~I

where the weights Iwt.J·(x») arc large for Ihose )'I'S paired with X,'s lIt'ar x,
alld small (Ill' lhose Y,'s wilh X,'s f;lr frolll x.
To impkllll'lll sllch a procedllrl', Wl'\JJllst dl'fill(' what WI' ml'an hY"llcar"
and "br". If we choose too large a nl'ighhorhood arol\nd x to (011111111/' thl'
 J2. Ntmlinf(I/-jlil'.~ ill Fi/liI/l/"iaflJa/a

<Iwra~e. 1111' wei~IIIt,,, aVl'I';lgI' will bl' 100 slIlooth and will not exhibil Ihe
~en\lille IlOlllilll'arilil's or III ( .). II' WI' choose 100 sm;,l1 ;t nei~hb()rh()od
aroulld x, thl' wl'ighll'd avna).:t' will hI' 100 variahll', rt'llntillg Iloisl' a, well
as tIll' varialions in 11/(.). Thnd(lI"t·, the weights (lv,.-r(x)llllust hI' chosen
can'IIIII~' to halall(,(' th('s(' two cOllsideratiolls. W(' shall ;,ddn'ss lhi\ and
other rl'latl'd issll(,s I'xpliritlv in S('('\iolls I ~3.1 to 123.:1 ;11111 St'ction 12.r).

An illl)lorlant silioothill!-:' tl'dlJliqlll' 1'01' I'stimalill~ 11/(') is !(I'm/'fogll·.llioll.

III thl' ktTlld n'!-:,ressioll 1I10tl('\, lilt' wl'i~lIl runnioll wu·(x) is cOllstructl'd
('mill a prohahilily dl'nsity rllllt'liOIl K(x), also c<llkd a kn'llfi:

K(x) :::. 0, ! K( u)du = 1.

Dl'spite thl' 1;I('t th;1I KCd is;1 proh;lbility dellsilY runction, it Flays IlO pro!>·
<Ihilislir mit- in Ihe sllhs('qu('nt analysis-it is lIIerely a rOlw(,lIil,1lt llIc1hod
lill' (,(lIIlpllting a wl'i).:htt'd ;tvnage, and does nol imply, li)r example, that X
is distrilHlll'd arrordin!-:, to K(x) (which would he a param('tric assumption).
By r('scalin!-:, lile 1..1'1/1('1 wilh respect to a vari<lhlt, It>O, WI' ran ch,"1~e
its spread hy varying It ir WI' (It-rlnt':

I
K,,(II) == -K(II/It), (I~.:ttl)
It
Now WI' cm ddilll' Ihe \\'l'i!-:,hl function lO be Ilsed in tilt' wcighlcd ,\\'l'J';I~C
( 12.:1.'\) as

( 1:!.:-I.7)

I r
g,,(.\) 1- L K,,(x - X,), ( 12.:~.H)
/~I

If II is V('IS ,lIIall, th(' <lvl'raging will he dont' with n'sl)('C( to a ralher small
nl'ighhOi hood ;111111/111 ('adl ,)1 the .\I'S. If It is vcry br~t', the avt'ra~illg will
h(' over largn lI('igllhOi hoods or III(' X, 'so Then'fi)rt" COlli r()lIill~ lhe deg-rt't'
of aVt'ra!-:,in!-:, ,lI110llnis 10 adjllstillg Iht' smoolhillg param('\er h, also kllown
a~ Ihl' hllllth/lidlh.11I SlIhstilillill!-( (I~.:\'H) illto (12.:1.4) yil'lds thl' Nadl/Illyl/'
\\'/1/.\/)// kt'ntd l·st ill\~\h>r 1;1" (x) ()f /tI( x):
J 2.3. Non/Jllwmetllc Estimation

. t ..
lI. lI. A ~

...
£I. l}.lI. lIfIrl. A

. ..
£I. ~ lI. C. 01 lloll.

"
t:. lloA lI. A ~

'"~I

1(L)--~~--~~"~~--~~~-w~~--~--~~~~.--~------~"w
2 " T ~"
x

• Figure 12.4. Simulation of Y, Sin(X,) + O.5f,

Unclcr certain regularity conditions on the shape of the kernel K and the
magnitudes and behavior of the weights as the sample size grows, it may
be shown that mh(x) converges to m(x) asymptotically in several ways (see
Hardie [1990] for further details). This convergence property holds for
a wide class of kernels, but for the remainder of this chapter and in our
empirical examples we shall usc the most popular choin' of kernel, Ihe
Gaussian kernel:
I .'
K,,(x) = --e-:;:E. (12.3.10)
h.,ffii

Au Illustration oj Kernel Regression

To illustrate the power of kernel regression in capturing nonlinear relations,
we apply this smoothing technique to an artificial dataset constructed by
MOille Carlo simulatioll. Denote by {X,} a sequence of 500 observations
which lake on values between 0 and 27T at evenly spaced increments, and leI
{r, }Ill' rdalcclto {X,} through the following nonlinear relation:
( 12.3.11)

where {f,} is a sequellce of liD pseudorandom standard normal variates.

Using the simulated data IX" Y,} (see Figure 12.4), we shall allemptto es-
tim,lIe the conditional expectation E[ Y, I X,) = Sin(X,), using kernel
502 12. Nonlinl!(lrilies ill HI/'II/rilll I )ata

regression. To do this. we apply the Nadaraya-Watson estimator (12.:t!l)

'th a Gaussian kernel to the data. and vary the bandwidth parametn It

~
h tween 0.10, and 0.50, where a. is the sample standard deviation of (X,!.
y varying II in units of standard deviation. we arc implicitly nOrlnalil.illf.( the
e~planatory variable XI by its own standard deviation. as (12.3.10) SIlf.(f.(cstS.
I For each value of II. we plot the kernel estimator as a function of X" and
t~ese plots are given in Figures 12.5a to 12.5c. Observe that for a bandwidth
0t 0.10•• the kernel estimator is too choppy-the bandwidth is too small
t provide sufficient local averaging to recover Sin(XI). While the kel'1lel
e timator does pick up the cyclical nature of the data. it is also picking up
dndom variations due to noise. which may be eliminated by increasing the
bjllldwidth and consequently widening the range of local averaf.(inf.(.
Figure 12.5b shows the kernel estimator for a larger bandwidth 01'0.30 A.
W lich is much smoothcr and a closer fit to the true conditional expectation.
As the bandwidth is increased. the local averaging is per/imned over
M ccessivcly wider ranges. and the variability of the kernel estimator (as

a \ function of x) is reduced. Figure 12.5c ploL~ the kernel estimator with a

b\mdwidth ofO.50'x. which is too smooth since some of the genuine variation
or the sine function has been c1imiuated along with the noise. In thc limit.
tIle kernel estimator approaches the sample average of I YI ). and all the
variability of YI as a function of XI is lost.

12.3.2 Optimal Bandwidth Seleclioll

It is apparent from the example in Section 12.3.1 that choosing the proper
bandwidth is critical in any application of kernel regression. There arc
several methods for selecting an optimal bandwidth; the most cOlllmon of
these is the method of crvu-validalioll. popular because of its robustness and
asymptotic optimality (see Hardie [1990. Chapter 5] for further details).
III this approach. the bandwidth is chosen to minimize a weighted-average
squared error of the kernel estimator. In particular. for a sample of T
observations IX" Y,l:~r. let

-
mh.j(X,l = TI ""
L cvu( Xj) Y I (12.:tI2l
It- ]
which is simply the kernel estilllator based 011 the datasct with observatiolJ
j deleted. roaluated at the jth observation Xj' Theil the cross-validatiolJ
function CV(h) is defined as
.,.
(''V(h) = I""
T .
L[ YI - mh.I(XI )] 2 o(XI ).
1=1
02.:1.1:\ )

wllC:re a(X,) is a nonnef.('llivl' weif.(bt function that is required to redlll'l'

bOundary clTcCIs (sec IHrdll' I 1\I~lO. p. Hi2] for furth('r (\isntssion). Thl'
 ,
o.
~'.::,~I 1
I·
I '''''\'1

~. L----~----~-·---~,.i"""'"-
'l.'f

(a)" = 0.1,;,

L-_ _ _ ~ ___ ~ _____

. \. ::::,\. i
~.;--- _

.. '

:, OS:£1iii~'~<~'~G:;<i:;::"
• .r r- ,"

~.'" II !
._._---------- ._..
"

Figure 12.5. I\,.II,I'I,.;,I;lIIlIlm

 1_. ""'1/1111,'(1//1/1',1 III "1111111' wi 'h,ll/

flillnioll C\'(/I) is (;lIkd IIII' /Toss-validalioll fUllctioll I)('callse it \'alid,ltes

Ihe SIHH'SS 011111' k('nll'l eslillJalor ill fittillg ! Y,j across Ih(' T sllhsailiples
! XI' i'dl l " (,;ll'h \villl 011(' oilservation olllitted. Th(' optilll;d halldwidth is
IIII' olle Ihal IIlillillli/('S Ihis fllllctiOll,

12, >. ., ,\pl'/age /)l'/illu(illl' I',\(ill/u((lr\

For mall)' fillancial applicaliolls, W(' wish 10 relale l'1 10 ,\I'llI'm! variahks
Xli, ' . , , XAt 1I0llparallll'lri('ally, For ('"alii pie, we lIlay wish to lIIodel th('
('''1)('('1('(\ H'tlln!'; of stocks alld honds as a nonlinear fllnnion or Sl'HTal
bClors: Ih(' 11Iark('1 r('IIIJ'II, illl ....('si rale spreads, dividelld yield, ete. (se(' i.o
and MacKilll;l), 11~I~Hil), SlH'h a task is cOllsiderably llIore alllbitiollS tltall Ihe
tlllivariate ('X<lttlple of Sectioll I ~.:I.I. To s(:c why, cOllsidn the cas(' of five
illdepelldelll variables ;lIld, wilhollt loss ofgclleralily, lei Ihese five variables
all lake 011 valtll's ill Ihl' illl('\'val 10, II. Evell if we divide thl' dOlllaill of
each variahle illio Oil1\' 1('11 ('l[lIall),span'd pieces, this would yield a lotal
of 10"= I 00,000 lIeighhorhoods each of width (>.I 0; h('IICC WI' would lI('ed
at !cast 100,000 OhS('\'V;ltiolls to ('nSIII'(' an avcrag(' ofjllst o\le dat;1 poillt
]leI' lleighhorhood! This ('w\t'"/tlillll'/lIiol/ulil.Y call 0111)' he soh-ed hy placillg
\('stri( tinllS till tl((' killds .. r 1I(1l1lill('arili('s that are allowilhk,
For ('"alllple, SIlPP"'" ,I lilll'f1r ('oillhillatioll of the .'l,t's is relaled I" )'1
IHHlparalll('tril'all\', This has tl\(' adv,lIIlage of captllrill~ illlportallt 11011-
lilll'arili('s ",hilt- prm'idillg SlIliicil'lll slrllclure to ]ll'I'IIIil eSlilllalioll wilh
n'asoll<lhll' S<lIII]I1t- sill'S, Sp('rilic<lllv, ronsider Ihe fi,lIowillg IlIl1lti\,;lIule
l\ol\lil\(';II'lIIodel:

wh('\'e XI = I XI,.,. Xlt!' is IH>\\' <I (Ii X I) \'l'clor and 1/1(.) is SOli\(, arbitrary
hili fixed lIoltlilll'ar (1IIICliol\. TIll' fllllClioll 11/(') lIlay 1)(' t'stilllatcc! b\' the
followillg 1\\'1l-stl'P ]lron-dlln': (I) eslilllate {3 with all aVl'I'age (\cri\'ative
('stilllalor /'1; ;I\ul (~) ('slilll<lI,' 1/1(') with a \;.('I'IIl'i regressioll o( 1',011 X;j'-J,
Stok('\' ( I ~JHli) oh"'I\'('s thai IIII' codlici(,IIIS /J of (I ~.:t I 'I) Il\ay he ('sli-
1\1;1\('(1111' 10 a ,,';d .. brlol' b\' onlillal'\' l('aSI sqllares if' ('it he\' ol'tllt' li>IIO\\ill~
Iwo cOlldiliollS is I nit': (I) tht' X/s an' IlIltltivariatl' lIorlllal \'('('tors; or, ilIon'
g('lll'rall\', ('2) 1",1 X" 1 X;/11 is lil\(';II' ill X;/-J li>r i =
I" .. , h,ll II' Il('illt('\'
oflh('s(' cOlltiiliolls holds, Sto[..t'I' (I(JH(i) propos('s all ill~('lIiolls estilllalor,
Ihl' 1/11,'mgt' 1II'I'i1'II1i1'I' ('slilll;llor, whidl rail ('stillla\(' {3 rOllsistl'llllv (SIT ,"so
St"k('r 11~1!1~ll,

II nih .. ,'e IIlulllllllllllllll I" ... I1I'1lit'd h\' IlIld,i\.1I i.llt' 1I01"l1l.1i X, \ 1.111 i... tl .. " "Ili .. li('d lor 110(1-
ntH u\.\\ dhlHit ~\n\" :-.\"unu"" it tll .. u ilm'iHu~. St't' (:hamh"rbiu (I~U,\:\h). (:hul\).!. .\lul (~,)ldht'l ~t'r
11~IH I), IlI-,II"" ,11111 It i,II II"H I), ,.. III RUIIII II~)H:\),
12.3. NOn?llrametric Estimation

Average derivative estimators are based on the fact that the eX1pe<:taCloI11
of the derivative of m(·) with respect to the X, 's is proportional to f3:

02.3.15)

Therefore, an estimator of the average derivative is equivalent to an esti-

Illator of (3 up to a scale factor, and this scale factor is irrelevant for our
purposes since it may be subsumed hy 1ll(.) and consistently estimated by
kernel regression.
There are several average derivative estimators available: the dire~t, in-
direr/, and slope estimators. StoKer (1991, Theorem I) shows that they are
all asymptotically equivalent; however, Stoker (1992, Chapter 3) favors the
indirat J/O/Je estimator (lSE) for two reasons. First, if the relation between Y,
and X, is truly linear, the indirect slope estimator is still unbiased whereas
the others are not. Second, the indirect slope estimator requires less.pre-
cision from its nonparametric component estimators because of the ~SE's
ratio form (see below). 1
Heuristically, the indirect slope estimator {J'SE exploilS the fact thaf the
\tI\kllOWn parameter vector (3 is proportional to the covariance between
the dependent variable Y and the negative of the derivative of the loga-
rithm of the marginal density of independent variables X" denoted by 1(-).
Therefore, by estimating Cov[ Y, 1(·)], we obtain a consistent <;stimator of
(3 up to scale. This covariance may be estimated by computing the sample
• I
covariance between Y and the sample counterpart to IC·). .
More formally, {JtSF. may be viewed as an instrumental variables ~IV)
estimator (see Section A.I of the Appendix) of the regression of Y, on X,
with the instrument matrix H:

(12.3.16)

whereY - [YI ... YT ]',

X'I

H- X= X'I (12.3.17)

X'T

i(.) is an estimator of the negative of the derivative of the log of the marginal
dellsity of X" and IbCx) is an indicator function that trims a portion of the
sample with estimated marginal densities lower than a fixed constant b:

(12.3.18)
506 J2. N0111inearilif.s in Fill(lI/(ia/ [)lIla

In most empirical applications, the cOllstant II is set so that betweell I % and

5% of the sample is trimllled.
To ohtain i(.), ohserve that if !(x) denotes the marginal dcnsity of XI,
then the Gaussian kernel estimator or !(x) is given byl2

. X ""
I
--
I L K (X-XI)
T
--- (I :l.:1.l9)
!() T '"
I 1=1 I
I '

where

( 1:l.3.20)

(:lJT )-k/~ ,:xp [-~(X

:lit'
-X,)'(X - XI)]' (I :l.:t:ll)

Therefore, we have

/(x) --
T hlr+1
,(X-XI)
IlL K --
T

1=1 h
( 1:l.:t2:l)

\ -I- - )
"J' 11r+1
LT K (X-XI)
--
II
·(x-X,)/II
'
I 1=1
I
I
I •
and we can define /(x) to be

j'(X)
/(X) _ ( 12.3.24)
j(x)

Despite the lIIultivariatc nature of !(-), obscn-e that there is still unly
a s ngle bandwidth to adjust in the kernel estimator (12.3.19). As ill the
ulivariate case, the bandwidth controls the degree of local averaging, but
no over multidimensional neighborhoods. ~a practical maller, the nu-
m rical properties of this local averaging procedure may be improved by
I~O!JllaliZillg all the Xi/'S hy their own standard deviation~efore ('Oll\llIllillg
!(. ,and then llIultiplying each of the Iii'S by the standard deviation or the
("ol,rcsponding XII to undo the normalization.
I
I
tl Nole Ihallh" ball<lwi<llh II illlpli('il ill j(X) i,. ill g('I1,.,.al, (lilf.. relll 1I01ll1h .. b,,"<1,,"i<lll. 01
Ih(' lIullparillHclrir ('Milll;t.lor of m(·) in (12.:\.1 ,1). <:ros~-\'aliclalion terhlliqlU'~ may he' ",{'ct to
,,'I<-rr hOlh; how",'rr, Ihis lIIay he fOIllj>III.lIiollally lOll <I('III,""lill~ all<l silllpl" rllh-'~lf'lh\llllh
may suflirr.
12. J. NOII/Jllmmrtrir /<:stilllllliml 507

12. J." iI/J/Jliffll iOJl: 1·.~\li 11/(// IJlg S/a/r·I', I, I' 1)1'1/ Iii il'.\

( ) IlC or the most ilIIportalll t 1I~'on'l ical ;t< ku Ices ill tI H" enll I< II lIics or ill\'cst-
IIICllt IIl1dcr IIIHTrtaillty is thc till\('-st;\I(' pn'kn'IH (. lIIodd ol"Anuw (I!Hi4)
alld IkiJrclI (I !);I!) ill which tllcy illtrodllcc prilllitiv(' St,("lIIitics, each pay-
illg $1 ill olle specilit: state ur lIatlllc allc\ nothillg othcrwise. Now kllOWII
as Anow-Dr!""ll securities, they ;u·(· Ihe fllll(blllctltal htlildillg hlocks rrolll
which we have derived 1I111t:h or otlr ClllTCllt tllHic-rslatldillg or c'collolllic
equilibrilllll ill all uncertain cllvirolllllcllt.
III practice, since true Arrow-Ikhrt'll sc:curitics arc not ),cttradeti Oil any
org;mi/.ec! exchange, Arrow-Dehn'\1 prict's arc nol ohsnvahk. I:1 Ilowewr,
usillg nonparallletric tet:hniqnes-spt'("ilically, IIlultivariatc kernel reg res-
sioll-Ait-Sahalia and 1,0 (I !)!)(;) develop estimators It)!' sllch prices, known
as al/ail"jJ1'irf(lrllJily (SPD) in the cOlltinllous-state casc. The SI'D contains a
wc;,lth of illr()flllation confeflling the pricing (;\llCl hedging) or risky assets
ill all (,("OIlOIllY. In principle, it can he IIsed to price olhcr assets. evell assets
thaI are flllTently not traded (sec Ait-Sahalia alld 1.0 II !)!);, J lin exalllples). H
More importantly, SPDs containllIllch formation ahollt preferent:es and
as.;('1 prke dynalllics. For exalllple, if parametric restrictions arc illlposed
Oli Ihe data-gcnerating process of asset priccs, the SI'D estimator may he
used to illrer the preferences or the represcnlatiV(' agellt ill all \~«(llilihrillm
model or asset prices (sec, ((II' example, Bick [I ~)~)() J and lie alld Lelalld
[I ~)!)3 J). Alternatively, if specific preferellces arc imposec\, the SPD estima-
tor may he used to infer the data-generating process of asset (lIkes (sec,
f"r example, Derman and Kani II !)!)4 J. Dupin' II !l!l4 J. .Iackwcnh alld Ru-
billstein [I!)!);,], LUllgstalf [I!!!!:!, 1!l!)4J, Rady 11!)~)4J. Rui>illstein II!!H5J,
,111(1 Shimko [1991, 1993]). Indeed, Rubinstein (1~)Hr,) 1i;ls observed that
allY two or the following implies the third: (I) the represelltative agent's
preferences; (2) asset price dynamics; alld el) the SPD.

/)rjlJlilicJ/l of Ihe Siale-Price Dmsily

To ddine the SPD formally, consider a standard dynamic exchange economy
(see Chapter 8) in which the equilibrium price /1, of a security at date I with
a single li(l'lidating payofr Y( Cd al date T that is a rUllctioll or aggregate
cOllSlImptioll Cr is givell hy:

(, r"lJ'( C r )
1', = E,l Y(Cr)Mu·J. (I'( (;,)
(12.3.25)

UThi~ lII.lY !oo(ioll rhallgt' with tht' 'Hi\"t'llt 01 W/wu}ulln, Ii", IHolll' . . cII hy (~"rlll.\II (197H)
alld Il.lk;.II.\sOIl (1~l7Ij, t !J77) and fllI .... ·lllly IIl1clel dndoj>IIH'1I1 hy 1.(,1,111<1 ()"!Irirll Kllhinsleill
:\.':-;oCictH.· . . , 11Il'. St'l' M.tSOIl, Merton, Pl'IOld. ,wei TIlt.1II0 (I!t~):)) 101 fllllli('" dl·I.lil~.
I~Of((lursl·. lU ..ukt·t~ lH\\s.l he dyt\~u"i<:<.llly «Hllpi(.'t<.· tot Mt<. h ~"in'!' HI 11<" 111<.·O\nin~I\lI~(·<.·.
l()rt'~;lIl1l'l('. c:OIl~f""tinid(,'5 (19H~), This ;l\\llIlIptioli i~ .t1I1ICI"1 .!IW;(VS ;l(loplC'<I. c'itlu'r ('xplic illy
or implicitly. ill potr.lIl1t'tl ic dt"ri\'.lti\'(' plic illg llIodch, alld WC' ,II lop' II ,I" \\('11.
 12. NVlIlillt'milil's ill J-Illuwia/ lJn(a

where Mu i~ Ihe m;Irgillal rale o/' suhSlilutioll hetween dates I alld T, alld
I) is the rale or liule prefcrcllu·. This well-known equilihriulll assel-pricing
rd;lIion ('quail's CIIITl'llI price o/, IIII' secllrity 10 its cxp('cted disc()llnlul
/'lItllre payorf, discouilled "sing Ih(' stochastic discoullt I;Inor.
I.ucas (1~}7Hl (,hwrI'('s Ihal (I~.:t~rl) Il('cdnol implya martillgale pro-
cess fill (I', I. supporting I.eroy's (I ~}7:\) ("()lItelltiou Ihat Ihe martillgale plOp-
('ny is IH'ilh('J';I Il('cessary 1I0r sllfliril'nl conditioll for rationally delerlllined
asset prices. Ilowl,\,("-. assumillg that the conditional dislrihlllion of future
consulllillioll has a d('mitl' representalion f,C'l. Ihe condiliollal expectalion
ill C12.:t2!il call he Ie-expressed ill Ihl' filliowing way:

1)1'-1(1.'.«(;..)

J r({:,) I
U; ((;, 1
I f,( Cd dC r

I" ",I r " J nCr) f,*(Crl dC,

0= I' ",II /)1':;1 l'U:rlJ, (I ~.:\'~Hl

.wht·I'(·

alld Ii. J is the cOlllillllously ('OlllpOlllHlcd 111'1 rale of rl'lurll bl'twl'en / and
T o/'an assel pnllnisillg 0111' ullil o/' COIISUIIlPlioll al T; i.e .• it is Ihl' relllrn
Oil the riskll'ss ass(·1.
This version of IIll' Ellll'r eqll;lIioll shows Ihal an assel's (lnTl'nl price r<ln
he expressed as i Is ciiscollnled (,xPl'r1I'<\ payoff. discoulltt"c\ at Ihe riskless rail'
ofinleresl (se(' Chapll'r H «II' a Illorc delailed disclIssion). Ilowewr, Ihe ('x-
peclalion is takell willI resp('C{ 10 Ihe SPD f*. a lIlarginal-rate-of-suhstiIUlioll-
wcightcd prohahility dl'nsit)' fllJlction, lIot the original prohahility demit)'
funclion I of' f'lItml' COIlSIlIllplioll. III a fOlllilluous-timc S('ttill~, is "bo r
known as III<' ril!l'I/I'II/m//I/-;rillgtl"l/litv (Cox allc! Ross \197IiJ) or the I'qllill-
a/I'll/ /IIarlil/galt- 1III"/\/IIi' (Ilarrisoll alld Kreps [197!1 J). I~,
(>111'1' I,' is ohlaillcd, it Cllllw IIsed to pricl' allY asst' I at datI' / with a single
liqllidalill)!; pa\'olf ~\I d;\I(' 'J' liI;1I is all ;Irhilrary fllllrtiOIl or
fOIlSlllllptiOIl
Cr· II; Sl'lh also prol'ide Ihe lillk h('I\\'('('1I pl'l'l'cn'IH'('-has('<1 eqllilihrillill
Illodds ollhl' 11'1)(' discussed ill Chapin Hand al'hilrag('-has('d dl'rivalivl'
pricillg 11l0dl'Is or lilt, 1\'1)(' disn"s('d in Chapter ~}. Indl'ed. implicil ill IiiI'

"'S"t' Ilu.lIIg .IIHll.it/cllh'·lgl'l (I~IHK. (:11;11'1('1 !",) for" moft' dl'IOIilt·d di~nl., . . i()11 o,-SPD .....
'''S('nllili('~ widllllul1iplc' p.I\,Cllb ,11111 infillilc'itori/olls call also h(' priced hy tIle" SPIl. hilt
ill 1111"(' fa",,',... lIu' SI'D lilli" Iw :lpl'ltlpri;lId\' It'e1din('d to (""pilin' 1IIl' til1H'-\';u';;nioli ill !lit,
margillal r.II('\ 01 ,"b ... lilillioll-.... CT Brec·dc'" .HHI LIIIt'lIht'rgcf (I~J7H) and R.uitwr (I!JH:!) lor
furth",. di.~(·IIS ... iol1.
12.3. NOlltJarumetric Estimation

prices of a// financial securities-derivatives or not-are the prices of Arrow-

Debreu securities, and these prices may be used to value all other securities; '. "
1\0 llIatl('r how complex. .

I'lirill~ Derivalives
wilh SI'J)s
r
Under some regularity conditions, we may express as an explicit function
r
of I and T so that a single SPD (C T ; I, T) may be used to price an asset at
any date t with a single liquidating payofT Y(C T ) at any future date T > I
(s("t' footnote 16):

(12.3.30)

and we shall adopt this convention for notational simplicity. For example, a
European call option on date- T aggregate consumption Cr with strike price
X has a payofTfunction Y( Dr) = max [Dr - X, OJ and hence its date-I price
G( is si III ply

(12.3.31 )

EVt'1l the most complex path-independent derivative security can be priced

and hedl!;ed accordinl!; to (12.3.30). For example, consider a security with
the highly nonlinear payoff function:

a-b
Y(C) ------:--~
1 + exp[ -(l(e - a)1
+ b,
a > 0, b < 0 (12.3.32)
I
Ct c + -log( -a/ b). (12.3.33)
fJ
This payofT function is a smoothed version of the payoff to an option portfo-
lio commonly known as bullish verli((l/ spT1'ad, in which a call option with a I,ow
strike is purchased and a call option with a high strike price is written (see
Figure 12.5 and Cox and Rubinstein [1985, Chapter 1] for further details).

ExtmrtinK SPDJ from Derivativl'J Prias

There is an even closer relation between option prices and SPDs than
( 12.~.30) suggests. which Ross (1976), BarlZ and Miller (1978), and Breeden
alld Litl.enberger (I978) first discovered. In particular, they show that the
second derivative of the call-pricing function C( with respect to the strike
510 12. NOlllineanlies in Financilll /)lIla

tI ----.--------.--.-r----- fl --.----.----------------------

() ~--------~---------- () ~--------~----------

b 1-----' b ------------------ - - --- -- - - ---

Figure 12.6. liul/ish Vrrlim/ S/m·(/(ll'ayoJ! I'iml"lioll tlwl SlIwolh,rI Ih,j'JII

price X must equal the SPD:

'\ ()~ G,
(l:.!.:I.:H)
I iJX~
I
-therefore. impounded in eve I]' option pricill!:: formula is the SI'D r.
i To estimate the SPD using (12.3.34). we require a call option pric-
iAg formula. Although many parametric pricing formulas exist (sec Ilull
l}993. Chapter 17] for some poplllar examples). Ait-Sah'lli" and 1.0 (19%)
clmstruct a nonparamellic pricing formula that places fewer restrictiolls-
pritnarily smoothness and weak dependence-Gn the data-generatin!:: pro-
cbs of the underlying asset's price. While parametric formulas such as
t~ose of Black and Scholes (1973) and Merton (1973) olTer !::reat advan-
t· ges when the parametric assumptions (e.g" geometric Brownian motion)
a e satisfied. nonparametric methods arc robust to violations of these as-
s Imptions. Since there is some empirical evidence that casts doubt Oil such
a sumptions, at least for stock indexes. 17 the Ilonparametric approach may
1
I~ave some important advantages}X
i Giv!=n observed call option prices {Gj • Xj. r;} (wtTt:re rj == '1; - I,), the
p,rices of the underlying asset {I';}. and the riskless rate of interest (r" /. we
may construct the smooth nonpara,uetric call-pricing functft>u as

G(l',X,r.r,) = E[G I P.X.r.r,] (12,3.35)

lIsing a multivariate kernel K. formed as a product of d=4 univariate kernels:

( 12.:t3ti)

17Secl.o and MarKinlay (1!)tlH).lor exam!'1<-.

I"Sec IIl1tchimon. 1.0, ~nd POf\~i() (I !)!)4) ;lIul Ail-Sah"li" ( 19!){;a) rur IIIher nonl'ar;III1('lrir
"plion pririnl! ahe .... aliv",_
/2. J. NOIl/mmlllelric fJli1flaiioll 511

alld hellcc

L;~I II,,~(I'- /',)II",(.\: - X,)iI",(T - r,)iI",(r, - r,,lC;

L:~I I/,,~ (I' - 1',)11", (X - .\')/('" (r _. r,)I1", (r, - r f ,) •

(1:!.:l.37)
TIll' optioll \ deita alld Sl'\) l'~lilll'llor dlCll follow h)' difkn'IIliating I;;

iJ(;(I'. X. r. If)
6(1'. x. r. r, ) (I:!.:UH)
ill'

I' (l'r I I', r. Ii) (,'It

( I :!.:l,3!1)

Under ~tandanl regularity assulliptiolls Oil the (bt.t-generating process

as well as slI\oothness assumpliolls 011 the Irlle call-pricing hlllnioll, Ail-
S.thalia alld 1.0 (J99G) show Ih,lI the e~ti1l1ator~ of the option price. Ihe
optioll's della, alld the SPD an.: all cOllsistelll <I11ll ;lsYI\lptoli<:ally normal,
,['HI they provide explicit expressiolls for the asymplotic variallces.
Armcd Wilh the SI'D. any derivative senlrity with characlerislic ( alld
pa),ortTulictioil n(.
1'1') at '1'=1+ r can 1I0W he priced at datI'l hy the pricing
function:

G(I'. C r. r, ) = e-·,r 1 u
00
Y«(.I'1'lj'U'r I I'. T, If) dl'r. ( 12.3.40)

If tht: payoff fUllction YU is twice"difkrl'lIti"bk ill 1'1'. th(,11

(;(1'. (. T. r,) e-','l"" u

l'(.l'rl/'U'r I 1'.r,I',llll'r (1:!.3.41)

"" iJ~i;
1 U
Y«(, 1'/ ) - " 111'1'
iJ I'i
(I :!.3.42)

Y«(. I'rl A. ,
1
00 (j2
------''--,2,--- (,dl 1'. (1 :!.3,43)
o ;)/'1'

Integr,\tillg against Ginstead of it:> second derivative speeds up the conver-

gence rate of the cstilllator-G converges at speed 111/2 ht/~ and its integral
;tj4ainst a slIIoo[h fUlIctioll or
I'.,. ('onvcq.;l'S a[ spcl'd 1/ 1/2 1t:1/ 2 , whereas the
secOlHI derivative of t; converges at 111/2 hK/~ and its intl'gr,,1 against a smooth
fUlIction of VI' at /1 1/ 2 h6 / 2 • A fanor of h: I/ 2 is gainl'd in thl' speed of conver-
gence by integrating the second derivative of thl' payoff ftull'tiol1-when it
Cxisls-agai1l51 i; instead ()fintegrating tht' payoff ftlll!'liOIl itwlf against the
second derivative of i;,
 J L. N()lIitllt'lm//l'.1 ill hlltlllnllJ / )I/{II

Ail-Sah;di;1 alltll.o (1~}~1I;) ;Ipplv Ihis ,'slimalor 10 Ih(' pricillg alld dell;l-
hedgillg of SK'I' r,oo call alld pili opliollS IIsin!!; daily dala oblailled frolll
liI(' {:hicago Hoard ()pliolls Ext'hallgl' for Iht' salllpll' pnill(l frolll.laIlILIl'\·
·1, I ~1!l:Ilo 1I"',(,lIlhl'l :\ I, I ~I!I:\, liddillg a lol;d sampk silt' of 1·1,,1:\ I olN'r-
";lliolls. The ('slilll;ll('s of Ihe Sl'lh exhihit lI('!!;;lti\'(" SkeWllt'SS ;llId exct'ss
kllrlosis, a conmlon 1"';111111' or Itislorical slock 1'<'llIrllS (se,' Chapl('r I 1'01'
!'xalllpl!'). AI,o, IInli",· nl;\!I)' paraml'lric oplion pril'ing models, IIie SI'I>·
g"lInall'<i oplio\! pricing limllllia is capahle o('captllrillg p('rsisl(,lIt \'ol;llilill'
"smi"',," and ollln ('nlpirical fcalllrl's or markel prices.

12.4 Artificial Ncural Networks

All ahnllalil'" 10 lHIlIP;ILlllll'tric rl'!!;rl'ssioll Ihal has refeil'l'dlllllCh IT(,'1I1

alll'lItioll illlhl' ('ngilll'lTing and hllSill!'ss commlmitit's is Ih(' IIrli/irilll 1II'IIml
lIt'lwllIk Artilici;lIl1('III;tllll'tworks llIay 1)(' I'i('w('d as a \lo\lpar;\lI11'tric t('('h·
niqllt', h"II(,(' IhI'S(' llIodels wOllldl;1 qllile naillrally ill Sertion 12.:1. 110\\'·
(,I'('r, h,'('alls(' inilialll' Ihl'\' dre\l' IIi!'ir llIolivalioll ('rolll biological plll·1I01ll·
('\la-ill IMl'linllar, frOl1l II\(' pl\\'siolo).\)' of 1I1'!,I'" n'lls-II\('y ha\'(' Iwco\l\('
pari of a sl'l',II'al(', dislilll'l, alld blllV;l'onillg literalllr!' (s!'e I I!'I'l I., Krogh,
and l'alllH'r I I'I!III. 1IIIId,illsoll,I.o, alld Poggio 1l!I!I·1l.Poggio alld (;iI'IIsi
II!I!IOI, and Whitl'11!11)21 ((,I' o\'('I'"i!'\Vs of this lilerature).
To 11lI1h-rs,'o!'l' till' COllllllOll lHlllparanll'lrir origins of artilicial Ill'llr;t\
lIelworks, \1'(' d('snilll' Ilm'l' killd, of lI('tworks in Ihis section, colll'Oilel1'
known as Il'IImillg 1I1'lll'O,.b (Sl'" HalTolI ;\IId l\;ll'l'OIl [I ~IHH J). III ~:t'rti()1l
12...1.1 \1'1' illl!'(ultlcl' Iltl' Illtlltibl'l'!' pl'!'ccpll'On, pl'l'haps (\11' Illost pO:)Illar
Iypl' ofarlilicialllCllrallll'llI'ork in IIII' rl'n'llllilerallll'l'-t his is whal IIt(' (( rill
"lH'llrallH'lwork" is IIslIalll' lakl'lI 10 llH'all. III Sectiolls I ~A.~ alld I ~A.:~ Wl'
presl'1l1 111'0 olher lecltlliqll('s Iltat also Itave lH'lwork illll'l'pn'I;lliolls: raelial
basis ftlnctiolls, alld proj!'clion pmstlit regression.

/2.'/.1 ;\II/Ililaw',. 1'I'I'fp/Jlmm

I'nltaps IllI' silllph-st ('Xaillph- of' all arlilicial 1ll'Ilrai Ill'lwo!'k is IIII' bil/tII)'
Ihll'\h"ft/I/I/II!t-i Ill' 1\1« :l1l1"dl alld Pills (1!1·1:1), ill wltit-It all o/ll/JIII variahk )'
lakillg Oil 011 Iv IIi(' "a!tu's liTO ;11)(1 (IIII' is lHlltlillearly relaled 10 a ('(lII"I'lioll
01'.1 iII/JIll variahlt-s "" i "" 1•..• ,.1 ill Ih" rllllowill!!; way:

r g (ttl,,,, -II)
I-I
(12.'1.\ )

gill)
iI if'
if'
/I

/I
> ()
< n.
( 12.·1.2)
J2.4. Artijicial Neural Netwurks

OUIPUI

It'pm
Layer
I

X5 \

Figure 12.7. fli1lary Thmho'" MotUl

•
According to (12.4.1). each input ;So is weighted by a coefficient Pj. called
the ronnection strrngth. and then summed across all inpulS. If this weighted
SIIIII exceeds the threshold J.I.. then the artificial neuron is switched on or
ar/iva/f(l via the activation junction gO; otherwise it remains dormant. This
simple network is often represented graphically as in Figure 12.7. in which
the in/ilIl [{/yl7 is said to be connected to the output Layer.
Generalizations of the binary threshold model form the basis of most
current applications of artificial neural network models. In particular.
to allow for continuous-valucd outputs, thc Heaviside activation function
(12.4.2) is replaced by the logistic function (see Figure 12.8):
1
g(u) =- -.
1 + e- U
(12.4.3)

- - - - - - -I

-J() -5 o 10
x x

Figure 12.8. COlll/J(lriJOII oJ /hm,iJitl, and l.ogi.lti, Arlillalion /oIl1I,liofU

 514 J2. Noniinearilies i" FiIUl/lrillilJlllll

Output

---------"
I

I
Hidden I
Llyer

I Input
I
Layer

Figure 12.9. Multilfl)'I'''I'em~/Jt/l)1l with f/ Sillgw llidtlml.flyr,.

Also, without loss of generality, wc setlL to zcro since it is always possihle

to model a nonzcro activation level by defining the first input XI = I ill
which case thc negative of that input'S cOIll\l:ction strength - fll hl~(,ollles
\ thc activation lcvel.
\ But pcrhaps thc most important extension of thc hinary threshold
imodel is thc introduction of a hidden lflyer bctwccn the inl'ut layer and
; thc outputlaycr. Spccifically, let

y h(t.a~g(.B~X)) (1~.4A)
{34 [.B~I PAt ... PAl r. X = [XI X~ ... XJ r.
whcrc h(·) is anothcr arbitrary nonlincar activation function. J.M...this case,
thc inputs arc connectcd to multiple hidden units, and at each hiddcn Hnit
they are weightcd (dilTcrcntly) and transformcd by thc (same) activation
function gO. Thc output of cach hiddcn unit is thell weighted ye~again­
this time by the a;s-and summed and transformcd bY'a second activation
function h(·). Such a network conliguration is an example of a lIlullilfl)'t'r
percef!tron (Ml.P)-a single (hidden) layer in this case-and is perhaps thc
l1Iost com 10011 type of artilicial nellral network among recent appliclliolls.
In contrast to Figure 12.7. the multilayer perrcptron has a more complex
,utwork topology (scc Figure 12.9). This can be gcneralized in the ohvious
way by adding more hiddcn layers. hence the term lIlultilflyrr percept roll.
For a givcn sct of inpuL~ ,md outputs (X" Y,), Ml.I' approximation
amollnts to cstimating the par,ullcters of the Ml.I' nctwork-the vectors
.B. and scalars 0'4, k= I •... , K-typically hy minimizing the sum of squared
dcviations between the output and the network, i.e., L,( YI - L~ 0'4R«(:J~X) I~.
12.4. Arlijirilll Neuml NelworiLi !)I!)

In the terminoloh'Y of thi~ literature, the proces~ of parameter estimation is

called ImininK the nctwork. This is Icss pretcntious than it may appear to
bc-an carly mcthod of parameter estimation was IlIu'k/m>/mgnlion, and this
does mimic a k.ind oflcarning hchavior (alheit a wry simplistic ol1c).19 llow-
ever, White (I !)~2) cites a numher of practical disadvantages with hackprop-
ag-ation (numcriCII instahilitics, on:asion'll IH>lH.:onvt'rgence, etc.), hcnce
thc preferred method for cstimating the parallll'lcrs of (12.4.4) is nonlincar
least-sCjuarcs,
Even the singlc hidden-layer MU' (12.4.4) possesses thc 1I11i1>mnl n/~
jnoxilllntionjlrojll'Tly: It can approximate atly nonlinear function to an arhi-
trary degree of accuracy with a suitable nluBher of hiddell ullits (see White
[1992]). Howevcr, thc univcrsal approximatioll property is shared by lIIany
nonpar.llnetric estimation tcchniques, illcludinl!; the nOllparametric regres-
sion cstimator of Section 12.3, alld the techniques ill Sertiolls 12.4.2 alld
I ~.'1.:~. or course, this tclls liS lIothing ahotll the pcrfonnalllT of such tech-
ttiqltl:~ ill practice, and for a given set of data it is possihk for one tedltli(llIe
to dOlllinate anothcr ill accuracy and in other ways.
Perhaps the most importallt advantage ofMI .f's is their ahility to approx-
illl.tle complex nonlillear relations through the compositioll ofa network of
relatively simple functions, This specilication lends itself naturally to /mml{P1
!})of/'.lSing, allli althongh there are ollTl'ntly no financial applications that
exploit this feature of MLl's, this lIIay soon change as parallel-processing
softw'lre and hardware become lIIore widely available.
To illustrate the MLP model, we apply it to the artificial dataset gen-
erated hy (12.:i.II). For a network wilh olle hiddell la}'"r alld live hidden
unil.~, dl'tlotn\ by MLI'( I ,:J), with H(·) set to the idetltity futlction, we obtain
the fol!owing l\Iodel:

- :J.<111g(-'2.6'28 + O.lHL\/)
- :-I.07Ig( 13.288 - 2347 X/) -+ (i.:-I20g-( -2,009 + 4.00!lX/)
+ 7.8()2gl-3.3I{) + 2.484.\/) (I '2.45)

where g( II) = I/( I + p- "). This modd is plottnl ill Figure 12.10 ami
compares well with the kerllcl estimator dcsrril)('d ill Sectiol1 12.:1.1. Dcspit("
the fan that (12.4.5) looks nothing like Ihe sil1e IUII("Iiol1, I1l'Vel thcless the
MI.I' per/i)J"Jlls quite wcllllllll1erically and i~ relaliVl'ly e<lsy 10 estimate.

PIl\arkpropag.llioll i:'\ ('s"('lItial1y 1ht" lII('tho(\ ot .\/o(/UI\III" flNmJXWIIII'''1I III"it l)lopo~'fI hy

Rohbi", .11111 Momo (1!I:lla). Set' Whil" (I'I'I:!) I,,, I"rlher del.lIl.,.
 J _. ~ ""1111111'(111111'.\ III "/lltlile /(11' Jella

7'

•, f .Y.: ....
.\

""

t,'"
"- "
7' MI.I'
I
n,ll.1

1 ~11l(.\)

1 II~------------~--------------------------~------------~ .1,
~ IT ~;r
:!
X

"'gun'12./O. "'1,1'(/.51,1/",/1'/ ofT,

12, ·1, 2 J:wlill{ I!I/\i,\ FIl//dill//\

The class or mdilll h(/\;\jll/J('li()l/\ (RBFs) wcre firsl IIscd 10 solvc iltlf"jJlJ/tlli()1t
prohlcllls--lillilll-\ a ('lIn'(' cx:tcll), I!trollgh a sCI of POilllS (scc Powcl: ( I ~)S71
Ii)ra rc\'icw). ~Iorc I'('('CIIII)" RBFs hav(' hecncxlcnded hy scv(,ral rcsc;tl'ciH"rs
10 pcr((>I'tII Ihe tIIon' gelleral task or approximalion (sec Broollll\cad anti
Lowe II ~IHH I. to. lood), and DarkclI II (IWI La lid I'ol-\gio and (;i rosi 119~10 1), III
parlic"lar, I'ol-\I-\io alld (:irosi (I ~1~1O) show how RBFs (,<1II1lt' <lniwd ("roil I II\("
rbssiral "",~'lIllIriwlillll plohl('111 in which sOllle IIl1kllmvll hllll'tioll 1'== miX)
is \0 IH' approxilll;IIt'dl-\ivclI ;1 spalsl' dataset (X" 1',) alld SOIlll' sllloothnl'ss
constraillts. III Il'I'lIIS or 0111' 1IIIIIIiplc-I'('l-\ression allalo).,,)', thc ti-dillll'lIsional
\'('('101' X, arc the l'xpLtllalorv \'ariahles, l', thc dcpcndent variahle, ;111<1 III ( ,)
the possihly 1I01llille,II blllliioll 11I;lt is Ihe cOllditiollal CXpl'('latioll or l',
l-\i\'l'1I X" alld 1Il'IIlT

)', = III(X,1 If" W!.,!.li)

The reglllari"lli,," (III' lIollpar;lIl1l'lrir ('slilll'lIioll) prohlelll ilia), !l1l'11 hc

vie\\'ed as IIIl' IIlillillli/;lIiOIl or 1111' Ii lllowi "1-\ ohjcl'liv(' I'lIl1rtiollal:

L (II i', - lII(x/)f + AII'flIl/(X,)II~),

, I
il. .... Artijlcilti Nwml Nl'tlllurh

where II . II' is some vector norm and 'D is a diITerential operator. The'
terlll of the slim in (12.4.7) is simply the distance between m(Xt) and
observation Ylo the second term is a penally function that is a decreasing',
function of the smoothness of mO, and A. controls the tradeolT between'
sIlloothness anrl fll. "~,j:." .

In its ruost general form, and under certain conriitions (see, for exam-
ple, Poggio and Girosi [1990]), the solution to the minimization of (12.4.7)
is given by the following expression:

lil(Xt) :::: L.B.rll.(IlXt - V.II) + P(Xt), 02.4.8)

.=1
where IV.} are d-dimcnsional vector cl'1!lers (similar 10 the knots of spline
functions), I.B.} are scalar coefficients, 1rn.} are scalar functions, PO is a
polynomial, and K is typically much less than the numher of observations T
in the sample. Such approximanlS have been termed hyperbasis Junctions by
Poggio and Cirosi (1990) and are closely related to splines. smoothers such
as kernel estimators, and other non parametric estimators.2°
For our current purposes, we shaH take the vector norm to be a weighted
Eurlidean norm defmed by a (d x d) weighting-matrix W, and we shall take
the polynomial term to be just the linear and constant terms, yielding the
following specification for rll('):

ih(X /) = au
•
+ 0'1 XI + Lfl.lilk (Xt - Vkl'W/W(Xt - V.»' (12A.9)
k=1

w!tnt" au and 01 are till' coefficients of the polynomial P(·). Miccheli (1986)
shows that a large class of basis functions "lkO are appropriate, bill the most
('olllll\on choices for basis fUllctions are Ca\\ssi~ms e-,/(J' and mUltiquaqrics
r-;--;; ,
yx+a-. ;
Networks of this type can generate any real-valued output, but in appli-
cations where we have some a priori knowledge of the range of the des/red
O\ltp"ts, it is computationally more efficient to apply some nonlinear trans-
fi:r fUlictioll to the olitpuL~ to reflect that knowledge. This will be the case
ill our application to derivative pricing models, in which some of the RBF
lIetworks will he augmented with an Olltput sigmoid, which maps the r~nge
(-00, (0) into the fixed range (0, I). In particular, the augmented network
will he of the form g(ln(X») where g(u) :::: 1/(1 + ('-U). •
A~ Wilh MLPs, RBF approximation for a given set of inputs and out-
(llllS (X" }'/), involves estimating the parameters of the RBF network-the

~IITo ,·"oIlOll1il.(· on terllIinolo).,'Y. hert' we m" RBFs to ('nmlll"a,s hoth the interpolation
1t'chlliqlle" 11-,<,<1 hy I'OWl'1l (19117) a'Hillll'ir "'\""'1'1('111 gt·neralil.alions.
118
I
J2. NOlllinearities ill Fi1lfI1lr;a[ /)111(1

tf(d+ I )/2 uni<jue entries of the matrix W' W, the dh clemcnts of thc (ellters
~Ull, and the d+k+ I coeflicicnts au, 010 and (till-typically by nonlincar
I 'ast-squarcs, i.e., by minimizing LI [ Y/-m(X/»)2 numerically.

12.4.3 I'rojrrlioll Pur.wit UPt,,,,·ps.lioll

'rojection pursuit is a lIlethod that emcrged from thc statistics l"Ollllllllllity
or analyzing high-dimcnsional datasets hy looking at their low-dimcnsional
rojections. Friedman and Stueu.le (HIHI) developed a version for thc
I\tonlinear regression problell\ called projcctiOl1 pursuit regrcssioll (PPR).

~
Limilar to MLPs, PPR models are composcd of projections of the data, i.e.,
I roducLS of the data with estimatcd cocfficicnts, but unlike MU's thcy also
stimate the nonlinear combining functions from the data. Following thc
I)otation of Section 12.4.1, the formulation for PPR with a univariate output
~an be written as
1\
III(X,) = au + Laiml(.i3~X,) ( 12.4.10)
k:1

where the functions mk(-) are estimated from the data (typically with a
smoother), the (all and (.i3 k l are coemcien\..~, K is the number of l"l1jrr/jOllJ,
and ao is commonly taken to be the s'lIl1ple mean of the outputs m(X,). The
similarities between PPR, RllF, and MI.» nctworks should be apparent frolll
(12.4.10).

J2.4.4 /.imilaliom of LeaminR Nplworks

Despite the many advantages that le'lrning networks possess for "pprox-
imating nonlinear functions, they have several important limitations. III
particular, there are currently no widely accepted procedures fo~tcnllill­
ing the network arehitecture in a given application, e.g., the number of
hidden layers, the number of hiddcn units, the specification of thc activa-
tion function(s), etc. Although some rules of thumb have eIllCl"!;l'd from
casual empirical obscrvation, they arc heuristic at best. ,
Dilliculties also arise in training thc network. Typically, network param-
eters are obtained by minimizing the SUIll of squared errors, bUI bel',IlISl'
of the nonlincarities inhcrent in these specifications, the ohjective function
may not be globally convcx and Gill have many local minima.
Finally, traditional tcchniqucs of statistical in/erencc such as si~nifi('ancc
tcsting cannot always he <lpplicd to nclwork models bccausc of the ncsting or
layers. For examplc, if one ofthc ak's in (12.4.4) is zero, then thc (onncnion
strengths .i3. of that hiddcn unit arl' unidentified. Therefore, cven simple
significance tesLS and conlidCIlCc interv<lls requirc complex conlbinations
of mainlain('(\ hypothcsl's to be intl'rprctl'!\ propcrly.
I
J2. -I. Arli/irilll Nt'uml Npllllurh 519

12.-1.5 AN,limlioll: 1.l'lImil/~ IIII' IIIwi<-.'i,-/wl", 1';1111111111

(;il'('n 11j(' POW('I' an<llkxibility or 1I(,lIraIIH'lworks 10 approxilllate COlllpleX

nlllliincar relations, a natural application is to (ierivativc sccllritics whosc
pricill).'; forlllulas an~ hi).';hly nOIlIiIH'ar I'WII wll\"lI 111I'y ~\n' availahle in dos(,11
!(>rIll. III particular, I lutdlinsoll, 1.0, alld Poggio (I ~I~H) pos(' Ihe fi.!Iowillg
chaliellge: If optioll prices were truly detennillcd hy Ihl' Black-Scholes It)r-
l1Iula exactly, can lIellral networks "leal'll" thl' Black-Scholes limllula? 111
11I0re slandard statistical jargoll: Call the Black-Scholes formula he esti-
m,ltcdllonp,lr,ullctrically via learning nctworks wilh a sllrJiril'nt dq!;l'cC of
an:llracy to be of practical usc?
Hutchinson, 1.0, and Poggio (1994) bee this challenge by performing
MOlltc Carlo simulation experimellts ill which various nelll'a\networks arc
trained Oil artificially gencratee! Black-Scholes option prices and then com-
pared to the Black-Scholes formula hoth allalYlirally and ill ollHlf-sample
hcdg-illg- cxperilJlenL~ to sec how close they come. Evell with training seL~
of ollly six months of daily data, Ieamillg- network pricillg formulas can
al,proximate the B1ack-Scholcs formula with reasonable accuracy.
Specifically, thcy bcgin by simulatillg a two-year samplc of daily stock
pric~s, and crcating a cross-section of options each day according to the
rules uscd by the Chicago Board OptiollS Exchange with prices given hy
the Black-Scholes formula. They refer to this two-year sample of stock and
(Illultiple) option priccs as a single Imillillg /ialh, since thc nctwork is trained
on this sample. ~I Given a simulatcd training path (1'(1)} ofdaily stock prices,
they construct a corresponding path of option prices according to the rules
of the Chicago Hoare! Options Exchangc (CBOE) for introducing optiolls
on stoc ks.
A typical training path is shown in Figure 12.11. IkGlliSC the options
gellerated for a particular salllple path arc a function ofthc (random) stock
price palh, the size of this data matrix (in terms of lIumber of options and
tot;t! numher of data points) varies across samplc paths. For thcir training
Sci, the number of options pcr sample path rang-e from 71 to 91. with an
a\crag-e of HI. The total llll/nhcl' of d.lla points rangl' from :),~~7 to G,H47,
wilh all average ofG,001.
The nonlincar Illodeb obtaincd frolll Ill'lIral Iletworks yield l'stilllates

:!l They as.'mlla' th.H the lUHlerlyillK CI..("st't tor the.' simulation {'xpet illu.'tlls i!lri a lypical NYSE
stork, ,,-.. ilil an initial price /'(0) ofS!">O.OU. all aTlnual fOlllillll()II.'"ly rOll1pollllfit'd «''''preted f.\lr
of 1('1111"11 J{ of I WYt" and all alJlHlal \'olatililY n of '2IJfYr,. lllldc'l lilt' gl.lc J,..·S( hole . . OI~."lInptioll of
.\ ~t·\\HH·\rir l\ro\\,ul.Ul llH)\\tm,

til' = /I/'tli + o/'tlU .

•1Ild (,Iking 111(' IItllllher of day."i pCI' Y('ar to 1)(' L:):~. 'he}' <lI.IW :,()(j p."'l'lIdol.lllciolll \'aridlc'!'I If,)
hom the.' dblrihlltioll N(Jl/:l:):l. (1 '1 /:l!"):l) 10 ohtaill two yc.'.us oftl.lily rOlltilHlOlI.,lyrolllpolllld('d
retllnt"i, which an' ("{Jove'fled to prin'~ wilh til(' lI.'iIlOl' r('tllioll I'(t) = /J(O) «'xplL::=-, f,J for
1>11.
 J":. ,\01///111'(/1///1'.1/1/ "'IIf/lIl)I,, 1),{/II

-or

'i.
"..

"',
"<- ::;:
'C
C- O':

~ ~
c.: ,...

"'-

'l.
"'

Mar!IU
FUIIII"(,S (:lIlIlr~H·1

figure ,2"" ·li,/.im/Sill/lI/ol,·d '/iolllillg /'IIlh (Vf II" Irxl j""/lfIn""I'1"n)

I)(/.\},,,I lillr 1'1"'-""11 .11". I, 1"';I'r, ",hi/I' Iii, I/i'/{Ill" Ifl",.iI'lIl Ilu 0ll/ioll.1 {III Iii, .1/01'11.
FiI,
.I'·aHI/dilluh- ott/II'li/, o/Ihl' (/011/1' iut/ili/h'., lit., I/,-ilu'/"ia (ill'/IIWI (/I, .lluulnllolllldu- tli//"'I'I/I
;"IIIH/lldi"" (/1/(/1'.\,/.;"11;",, tloll'I ";.,ib/I').

or optiOIl plices "lid ddl;" Illal ;11(' diHindt to dislill!!;lIisll vislI"lI), rmlll IIII'
tllll' Hbrk-Srhoh-s "allies. All (,xample or the estimates alld e!Tors 1'01 ;\Il
RIIF lll'tIVOIk is showlI ill Fi!!;lIrc I:!.I:!, The estimated (,flllatioll fClI' tllis
particlllar RIW IH'twork is

-O,O:IJ ["/'\ - I.:I:'J -I- :!.",;-,

I<I.:!.\ T - n.·F,
----

~
--------

11.0.'I [/·IX-I.IK]'[:,l).7~1 -0.0:1] ["/ X.- I.IHJ. .',-,

r . II.:! I -0.0:1 I (I.:!-\ . T - II.:!.' f- I
/2.4. II rtiJiritlI Neural Netwul1i,
,.521

(a) NI'lwork call price (;j X (h) Nelwork delta \W

(c) Call price error ejk - Gj X (d) Delta error ¥s - ¥s

Figure 12.12. Typical BehavioroJFour-Nunlintar-Term RBFMOlkI

o 10 [PI X - 1.05]' [59.79 -0.03] [PI X - 1.05] + 1.62

+ . r +0.10 -0.03 10.24 r + 0.10 .

+ 0.14PI X - 0.24r - 0.01, (12.4.H)

where r ==:: '1'-1. Observe from (12.4.11) that the centers in the RBF
IllOde! arc nOI constrained to lie within the range of the inputs. and in fact
do Itot ill the third and fourth centers in this example. The largest errors
ill Ihese lIetworks tend to occllr at the kink-point for options at the money
at expiration. and also along the boundary of the sample points.' .
While the accuracy of the learning network prius is obviously of great
illterest, this alolle is not sufficient to ensure the practical relevance of the
1\()l\parametric approach. In particular. the ability to hedge an option posi-
tion is as illlportant. since the very existence of an arbitrage-based pricing
[(H"llIula is predicated on the ability to replicate the option through a dy-
Italllic heclging strate).,'!' (see the cliscussion in Chapter 9). This additioo;al
f)22 12. Nonlinearilies ill Fillal/cial /)a/II

j. onstraint provides additional motivation for regularization techni<lllcs and,

. pecifically, the RBF networks uscd by Hutchinson, Lo, and l'oggio (1991).
I In particular, delta-hedging stratcgies require an accurate approxima-
~ion of the derivative of the undcrlying pricing formula, and thc nccd for
Jccurate approximations of dcrivativcs leads directly to the smoothness
Jonstraint imposed by regularization tcchniques such as RBF nctworks.~1
flutchinson, Lo, and roggio (1991) show that both Rl3F and MI.!' networks
provide cxcellent delta-hcdging capabilitics for the simulated Black-Scholcs
data as wcll as in an empirical application to S&P :)00 futures options, ill a
fcw cases outpcrforming the l~lack-Scholcs formula (rcc~llthatthc formula
is dcrivcd undcr the assumption that delta-hedging is performed continu-
ously, whereas these simulations assumc daily delta-hedging).
Although paramctric derivative pricing formulas are prcfcrrcd whcn
they arc available, the results of Hutchinson, Lo, and Poggio (1991) show
that nonparamclric Icarning-network altcrnativcs can be uscf,,1 sllhstitll\(~~
whcn parametric mcthods hlil. Whilc thcir findings arc promisin!{, Wl' can-
not yet conclude that such an approach will be succcssful in general-thcir
simulations have focused only on thc mack-Scholes model, and thcir cmpir-
ical application consists of only a singlc instrument ,mel timc pcrio(I, S&P
!i00 futures options for 1987 to I ~Iq I.
However, this gcneral approach points to a number of promising dircc-
tions for futurc rcscarch. Perhaps thc IIIOSt pressing itcm on this agellda is
the specification of additional inpuL~, inpuL~ that arc not readily capturcd hy
parametric models, e.g., thc return on thc markct, general market volatility,
and other measures of business conditions.
Other rcscarch directions arc motivated by thc need for pro~ statis-
tical infcrence in the specification of learning nctworks. First, wc rcquire
some method of matching thc network architccturc-numbcr of non Ii Ileal'
units, number of centers, type of basis functions, etc.-to thc specific dataset
at hand in some optimal and, prefcrably, automatic fashion. I
Second, the relation bctwccn sample size and approximation error
should bc cxplored, either an,llytically or through additional Montc Carlo
simulation cxpcrilllcnL~. l'erhap~ somc data-dependent metric call be Cllll-

~~In fact, it i, well known Ihal Ihe prohklll "f 1lI11l1erir,,1 clilkrcllli;l\i,," i., ill-po.,,"\. '1'1",

l
,'.. "I.,iral approach I Reinsrh (l!lfi7) I i., 10 rq:lllariw il hy lindin!: a wflicie,"ly sn"",lh IlIlIClioll
I al ",Iv(', IIII' varialional prohl"111 in (t 2.4.7). A, we disf\"sed earlier, RBF nelwo. ks as wi'll
;'t 'plilles alld ,ever;,1 1111'1'" of MI.I' '1l'lwurks follow di\{'l'!ly fru\\l Ihe rc~\\lari"\lioll app .... Mh
a III arl' Ihereforl' exp"C!"d (0 approximall' 1101 onty Ih" pririn!: lemnll);' hIll also i" dl'ri,· •• lin·,
(provided the ba.~is function corresponding 10 a smoo(hnes..~ prior is ora ~llf1iri~llt (h-gr('(', ."i('('
PlJK~i() and Gir()~i (1990): in particular. the Gaus",ian is certainly sufficiclllly ~t1Iootll lor 01lr
prublem). A'pecial cas" "flhi. !:cllcral ;1If:uII"'nl is Ihe result .,fGallan! and While' (t !J!l2) alld
linrnik. Slinchcomhe, and Whit<, (1~)~ln) wlu) show that singh·-hidden-Iayt·:, Ml.1' 'It'lwflll~ f<l"
a(JprOXirnalf' the derivalive' of an ;lrhilr;uy nOIlIiIH'tlt' mapping arhitraril)' well OIS Ih(' IHl1ul)('r
or I
hidden unit, inCl'('a<c·,.
J 2.5. {)pl'1jllling and I )ala-SI/()o/Iing

slrlleted, thaI can provit\c real-tim(, l'slilll;l\l's of al'l)loximatioll ('/Tors ill

milch the S;lIl1C way that stalldard elTors lIIay hl' oht;lincd lill' typicil statis-
tical estilllators.
Alld filially, the lIeed for he II ('I' pnf(>nllann~ lIH'a~lIreS is dear. While
typical 11IeaSlires of /{oodness-ol~lit such as J{l. do olfer some /{uidance for
lIlodd s('\(octioll, they an' only in('tllllpkt(, llH'"SIIITS of pl'rforlllancc, More-
ovl'r, the Ilotioll of de/{rees of freedom is 110 IOIl!!;('r wt'll-defincd for nonlin-
ear lIlodels, and this has illlplicitiolls for ;111 statisticil III('aSIIITS of fil.

12.5 Overfilling and Data-Snooping

While each of lhe nonlinear lIIethods discllssed ill this dlaptet' has iL~ own
coslS and bellefits, the prohlems of Ollr>jllii/lg and dtl/fI-l//(/o/,i7lg alfed all of
thelll to Ihe sallie d('WTe, Overfillill),; on:llrs wh(,11 a IlIodt'llits "too wdl," in
the sCllse thaI the lIlodel has captllrcd both ralltiollllloise as well as genuille
!lOtllinearilies, Heurislically, lhe primary suurce of overfilling is having 100
few "degrees of frcedom" or too mallY parameters relative to the l1umher
of datapoints, and a typical symptom is an excellent in-sample iiI hUI poor
ollt-of-sample perforlllance,2~ Data-snooping is a related prohlelll that can
lead to excellent bUI spurious oUI-()I~saJllpk pnforlllancc. Data-snooping
biases arise wlten we ignore lite hlCI thal many sp{~cillcatioll searches have
becn conducted to obtain lhe final specification of a model we arc filling
to the data?1 Even if a model is in fact incorrect, by searchill),; IOllg enough
over var'lUlis tialase\s and/or parameter valu('s, we arc likely to filld sOllie
combination thaI will fillhe data, llowevn, this {it is spuriolls and is merdy
a s)'mptoJll of our eXlensivc search procedure,
Unfortunately, lhere arc no simple reJlledics to these two problcms
,ince lhe procedures lhal give rise to them are the sallie procedures lhal
produce genuine empirical discoveries, Thc SOllrce of both problems is lhe
inability to perform cOlllrolled experiments and, (Ol\Sc<j\\{~ully, lhe heavy
n:liance on statistical infercnce for our understanding of thc data, As with
all fi>rlns of statistical inference, there is always a margin of error, .lIId this
llIar),;ill is often sensitive to small chatlgcs in the IVa), we process lhe data and
revise our models,

:!:tTIIl' d('grt'l'~ of In,'l'dolll of a 1I01l1ilH';1I lIlockl ,II (' ollt'll clilli( 1111 10 c!t'U'llIIim' 1H.·C:'III~(·
,IH' lIotioll of a Mp.U.JlIlC'tcr" ll1.ty b(~ hluru'd. For example, lilt' )"'c'lll('l fcgrl'ssion may ~('elll
to have only OHe fnOt· p~'ramctC'r-tlu." h.uul ..... i,hh "-hu, ,h~s i:-. flt',\1"Iy ml ... h-<1thng :\;lH t' t' ..... h
d.H.lptliul ~l'n'('S as a n'IHt'r for 10lal aH'I.tging. S(T 11.11I1J1{'1 (I~IXI)) .lIul \\'.thh,t (l~mO) 101
1111 tht'r (lisnl~.,ioll.
:!.IS{'(' 1.(,;1111('1' (I !17H) ;111(1 1.0 al1<1 ~I;H "'illl,l), (I !1!IOhJ 101 1o! 111;11 ;1I1,iI\,c' Cli '11( It hi.\,('!Io .. Hul
Black (l!)!):~) lor ,11('("('111 ('x;lIliple ill Iht' fill,1I1( ('I1I('/",HIII('.
 /2, iliul/ lil/nl l/lll', l 11/ Fil/a l/ri(l l
J)al( l

N('v crlh clt's s, Ihc/ (' an' s('v('r;ll

wa~'s 10 miti~ale the l'I'i(oCls
aile! e!ata-slloopill~, For ,'xal llplc of OVt'rfillill~
, the imp act of syst ema tic spec
se;lr t'ilt's lIIay ofll' n he clln rlat( ifica tioll
'd ('xpl icitly , as ill to alld Mac Killl
III slIch illst ance s, IIsin~ a ('o!T ay (1990b),
ect(' d stati stica l distr ibut ioll for
safe~lIare! a~ainst findin~
illfcJ'(.'llcc will
si~lli(i('allt resu lts whe re
110111' exis !. Care ful Ollt-
ol~sallll'lc peri'OJIII;IIII'(' el'al
llali on (';111 IIIlCOVCr ovcrfillil1~
if rdat ivt'l y few oill-of~salllpl(' lesls proh lem s, ;1I1c\
are ('oll lillc led, or il' lirey are COl
over dilf en'n t (;11111 ",('akl), corr ldll!'lcd
elal ed) dala s('ts , Ihis will lllill imiz
of data -sllo opil lg, e the eUi' us
Bill pnh aps till' II lOSt cl'kC li\'c
IIH'allS of recltl('ill~ the imp act
lillill~ alld dala -sllo opil lg 01' 0\'('1 '-
is to imp ose SOIlI(' disc iplil le Oil
sear ch Il)' 1/ I"i",-; Iheo r('lic ;t\ COII the sp('c ific' llion
Si(i<'raliolls, The se cOll sidc ratio
ilJ Ihe f011ll or wi'll-art i('JILrlec\ lls may he
IlJalll('lJIatical mod els o[ ('COIlOll
ior, or hcha \'ior allJl Odd s lJIot ivale lic beha v-
d hy (>sydJOl()~ical ph(' nom ena,
hellr istic rlllc sofl hlllJ lh hasc d or silJlply
ouju dgll J('nt , illill ition , and past
Whi le all of thcs c SOIlIH'S an' also c'xp cricn ('(',
afli'c tee! hy clata-snoopin~ and
to SOIlH' c'xtC 'lIt-l Io form of illli' over li 1I i Il~
n'lIc e can esca pe thes e pro hlem
kss slIsc q>ti hlc alld offt- r a !t'ss s-th ey are
(Llta -dep (,lId ('nt mea ns 01' mod
AI! this SllggcSIS the l1el'd fill' ('1 vali dali on,
all (/ Illio n [ralJ l('wo rk or spec
f(lI' Ih(' 1IJ0del hefo n' cOll ifica tion
frolllin!-\ IIlI' (Llta, By prop osil
lioll , aloll!-\ wilh lire kind s of plll'n lg slIch a spcc ifica -
OIIl ('lIa ont' is seek illg 10 capi llre
r(')('valll varia hll's to hc used ill alld Ihe
lite sear ch, Ihe chaJl(,(, or cOlI
spur ious ly slIcc(,ssful lIIod el is Jing IIpOIl a
r('du ccd,

12,6 Con clus ion

NOl llill( 'arili ('s ;tn' cI('a ll\' play illg
a lIIor e prol llilW lll role in fina
calio ns, Ihal lks 10 illl'\'('aWS ill COIl ncia l appl i-
lPJllill!-\ pow er and the avai lahil
dala s('ls , Unli k(' tltc Illal nial ilY ofla rg('
pn's ('llle d ill ('arl iel' chap lers ,
id('a s ill this chap ll'l' arc less well SClIlle of till'
-('sia hlisl lt'd and 11101'(' 1(,lllaliv(
shor t tillJe Illall), 01 Ihe I('ril l Iiqlll ', With ill a
's we hal'( ' cove red will h(' r('li lied
lIJay h('co llll' ohso lete, Nl'v('J'tl , and sOllJe
ll'lcss, il is imp orta nt to dl'v clop
Ihl' dire t'lio ll of rese ard I alld Ihe
opel l ques tioll s 10 h(' addr esse d,
a sells e or
at till' carl y St;I~('S of thes e n:pl ('spe ciall \'
or;lt ions ,
Des pite Ihe /lexihililV oflh e lIoll
lille ar lIlod e)s we hav( ' cOll si(lc
do have SOIllC s('rio lls lilllil;tlio r('d, 111('\'
Jls, TlI('y are typic ally mor e dif'li(
lIJate prec isely , ilIOn ' sCIISili\'e to 'J11t to esli-
ollll iers, IlIlIlH~rically less stah lc,
pron (' 10 oV('l'liII illg alld dala -sllo alld mOl ('
opil lg hias(,s Ihal l rom para hl('
(,Is, COl ltl'ar y 10 pop lllar 1)('lief'. lille ar mod -
lJoll lilll' ar I1wc\els reql lir(, /lion
Slnl ctllr c alld f/ I"'iori cOll side ralio ' ('col lolll ic
lls, 1101 I('ss, Aile! Ihei r illie rpre
J'('()Ilin's ilion ' ('Hi"'1 alld carl' , lalio ll 01'1(,11
ll()\\'('\'er, 1I0nlillL'arili('s ar(' OftC
('('Oll(llllil' lik, ,llId for lIIallY lilla II a faCI or
llcia l appl icali olls Ihe sOUJ'('('S
alld ll.tlllI'!'
l'r"hlelll,1 525

of nonlinearity can be readily idelltified Of, at the very least, characterized in

sOllie fashion. In such situations, the techniques described in this chapter
are powerful additions to the arlllory of the financial econometrician.

Problems-Chapter 12

12.1 Most pseudorandolllnumbergenerators implemented on digital com-

puters are multiplicative linear (ongrumti£ll gmerators (MLCG), in which Xn '=
(aX,,_1 + r) mod m, where a is some "well-chosen~ multiplier, cis an optional
constant, and 1/1 is equal to or slightly smaller than the largest integer that
can he represente.d ill one computer word. (For example, let a = 1664525,
r = 0, and 1/1 = 232.) In contrast to MLCG numbers, consider the fol-
lowing two nonlinear recursions: the tent map (see Section 12.l.1) and the
logistic map, respectively:

\
{2X,,_1 if X,,_I < .,! I
)\" = I X. E (0, 1) (12.6.(1 )
2(1 - X,,_tl if XII-I ::: 'l
XII 1Xn - l (1 - X,,-I). Xo E (0, 1). (12.6.2)
"

These recursions are examples of chaotic systems, which exhibit extre~e

sensitive dependence to initial conditions and unusually complex dynamic
behavior. •

12.1.1 What are good properties for pseudorandom number generawrs

to have, and how should you make comparisons between distinct gener-
ators in practice (not in theory)?

12.1.2 Perform various Monte Carlo simulations comparing MLCG to

the tent and logistic maps to determine which is the better pseudorandom
lIumber generator. Which is better and why? In deciding which criteria
to USl', think about the kinds of applications for which you will be using
the pseudorandom number generators. Hint: Use 1.99999999 instead of
2 in your implementation of (12.6.1), and 3.99999999 instead of 4 in your
impkmentation of (12.6.2)-for extra credit: Explain why.

12.2 Estilllate a multilayer perceptron model for monthly returns on the

S&P !'iOO index from 1926: 1 to 1994: 12 using five lagged returns as inputs and
one hidden layer with ten units. Calculate the in-sample root-mean-squared-
nror (RMSE) of the one-step-ahead forecast of your model and compare
it to the cOITesponding ollt-<>f-sample results for the test period 1986:1 to
I !)!)·1: 12. Can you explain the differences in performance (if any)?
I

526 12. Ntmlinearities ill Fi1lf1ll(ial /)ata

12.3 Usc kernel regression to estimatc the relation between the 1I\0\IIhly
returns of IBM and the S&P :)00 rrolll 1%:>:\ to 1994:12. How wllulcl a
convclIliona! bCLa be calculated rrom the results of the kernel estil\lator?
Construct at!easttwo measures that capture the incremental v<llue or kl'l'l1d
estimation over ordinary least squares.

I I
I
\
 Appendix

TillS ApPENDIX PROVIDES a briefilltro<lucliun 10 the JIlost comJllollly used es-

tilll'llion techniques in financial econollletrics. Many olher ).\oud reference
texts cover Ihis material in more delail, hellce we foclis only on those aspects
that are must relevant for our imlllediate purposes. Readers lookin).\ for a
Ill( .re systematic and comprehensive treatment shuuld Cl»lSl1lt Hal\ (199~),
lla:niltoll (1~I~H), O~aki (199~). and White (19H4).
We he~in hy [l)\lowin~ Hall's (l99~) expositiun of linear instrulllen-
t,lI v,lriahles (IV) estimation in St~rlion 1\.\ as an intuitive introduction 10
I btlSt'n 's (I ~IH~) GCllerali/.ed Mcthod of MOIIWllts (CMM) {~Mim'\lor. We
dcvelop the GMM method itself in Senioll I\.~, atld discuss lIIethods f()r
handlin).\ scri<llly correlated and hcteroskedastic errors ill Scctioll 1\.3. In
Section 1\.4 we relate GMM to maximulII likelihood (MI.) estimation.

A.I Linear Instrumental Variables

COlISider a linear relationship h{~twl~en a scalar Y, and a vector "I: Y, =

X;Oll + E,(Ou). I := I .. , T. Stackill).\ Ilw T oh,ervatiolls, this can he written as

y := XO" + dOll). (1\.1.1 )

where y is a (Tx I) vector containiJl~ T ohsl'I"valioJls of )'1. X is a (Tx N.,)

matrix cOJltaiJliJlg T ubservations of the N.\ indepeJldent variables in "" 011
is an (Nxx I) parameter vector, alld dOu) is a (Tx I) V('ClOr containing T
OhSlTV;l(iollS of (he error (crill f" The l'nor (1'1111 is wri((('11 <IS a function of
the trlle parameterveClUr so that the notation ( ran he used li)r hoth the true
cC]uation error and the residual of an estimated eqllatioll. For silllplirity.
assuJIle that the error term is serially 1I1icoiTclatcd and hOllloskcdastic. with
v~lriallcc a:l; thus the variance of E:(Ou) is Var[dO\l) 1 == a:l[ r. where [r is a
(Tx T) identity matrix.
 '1'11 .... 1' all' also ,lI',li lahl, ' N" illSlrllIll
!'lllS ill all (N" x I) col 1111111 v('C
Tht' T ohs, 'n'al iOlls of I hi,s V('(' lorh "
lor 1'01'111 a (Tx N,,) ilia tri x II, TII('
have III!' prop erlv tllOll F{h; f ,(Oil illStJ'l11l11' IllS
)) is all (N" x I) vecl or of zero
illSlrtllllt'II1S an' ('OIl l<'Ill POL es; Ihat is, IIII'
llll'o lisly III1C olTd aled wilh Ille
slalt 'lIll' lIl Ihat a 1"lIl iclli ar illSl erro r ("I The
nJlIU 'llt is IInCOITl'ialCd with
erro r is kilOI\'II as an ,"lho gol/( the e<jJ ldlio n
tlil)' ('IJIIf/ilioll, and IV rq,:- ressi
avai lahle onho ).\"o llalil ), cOll dilio oll Jlses til<' .'II"
ns 10 estil llale the lIlod el.
(;i\'('11 .111 arhi ll;II \' ('()('I'ticiellt
\'('('t or 0, W(' call rorll l Ihl' corrl
resid llal (,(0 ) =0 v, -- x;£J. Slac 'spolirliJl).\"
killg Ihis r('sid llal illlO a V('('IO
Y - XO. WI' call also tid i III' all (N" I', W(' gel (0) =0
x I) colll JllJl ve!'l or con lain ing
prod ll('l of Ihl' inSll 'lllll l'nl vecl IIII' t'l'os s·
or wilh tl)(' I'esicillal,

Tht, expe ('lal ion of Ihis cros s-pr

odli ci is all (N" x I) ve(,l Or of
11'111' P;ll"1II 11'11' 1 \'I'('i or: ,,'ro es al Ill('

FI 1',(011 ) 1 == o. (A,l.:~)

The hasi c id,'a of 1\' ,'slil ll'lli oll

is 10 cho ose c()(' fliri enls 10 salis
tion as dose h' as poss ihle. ()i'C l)' this cOll di·
()lIrS ", W(' do nol ohs( '/,vl' 111('
offa lld so W(' IIIl1sl wo/' k illsl ead I nit' I'xpl 'l'I,\ lioll
lI'ill llhe salll ple aver age off.
as gr(O), IIsili g Ihl' slIhs .... ipl T W(' wril e this
10 indi cate clc(>elldC'II(,(' 011 Ihe
salll ple:

1
gdO ) - r I L 1',(0) TI Lr h,( ,(0)
,~ I
= T- I H'dO ). (A.I .'1)
'~I

Alil/i ll/lIl1 / Oi,'/lI l1f'1' C;,.ill'l'i(J1I

III g(,II ('/'al lh('l' 1' nla), he nlon '
e1"IIII'IIIS of grlO ) than (her e
and so in gell nal il is IIO( poss arc coef lici( 'IIIS ,
ihle 10 sci all titl' ('It'l Ilt'll Is of
I IIs(e ad, \v" III illill lile a qJla dral ic {(mi gr(O ) to I.t:ro.
l, a weig htec i SIIIll of sCJllan's alld
prod Jlcls 01'111<' ci<'lll<'IIIS ofg (TOss·
l (0). WI' cldi lll' thl' CJlla drati c fonl l Qr(O
) as

\\'11<'1'1' WI is all (N" x ,VII) S\'III

1II1'I/,i,', !losili\'1' c1di llilt, weig
lilill g lIIal ri);.
IV rl'gn 'ssio ll dloo,,'~ () I OlS IiiI'
\,~IIIII' or 0 Ihal llIill illli/ ('S Q,(O
slillilill~ Ilwt ldill iliol l ). Sill>·
off'( {J) illto ('\.1.:1),1111' lirst ·orc
\l'r(' ollti iliol i/(II 'lile

'IIIIII ,IU\ ;ll'l'\ic .lIillll ....

, I i. . ,,'1111 '( ,1"1 ('11111 Ih.11 j, 1Il1l'
ond,l It'" willi ;111\' \.11
;UIV.l llft', tUllI j, •• 1'" Ih(' i",1111I11("1I1 \1" Inl
i;lhl('." kllllh 'lI ill
h, \\.11111( 'wit' ollly tagge!l \';11 i.III"·
al lillie' I· l 01 ,',II lie-I. NUlw llwlc' '''' , liI;11 ;11"{' kill t\\'Il
\\C' WI ill' ., .• \ h, luI' II01;l Iiolla
l ~illlpli('i'\' ;11)(1 ~(·ll("rftlil\'.
A. J. l.iruar/rlSl,.umenlal Variables

minimization problem is

X'HWTH'y = X'HWTH'XO T. (A. 1.6)

When the n umber of instruments, Nil, equals the number of parameters to

he estilllated, Nx, and the matrix H'X is nonsingular, then X'HWT cancels
out of the left- and right-hand sides of (A.1.6) and the minimization gives

(A. 1.7)

This estimate is independent of the weighting matrix W T , since with Nil =

Nx all the orthogonality conditions can be satisfied exactly and there is no
Ileed to trade off one against another, I t is easy to see that (A.I.7) gives the
uSlIal formula for an OU; regression coefficient when the instruments H
are the same as the explanatory variables X.
More generaIly, NJlmay exceed Nx so that there are more orthogonality
conditions to be satisfied than parameters to be estimated. In this case the
- I
model is overidentified and thc solution for 0·[ is
I

(A. ~.8)
I

AS'yIll/Jlolir Disln'bulion Theory

The next step is to calculate the asymptotic distribution of the parame~er
estimate OT. Substituting in for y from (A.l.1) and rearranging, we find t~at
I

fi(OT - Do) = (7'-'X'HW T r'H'X)-1 r'X'HW T T- J/ 2H'£(00). !

(A.I:9)
Now suppose that as T increases, y-1H'H converges to MIIII. a non-
singular momen.t matrix, and T-'X'H converges to MXlI. a moment matrix
of rank Nx . Suppose also that as T increases the weighting matrix WT
converges to some symmetric, positive definite limit W. Because we have as-
sllllled that the error £(Oll) is seriaIly uncorre!ated and homoskedastic, when
the orthogonality conditions hold T-1/tH' f(OO) converges in distribution io
a normal vector with mean zero and variance-covariance matrixo 2 MIIIl. ~e
lise the notation S for this asymptotic variance-covariance matrix:

S == lim
T~oo
Var[T-'/~H't(Oo)l = a 2MIIII' (A.l.IO)

Using (A.I.4), S can be interprcted more generally as the asymptotic vari-

allc(' oj' '1'1/2 limes the ~alllple average off, that is, TI/2 times gT:

(A.Ul)
530

With these convergence assumplions. (A.1.Y) implies Ihat

Jhor - ( 0 ) ~ N(O. V). (A.l.l 2)

where

v = (M.wWMl/x)-lMsI/WSWMI/.dMxI/WMl/x),-l

= a2(MsJ/WMI/.d-lMxI/WM/lI/WM/lx(M.\:J/WM/I.d-l. (A.!. 1::1)

and MI/x == M'x//'

O/)Iimal Weighting Mahix

We have now shown that the estimator O-r is consistent and asymplOtiGIl\y
1I0rmal. The IInal step of the analysis is to pick a weighting matrix W that
minimil.es the asymptotic variance matrix V and hence delivers an aSylllp-
totically e!licielll eSlimalOr. It turns out that V is minillli/.ed hy picking
W equal to any positive scalar times S-I. Recall that S is the asymptotic
variance-covariance matrix of the sample average orthogonality conditions
~T(O), Intuitively, one wants to downweight lIoisy orthogonality conditions
filI(I place 1II0re weight on orthogonality conditions that arc precisely mca-
l;lIred. Since here S-I = a-2MI/~/' it is convcnient to set W cqualto
I
1
(1\.1.14)

~he formula for V thcn simplifies to \

\ V" =:: a 2 (M.\:J/ M,,~/ M/lx)-t.
\11 practice one call choose a weighting lIlatrix
(

~
W;. = (T-1H'H)-I. (A. I. Hi)

S T increases, Wj, will converge to W',

With this weighting matrix the formula for Or hecollles
I 0;. = [X'H(H'H)-III'X]-IX'H(H'I-WIH'y == d('xrIX'y. (A.1.17)
I .
,yhere X == H(H'H) -I H'X is the predicted V;tllle of X in a rC!~ressi()1I of X
011 H. This is the well-known two-stage least squares (2SU;) estimator. II
call be thought of as a two-stagc procedure in which olle first regresses X on
H, Ihell regresses y on the fitted value from the first stage to estimate the
parameter vector 0 0 •
Alt'emativc\y. one can think of ~SI.S as regrcssing hOlh X .11\(\ yon H in
the fJrststage, and thell regressing the lilll'd value of yon the filled value of X;
11.1. UI/I'{l/' IlI.linwwi/a[ Varillblr.f 531

exactly thc same codlicient estimale (A.I.17) is iIJlpli('d. Note that IInd('r
this alternative interprctatiulI, lhe second-stage regression asymptotically
has ,lIl Il~ slalistic Ofllllity becaus(' lhe error I('rm ill (A. I. I ) is orlhogollallo
lhe illslnllllellL~ alld llwrefore has a filled v"llle of I.ero whell projecled on
lhe illstfllmcllls. This implies lhal asymptoticall)" if (A.I.I) and thc orthogo-
nality cOllditions hold, thcn the co\'l'liciellt cSlilllal('s shoul<lnot depend on
which variable is chosen to be tlte dq>eJldeJlI variable in (A.I.I) allli which
are chusen to be regressors. A~ymptotically, tlte saltlt: codliriel\l estimates
will be obtained (lip tu a nOl'lnali/.ation) whichl'l'('t' way the regressioll is
writtcn.
Thc variaIlCl:-covariance matrix or ~SI.S c()('i'lici('nl cstimates, V', can
be cSlimatcd by substilllting consistenl cstiJllales of the various momellt
matric(,s into (A. I. I !i) to obtain

(A. 1.1 H)

wherc a~ is a consistent estimate or the v,lriann: of the (,£Illation errur. This

formula is valid for just-icientilit:d IV and OI.S coefficicnt estimates as wdl.
In place of the weighting matrix W' defined ahove, it is always possihle
to use hW' where h is any positive scalar. Similarly, ill pl,\('(' of th(' weighting
1ll,llrixW;. one ran use hrW;" wherc iiI' i~ all)' positive sCllar that cOllverges
to Ii. This rescaling does not afleclthe formula lill' the inslrumental variablcs
estim;ltor (A.I.17). Onc possihle choice lill' the s(alar II is (T .. 2, tlte reciprocal
of the variallce of the equatioll error f/; tltis makes tlt(' IVeil-\ltlillg matrix
equal to S -I. The correspolltiilll-\ dloice I()r the S('abr k r is sOllie nmsistt'lil
a
('stim" te -~ of (T -2. Hallsell ( 1!IK2) h"s shown t h" t wi III 1his sc"ling. T Iilll(,s
the Illinimilt'd value of the ohjective fUllctioll is asymptotically distributed
X ~ with (.'11,,- Nx) degrees offreedolll under til!' 1I1111ltypothesis that (A. I. I )
holds and the illstrumellts arc onho!-(ollal to the equation error.
Iiallsell's test of the null hypothesis is related to thc intuitioll thatumier
the l1ull. the residual from the IV rcgrt~ssion t~qllati{)lI shuuld he unconc-
\,t\cd with the imirumellls and a regressioll of the r('si(lual on the illstru-
In(,lIts should ha\'(' a "small" U~ statistic. To IlIldcrst;Uld tltis. note that whell
WI' == (a~T-IH'H)-I, tlte minimil.cd objt'oi"e fllllclion is

(A. 1.1 !l)

No\\' consider regressing the residll;11 f(i}~) on the illslllllllellis H. The filled
v.tllle is H(H'H)-IH'€(O:.). and lltc U2 statistic of the regn.:ssioll cOllwrg('s
to the salllc lilllit as (A.1.19). Tltlls I bIlSCII'S resliit illlpli('s that T timcs tlt('
U~ ill a regressioll of the residual on Ihe illslllllll('llls i., asymptotically X~
\Ii 1h (Nil - N,) dewecs of fret:riom. Tltis is a st;ItIlLm It ('St of OI'Clidcn tifying
i'esl rirl iOlls ill tIVo-stal-\e IC;lst squares (Engk ( 1!IH'll),
 A.~ Gl'Ill'ralizl'd Method of Momen ts

'IIII' (;('Il(, .. &li/('d I\klhod "r.\IOIIH 'lIls (I lOlliSI'll [1!IH~I)

(';11l h(' Illlcl('rsl o"cI
as ;IIlI'XI(' llsioll of ill!' lillc;lr 1\' rq~r('ssioll w(' hal'(' disclIsse
d, SIlPPOS(, 1101,'
111;11 11'(' ha\'(' ;1 IIlod..! IIhidl "dilles a 1'1'('101' £1 = £(x l , fJ). II'I)('r(' x, IlOII'
illdJl(ks ;&11 III!' ,Lila r .. lel';1111 lor III(' IIlodd (i1lal is, WI'
ha\'(' droppec lll'"
dislillCl ioll 1)('111'1"'11 .I, ;111<1 x,), ;111<1 () is a 1'('('lor or Nfl
I'IH'lIicil'IIIS, This
li,rlllllL ilioll gCIII'r;a1i/('S ill!' lillcar 1\' r('gl'l'ssi oll ill Ihn'('
Il'al's. Firsl. fix"~ 0)
call 1)(' a 1'011111111 1'('Clor lI'iill .V, 1'I('III1'lIls railler Ihall
a scalar. SI'('ollcl.
f(X I , (}l (';1111)(' a Ilolllilll 'ar 1;1I1,,'r Ih;1I1 a lill(,ar fUlll'liol l
oflhl' d;II;1 ;llId Ih ..
par;IIII1' I('rs. Third, f(x" 0) ('all 1)(' 1)('I('I'os kl'dasli(' alld
s('('iall\' corn'lal .. d
ralh('1' Ih;11l hOlllosk l'lLlSlic II'hill' Iloisl'. 0111' lIIodel 1('lIs
liS Oil II' Ihal Ihnl'
is SOIl\(' IIIH' sl'I or pal'allll'l l'J's Oil 1'01' which f(X , Ou) is orlhogo
I llal 10 ;1 '1'1
or iIlS(I'IIIl\('IIIS; as '1I'f(,1 (' Ihl'sl' arl' II'rilll'lI ill all (Nil x I)
1'011111111 1'('('(01' h"
HI' ;lIlalogl' wilh (,\.I.~) Ill' ddil\('

f,((}) ,.= hI ® £(x{o 0).

'I'll(' Ilolaliol l W d('llOll'S Ih .. l\'II/{l'lhl 'l' /I/'odlll'/ or Ih(' IWO

\'('(,loI'S. Thai is, f
is a 1'1'1'101' 1'IIIIIail lillg Ihl' (Toss-pr odIH'1 or I'adl illSlnlllH
'll1 ill h wilh (';1"'1
1'1('111('111 Orf, fis 11"'11'1.,1'(' a 1'011111111 \'('('Ior wilh Nt = N,
Nil 1'I(,11I('IlIS. alld
Ih(' mod('1 implil's II)' allalo)..,'\' wilh (,\.1.:\) Ihal

E I J',({J,,) I == O. (,\,~,:!)

.I"SI as ill (,\.1"1). \\,1' "dill(' a 1'('1'101' g,(O) ('olliaill illg (he
salllpl(' ;:\'('1'-
ag('s COITI'sp olHlillg (0 Ih(' 1'1('1111'11 Is orr ill (A,I.I!» :

I
J.: I ((}) r I Lf,(OI . (.\.:!,:\)
'~I

HI' all;llogy Idlll (,\.1.:,). (;1\1.\1 IlIillilllil l'S Ihl' qlladral ic filllll

(.\.:! ,.1)

Silln' Ih .. !,lohl('11 I is 11011' 1""a1ill( "II. Ihis lIIillillli /;llioll IlIIISI

he "l'Ilill'll l('d
1Il1ll1cri Cllh. 'I'll(' lirsl·"nl( '1 "Clll<lilioll is

(.\.:!.I.)
,\. 2. (;l'IImdiwl MI'I/wd of M(I/III'IIII

tI.I."IIII,Ioli. /)isirilllliioll Till'Ory

The aSYJllptotic distrihutioll or the coefllciellt estimate 61' is
no, - 0
vr.: - 0 )
"
....... N(O. V). (A.2.7)
I

(A.2.H)
These ('xpressions arc directly analogous to (A.I.12) and (A.I.13) for the,lin-
ear illstrlllllclltal variahl(·s case. Du is a generalization ofM"x in those e(ll1a-
tions and is defined by Du == E[Clf(x/o Oo)/aO u]. Dr(O) converges asymptot-
ieall)' to Do. S is defined as in (A. I. I I ) hy ,

S == }~~I~ Var [TI/~ t

1=1
f/(OU)] = }~l.!., Var! rl/~gr(OIl)J. (A.2.9)

OIl/iII/til Wfighlillf,; Mllirix

.I"st as in lhe line.lr IV case, the optimal weighting matrix that minimizes
V is any positive scalar times 5- 1 • With an optimal weighting matrix the
aSYlllplolic variance of '1'1/2 tillles lhe (oef(icielll estimate iJ~ is

(A.2.1O)

Also, whcn the weighting matrix S-l is used, T times the minimized objective
functioll is distribull'd X2 with (~- Ntll degrees offreedom. where Nj is the
Iltllllher of orthogonality conditions and Nfl is the number of parameters to
he estimated.
III practice, of course, 5 and the other <Juantities in (A.2.8) must he
eSlilllal('cl. To do this, one starL~ with an arhitrary weighting matrix WT; this
could he Ihe identity lIIalrix or could be chosen using some prior informa-
lion ahoul lhe rclalive variances of the difTerent orthogonality conditions.
Usillg W" on(' lIIinimizes (A.2.4) to get <In initial consistent estimate rh.
To ('slimale V in (A.2.R), one replaces its clements hy consistent estimates.
DII can hI' r(,placed hy D'de'd, W can be replaced hy W T , and S can be
replan'd hy a consistent estilllate s,dJr). Given these estimates, one can
(OIlSlrul'l a n('w weighting lIIatrix Wj. = S,CO'r>-1 and minimize (A.2.4)
agaill 10 gel a second-stage estilllate iJ~ .. The ;lsymplOtic variance of '1'1/2
lillles th(' second-stage estilllate can he estimated as

(A.2.11)

alld Ih(' sec()lld-~tage minilllized ohjective fUllnioll is distrihuted X2 Wilh

(N, - Nfl) degre('s 0(' ('reedolll. AlillOlI~h a two-stage procedurt' is aSYIllp-
loliedl" ('ffici('llI, il is also possihle 10 iterat(, Ihe procedure further un.til
534

the parameter estimates and minimized ol~ective function converge. This

eliminates any dependence of the estimator 011 the initial weighting matrix,
and it appears 10 improve the finite-sample performance ofGMM when the
lIumber of parameters is large (Fcrson and Foerster [ I!l!l4J).

A.3 Serially Correlated and Hcteroskedastic Errors

One of the most important step5 in implementing GMM estimation is eMi-

mat~ng the matrix S. From (A.2.9),

\ S = f~I~E[rl (tf,(OO») (tf,(OO),)]

I
I 00

= ro(6 u) + L (r,(6 0) + rj(6 o») , (A.:~.I)

j=1
1
whde
II (A.3.2)
is th jth autocovariance matrix of [,(Bo). The matrix S is the variance-
cova 'iance matrix of the time-average of[,(Ou); equivalently, it is the spectral
dens ty matrix of [,(0 0 ) at frequency zero. It can be written as an infinite
slim f autocovariance matrices of [,(0 0 ),
fthe autocovariances off,(Oo) are zero beyond some lag, then olle can
simp ify the formula (A.3.1) for S by dropping the l.cro autocovariallccs. The
auto ovariances of f,(Ou) are zero if the corresponding autocovariances of
E(X" !Bo) are zero. In the linear IV case with serially uncurrclated errors
discyssed earlier, for example, t:(x,.Ou) is white noise and so £,(0 0 ) is white
noise; in this case one can drop all the autocovariances for j > 0 and S r,
r
is just o, the variance of f,(Ou). The same result holds in the conslimption
CAPM with one-period returns studied in Chapter 8. However in regressions
with K-period returns, like those studied in Chapter 7, K - 1 autocovariances
of [,(Ou) arc nonlero and the expression for S is correspondingly Il\ore
complicated.

The Newey-West Estimator

To estimate S it would seem natural to replace the true autucovariallccs of
[,(0,,), r j (90 ), with sample autocovariances

'1'
rj.7·(o·,) == r I L f,(Or) [,_ ,{Or>'.
,=,+1
and substitute into (A.3.1). Ilowever there arc two difficulties that 1II11st
be faced. First, in a finite sample one can estimate only :t finite number
A. J. Sl'lil//~v (;ond(/II'II tlllt! J JI'I"l1I.l/it'dtl.l/ir 1':mll.1

of alltocovariallces; and to )!;et " consis\('nt estimator of S Ollt' (";11I11I)t "lIow

the 11I1II1ber of estimated autocov.lrialln's 10 ill(T('aSI' 100 rapidly wilh Ihe
sample size. Sccond, there is 110 )!;lIaralltec that all ('stim'ltor of'S limlled hy
substituting (A.:13) illto (A3.1) will bl' posiliV(' c1dinilc. 'Ii) halldle thcs(~
two problems Newey ;llId West (1!IH7) sugg('sl('c1lhl' following ('stilll;ltor:

• •'I ( '/- I . .
Sr('1,fh) == ro.r(lI'[')+L -,-'.) (rj.rw/) + r;rWrl) , (A.:U)
}=I I

",herc '{ iIHTC'1S('S with the salllple sil.(' but 1101 100 r;lpidly. ,,-I is the II1;1X-
inlllll1 lag length that receives a lIonl.('ro weight ill Ihl' Newcy and West
(19H7) estimator. The estimator );lIar;lntccs positive definitcness hy down-
weighting higher-order autocovarianccs, and it is consistcllt hccallse the
downweighting dis;lppears asymptotically.
In models where aUlOcovariances arc known to be I.em beyond lag K - I,
il is lempling to \lse the Newey and West (19K7) eSlilllator with II == K,
Thl.' is icgitirn;lte when K= I, so that oilly the variance 1'(1.'1·(0],) appears in
the e,lim;llOr; but when K> 1 this appro;lch can severely dowllweight sOllie
1I0llzero autocovariances; depending 011 the sample size, it m;ly he better to
use 'I> K in this situatioll.
Although the Newey and West (I !IH7) weighting schclllc is the most
('OIllIllOllly lls('d, there arc several altcrnative estimators in the litcratllr("
indlldillg those of Andrews (1991), Alldrews alld MOllah,1II (I!19'l) , and
C.lllallt (19K7). Hallliiton (1994) pl'Ovi(\('s a llscflll overvicw.

Thr j,illt'flr jl/.\lrlllllfllial Variablf.5 emf

The gl'llcr;d formulas givcn here apply in hOlllnonlinear and lincar 1J1l)(lels,
hut they can hc understood lIIore silllply in liJlcar IV regressioll lIIodels.
Retllm to the linl'ar model of Scction A.I, hill allow th(' enor tCI'I1l f,(Ou)
to he serially corrc:lated and hetcroskcdastil'. EquatioJl (A.I.IO) I)('collles

S = lim Var[ r
[-':Xl
I/~H' 1'(00) 1 "" lilll T Ill'!:1(O,,)Il,
T-':X.J
(1\.3.5)

wllerc H(lJo) is IIII' variance-nlVariallu' matrix of ,,(011)' This (';\11 bc ('sti-

llIal cd h)'
(A.3.tJ)

will'l'c H, (0 r) is .111 cstimator of HWo). Eqllation (A.:!.II) IIOW hccomcs

(A.:t7)

III the homoskedastic white lIoise case cOllsidcred carli("r, 12 == (1 "I r so

wc used all estimate n"'{o'rl == where a"l/ a"
= ,[,-I 'E.::I (;cilr). Suhsti-
tuti;lg this illto (A.:U) gives (A.I.IH).
 W!at'll III(' I'ITOI 11'1'111 is scriall" IIIH'olTclalcd hill hcll'roskl'<iaslic, IIII'll
H is a dia){ollalll\allix wilh <lilll-n'lll variances 011 earh dt'llll'llt of the lllain
dia!!;ollal. ()lIl' e;lIl eOIlSlrtlll a salllplc 1'(I"iva!l'1l1 ofl'acill'klllt'1I1 as lilllows,
For I'aell dl'lIlt'llI 1111 1I11' Illaill dia)!;ollal of thl' malrix, o.·r.ll dJ.r\==</(O, )~,

II'hill' ('a("11 oll~dia!-:oll;d dl'llll'llt U/.,/(iJrl == () for s-:pl, SlIhstitlltillg lhl' rl'-
SlIlIill!!; lIIatlix U I (0 I) illto (:\.:l.Ii) (1I1l' !!;I'ts a 1'0llsisll'Illl'stilllalor ofS I (ill.
alld SlIilslillllilig il ililO (A.:I,7) (~II(' gelS a ('onsiSI('1l1 l'slilllator V'r. This is
11111' ('VI'Il IhOIl)!;hllll' 11\;lIrix n(o
I) is 1101 ilSl'lra ('ollsis«'1l1 I'slilllalor of n
",'('ails,' Ill<" Illlllllll'r .. I' dl'lIwnh "I' n Ihal IIlllsl he eslilllaled elj\l;t!s lil,'
sa III pll' sill'.
WIll'1I II", cnor 1t'lllI i.s snially ('oITclalt't! alltl h(1I110sknlaslil, IIIl'II (>Ill'
("all ("ollsll'llli I'alli cI"llI('111 of thl' 11l:ltlix o.r(O rl as tClllolI's:

H, "UI,) = "I,'1
I L...,~f.11 (L.!.)
'I
(") 0"
f,( r)f,-,( r) III == I1-.11 < ({,
"

to olhl'lwiSt,
(A.:I.Hl
wlll'rc Ihl' N('w<'\' <llId \\'('SI (l'IH7) wl'i)!;hlill)!; s('h('1I1l' wilh 1Il'lxillllllll lag
1('II!!;lh If is IISl'd, ;\lil'lllali\'cI)" Olll' lall rl'plan' Ihl' Iriall)!;lIlar w('i)!;hls ('{ -
/)j'l \\'illi IIl1il \\'I'igh" 10 gI'l Ill<' I'slilllalOl of IlallSl'li and Ilodriek (1 'lHO) ,
IHII Ihis is 1101 ),\lIarallll'('<I 10 Ill' )losili\'!' dl'linil(',
WIII'II Ihl' I'nor 1"1'111 is serially eorrl'\all'c1 and hl'll'roskl'daslic, Ihl'lI
Olll' (';111 (,Ollslrll(,{ n I (() I) as:

0.",(0,) =
" { ('L~) (',Ii) ,)
'I
f (0,) if I == II - ,II < 1/,
. . 0
olll('I'II'isl'

whl'll' IIII' Nl'\\'I')' alld \<\'<,st (1!)H7) Wl'i){htillg sclll'lIlt' is IIsl'd, Again 0111'
call Il'plan' till' lriallglliar wcigll1s willi IIllit lVt'i!!;II1S 10 g<'l ~hl' ('slilllalor of
I LlIISI'II alld Ilodriek (I!)HO), III I'aeh CISI' SUhSlilll1ill!!; 0.(01') illlo (A.:~.(j)
!-:iws a (,()IlSiSIl'1I1 ('slillla1<' ofS, alld SUhslilutillg il illto t'<jIl,llioll (A,:I,7) givl's
an mSiS\l'1I1 1'~1 illlalor V~, 1'\'1'11 I hough t hI' 1ll'l1rix o.(il'rl is lIot ilsdfa ('ollsis-
1l'lIll'Slilll;lIor (11'0 h"CIIIS" IIII' 11I11lI1)('r OrllOlll.I'rO dellll'lIts illcreases too
r;lpidll' with 11)(' sa III 1'''' Sill', Whill' (1!IH,l) !!;ives a rOlllprcll('llsi\'1' Irl';ltlll('111
of Ill(' lill,'a)' lllt"lI'I willi s''l'i;,lIv ('(11'1',,1;,1<'11 ;lI\d IW\l')'(lskt'<iaslic ('HOI'S.

A.4 GMM and Maximum Likelihood

Followillg 1I;II11ill(lil (1!)!)I),wl' \lOW .show how SOIll<' WI'II·kIlOWII projll'lIil's

01 Maxillllllll l.i"dih",,,1 .-slilll;IIO)'S ([\11.1-:) rail 1)(' IIIHkrslo(ld ill relalioll
to (:[\1M. WI' lil,t I,I\' 'lilt SOIIl(' Illll;ltioll, We liSt' I., to d('lIotl' 1I11' dl'lIsi!\' of
:\.·1. (;i\L\l fllld Maximum l.ikelihood 537

X/+I conditional on the history of Xt and a parameter vector 9:

(AA.l )

We lise the llotation i, for the log- of Lt. the conditional log likelihood:

i,(X'+I.l/J = log- L,(x'+I> 0). (AA.2)

The log likelihood [ of the whole data set XI •...• XT is just the sum of~he
conditional log likelihoods: \
I

(AA.3)

Since I., is a conditional density. it must integrate to I:

f I.t(Xt+l. £J)dxt+1 = I. (AA.4)

Given certain regularity conditions. it follows that the partial derivative of

L, with respect 10 0 must integrate to zero. A series of simple manipulations
then shows that

()

=
(A.4.5)

The partial derivative of the conditional log likelihood with respect to

Ihe parameter vector. ait(xt+l. O)/ar}. is a vector with NfJ elements. It is
known as the score vector. From (AA.5), it has conditional expectation zero
when the data are generated by (AA.I). It also has unconditional expecta-
tion zero and th us plays a role analogous to the vector of orthogonality con-
ditiolls f, in CMM analysis. The sample average (11 T) 2:.;"'1 3l,(XH;t. 9)/39
plays a role analogous to gT(O) in CMM analysis.
The maximum likelihood estimate of the parameters isjustthe solution
o to Max [(fJ) == L:~I i,. The ftrst-order condition for the maximization
can he written as
T
gT(lJ) = rl L ili,(x,+l. O)/(){J = D. (AA.6)
,=1
whirh also characterizes the GMM parameter estimate for a just-identified
model. Thlls the ML1~ is the same as GMM based on the orthogonality
conditions in (AA.5).
538

Ih.~ml)totic Distribution 71U'1Jr)

'1~lle asymptotic distribution or ML parameter estimates is given by the I()I-
" wing result:
I fl(O - 00 ) ~ N(o.r'(Oo)). (1\.4.7)

wi,ere I given by:

I [I ()~£.(O)J
I 1(0) =: lim -E - -.- .-, •
,,~oo 11 ,JOiJO
(A.'Ul)

a'~d is known as the jlljOn/Ulti()11 matrix. I Gill be estimated by tht' sample

Clbullterpart:
_ I T iJ~e,(iJ)
I" = -7 L
1=1
iJOiJO' . (A.'I.!I)

The information matrix gives \\S;I measure of the sensitivity of the vallie of
tIle likelihood is to the v,llues of the paramcters in the neighborhood of
tl e maximum. If slllal\ changes in the parameters produce large changes
ill likelihood ncar the maximum. then the parametcrs can bc precisely es-
ti/natcd: Since the likelihood function is lIat at the maximum. the local
s~nsitivity of thc likelihood to the parametcrs is mcasured by the local cur-
vaturc (the sccond derivative) of likelihood with respcct to thc parameters.
cvaluatcd atthc maximulII.

Infimnrltioll-Matrix Equality \
An alternative estimator of thc information matrix. Tb • uses thc average
ollter product or sample variance of the score vectors:

i =: rl ~ al,(O) iJl,d})'.
b L, ao ao (A.'I.I<V
,=1

To see why ib convergcs to the salllc limit as differcntiate the third t.

equality of equation (A.45) with rcspcct to 0' to gct

o
J a~e(XI+I. 0)
iJOaO' 1" dX'+1 +
J iJf,(X,+I. 0) iJI-,(XI+I. 0)'
ao ao dX'+1

=
f a2e,(X'+I. 0)
ilOilO' 1"
.
rI'\111 +
f aC,(X,+I. 0) afl(x,+I. 0)'
ao ilO 1"
.
rI.\( \ I

. ()~l,(xHI.O) . af,(xl+l'O) ilf,(x".I.O)'

I'.( iJOiJO' +1'., iJO iJO

E iJ~f,(x'+I.O) E ;)f,(XHI.O) iJf,(X,+I.O)'

= ilOao' + ;)0 iJO
(A.4.II)
I\. ·1. (;Mt\I find II/flxi/llllllll.illtlill/l/ld

This is known as the illjimlullil//H/IIl/rix "'II/fllily, ,11111 ililpli('s lh"l lhe exp('c-
laliolls 10 which lh(' s,ulIpk aV(,)"lg('s i"
and II. ('oll\','rg" ;II'l' ('l(lIal. TIl('
illj'oi'lllalioll IIlalrix (''lu,dily holds 1111111-1' Ih(' 'ISSlIIlIl'lioll liJ,lI III(' d'II" .11"
gl'IH'I'alcd hy (tvl.l),
CMM allalysis gives ,Ill allel'llaliw lorlllllla 1(,,' illl' disll'illlllioll of MI.
paralll~~lcr ('still\al~'s, RccllI frolll (A.':L II) Ih"III,,' (;MM {'stim"lor is a5YIIII>-
IOlicdly llormal wilh aSYlllpll>li<' V<Il'i<llll'1' ('slilll,II,,1'

III lhis (<IS(,

r . 'r '
a,l.tr<l/r) == '1'-1,--' cJ-t'/(O)
1111 (A.4,12)
ao S ilOilO'

",hill-
51 (i/ ) - rl ~ ilC,d) il£,dJ)' - I
I
- S ao ;)(} - " (A.4.1:H

silll''' lhl' scorc vcclor is serially uncolTdal('d so S rail h(' ('slilllalt'" 1'1'0111 ils
s;llIIpk v'll'i'III(,('. Thereforc, llw dislriblllioll "j'11I1' CMM ('slilll,llll\' 1'<111 hI'
exp\'('ssl'd as:

(A.4.14)

where In alld If, are lhe limits of i" and i" as '{' increases wilholll bound,
('vaillated al the true parameter vector 0 0 •
\,\'hen the lIIodel is correctly specified, in and II, bOlh cOllwq~e 10 the
informalion matrix I, hence (AA,14) simplifies in Ihe limit 10 (11- 11)-1 :=
1-1 which \'educes to Ihe cOllvenlional t'xpressiotl for the asymptotic vari-
allce in (A.4. 7). Therefore, dlher ia or i" (or bOIIl) ,<In be IIsed 10 eSlimate
1 ill this case.
llowever, when the model is lIIisspecilil'd, ia and i" converge to dif-
fen:lll limils ill general; this has beell used as the l><Isis for a specificatioll
t(',1 by White (10H~), But MI. estimates of t1w lIIiss»l'cified lIlodei arc still
consislenl provided thal the orthogonality conditions hold, and one can
lise the g('ll\'ral vari;lJ\ce ('onnllhi (A.'I. H) proVilktl tll;1\ 11ll' srore Vl'l'tor is
s('/'ially lIllcondaled. White (1 !lH2) slIgg(,sts this approach, Ivhil'h is knowJI
as fjllmi-/Ilm:i 1Il1ll1l Iillplilwor/ estimation.

l/Y/Jnllil'li,1 Tr.llill/!.
The aSYIll»tolic variallces ill (A.4.7) ,11111 (A..I.I·I) call 1)(' IIwd ill a straight-
f<lI'ward mallller to COIISlrucl Wald (('s(S of n'slrirti<llls Oil (h(' JMrallll'(('rs.
.1 "1\1

Tht' idea of sud I It'SIS is 10 SI,(, \\'1It'lIl1'r Ihe ullrestricted paraml'ter estimal('S
an' siglliliralltly dirh-n'lIt from IIl1'ir H'Slrit:led values, where the variance of
Iht' IIlln'slriC\l'd t'Slilll;lIt'S is caIndall'd wilholll imposing lilt' n'slriCiiolls,
Ahefllaliwly, 0111' ilia), W"1I1 10 It'sl restrictions IIsing estimates 0111)' of
III<' restrictt'd modcl. OIlCC n'striCliolls "rc imposed, thl' minimizl'd (;:-'1\1
ol~jccti\'c fUllction is 110 IOllgn idclltically Zl'ro, IlIstl'ad, Ihl' I IaIlSI'll (1~IH~)
rl'sllil is that 'f' tillles Ihl' IlIillillli/.l'd ohjt,t"livl' funClioll has a X~ distributioll
wilh dl'grcl's of fn'cdolll eqllalw tht' IIl1mht'J' of restrictiolls, III Ihis casl' T
tilllcs Iht' IIlillillli/('d oi>jcni\'(' fUllClioll isjllst

whirh is tht' l,agr;llIgt'llIllltiplin tl'St slatistic rora resiricletllllodd estimatl'd

by lIlaXillllllll likdihood,

nil' /)"//11 /l1"th,,"

MOl"<: cOlllpliralt'd illh-n'llt"t's I'or ;nhilrary lion linear funniolls of Iht' l'S-
lilllalor 0 lIIay \)(' p .... lill·llIt'd via Taylor's Thcorem or tht, (Mtll 111ft/lilt!, If
fldJ - 0 0 ) .~ lllO, I;d, tht'll ;\ 11t)lIlilll'ar functioll I<fJ) has Ihl' lilllowilll-:
aSYlIlptotic dislI iilttliotl:

ilf ilf
(1\.4, Hi)
Vf == -\",-
ao' aO
which follows frolll a tirst-ordn 'Elyl"r series approximalion tilr f{O) <ll"OlInd
01), Iliglwr-onll'J' tcrlllS ('OllV{'\"!-\1' to Il'ro rastel' than 1/ ft hl'lIcl' ollly the
(irst tl'rlll of tht' expallsioll lIlall('\"s li)1' tht· asymptotic distrihutioll of fW).
 • 541 \

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I\.I('\,IIS. ll .. '" (;I"~O")', alld S. I.ill. I\IH\I. "Ri,1... 1'1"llIiIlIIlS ill Ih,' '1<-1111 SIIII!'IlIn':
h'id"lIn'lrolll Anilidal 1-:('1'"01 II i,·s."./III/II/(// 0/ M/",f'lI",\'/':",I/OIII;, I. 2·1. :171-
:1\1\1.
B.lllrill.lllt. S .. "alt-. J. ;IIHI T. Nm·. 1\1\),•. "()I SIt"I'It,·"". SI\('q'. ;IIHI lite (:""'-
;\111111'1)1'1 !'i;lIinns in Eqllit)' R"I\II liS." H/1';I1/' "/ fil/(/IH ;(//.\/I,,/;n. H. ·11l1-·I:\Il.
B.I~l'IIt)I. W.. (;l.k.a ..Ial'k Tn'plo,,), 1!171. "Tit,· (lilly (;'""" ill '1'011'11." /'//11/1" ;11/;\1/(//\'111
./,,1/1'1,,11. '.!'2. 1'2-1·1.
Ittl...,lti. (;" alld I.. (:1"'11. 1\1\11 •. "Tlte Spi .. il 01 (:.ll'il.III,," .lIl1l Slo, I... ~1.1I1...'·1 1'1 il'n:
:\/1/1'1';1'111/ /':WI/II/II;I' 11,1';"/'. Hli. 1:1:1-1:,7.
Ibldlll.li. 1'.. t;. 1\1'I'10la. alld S. Fmcsi. 1\1\1:1. ",\ ~11I1"'1 III '\;lIg"1 Cltallg'·s alllllh,'
'1(01'111 SI"I/('IIII'(' 01 1IIIt' ..esl Rail"." \\'l1ll...illg 1"'IlI'l'·1:\ 17. NIIER. (:alllh .. idg".
~I'\.

Il.tll. (:" I\)HH. "hlilll;lIion Bias Indlll'('d hy lJi"'\"'I(' S"I IIlil' I'lin·"'·'/II//ll/lli II/ h-
1/1/11(('• •1:1. H·II-HI""

Il.tll. ( "" .I\\(\ A. RI)IlI.I. \\1\).\. "Swclt",ti,' VIII;\lili" ( )1'1'1<>11 1'1 i, illg." ./lI//lI/(// II/ /"i 1/11 1/1';11/
1/1/1/ (LI/(/I/I;I(/I;",' tll/lI/pi.l. '2\1, [,H\)-Ii07.

lI.tll. 1:.. alld W. TO,..,IIs. I !II{I. "A Silllplifi .. d .I I\IIl I' 1'\Il«'" 10' COllllllOn Siock R.. -
IIII'IIs,"'/III/('I/lli II! /'/1/(/1/(';11/ (lilt! (LIIIIIII;llIliI'I' :\1/(//\'1/1. IH. :,:I-li:,.

- - - . I 'IH!i. "( )nJ II III Jls in (:olllllllln Slol'k I' .. in·, and TIt .. i, 111111;11'1011 (:;tli Oplioll
I'l'il'ill),;:·./"'"1II1i 4 hll II III 1', '10, 1:."._17·1.
- - - , I \)HH. "11I\'('sligaling SeclI .. ily-P";I'(· I',· .. fi" 111.1111',' ill lit .. 1'1'1'''''"''- 01 E\'('III-
1l.llc l" 1('(· .. lai III),," '/111/1'1,,11 "I/'/I/(/II/ ;(// "'1'111///111;1'.1. 22. 1'2:1-".....
lI.tll. R..• II,d 1'.11"011'11. 1\lIiH, "All Elllpi,,;cll b'alllalioll 01 A(,(,l1l1l1lilll\ 111('('1111' NIIIII-
h(' ..,." ./"/(I'/ull /// ;\u'II/il/I;I/K 1II'.I/·I/I,}I. 1,,\I--17H.
I\all. C" W. T'>lI)\Is. ;tlld 1\. Tsrhocgl, \\IW" "Th .. I><-g"'" 01 I',ir .. R",ollllillll: Thl'
( .. I'" oiIIH' (;111<1 Markel," ./"1/11/(//"/ F//I//II'.I M(/'/uof.,. ~" '2(I~I:I.
Balli. R" I \IHI. "Th .. I{l'ialioll helweenl{('11I1'II alld Ma .. kl'1 \'alt,,· of'( :0111111011 Slocks."
}!/I/'I/ld "/ i'l1/01/(';0/ /:'((J/IIJ/Il;CI, !/. :I-IH.
H,,'II. R. •. IIId M. Milll'l', 1\I7H. "Prices f(,r Slate-Conlingent LI.lilll.': SOIll(, Eslimal('s
"nd A\lplie;lli()ns," ./0111'1/(// 'if' !l1ll;'If'\!, :11. (;:,:1-(;7'2.
1\;" hni.,. 1\: .• A. Shlciler. ;IIHI R. Vishny. I\/!}(;. "A Modd "I I1\ \'l's (or Senliment with
holh ['ndl'IT(,"l'lioll and OV'·IT,·anioll." IlIlp"hli,I"'d 1'''1'' .... ['lIi\'l'I'sil), 01'
(:IIi(';'go a,"lllarl'ard llniv('I'sil),.
lI;II'r\;t\', ~I .. ,,1111 R.I.iIl.('nh('J'gt'r. I!/HH, ""nn,lI\1\('('II\('1I1 Eik ... , "I'N('w 1-:'1"il)' I,,"('s
.llId du' lIse (If Illlraciay PritT I>.lI~t." .I0IiJlud (~f FUUlll(ill1 r:fUlwmio, 'll, 71-
1110.
I\"rl...('\'. (:" I \/:,Ii. "1·JfI'rti\'(, Stork Splils," //(/II'/IIt! /1'";""11 1111'1/'/1'. :',1 ( I) . .l.lIl1lal),-
Fehl'll"r),.IOI-lOti.
- - - . 1!):.7. "Slorl... Splils ill a Bull r-Lllk'·l." 1/(/1I'1IIt! 11'";111'11 1i11"''II'. :1:,(:\). r-Lt)'-
.1"1"" 7'.!-7\).
- - - . 1\l'iH, "E\'"I"alioll "I'Slork Di\'idends." I/(/I/"/lt! 11",/1/1'.11 IIn'I/·II'. :IIi(-I),.I"I\,-
. 1\II.l:U'I. \)!)-114.
.1'1 1i1'/1'1i'liffl

BaIT, D., and/. (:;""1'11('/1. 1'1'1;1, "Inflalion, R"allnlt'f('sl R'llt'S, anelllll" Bonel ~f:tr­
kl'l: ,\ SI"d\' 01 (IK NOlllinal alld hult'x-Lillk"d COVt'l'IIlIIt'lI! lIund p .. in·,."
I )j"'II,,iulI 1',1/)1'1 17:\'!., I b.-\,.lnl Inslilllll' o\" Ecol1olllic Rt''''arch, 11.,,·\'anl
(llli\' ....,il\'.
lIartoll. A .. I~I'I:\. "(I"i\,l'Isal I\Pl'lOxilll'llioll IIOIll1(\S (il\' SlIpt'rposiliollS o\" a Sig-
lIloi,"'1 FIIII('lion." IHJ·: 'Jilllll. 111/0. nlnll)" :{!I, !I:\O-!H:I.
I~I~H. "'\PllIoximalilln and Eslimalioll BOIIII,ls ((II' Arlilici;II Nt'mal ""1-
wllIks," ;\/111'11;111' /.l'IInJ;lIg. 1·1, 11:,-I:l:t
Ibll 1111. A., awl R. B;"T"". I ~IHH. "SI,lIisli .. all.t'anrill~ N"lwork'jf,A ( IlIir)'ing Vit'\\'." in
20lh S\'/11IItIl;II/IIIIIII//I'/ull'll"rr: f.'1I1II1'lIlillgSrimrf IIntlSIIII;llin."". I!I'!.-'!.O:I,
Rt'slllll, Virgilli;).
Ihrsk)', R., andJ, Ill- I.on~, HI!I:I, "Wh)' Do,'s Ihl' Srock Markel FlnCln'llt'~," C!.IIIIII/·"r
'/OIlI'l/II/o/hlllwlII;n. 10H, '!.!II-:I II.
lIaslI. S., 1!177, "Thl' 11I\·.'slllll'l\l I't'rli>nllanf(' of COlllllHlII Stlld.. s in Relation 10
TIIl'ir Prill' III F."nin~s Ralios: /\ 'Ii'sl oftht, Ellident M'llkt'III),!,Olh",i,,"
./11110111/111 ""1111111'. :I'!.. titi:l-tiH'!..
II .. .-I.. ,'rs, S., I!IKO. "Th,' (:,,"slalll Ebslilily of Varialle,' Mod ..1 alld It, IlIIpli"ali, ,'"
iiII' (1IlIi'''1 Pricing. "jllllntlli o/I-IllIlItrI', :1:1, liti 1-li7:t
- - - , I!IH:{, "\'01 ria II ... ', "I' Sl'lmil\' Prin' R.. I\I!'us lIas<'c! on Ili~h. I ...' .... and (:\,,,illg
Prin's:' /",,,ulIl tI/lhl\inl'.\\. :){;, Q7-' ,~.
111'11;" Iii. S., and IC Tioakl. I~I~I',. "~I\,IlJ>i .. I...s.s An'r.,ioll and 110 .. E'l"ill' 1',t'llIi,"n
1'11111.· ... (!IIf/llnhjlllllllll/ °//':,.,,1111/11;1'1. 110. 7:1-!1'!..
111-11',,111. C .••11)(1 IC I Llgt'n",,". 1\/7·1, "nl'\t·llllin.lllls of l\itl-t\.sl..l'd Spr"ads ill Ihl'
(1\'1'1'-111,,-( :1111111 .... ~larl."l."jllllml/l o//;illl/nrillll·:mllolll;n. I. :1:,:I-:\(i·1.
IlI-m·t·I\(·Io. It, I'}H·I. "Thl' (knIlT"nn' of S.·tllll'\Ke "allt·nts ill Er~o(li( :-'1a .. l.o\,
(:lIains." Slm}III.,/;{ /'W{I·''''.' Itlld '/'11/';" AN,lim/io/l.,. 17. :\ti~I-:I7:I.
1I.... llanl. V.• 1!IH7 ... ( :l'IIss-S"l'IiOllal III'p"lId"II(,(' alld "rohl"lIIs ill IlIfi'n'IIIT II,
I\I"rl..'·I-lIa,,,d A'Tolllllillg R'·"'OI,,·h." ./(1111'11,,1 (lrAnollll/i"~ lI/v/1Il1,. ~r,. 1-
·IK.
Ilt-mdt. E .• II. II~"I. R. 11.111. .,,"1,/. I 1.11 IS" 1;)1 I. 1!174. "Eslilllalioll and Inrl'lt'net· ill
NOlllin""r Sln'l'I"r,,1 ~llldt'I<' ;\1111111, II/Fmll/llllir 111/11 SlI{illl ""'mIt 0i'1I/1',,1. :1,
lir,:I-titi'l.
IkIIlSI"ill. I'.. I'I'I'!.. (:II/,ill///d,.I/,: nl,./IIIII/IlIItIh/,· (hiK;II.\ II/ fI/"d/'1I1 IIltil SIII'I'I. (-,,,.,.
Pn·s.s. Nt'\\' V, >I I..
II,""illlas. 1> .• alld A. 1.11. 1'}'lIi, "()"lilll;11 (:1111'1',,1 "I' EXl'l'IlIi"lI (:'"Is." \"'''rking
I'ap"r IYF.-III'!.:I-'lIi. ~Ia";,, IIIISI'lh Illstillll" "rT':chllol"h/\' 1."hor.lll1rl' f(,,'
Fill;IIII i.11 Fllgill,·.... ing. (:0111,1>, idg'·. o\IA.
Ikll,illl;". n .. I.. hog.lIl. ;11)(1 ,\. l.o. l'I~Hi. "WIll'1I Is Timt' CllllliIIllOIlS?," 'v\'orkill~
I'apl'r I.FF.-III·I:I-!Jli. !,-1;."a.-lllls,·I" IIISlillll" "fTi.'chnllloh/\' I.ahoralon· IIII'
Fill",,('i;,1 Ellgill'·'·lillg.
IIJ.'II I.... harp. t\1.. I '.IH:I, "Tr~""~\l1 iOIl' \);11.1 '1',"1, of Eflirit'nry ,,\" I h .. ( :hil~lg() l\o~II"
(1I'Ii'>lI' F.~, h""gl'." ./"/11110/ "/ "'"11"/ iI/I /·:,.,,/llIlIIin. I:!. I HI-I W,.
Iliek, ,\., I'I~IIJ, .. ( hI \',,1111,· l>illl"ioll 1'1 i, " P'li' ,·ss,·s (If Ih .. Mal k"1 l'oll«,lio ... .//I"n"tI
,,/ Fill/HI,,'. 1'>. ti7:1--liH'I.
Jll'jn"fnm 54!>' :MB'
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MOII,!m) '~(()lIml/jr.l, :17, 4(i~H7.
COCllr'llll', J., and I.. lIansen, 1992, .. A\sct l'rkillg Exphll "tions lor Macroeco-
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Tl'chlloloh'Y l'ress, Cambridge, MA, II :,-\(i:).
(;01,,'11. K., (;_llawawilli, S. Maicr, R. Schwa!'lI, and D. WhilcOlllh, I I)H:I:., "Eslimating
:tlld Adjusling for Iht' Inlerl'allillf;-EIlt'l'1 (\i; .., ill Ilt-Ia: Ma'lflJ,'I'/lU'I/! S(int(l',
2!I,I:l!",-I'IH.
I !)H:lh, "Friclion in Ihl' Tradinl-: 1'. OCt'SS and Ihl' !-:slilll;lIion of SplcllIalic
Risk," ./011/1/(/1 'if'/-l'lIflllriflll';(IIII{/lIIin, 12, 2Ii:I-27H.
Collt'll, K., S. Main, R. Schwan/., and n. Whilcomb, 1!)7H, "Tht' Rt'lurns (;t'llt'l':.-
lion Proct''', Relunls Variancl', ,nHI tht' Fllt-n 01 Thin,u'.'" in St"1II iii""
M:.rk,·ls," jOIll'l/fI! (if J-IIIIII/Cf, :\:\, 14\1-lli7.
197!I, "On Ihe Exislt'nel' of Sl'rial Correlalion ill ;111 Eflil'i"nl St'Cllrilies
MarKel," 'rtMS SIIII!ip,,' ill alP MIIIII/Krlll/'"! Sri/'IIO',I, II. I:, 1-lliH.
I!IHI, "Transaclion COSL" Order I'Ian'nll'Il1 Slralt'h'Y _IIId Exislell(,{' 01 the
Bid-Ask Spre;rtl," '/0/1,.",,1,,[ I'olili,,'{ /';",,,,"n). K!I. 2K7,-:\WI.
 Ur l/'Il'IIIP.1

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,\( linll," F'"II"lIId"ul. :1, '.!SO<!!J I.

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I.Hlldoll.
/(I'/n-rllrt's

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Jir/PII'l/fI'.1

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EiIlSh·ill. A.. I~IWI ... \ 1"h"1 di,' \'1111 ,ll'r Illllkklllar-killt'lisch"1I TIlt'oric <1<"1"
W;inlll' ~dlll d"III' 11"I\"'~III1~ 11111 illl"llll"lIdcll FlilSSil-:kcill'll SIlSPl'lIdi"1 1"11
T,·ildwlI." .11/111/11'11 ",') l'II)'1il... 17. r,·I~)-:,liO.
F.II~"'. It., I ~IH'.!, .. ;\"IIII'l·J.\II·,si\'(· (:, >llllil illll.II I !t-ll'I'mk",IOIsI iril)' wilh ESI illl'.,I!" III'
Ihl' V;lIi.llln· III I'" 11I1l;lIillll." /-.',ol/tllI/"/,im, :,0, 'IH7-IOOH.
---, I~)K·I, "\\'OIld, l.ii-eli!.lIl1d ROilio, ;1I1111.;ll-:rallgc r.tllltiplicr 'li'sls ill EIOIIIIIII"I-
lin," ill I .. (;,ilidH" OIlId ~1. 1IIIIiligator (l·Ib.). /llIlItlhook "I 1-.'....'111/"'·1,.,",
I'olll/ll~ 1/, Nllilid 11111;11111, . \11,,"'1'1\;1111, dIal" 1:1.

Ellgl,', R.. ;l1ul (;. (;IIIl"IIt'/-I~i\'(·r;\. I~}'}I, "St'lIlil'aranH'trit' AIH :11 t-l"''''h,'' ./"'"11({/
0/ Il'Hilll'\\ anti j',lOJltllllU' S/(lI;\lil".\, ~ •. :\'I:)_:lr)~).

En~t.., It, 011111 (:. (;""lg,'r, 1~)H7. "( :oilll<'gr;lIioll alld Enm-Corn'l'Iioll; R"I'I'l',,'nl;l-
lioll, E.·.ail)lalioll, .IIHI·I(.'Slill~," 1:'UJltolllt'lll((l. !"!'. ~:)1-~7(1.
EIII-:II', It, alld K. I'"IIH'I, II/I}:" "l\llIlti\';"iOlI<' Sillltthallt'lltts (;"II,'rali/l'd ARCII,"
/-.'('/I//lI/II,'IIi,. '11.1'111'.\', II, I'l'l-I:>O.

FII~I,·. R" ;IlId \', N~, I~I'I:I, "~kO\,,"ill~ ;",.1 '!','slillg Ih,' 1111110\('\ "f Nl'ws "" VII/.ltilitl,"
/1111/1"'/ "I "'1I1/1I11',IH, 17·1 ' 1-I77H,
ElIgII'. It, }), l.ilil·lI. OIlId R, R"hillS, 1~IH7, "E'lilll;llillg Tilll"-V;II)'illg Risk PIt'lniOi ill
Iht' Tl'nll SlnH'llIle'; TI\(' ARC :II-~t I>-\od"'," /'.'wI/II/1lrlr;m, ~)~" :IC) 1~I07,
EII~"', It, \'. N~, ;,,"1 ~1. /{olll,cllild, I ~I'IO, ",\''''1 Pricing with a FarlOl' ARCII (:""; .. ;.
all,',' SII· ..... " ... ·; hlll'i, ;1',,1 E,t;IIl"h's I'llI' Tn'"slIl,)' 1\;lIs," ./"11""0/0/ Frol/o1l/"',
'In, ·1~>, 'l I :I-:!:IH.
Epstein, \.., allel S. Zill, I\)H'I, "SIIh.'lillllioll, Risk AVI'rsioll, alld Ihl' Tl'mpo .. al llt--
!.av;o .. of COI""I1'IHioll alld ,\SS(' I 1~l'lllrllS: II Tllt·o ...·lical Fr;lIl1c"·O .. !.. ...
fUIIIII""·/,i,,l, :>7, \1:17-'lIiH.
-'-,1\1110, "FilSt·( IId"1 Ri,k AI'I'/Sioll "lid IIH' EI}llilY I'rl'lIlillllll'lIl/h-,"./OI1J'11l1 i til
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- - - , 1\)\11, "SIIIl\lillltioll, R;,k A\'(· .. ,ioll, ;111,1 Ih,' T,'IIlj>orallkhavior 01' (:OIlSIl'"I'-
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/.:, OllH"'.V. ~J~l, ':!(;:~-':!H(;.

Eslldla. ,\ .. alld C;. II;lI'IIIItt\'cli" I C)~II, "'I'll,' '(('nn Slnlctlll'<' as a Pr"dirl"r ,,(, R""I
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F;"lolli. I':, allel T. Faholl; (I',k). 11 1'1:., nil' /JII/ld/lltole o(/'/.\'I'I/,/",·01l/".\·,'(//I-1lil'l (·111>
,.,\.), ""ill, 11," I ItidJ.\'·, 1\ ..
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1!1711, "Elliril'lIl C:al'i{;ll ~farl..'·I" " Rc\,;nv ofThl'ory alld Empiric;,1 Wo .. k,"
'/''''1'1111111/1'/1/'11111', 'lr>, :IH:I-·117.
1~17~" "SholI-'kl11\ 11111'1',"1 R;III";" I'''',linnr, 0(' 11I1I"lioll." ;I/llI'Iil'l/l/ I':''''
Itmlllt U/1'11'1I1. h~l, ~(iq ·~H:.?
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L,·"rgl'. '1'.. C. 1",,,11,0111<1 M. Ni ",,,Il' I"I,." II , 1!1!1I. "E,lilll"li,," "I th,' lIi,I-I\'-k Splt',HI
and hs (:OtHPOlll..'tHS: A Nt'w AppIOad\:' UI1'il1(' 0/ "'OllllO iut .\j(w/i,·,\, .1. ~:\-
1.:,(;.
L .... hn. II., ,,,,,I 5. I.i, I\IHI, "Th,· Ornll"·I1 ... · "I 5"'I""IK" 1'"II"nlS ill Rl'pl'''t''d
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(;,·,k,·. It. "lid K. Sh'lstri. I !/H!'" "Vah""ioll hy "l'l'l'Oxillo;"ioll: i\ COIllI'''1 isoll or
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(;"ldlll.llI. II .. II. S",ill .. 11,,1 I.. SI I<' 1'1'. 1~17~1. "Oil COllli1l1\C1I1 O .. il'" Ih .. 1 11I'lIn'
Ex·I' .. ,1 ()I'I;III;t1 SI,I( k ~f.lI k"1 Tilllill~,".!Ollflllll 0/ 61/111/1'" :\·1. ·10 1-·11·1.
(;"Ifl.-I .. ill. ~t.. I')~n. /li'/·. I,/; .\/"/'(11" Oil I '.S. flJllill' Millkdl, lJllfJllhli.sllf'ti I'h.D. til"
'<'11;11;,,". \\'11;11 11111 S, h""I. l !lIin· .. ,ilv of 1"·lIllSylv'lIIia.
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1'00I'igll E~f 1i;lIIgl' \l;lIk,·I." IIlIfJllhlisllt'd wOl'kill~ papn. l.olldoll School
01 F, 0110111;, '.
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(:OI"I".. blioll." /-."""111110'111, rll,·tII.\'. I, :ll:,-;{·IO.
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.. Is." .lOIt/IIti! 0/ /'.'IWfI)/lIl'lrio. I·\. :!~7-~:\H.
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1'1 i ... ·s:·
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I.('xillgloll. I.c·,illgloll. MA.
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Iraf IIlIS." I'hl'liltl. fll>. IHII-~OH.
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S\\'itrhing PI (,n'~""" ./ourll(l/ 0/ FiIlO/1I iul Jo.'rONlJlIlit.o.;, ,12, ~7-1):!.
(;lilllrl,I". ~I.. ;11111 S. Tillll.II •. I'IW,. "1';" 1111 Plic"illg ill a Fillilt· EnlllIlIIlY."./llIl1md or
/'iUflll,.ifll F'IIII(l1II11 \, I:!. ·1!li-:.{)7.
(~lo."llI;'II, S., PJr\q, /"lit' IlIjllilllfililll/a! No/,' iI/ J'lin'\, f\LI's;,u hlisClls IlIslillllt' oj '1'('( h·
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1;2 /(,./,'/,'//(/'1

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I .lm/llI'/slI'y•.J. ••11111 n, 11.1111", olllh. I!Hi·l. M'I/I/,' ((11/0 "'('Illmh. (:h.lplII.1I1 .111(111.111,
I 1.1111/1011,

I !allllllerslq'•.J.. allel./, Mallidoll. I!l[,(;, "(;"/I('ral I'rillcipll's or Alllillll'lir \'a/;;,/(","

1 I'monl;IIg.1 oflilp (,'lIlIIhrirlg.I'I'h;/lJ.Io/Jh;ml Sot;',/y. :'2. ·171).-,IH I,
aml)('l. 1'.. I\lHI\. /101>11.11 SIII/i.l/i,..,: 'J1U' :1/,/mulI}, J!(/\(,r!II11 111//111'1/1/' Fllllrlilll/\, .1,,111,
Wiky alld SOilS. New York,
alls,'Il. I... 1!)H2. "Large Salllpk Properlil's or (;(,'H'ralil.l'd M,'IIo"d "I' ~I"""'",,
1 Estimators," EmIllJIIU'lrirll. :,0. I02!1-1O!',·1.
+-. I!lH:,. "A Melhod /ill' Cairulalillg BOllllds Oil Ihl' Asy"'plolil' <:",';"-;;/1,,,'
!I Manices of(;ellerali/l'd Melhod or 1\1 01/1('1 Its Eslilll:llc"·s ... ./'I/I,.,,fJl 11/ /-.'{(I/(lI-
IIIP/l7n. ~O. 20~-2~H.
Ilalls,·I\.I. .. alld R. 1·lml.-irk. I!IHO. "Forwanll·::<d"\1I\\,, RaIl'S as OplilIlOlll'n'<lil'lc"s
I or Fllllln' SpOI Ral,'s: '\11 E('ollolll('lrir t\lIalysi.\ ... ./rJlm/lI/l1/ 1'lIliliml /-.', (lI/IIII/L
I HH. H29-H:,:1.
-'----. I\IH~."Risk (Werse SPI'CIl\;llioll in till' Forward Forl'ign Exrh;llIgl' 1\1.11 \..1'1:
An En'lIolllelric Allal)'sis or I.illl'ar Modds," ill J. Frenkl'l (ed.). /-.'XtlltlllP'
/(nlpJfwrlll/lpnwliol/lIl/\/lIfIlJP/'(J//tI/II;n. Lllli\'l'rsil)' orChicagol'rl's" (:hir:lgCl.
II..
Ilalls,·II. 1... alld R. Jaganllalhall. 1!1!1I. "Implicaliolls or Sl'mril), ~Ial \..1'1 D.II;I (i"
Modds or D)'lIamic Economil·s." jrllm/(tlo/1'olilimll:'('(JlloJJJY. !J!l. 2~r,-2Ii~,
IIansen. I..• alld S. Richard. 19H7. "Th,' Roll' or Condilioning Inlill'lllalioll ill Ik-
ducin~ Testahle Reslrictions Implil'd hy Dynamic AS"'I PI idng ~ \0,1<-1-."
I;((JI/omrlr;rfl. [,f,. :,H7-li 1:\.
I lansell.!... and.J. Schdllklll~tIl. 1!I!J5. "Ibck to Ill .. Flllllre: (;cllnalilll\ ~1"n"'I1II,"­
Illication~ lill- COlllillllous-Tilll.. Markuv 1'1'0<'''''''''" !-:('(/J/C/I",'flim. ti:I, 7(i7-
H04,
I lallsell.l... and K. Sillgleloll. 1!IH2. "C,·n,·ralil.ed IIISII'lIl1H'lIlal Vari;Ihll's ESlill1alioll
(If Nnnlinc<ll' Ralional Expntalions Mmlt-Is," Emlll/lllfh7f11. ;,0. 12\;\1-12HH.
- - - . 19H:I. "Slochaslir CO/lSUllIplioll. Risk /\\'('rsion alld Ihe Tl'lllporallkh;I\'ior
of Ass('1 Relmlls." jll/lll/III o/l'lIlilir'flll·;nll/lJlU\'. \ll. 24\1-2liH.
IlaIlSl·II. 1... J. Ilealoll. alld E. LIlli Iller. I!)\l:,. "ECOllollll'lric Evalualioll o( A'sl'l
I'ridng Modds: /(l1lil1ll "I Filll/ll('icli S(lIdil". H. 2:\7-274.
IIaIlSl·II. 1.. • .J. II('aloll. alld M. O).(aki. l!lHH. "Ellici('IH'), I\oullcls I",plit'd hy 1\11I"i-
p"fiod COlldiliollal MOIIH'III i{('slricliolls ... ./II/IJ'I/,t/ 1I/,/I",!lII".riml/ S/n/;I/Iml
"~'-"lfif//iIJII. H:\. H\;:\-K71.
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hrid).(·. LIK.
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r-.'\;l1kl't Prin's: .lOll ,.,1111 oj Ihr Amrr;m II Slal;"I;ml A.~~ofilll;OIl, 69, 10K-II :~.
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I ht;llq,~. (:,. and R. Litzl'nberg,'r, 1\IHH, l-il/llllll/lilJlIl (r," Fillnllrial f:((I/lomin, NOI'th-
Holland, New York. . •
111I"lIg, R" alHI H, Stoll, 199:>a, -Th .. COlllpOlll'nts of the Bid-Ask Spread: A Cen-
('rOIl Approach: Financial Mark("1S Research Celller Working Paper 94-~~,
OW("1l (;r'lduatt· School of Manag('J1ll'nt, Vanderbilt University,

- - - , I \)\):>h, "Dealer Verslts Auction Markets: A Paired Comparison of Execntiull

Costs on NASDAQ anrl the NYSE: Financial Market~ Research Center
W"rking Paper \):>-1/), Owen Cra(\uatl' School of Manag~m~nt, Vandl'rhill
llni\'('rsity,
llulll'r, 1'.. I !)W>. "Projection Pursuit." AllllfliJ "ISlalislin, 13(2) • .j35--~2~,
IltlhcrJnall, (;" 19H2, "A Sill1pk Approach til Arhitrag~ Pricing Th~ory: j()unlalllf
1'.i()lIl1mir 771f(1I),. 2H, I H:{-I!I I. .
II Uhl'lJ1l;ln. C., S. "-mdel. ,1Ild R. StaJllhaugh, I!lH7. "Mimicking Portfolios and Exact
Arhitrage Pricing," jOlll7wl iif Fi/l(llllf. 42. 1-9.
111IllI'rJnan. (; .. and S. Kandel, 19H7. "Mean-Variance Spanning: jounUlI oj hnflllU,
'1~(4). H7~HHH.

J IIIII . ./.. I '1~}3, 0l,liolls. l·illllrl',I, 1I11t! 011",1' /)1'17I'lIliw Sfrun'lifl (2d ed,), Prentice-Hall.
Englewood Clitls. New.lersey.
111111, ,I., and A. Whitt', 19H7, "The Pricing of Options OJl A~set~ with SlOcha~tic
V"latilities ... ./llurlllll t1'Fil/fll/ff, 42, 2KI-~()0.
- - - , I '}\IOa. "I~ricing (Jlt,'resi-Ratt'-Deriv<ltive Securities," RFl.linu of Finnnrini Slud-
il',l. 3. ~7;\--:)92.
---, l'I~I()h.
"Valuing Derivative S"nlrilic~ Using th" Explicit Finile Difference
Method: JOl/m1l1 of Fillnllrilll flllIl QWII/lillllillf Analysis, 2~. H7-IOO.
Illls q, II.. I ~I:>I. "l.ong Term Storage Capacity of Resen'oirs," 'li-nnsllrliolls Ilf tI"
Alllflil'fll/ Swirl), '1Th,il Hligil/mI. 1 Iii. 770-799,
IIIllChillsoll . .l .. A. 1.0. alJ(l T. Poggio. 19~)4 ... A Nonparametric Approach to the Pric-
illg and lIedgill~ of Dl'rivativc Secllrities Via l.~arning Networks," JOlin/fit
"I Fil/Illllf. 4!1. H:>I-KH!I.
Illgl'lsoll.J, I!IH7, 'f1/fIll)' of I-';'/III/(il/[ /)1'(iJiOIl fIIl/killg, Rowman & LiuldicJd. Totowa,
~I·
111),\"1',011, J.I r.. J. Sk,'holl. ,Illd R. \\'(·il. I!17H, "[)ur,ttion ForlY Years Lu,'r: .llIunUlI (If
I-/l1ll1/rilllal/" QIIIII/lilll/it'r /\l/lIl)'.\i.I, 1:,.1;27-1;:>0. "
It .... K.. 1'1:>1. "Oil StorhaSlir Dillt'n'lliial Equations," MOl/oin IIf a,r AIII"i,."" MIIIII,...
IIIl/lim/.'iorirly, '1,1-:>1.
JII\-II'('Iill.J. ,lIld M. Rubin.stein, III!):" "Rt'co\'t'rin~ I'rohahility Di,'lrihutioll,S ffl/,111
(:"'lIt'lllporary S('curity Priccs," working p.lpcr, Jlaas School of l\mill(~ss,
lllliYt'rsilY llfCalii'ortlia al Ikrl<l' It,\,.
,1;\I"llIin. F... N. POISOIl, and P. Rossi, I\I~)'\. "11,1\'('siall Analysis ofStodl<lsli(' \'ol,lIi\ity
~1"dcls.'·./lI/lmlll 0llllllilll'\\ 1/1111 fllillolflit .'ill/lil/in, l~, :171-:IH~.. I
!JGG

.Iagal nathan, R., and Z. Wang, 1!I!)(i, "Tht' Conditional CAPM and the Cross·S.... tioll
of Expected Returns," jOUnlrtl '1 Fillllllff, [, I, 3-!>3.
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Jan'cO, G.• and A, Puulscn, I !J!l9. "The Returns to Acquirin~ Finns ill Tender 011"1 s:
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Jarrell, G.,j. Bricklcy, and]. Neller, 1!)HH, "The Market (('1' Corporate Control: Th ..
Empirical Eviclence Since I!)HO.".Ioltnllli if frtlllfllllir J>rn/,rr/irw.I, 2, li:I!)-h:)H .
.Iarrow. R., and A. RUlhl, I!l1l2, "Approximate Option Valuation fi.r Arbitrar), Still has-
tic Pron·s.~es: jour/1II1 '11'llIlIlIfilll /':mllo/llir.I, 10. :117-:16\1 .
.Il'gadeesh, N.. 1990, "Evidence ofPredictahlc Bchavior of Security Rt·tlllllS ... .It1l1nud
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- - - , 19\11, "Seasonality ill Sto.. k Price Ml'all Revl'I'sioll: Evi(\eIlCl' frolll tlt(· \ I.S.
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.Iegadecsh, N., and S. Titman, 1993, "Returns to lluyin~ Winners and Sellill~ I.osns:
Implications for Stock Markct Efficicncy: jounUlI lif Filltmr,. 4H. li:l-!ll.
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Evidcncc." Joumal oj Fillt/llrilll hOllolllirJ, II, :/-:/0 .
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.loh~(m, D., amI R. Kur\<'ie, I!)H'2, "Potentiall'erfonll<lIllT and TesL\ of Pmtfolio Elli-
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jOllnlfl1 of Finanrial wltl QUIII/tittl/ill' Alltllpi.I, 22, I 4:~-1:; I .
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1~'.vrh~I/."t:l/(fl. 3.1, IH:~202~
\t ' .. ., ..
Jndge. ( ' .. W. (.nfhths, (,. lilli, II. (.Ikql< .hl, and I. (.('t'. I !IH;•. IIJ,' Illt'tlly (//ull'/(/I/'/I'
l
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Kagd. ~I., and A. Roth. cds., 1!)9[). /lIIIItI/J(lOH til J:'x/It'lill/l'/I/1l1 fo.'((IIIIIII/;I'I, l'riIHTt()n
University l'ress. l'rincelon, N.J.
K.;lhne~lan, D., and A. Twrsky, I!17!), "Prospect Thl'ory: An Allal}"is or Dl'rision
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Ntft'/'{'/1 {I',I

I\.;d"" M .. and 1', Whitlock, 1~)Hli, /11111/1" (;111/11 Aldllllt!.,. lidulllt, /: 1I,l.\;n • .John Wiky
and SIIIlS. Nl'W York.
I\.;lIl1kl. E .. 'lIlcll.. Marx. 1~)~l(i. "NASDAQ M,Irkl,t Stll.ClIIII· alld Spread Patterns:
IIIlIJl.hlislll·d working pap ..... SilllOIl (;radllal<' School 01 I\lIsi,"'SS. lIIIivl'r-
,it)' or Rochester,
K.I"dl'l. S,. I !IIH. "The I.ikelihood R.llio 'I"sl 01 ~k.III·V.lli.IIIII· I'Jlil il'lIl)' without a
Riskll'!\s Assl"t," .Jourllul of Fillilllf;all':nJlwm;t \, I :~. ;, 7:,-:,~)~,
1",.,111\'1. S,. R, McCulloch. alld It Stalllhallgh. 1\1\);,. "1\.1),<'si'"1 IIIIlTI'nc<' ,"111 1'011-
lolio Elfiriency." n,~/;t'l/I o! I-/lIl/l/f;l// SIIIt/It". H. 1-;,:1,
Kandel. S" and R. Stalllhaugh. I!lH7, "On (:ol'll'I"lions '"l1llllnl'll( es aholll Ml';I1I-
V"l'i'"I('(' I'Jliciency," .Imm"t! 0lhl/l/llf;1/1 fUJlllllltln. I H. Ii I-\)().
I')H\), "M\)(lc\\in~ Expl'cted Stock Rl'turns lor I.on~ ,lilt! ShOll \loriwns:
WOl'kill~ Papn 42-HH, Rodnl'Y I .. Whitt, (:l'lIlel'. Wh"rlon School. Uni\'t'r~itl'
or I'enllsylvania.
- ' - - . 1\)\)0. "1\ Mean-Val'i;III1:C I'r;lllll'wllI k forT,·,ts 01 Asse' 1'1 iring Mo"ds." Un/;ntl
11/ /'/1/1/ I/f;1/1 SIll/lit'S, 2, 12;'-1 ;,Ii.
I \)!I I. "Asset Retllrns and /ntert"lIIpor;d I'rd'·f(·nl'l's." ./11/11 11ft! or "'nl/t'l",y
1,'uJlIfII/I;n, 27. 3\)-71.
I !)')!i. "Portllilio InetlicienC)' and the CIIISS-SITli"II 01 Expl'cted R,'wl'lls,"
./0111'111/1 'fl'/lIIlI/a, ;,0, 1!",7-IH·1.

I".,,,,, L, 1\170, "The TI'I'1ll StI'IICI,"'1' of 11111'11'," R'IlI''' '\11 Atto'lll!,1 10 R''foIKill'
Teal'hillg with Practice," 10111'1111111/ i'lI/III1IP, 2:,. ~Lt)'. 3Iil-:17·1.
- - - , I \)W>, "Nl's,ed Tesls of Altel'llative '('1'1111 Slrul'III"" Thl'mi,'s." 1I"1;'~" or Fro-
lltJ1uin and .')Ial;.,lir.\, (i;), 11 [)-I ~:t

1\..I1It,. F" ami II. lIn,ll. I\lHH, "Chan~1' ill A'''',mH'1l1S "I \)"I""il 11Is,illllioll Riski-
or
III'ss,"'/lIIlnwl /'I11Il/II'illl Srn';t't'.' IIt',\rwrh. I. :!07-:!:L\I,
K<lrpolf. ./.. 1\IHli. "A Theol], ofTl'adill~ Voillme,"'/ou,."tli 0/ "'"IIW,'. ,11. IOli\I-IOHH,
- - - , I 'IH7. 'Thl' Rl'Ialioll helwt'l'nPrice (:hall~l's alld Tt;"lill~ V"I II IIII': A SIII'VI')':
./""mlll o/l-iIl((lIc;lliuwi QU((lIlillllil'r A 11111."';.1, ~2, 10'1-1 :Lli,
Kl'im. D,. I!IH!). "Tradillf( Palterns, Bid-Ask Spl 1';l(h. alld Eslimaled St'l'lIrily RI'IIIIIIS:
Thl' (:as,· of (:OIllIllOIl Slocks al (:<llI'nd,,1' Turninf: PoiI1IS ... ./oll,.,,1I1 ol Fill II 11-
(iall·:("ollomil.\, '2~l. 7:)-~}7.

K('il", Il,. al1d A, Madhav"n. 1!1!l:,a. "AII<llolIl)' "I' Ih .. Tr;lIlillg 1'""',,,,: Elllpiril',.1
E\'idl'l1t:t, 01) (hl" Bt.·hilvior of 111~lill1li()Il;l1 TI,HIt'I~." '/OUI"I",{ II/ Fi"(III1'illll';n~
lI"min. :17. :171-:>!'H.
I !)!):,h. "EX(Tlilioll (:osls al1d 111\'('sll1l1'nl PnIOl'ln.lllce: A" bnpiril'al Anal-
)'sis "I' IllSlilliliollal I-:qllil)' Tlad,'s." 1'01 killf( pal"", S, h",,1 "I III1,illl''' Ad-
ministral ion, UniVl'l'sity of SOllt h"111 (:"IiIOl'l1i,1.
1!1\J(i. "The Upslairs Markel li,r LIlf(,'-lIlo, k TI."I.,,,cli,,"s: Al1al)"i, .1I1l1
;\ll'a""'1'I1I1'11 0,I'l'l irl' Elkl'ls." 1I,~,1t1l' 11/ /-iu,f/It illlSIWllI'l, 'I, I-:Iti,
hl'JIlI. ()" and R, Slalllb,,"~h, I !lHIi, "('I'I'dining R('IIII'IlS in Siock "llllllolld M.II kl'ls.-
./11I1171ft! o(hllllllr;al Frollolll;n. 17. Y,7-:I\H),
1\1'1 u 1;011 , f\1., I ~lr,:I, "TIr .. :\II;lIl'si_, "I' E.. ollllllli .. Tillll' S.. I i,'s-l'aH I: I'rin's," .l0IIIl/tll
0/ Ih" /lowISII/I;II;mISor;l'll'. 'Iii, II-!!:,.
I~':"', "~Olt' Oil lIi,I.' ill Ilrl' blillialioll of AlllOco,.. ,'Iollioll," lI;oll/t'lI';Iotl. -II,
.JO:I-IIJ I.
1\"lIl1all, n., ali<I ~l. ()'1I1 i"II, I~"':\, "( :()IIII"'liliol\, C()lillsi()lI, ;\11l\ (:\""","'/111111/111 01
I':WIIOII/;I /)\,1/11/11;11 1/ 1/1/ (:0111'0/, 17, :1:!7-:I:,:{.
1\"IIIIl'dl',Il., 1~'7Ii, "TIr .. llislrihllli"lI ofllr .. f\la;"illllllllllrowlli"lI Exnlrsion,".lolIlIlIIl
0/ """Iit'tII'",/lI//lllily, I :1, :Ii 1-:17(i.
Kill" ~I .. C. !,\,'h,,,,, ,lI,d It SlaH/, I~'HH, "1.I<'all R('vl'rsioll in SI() .. k I'ri .... s:- ,\ Real'''
l"ais;1I ,,111r .. ElIIl'i, i.. ,,1 El'id"II"'," 'Ii'chnical R"p'"1 :!7~':" NilE\{, Call1''
III id~,·, \1.\: 10 'lI'I"'ar ill /111';171' 0/1'.;'111/11111;( SllIdi"I.
"in""'hngn, (: .. I"K", .\/1111;(/1, l'tllI;n, tllld (:/lI.I!WI: A IIi_lIM\' 0/ /-IlItlllritl/ CUll",
n'l-iwd .. d .. lias; .. 1I0oks, !'\"II' Y"rk.
1,1"id"n, ,\., l'IHli, "\';11 i;lIln' 1I11111«1, -"'sls;II,,1 SI .... k Plin' Vaillalill" f\lod .. ls,".lo,,, /II/I
o/I'olil;II/II-.''''''"'III.\, 'I-I. ~'!',:1-100 I.
"kido"., ,\., alld R. \\,illi~, I'I~I:" "\\,hl' Do (:III;sl;1' ancl SChllll/lllft... (:OIiIlSi,," froll1
TIIt';r Ibla~," nnl'lIhlislll'd 1\'eI' ki,,~ 1';1("'1',
J;.",IIl'II,lkola, :-':., I·'·'r., "Thl' F.qllill' I'II'llIillll1: II's Slill a 1'11111 ","./olll'l/tli 0/ (tll/lfl/l/;(
1_;10111,,,,',:1 I, I:!· 71.
!;.orajul'k, It, and (:. \'i;dl,'\, 1'IH'I, ";\11 hllpirieal IlIwslig;lIioll of 11I1,'mal;o".<I A""t
PI i< i,,~," 1\f1 1jf'1I 1 1I/I:ill(lIl(;II/ Slwlif\, ~. r,:,:\-:>K(l.
1'''lhari, S.,J Slrallk"II, ;IIHllt SI,,;,", I~",r" "Allolher Look;\1 Ih(' Crms"SI' .. lioll "I'
1-:'1)(" I.. d I~"III""," .10"011110/ /-ilill/III', :,0, I H!'",-!!:!.1.
"II'I'S, \) .. ;11,,1 F.. 1'",ll'II_S. l'17H, "T"'III'"r,,1 R,',<,llIliOIl or lIncnlailll), and Ihll;('lIie
(:I/I,i.-I' '1'111', IIY." I·:, ol/lIlII,'lrim. ·lli, I H"-:!()()'
I\n'I", I l .. l'IHH • .\',,11'1 "" litt' -n,,·OI.\' "/ (:1111;((', \\'I's!\'i,'w I'rl'ss, l\o"I,it-r, (:( l.
l,rllll,'I, I, .. all,l \'. Ng. l~I~I:\. "1'.llId.-llillg II, .. Tilll .. Varyillg (:Ollll"'t'IIH'II! "I' ;\S ..
Sl'1 R,·lllr",." ""I"lhli,l ... d I'al"". I Illin·rsil), "r Ari/oll" alld 11I11' .... ali",,;"
~I""I'I;,, .. Flilid.

1\.. 1<-, .-\., I'IW" "Colllill""'" ,\"l'li,"" ;11111111,i.i.-rTradillg," I~'II"I>II/rllim, :.:1. I:II~.­
I :l:Ir,.
I _.Ii h" III, D., I ~1')li. "I "I'l'l h"li .. ilis ... '"111 Flillniolls, lilldl'rsa"i IIg, alld Sa .. i ll~' 1'01-
in-." \\'0' killg 1';'1"" r,Ii:I!',. "JIIFI{. {:;lIllhridgl', MA.
1.,klllllsh"k,J, .\. Shkiln, alld R. \'isIIIII-, 1~1~)·1. "(:olllrariallllll'l'slllll'lll, EXlrap"!.'"
lillll, ;1l1l11~i,k,".I"l/lIlId 1>1 hl/(III1I', -1'1, 1:>-I1-lf,7il.
LII II' II , W.. ;11,,1 R. Th"IllI'SIIIl, I'IKK. "S'o.-k 1'1 ir .. Rl'anillll.S as Sill! IIgal,'s for II ... ;-\,'1
(:ashllllll' Flit-CIS "I (:IIrl'"r.II,· Fillall.-ial Dl'cisiolls," JOllmal oJ' Af'llJlIl/lillg
,lIl1/h 0,/11'11'11. Ill, :11 1·.. :1:\-1.
[ .. lIlg, S .. ['17:1, (:It!, 111,/1 ,,/Sn','lft! lill ",b/l'l, "<I<Ii,.. II-\\'I",,"y, R"ading, "'IA.
1 ... ;11111'1. r., 1'17H . .\j,,., illl 1/1,,,,, \,'11/, /In. I"hll Wi"'\, ;11111 S""_S, NI'li' YIlt "-
1... II,IlIlIl, II .. PI'lti ... -{(-, itlli, "I T",<\illg ({lilt- 1' .... li!"hilit)' all<l F()n'i~1I rXdlall~"
Illnl\·\lli,,"." WOI killg \'''1''''- ",.W"
NIIER, (:;lIllilridg.', MA.
 569

I.l'l', (:., ami M. Ready, 1991, "Inferrin~ Tt,l(\t, Din'nioll from Illtr.\day Data," jau";lal
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l\Iocks of Dividend Policy Invariant Ca~h Flows," Working Paper 3676,
NBER, Cambridge, MA.
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.J. Eatwell (eds.). nle New Pa{gmve Dictionary of Monry and Finana, StocktOn
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I.ehmallll, B., and D. Mo(lest, 19RH, "The Empirical Foundations of the Arhitrage
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Leroy, S., I!17:l, "Risk Aversion and the Martingale Property of Stock Returns," Inter-
Illltiolllll1~(o1!olllic Heview, 14, 'Bf>-445.

I.e Roy, S., I!lH9, "Efficient Capital Markets and Martingales," journal 0/ Economic
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I.d~()y, S., and R.Porter, 19R1, "The Present Value Relation: Tests Based on Variance
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l.itJellher~t'r, R., and K. Ramaswamy, 1979, "The Effect of Personal Taxes and Div-
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 [{''1 m '"n'.\

Ljll/l~. C., ;11111 (;. lIox. 1\)7H, "Oil ;1 ~1t-aslln' 0) L,ck 0) Fil ill Tilll(, S.. , i('s ~I"dd<'
1I;1II1/1'I1I11I/.lili.1i7-7:!.
Ljllll~. 1... ;11111 T. Si"'I)(orslri·'III. 1 \)Xli. 'fIII'lIft' 1I11t/ I'II/dill' II/ U,'(III\i!.,. 1t/,'I1I,/,II"'III'.
;\lassad1llS\·tts IlIslilllll' O)T(,c/lIlOlog,·l'r('ss. (:alllhridg<', MA.
J.o. ,\ .. 1\)Hli. "Slalislit-al T ..Sls 0) C"'lIill~"1l1 Claillls "ss('I-l'ricill~ ~Iodds: ,\ I'\"w
~f<oll.odolo),')·:./III/n/(ti 0//'/11111/1 ;111 1·:/IIIIIIII,in. 17. 1·1:\-17:1.
- - - . 1\)H7. "Sl'lIIiparalll('lIk l'pp"rllotllllis lor l )1>liOIl I'ri,. .. s alld \'.'1>1"' 11·,11'.,,·
o'IS." ./"lIm,,1 tI{Nlllllldlll 1·:flllIlIlI/;n. 1\1. :li:I-:IHH.
- - - . 1\IHH. "Maxim'lIll Likelihood Eslimalioll of{;'·II ....alil.,·,IIt .. , 1' ... 11 ('",·s with
Pis(I"l'll'I), Salllplt'd Dala." !:rllllllll//·tr;,. "1111.",,,,, '1. 2:{1-2-t7.
- - - . 19\1\. "I.,,"~ T\'flll t-.h·.llmy in Slo,.k Mark('1 I'ri ... ·s: I·:mllil/I/tirilfi. ;,\). 12i\l-
l:ll:t
---.1'11.. 19\):1. Tit, 11/I/lI.\lrill/ O'glll/il.lllitll/ 1/1/1/ /l1'K1I/lllillll II/II" .~""I/Iilil"\ lilt/win
(NIIER (;ollkr(,lll"l' R'·pon). l 'lIiH'r,ilr 0) (:hi ..ago I'rl'ss. (:hi,.a).\o. II ..
- - - . ("\.. I\)\)(i. M",III'I El/llil'II'): .~/"I" ,1/111"'" H,·III/l.i,,/Ir i" Fi,,''''.' 1/,," 1"111 Ii,,·.
Edward fo:lgar I'lIhlishill~. Ltd .. I.olldoll.
[~" A.. and A. C. MacKinlay. I\IHH. "SIIKk Mad;"'l l'ri ...~s Do Nol Follow Randoll\
Walks: E\·idl'n(·(' lrolll a Silllp!.. Sp"ri'icalioll Tl'sl." /In';111' II/ 1·/I1II11,.;nl SllId-
;r.I.I.1Hili.
- - - . Ill!!!). "TIt(' Sill' and POWl'r of Iltl' Variallcl' Ralio TI'SI ill Fillill' Salllples: ,\
I\lonl(' Carlo Ill\"('sligalion." .f"l/rnlll o//\rt/l1l1l11l'1r;r.\. 40. 20:{-2:\H.
I!)90a. "All fo:~onoIlH'lrk Allalrsis of NOlls)"lIrhrollolls·T, adill~:' ./>lIIII,nl "/
',i·tllIl/lI/'/rit·.•• '15. IHI-:.112.
1\)\)Oh. "nala-Snoopill~ Iliasl's in T,'sls or Fillallcial A''''I I'ririll~ Mlld .. I",·
Iln.';"", 1I/"'l/flllI;,,1 SII/II;".I. :~. 4~!~lIiH.
- - - . 1!)!lOc. "WIt(,1I Ar(' Conlrarian 1',"lil., \)11 .. 111 SllIfk M;lrk .. 1 (h .... '('.lIlillll; ...
Un.i,.", 1I/1·/I/IIII(;IIISI/ltI;",. :{. 17;,-:.10H.
--:Y-. 1!)!lIi. "M;txjmjl.in~ I'rl'diclahi!il)' ill Ih,' Slo.. k alld BOlld i\larkl'ts." Wo, kill~
I I';'p"r I.FE-IO!!)-!)(i. MIT 1~.horalOr)' ({II' Fillall";al EII~i'H·l'Iillg.
l.o, f\.. all(l.I- Wallg. I!)!)!",. "Implt'Il\('1I lill~ 01'1 illll I''';cill~ Modl'b wll('II,\"l't Rl'ilIIIIS
I ,\re I'rl'diflahll':'/lIl/mlll II/ I-IlIlIlIfI'. :,0. H7-1:!!I.
l.O\;\\,\·lIsll"in. (; .• alld D. I'rl'lt· ... I!)!):!. """o."alil's ill 11I1l'rI"IIII'"ral Chok .. : Evi·
d('lIn' and all h\l,·rl''''·'''lioll.'' (LI/IIIII',I)"./IIIIII,olll/Tmlllllllin. 1117. :,7:1-:,\IH.
I
I.o'jgsla.f. F.• I!)H!I. "A NOlllillear (;"II('ral Etp'ilihrilllll Mod..! o/" IiiI' ·Ii·, II. SI, III III' ,.
I of hll"n'sl Ralcs ... jll//llIlIllI/ 1-1110//(;01 I·.illll"'";"'. ~:l. 1!1:,-22·1.
~. 1!1!12. "~IIIlIjl'll' Eqllilihria alld .« ...... S,no",", I' Modl'ls ... jtl//I//I,/ "/ hI/Oil> iol
I /:/11/11/111;11. :12. :I:I:~:HI.
-r. I!I!I:•. "()I'lioll I'ri(ill~ alld III<" ~1.lllill).\alt- \{('.\I,inioll,'· /In·;,,,· II/hllil/I>"d
I .'i/Il,lil·.I. H. 10!1I-112-\'

J.OIJ~slalr. F.. alld E. ScI.\\,an,. I!I'J:!. "IIIII'I"SI \{all' Vllblilil), alld Ih(' ·k.1II SI, 11"""":
II A TIVl>·F"nor (;"II("ral F.I)lIililllilllll ~Iodd: ./11//1110111/. "'"0"/1'. -17. I~;.!I-

,I I~H~.
1IIII'II'lIt1'J

l.on·ll/. E .. 1~l(i:l. "lktcrll1illi~tir Ap,·,iodi .. Flow ... ./"I/II"" "I ,1 I 111111/11/"1 ir .\,il'llIl'l. :W.
J:\O- ).II.

1.11 .. ;". R .. .ll.. I~I7X. ",\",'1 I',i .. ", ill ;111 E~, h;lIlg" E< Olltllll)." ":""'''I/"·I,,m. ·Ili. ).I:!~)-
1·1·11i.
1.1I1",daill'·. It. I\I~I:>. "Fillil,·-S.lIllpk 1'1l11"'lli," 01 Ih" ~J.I~illllllll l.ikdihood !-:sli-
111;1101' ill (;AR( :11 (I.I) ;11\(1 I( ;AR(:I I (I. I) Mod"I,: " ~lollll' (:," In 1I1\'("li-
g~l\i(JII." ./oll"Jlnll~1 HU,\;Ut',\\ l1ud l',t mWNIlt" St/l/n/lt \, l :~. , - \ n.
1.1l1t1l1l·1. L. I~I~H, "A''''I I'l'icilll{ ill 1-:... """lIi('.\ with hi, liolls." IIIIPllhli~ll<'d l'al"·I.
Kl'ihll{g (;1'.\(llIa'e School o\' M'I\',lg"I1\(·o', No, Ihw\'\"'1 n Uniwl',i'Y.
1.1111, E, I\HIl, "The Sll'lI('(lIl'e or Illtl'l'''~' R.III·S," (~I/,"ll'dy/lll"'/ilI/l1 /-.'fOlI/llllin, :>:1,
:1I>-li:l.
~"'(,:tllla)', F., I II:IH, SIIIIII'
T/',·/I/I'limll'/11"'I'///.1 '\1Ii!X1'.1/1'I1 by IIII' '\/111'(11"'11/.1/1/ III ft·/I'.I I 1111/1'.1,
Hlilllll'idd.I, III11/Slork 1',1,,'.\ ill I"" (ill ill'll Sill II'.> .\ill''I' ISS(" National 1~lIn"\\1
or E('olloll,ic Research, New York.
~1.1\ Iklh'.I .. a'l(l L Mnvilk, 1~17!I, "/\11 \':lI1l'ili","\ E"allli",I,ioll o\' til\' 1II,llk-Slh"""
( :all 0p,ioll I'rici III{ Modd," }tllllllllllll 1'/1/111/1'1'. :1-1, I 17:1- I \ Xli .
.- - - , 1\IXO, "Tesls of the mack-Srh,,"'s "lid C"x Colli ()pti"l1 \'"III.llioll Mmkls:
./()lll'lllli 'if Fillllll(f, :15, 2H5-300.
~larLly, (:., IW>:!, MfIIWil'.1 'ifJo:xlrtllmlilllllJ I'll/lit/III' /If'll/I;,,III IIl1d I/'" '\/"'{II".I.I <1(.'l</w,I.I,
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\l.leNnl"y, i\. C .. al\(i M. Richardson, J!I!II, "U,illg (;l'lIn,tli/l'll M('lhod~ 01 MIlIIH·III.'
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\LtI'Ill'Sla. 1'.. and R. TholllpSOII, I~IW" "I""li.tlly Alllicil'",('d EVl'lIts: /\ Model or
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I/rli oj Fillflllrilll/~'roll{Jmin, I-I, ~:~7-~r)o.

\1"lki('l. B., I ~1\12, "Elfil'iellt M;IIlet IIYl'oth"sis," ill N('\\'nt;lIl, 1'., M. Mill{a\(', alld
.1. L,t'I',,1I (,'tis.), ;\'/1(1/'aIK'I/1'" IJil/;III/lIn' 01 ,\{"I/11' lil/,I hl/'iill", Manllill,llI,
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\I;IIHklhl'Ol, B.. I !Hi:I, "The Variatioll or (:,., tain Sp'" 1I1"li,,· 1', i('cs," .lolIl/"d u( 11,";,
1//,11. :\(;, :1\H-41 !I.

I 'Hi7. "The Varialion or c,"I"ill Sp\'(,III",iv(' I', i, "'." ./"1111,,11 01 1I11.\IIit'I.I, :\(i.
:\~H-II!I.
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ll OIg('d ElJic il'llfl y? A I,illli l 10
lIlt' ({," It (01 II \\',rlk 'lIId ~IMI illgal Ihc' Valid il,· of
c' ~lodl'ls," IIn,in ll,,/t- :I"/lI/ lIlIIin
:~:~. :!~.r,-:!~~h. til/(l SIt/li ,li[ '.

1~17:!. "SI,, ,i'lic ,Ii ~kllroelCllogl' 101' NOli -Peri odic Cyric'.s: Froll l Ihl'
;111 ... ·10 R/ S .\II,I i",i,, " . I II lit/II COI'OIl'i-
II/ ,..-[[J llllllli nl/ill SII(i tllllln /I/lIP
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I CI7:., "(.ill lil Tlll' ort'l I" oil
rill' Sc'If~N()rmalil.c·d Rallg t' for
Sir clllgll' Ilcpc 'lIck lll 1'1 O... ·s,,·s Wl'a kly alld
, .. I. l\'dl/w ilpill/ i(ilkp il.lliln Il1['
,'I"l/'. , (:c·hi c·lt·
:11, :!71- :!WI .
~lalllll'lhrol. II .. '"111 .\1. '!;"I' I"' 1<J7~1, "Roh
llSI RIS '\lIal ),sis of LOllg RIIII
( :01'1(''''1 iOIl." IIl/l/d il/ II/Ihi ' 11111' SC·l'i.rI
1 I/I/Iil llltli SI(/I i,lim l ""liII lIP.
101. ,II< (Boo k :!). :1'/-

~lallell'lhllll. B., ;11111 II. 'Lldo l', 1~)(i7, "C)II rill' Disl l'i""l ioll of Slo('
('lIn 's," k I'l'icl ' llillc l-
()/WI' r/I/(JI II /I['I['[ I/Ih, I r., IW.7 -IOli :!.
\1;11111.'/"1'01, B., '"I1I. J. \';111
,'\lc·". IClfil<. "Flac 'lioll al Brow
lliall ~IOlioll, Fl'an iolia l
Nois .. s '"111 .\ppl i, ,"iol l'," S.I.,\
.i\I. /(nlin c', 10, '1:!:! -I:I7.
\\.I1I 1"'lh l'ol, II., :11,,1 J. \\'all i"
I~II;X. "No. dl . .lo"· ph allel
Opn ;"iol l.rI 1(~·dl'olo.l\Y."
. \1'1111'1 !It'11I1 /1l ['I /(nl'l l/I It. ·1. ~/(I~I-
~II 1<.
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I[[lIIi[ I. 17, :! II-:! I ~l.
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,". I ~IHli. "TIr .. (:hal lgin) ,( 1I1'1r
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011111,·,,·,,1 R.II" '," (~//I/[ll'Ih)[llIm
l/l oj'ff' ll//ol llin, 101, :!II-
:!:!I .
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'!CIO Of Ie II? Sma ll Sam
I'l'ol' ('nic" ol"" "ls III R:llillll.rI plt
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' COII ..srlln pliol l 01 Sioc khol dc'rs
Slo('klrolclc,I.s ... ./Il//1' II1I/1I 1 "'//[1//1 alld I\:on-
';111 f([l//III11;('.{. :!~l, !17-1 1:!.
~Iallki\\', N. C., Il. Ro II 11'1'.
all" ~1. Shap iro, I'mr•. "An lillhi
;IS('d ({"c' xalll illali oll or
Sior k ~1;rlkc'l \'o"'f ilil\', " ./O//IIIfI/II
/ /'IIIII//I·P. 10. li77- liI<7 .
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:lIld IIII' ~l;rlkl'l 101 (:olp oralc '
(:"'11 ml," jlllll l/,t! IIf 1'1I1;liml
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Flllld alllc' III;ll s: Evidc'II('(' 011
p,.cdklahilil\,o" :\ 111/'1";1 (III 1'.',.,11111111;' (.oll) ,(-llo lilOl I
UI1I;I711, H:), ~() I-~ I H.
~Ialko\\'il/, II .. 1~lr.CI. 1'(l/I/ lllill SI'i['['lill//: /:,/lIi
l'lIl lJillP nij;m lilll/ /IF ""'['11111['11/.1, .Iohl l
Wil,,\,. N .. w York .
~Lrl"h, '1'.. '""\ R. ~I('noll, I'll«i . "J)il' id(,lI d
\'ari: rhilil y all'\ Vari an ... ' lIoll
)(11' III<' Itllio llalil \' lld, Tes"
01 Sfo .. k \1:11 kt'l 1'1 il'l's, " AIIIN imll I-.'([[II[l/lIi(
·11<:1-·1'11<. 111'1[;111'. 71;.
~LII'.,h. '1'...lIld L l{oSl ·III"' ''. 1~ll<li. "1\ol l-Tla dill), (. Malk
.. 1 Mak illg. alld E"lilll:ll<" of
SlIu k I'li .... \'ol;l Iilill'... ./Il//I I/["
III Fil/(l/11 itlll'.i 'll//ilI I/;n. I rl, :lrl!I-:17:!.
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 'nl Ikci,ion s
~l)'ns. S .. and :-.I. Maillir. 1!IX·I. "Corpora t!" Fill;lIll illf.: alld III\","-,tllll
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,
, 2H.34-:,3,
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Su!;);estiolls ... .1I11I1'1"t/ oj l'i'l/ul/l'/', 1,1. 1-10,
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A Slud), or Pricing Behal'ior alld l\larkcl Ellicienc)'." 11Iljll,hlish .. d "h,ll,
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'I:):,~IHO,

1\1\).1. "Implied lIinomi;\1 '1'1 el·s."./IIIII,,," "//'/111111"'. ,1\1. 771-HIH.

RlI(khllsch. C .. I \}!I:> , "Federal RescrVl' Inter.. sl Rate 'l:lq;etilll-\. Ration'll Expecta.
tions. and the Term Structurc,"./olllllil/ ofMolil'/af)'/"((JIIIIIII;(\, Y,. 24:;-27·\.
Rllllll·lh.lI'!. D,. (;,llinton, and R, Williallls. I'IHti. "1.l'aminl-\ Internal Representation
hy E ........ Propagation," in D. Rnnll'1I1.,n ,IlldJ ~f<CkILIIIII (,'ds.1. I'II/allr/
I J;\/nhuil'ti P'IU ".\\ i II}.!: J';x/,/lHullIH'\ it/ (hI' J\Jil )f)\/f HI tUII' 0/ (:oJ.!'IIiliOIi. \'O\"\\H," I:
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1\17:1, "1',..,01' tltat !'rop.,,-I)' llisCtlllnted Prl'selll \';tilil's ol,h"'b Vil".tle Rail'
<lolllll'," 1It-IlIolI"''''/''( fllll/olll;" IIIld MIlIlII!:"II"'I/( .\, ;1'," 1'. 'J. :lli\I-:\7'\'
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,IW'-:IO:I.
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./lIlmlll/"1 1I1I"illl'.l,'. li'2. :111-:\:11'\.
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011 tilt· ShOlrl'lIold,-r., or '\(''I"irilll!: Finns." ./IIIIIII,t! II/A (0111 IIlill,/! /1""'1/111.. :! I.
IX·I-:!':! I.
I ~IW,. "TIll' 11111';\1 I "I t\lt-I v.'·l-R .. Lit .. t\ RI');:II\'lIiollS I lsi II!!; E\ar! 'li',1 SI,II i,-
lin." '/IIIIII/lt! "/ ,Ifilllllllillg /1,."'11111,. ~:I. ·IOX-,II ;1 .
....,hole-s. ~, .. alld/, \\'illi.III1'. "177. ",·:,tilll'llillg- Betas 1'1'0111 NOIIWllcillllllOIiS 1);11.1."

./11111/111111/1-/111/1/1 ;111 1~'f'"IIIIII;' I. [". :IO'I-:I:!X.

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.lIul SOIlo;. ~,,\\, \',,, k.
Sdlll';III/. E.• 1!177, "Tilt· \';IIII;llioli of \\'an;lIl1s: Illlplt'III"lIlillg- aN,·\\' ,\ppItIOl' h."
./11111'1111111/ i'l1I11/1I illl 1:'I'IIIl/IlIIil'l. ·1. 7!)-!):\.
Sdll\'t'rt. (; .• I!ISI, "['silll!: Fillall('i;d 1>;lIa 10 r.-leaslIJ'(· tht' Effi'Cls of Re!!;IILllioll."
./t1l11'll1l!1I{1.1I11'1/1It1 I·.illi/li/I/in, ,:!'I. 1:!1-1!i7.
I!IX!I, "\\,111' n",·, Slo,k ~Iark", \'olalilily Chan!!;,· OWl' Tilll.·?" ./"lIntld II/
1'/111/111'1', ·1 I. II I r,_1 !:I:I.
Sdn,·.'I1. \\' .. l'I!IlI. "Slo,r.. ~I;II 1;,'1 \'/lblilily," I-'illl/l/l'ili/ .11/11/\'.1/.1./"1/1'11111, r-.LtI'-:/III1'"
':!:I-:I1.
S,lol'l', S,. 1!IX:la, "TIlIIt"-Snin S'·glllt'III.llioll: "Model alld a r.lt-lllOd." 11//111/111/1 ill II
Sl i"IUI", ~~t. 7-~!L

I'IX:\( •. "( III S"V,III"IlI;lIillll III Tilllt, Snit's: ill S. "-arlill, T. l\nlt'lIli\';!, ;(11,1
[" (;o'''[lIIall, I"" .. .'illlll'l·\ ill t-:mllllll/l'I)';n. 'filii' S")'il',l. 111/1/1111111;1'10;1111' SII//II-
Iii I, ,\, .ul"llIi,' 1'It'''. N.. \\, \'''1 \...

S'OIl, I ... I!IW" "Tilt, l'It's"1I1 \'ahll' ~lo.It'1 "I' Stock Pric('s: ){eg-r('ssit>1I 'ksl.' ,lIld
~Iolllt, (:allo R""llts," 1I/1·il'/lllI/ Fml/lllllit'.l 111/11 SllIli,ll;n. (i7. :,~I'I-(iOi,

- - - . 1!IX7, "( ll'lioll I'ricilll!: wht'll Ih.· Varialln' Chan!!;t's ){allc!ollll\,: Thl'or~ hli-
Illation. ;IIHI ~'II Applicatioll," ./0"1""0/0/ Pi 1111 II (';11/ (l"d Quall/italitl(' AU'l(' \i\,
':!:!, ·11 !I-·I:\H,
St'Cliritic."!\ and F.xchang,t.· (:Ol1\1Hl'\sion, l~I~H. j\t"rH.1'1 2()()(J: Au /':xflminal;on (~ICII""1I1
I"tjuilv '\/l/tI"'1 /1.'("'/"/1/11/'/1/1, [IS (;owrnlllt'nl I'rillling OlH ..." W.lShillglllll.
D<:,
St'lItana, F... I~I~II, "Qlla(11 alic AIH:J Il\lotl.,ls: " Pott'nlial R('intt'qll('lalion ol',\){( :11
r.lo(lt·Is;" S"COIIt\-( >rein 'LidoI' ;\Pl'ntXilllalions," IlllJlllhlishl'd Jl"I"'I'. I., 111-
dOli Sdltlol 01 Ft 01 II 1111 i!.s.

Snllillg, It. I!IXO. ,'I/tI"II,"illlil/lfllI 11/1'11/,.,1/1 "/ Mlllhl'lllill;ml Slltl;,I;", .1,,1111 Wil,'" ;\1\(1
Sc HI'\. l\'('\\' \" II h.
Sh;II,r.."I\, , .. I'IH~. "Th,' ,\!I,iIL'),;" 1'1 i(ill~ '1'111'01')': l.s It 'l('slahl"?,".!III/IIII//II/IilllJ/III'.
:17, II~q-11 III.
----, I'IW';I. "\llIlti-lkt.1 (:,\I'~I <>1 F'I"ilihdllll 1\l'T? 1\ Rl'I'I\',"./"I/IIIII/ II/ /-i'1I1/1I"',
·1O.IIX!I-II'Hi.
- - - , I'IX:.II. "~llIltil;lIi.II., 'In" "I lilt· /"1'<.1\.'1" (:t\I'M,"./lIlInllli II/ 1'/lIillIl/l// }-..".
1I1I1It;,I, 1,1. :1':!7-:1 IX.
' - - - . I'lXli, "'''''lill~ !'ollluli" Llli, i,'II(' Wh"lIlh .. /"I'II-Ikl" Itll,' I, [llIk"""'II."
/"11111111 "/ hllfllli/" II, ~li'.I-:Dti.
 581

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Derivalives: in V.;. lIarnell,.J. ('OIwH, alld C. 'I:llldlcn (cds.), /\'''/11''/11/1111'11'''·
lint! .'irmil/(I/'tI/l/p/rif' II1f/hod,1 ill hwwlIIP/rin IIlId SIII/i.I/in, Calli I .. idf,;" lllli\'(',·
.sily I'IC.S, Call1bridJ.:'~, UK.
1!192. l.Prtmp.! till Srlllillll/llll,,'/rir I:imllllllri,in, (:( )RE 1.",:1111" S," it'S, (:( lIU:
Foulldation, Louvail)·Ia-Nt·II\'t', 11<-1J.:illlll.
Stoll, II" I!J71i, "The Slipply of Ilea),'r Servin's ill S"lurilies tl-Lu ~"IS," ./,,",,"t! "I
:1:1, II :n. . II:,[.
/'/III1I/1P,

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llrolhl'l's Ccnler, New York l'lIin'rsit)', Nt'w Yo, k.
I \l1i!I, .. It' .... nillJ.: Ih(' COlllp"",'nls of lh,' lIid·Ask Splcad: Th('o,), .II,d EIII-
pilkal Tesls: ./"'1/1/11/ ,,{hIlIIlIU', '1-1, II ;,-1 :\'1.
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;1t inn," \\"01 \"'itlg papl·f. ( :.u hon S( 11110\ 1d i\1.\lJ,lgt"IlH·lll, \ 'lIi"·I.'il~· lit t\.\ill·
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Wallis, W., alltl II. Rohl'1 IS, l'lc,li, .'i/"li,lin: ;\ ,v'7I' ;\IJI)//II/(h. Frl'l' 1'1 I'''. t\1'W York.
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- - - - . I'IKI. :\1\'111/"11/;' nll'lII\' 111/ I-.III/I"/I/I'/,i(;'/I/I. Acadl'llIic 1'1'1"". ()rlallclo. 1'1 ..

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Dick,'y, Ii:> Free.s, 117, 121---12:1

Dilllson, W> French, 72, 7H, 79,157,211,212,
Ding, 'IHli 240,241, 24H, 249, 26f)-26R, ~74,
Dolley, 149 :llili, 421, 497 \
DOIll()witz, :>4 Friedman, !) I H
Don<lI,lson, 2il:l Friend, 211, 220, :12:1, :124 I
\)ullie, H, :lIH, :lilO, HI Froot, 2:>9, 2HH' :1:1:1, 424
Dufour, :>:> Fuller, 4!), 46, Ii!)
\)UIlIl, :~'27 FllrhllSh, 110
DUllill', :)07
DurI:luf, '27t>---27H Cahr,472
Dyhvig. 220, 221, :1:>1, ,n~, 140, 44:1, Calai, 10:1, 107
-1+1. '1.~2. ';!ili, 4!i4 Gallant, A., 522, 5~5
Galli, H4
Llsky, 44, 99. 10~, 107. 140 Garber, 258
Eckho, II .. 17'1 Garcia, ~34
Eckho. E., 17:) Garman, :180, 4H I, 507
Edwards,4:{ Gatto, :185, 391
EiclH'nhaulIl, :l2ti George, 107, 1:15
Eikdu)()IIl.I02 Genler, 316
Eillswill. Ili. :12 Gihb()ns, 193, 196, 199,206, 24S,
I/I>gi<'. :),1. '2:)7, :~HI, 41i9. 4HI, 4H'2. 24ti,2YH,317,44S,446,448,455
·IW). 'IHli. 'IH~), 492, 4~14, 4~)(i, :>:-\1 Gilles, 275
Epsl('in, :10:>. :\ I :>. :I I ~), :{20, :\:14 Ciovannini,A4,320
EslI ,'11;1, ·12·1 Girosi, 512, S 16, .517, 522
Eq:ll>. '12 Gleick,47::1
Glosten, 101---103, 106, 107, 1::15,486,
I-',Iho"i, :1!Hi, '10", ·lIl1i 4HH,497
1-';01>;1,20, 2'2, ·11---4~, S4, (i", 7H, 79, Godek, IIIl
1:>0.1:>7, '20H, 211, 212, '21:>, 221, (;o"tzmann, ::III
'2·10. '241. '24H, 249. 21iti-2tiR. 274. Goldberger, 504
:17!I. ·11 H. '1'21. 4'22, 4'24 Goldenherg, :'179
Fang. :IH7. :~HH Co\clrnan, 3W>, :191
10';111.'1. ·IR. ·I~I. :)'2 • Goldstein, 102
Fell<-r.7 Gonedes, 17, 20H, :179
Ft·rguson .. \-1 GOl1lale7.-Rivera, 4H9
1-"'IStlll. :t!7, 'HH, !i:H (;oodhart, 107, 1()\l
Fi,'lil'. 17 Conlon, 256
Fi"·,,,·I. 110 (;oltlieh,12I---12:1
Fisher. H!i. 1:)0 Graham, 114
Fi,hman. :~H7 Crandmont, 474
Flavin. '27!) Granger, 17, .59, 60, 6.5, 91, 257, 470,
Fonsler, :>:\-1 472,4A6
FOllg, ·112 Cranito, 406
Fon',i, '12:1, ·1:>7 Grassuerger, 4 7C)-<j 7A
Fosl('r, :\1'1 I, ·IW) Gray, 4')2, 4:)5
Frank..!. H'1 (;regOl)" 4::15
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(;rin:hlatt, 221 11",11 ick, 2Ii7-270. 21,1. 2W•. 2Xli,
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(.ru,,~mall, S., 1." :1'1, 110, .~(l:I Ilul'!. 7. :\oI<i
:I()H, :117, :{IH, :1:15 Ilohnann. :17!1
Gultekin. H., 220 Iloganh, :1:12
(;lIhekin, M., 2:10 I'o'd('n. -17-1
(;nlu'kin, N., %!I 11011. H'I
(;lIrland, 12:1 Ilornik, :>22
Ilosking, :,\1, 611
Ilagerman, 17 Ilsil·h. '17,1, 17:>, -17!1
II"kanssoll, :107 IIsII,I7
Iiald, :{O IllIang. C., H, :IHO. :1!1I. 4(il. :IOH
110111, A., :,27 IIl1ang, R., 107, 110, IY>
110111, /{., 27(;, :17H, :10:" :111 IIl1hl'nmn, 221, 2:1l
1I,lInillon. 7. 2:,7, :1(iO, :172, ·1:,1. ,172, 111111. :1,/0, :I'I!I. :17H-:IK I. 'I'>!I. 'ltil.
473,1HI,527,535,536 :>10
Ilallllllersl('),. :IH(i--3HH I11IIsl. :.!I. (i2
Ilampd. :,2:~ 1llIlchinsoll. :1,10. :1'12. :> I O. :.12. :> 1!I.
Iialldscolllh, :IH7 :,~2
Iiallsen, H.. 4HB
IlallS('n. 1.., 2(i\l. 270, 2!12, 295, 2!Hi, Ing(,I",II. H, 210, 2!15. :IIH. :1:">1. :IHO.
:IOi, :102, 304, 30G, :109. :111, :11'1, :IH2. -(O(i, 414, 42!I, .1:1:1. '1:1:•. ,1:lIi.
:11 :', :12(i, 33:1, 3:,Y-:l!i I. :1Y2, +tH, +10. oH 1,41:1.1'1-1. -H!I. ·\'.(i, ·I:.H.
:>27, :131, :,:I(i, :>.\0 ,lti:1
II;inlle, :>0 I, :,02 , Irish, :10,1
Ilardoll\'e/is, 4:14 Jr", :HH
Bari('s. 4:'2, 45:,
I larval, 92 V"r('skog.2:14
lIarris •.J., 107, 110 .I,lckwenh, :170. f,07
lIarris, I ... 10:1, 107-lml. 121-12:1, .\ an llli"r,4YO
\:15 .I a gannalhan, 214. 2n, 2%. :101.
Ilanis"n, :1 I. :1:1:>, :IHO, :>OH :10,1. :IO!I, :Il:>, ·IHli. -IKH. ,I'lli. ·1!17
Ilarn·),. A., 4!IO, 4!l:1 .I a ill.l77
Ilarwy. C., 217, :11-1, -1!)o\-1!17 .I;)nll·s. IHII
Ila,hr<llll'k, 107 ,Iamshidian. ·lIi:1
1I;\II':Tan: :>11. :>,1, III!I. 122-12,1, 12H, .Iarr('II, 17H. 17\1
Ltb-l.IH, 1·1.\ ,!;tnow. ,1:,:,. ·1:.7. ·!:.H. ,lid
Ilaw;i\~illi. H;> .I'·g.IIlI'l'sh, 212, '21;li. 27,1
I k. II .. :11:>, :111;. :>07 .I'·llliings. ·1·1
Ill'all:), ,I:>:>. '\[>7, '\:>H, ,\(i·\ .I'·IIS('n. 1;>11, 17!1. 211
lIealon, :10,1, :{J(i, :IlH, :127, :n2, :11;0 .Jnison. :I'IH
IhWfe, 1117 lo\'soll, 1'Hi, 22:1. 22,1
Ilelll.~(hd, 'IH:" ·IHH. '1!17 lolll).">n. :17!1
I krill, :J 12 .JOlIl'S, II., :1:>-:17. (if>
I ks((~n, 37!I, ·1·Hi, +IH .JO)'I·nx. :>!I. (iO
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1,.1111111.111. \111"0 I .... '211. \/-\~l. :,'2'-:'~'. 1",::. Iii. 7·1. 71i.
kill\. Illi. 1:lr, i,';. i!l. X I. X:-'. X'I. '1:\_'1.',. 'I!I. 107.
1"'1111.11111. 111i". ~lii. ·I~I 1m. I~~-I:!I. I:!,';. 1:111. I:',::.
kt'lHl.dI. 11.-), :27:) I :',Ii-I ::X. I 1::. :!I:!. :! IX. :! I!I. :lr'l.
1,\('1111,111. 17~) :~ If), :·':·I~). :Hi.-', :',1111. Tio. :\71. :ri' I.
I,ill!. \ I.. 7~). '27 I Ti:", , Til. T/~I. YI:!. 17:.!. :,0 I. :,07.
1'\"11. :-' .. Pill :'d ()",-II '.!. ,-J! ~I . .-,'.!:!-'-,:'!·I
1'111 Ilt·!>('q.;:t'I, '.!.:IK 1.1)('\\"('11'1('111. T', I
I, I.,,,. I,'; I I,tlllg"d,dl, :~q:.!. I:.!q, 1:~7-1:~q. ·1 I:!.
h.kid"II. Illl. '.l77. '.!.7H I I I. I I~I. F.',. ,-.lIi
I" '"111. I I I 1.(11 "III. 17::
l'tlllH'tI.d... tll.l. :Hl'.!.. :'dll 111\\(', :,111
he 'g.llI. :~I):), :hil; 1.11(.' .... I) .. :~Il). :~IK
1,,,111.,,,,. \7·1 1.11' ...,.1( .. 11.. 'I. ::1. III:!. ;-,ox
I'CICI, T.!I 1.11I1I,(l.lillc', IXK
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I,,,d.\(". 1%. ~~:I. :!~·I 1.111/. II::.IIX
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h.lt'p"', :) I. :',1 ~I. :)I:~'.!.. :V)!l. :~HO. [,OX \\.'<".1111.11. Ill::. I:!II
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I .ld"'III. :::: I l::li-I:;.". I I::. I !I:I. :! III. :! I:!. :! F,.
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1.,'.1"'1. II:: \ I.li,·, ..., I. ,';.-, .."X. III I. tIli"
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I , .... \1.. I.-,~. 1.-,,-, \ 1.11,'11111)\ II. 17:',
r.,·,· ..'-. .. [",-1.-,';. Iii I. Ix,'; \l.d.II",I.1. 1107 17.-'
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\1.lIIcll·lIlIlIl. 17.-. I. 7.~J. Ii:.'. li:l. li~•. "lilliI'll. :,1:,
:171 , "llIlId. :I~I. ·11
\l.llIki\\,. I". :.'Iill ~(lIod\'. '>IIi
~1'1I\l..i\\'. N. I;" ·Ix. I~I. :.'ix. :.'XII. :\ I :\. ~llIlga\\\It·III. 17. I{,
:117. :111>. :1:.'0. :',:.'1>. :1:\7. 1:.':.'. I:.':', MOil i"oll. :.';1". :.':IH
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~(.lIk. :.'71.:1t1 I. :110 ~IOlll"\. '(:':'. ·\'.7.I',H. ·iti·1
~I<lrkll\\'itl. IXI i\lossill. 1·(
~la"lI. 1:'>1. 1:.':1-1:." •. I U. :.'77. :.>is. Mllirl\l';u(. III:.'. I'n
:!K~. "(1111,'1'.. (7:.'
:\1.11\. 1111 "(ulli"". (7 (. 17'1
~1a""I1. ;\ .. ·110 "hlslIlIII· .. i. \(i7
\1.""11. S .. '.117 "llIlh, :.(i
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·11',. ·117. ·1:.'(1.1'. I, 1'.:1 N,·(soll. C" 7!1. :.'71. :11 :\. ·1 1:\
\1, (:l1l1l1lh. It. :.' 17 Nl'!soll. n .. :IH (. ·IX I. IX I-lXii, ISS.
\I,CIIIIIIIII. W,. :-. I:.' ·IH!I.,I!'"
\ldlllllal<l. :.'IIH 1\:1'1"011. \\',. :117
"'.-I~III·'·II, II!I NI'Il('r, I·(~I. 17!'
"'''Ih. 1:1·1 N'·IIc1'·lkn. Ii
""'hra. :.'!J:I. :10:.'. :\1):1. :10/. :1:1:.>. :1:1-1 N"WI')', :':'. 1:10. :.'Ii". :.'70. :.:\". ',:,(;
[\I('i. :.':17 Ng. :17!1. :IH I. ·(W,. ·IH(i, ·1'11
MelillO. :IIIH. :117. :1%. IHII. I!HI Ni .. d,·rlllllIi .... 107. 10!J
:\1<-11<1<"1'"11. 10:1. 1111. 107. :1 IIi :\Iilll<lI(,II<1rall. 107, I:\:,
\1"1'11111. Ii. X. IH I, :'>I~I, :.':.'1, :'>77. :.'7x, Norlllall. :1 IIi
:.'H~I. :llr•. :IIH. :1:.':.'. :1:11'. :1111. :llli.
:1111-:1'>1, :1:11. :lli:•. :111:.'. IHI. ,.lIi. I )·l\ri(,lI. ·17:.
:>1 II (>'Ilar<l. ·(·1. H·1. "!I. 111:1. 1117, 1·10
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~Iikk..r"",. Ii!' ('g.lki. :llill. :.:.'7
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\lilll". II" i (>-1>11111", I;:•. 1117. 111'1
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:1 Iii 1';II,,,lrllik. I 1·1
;\III/lOr Iwlfx 593

Pau, +t Rolfo.412
PealSOll, 1:lH, 111 Roll, 17,7'2,101-103.106,128,134,
(','nnacchi, 4.J', 1:~5. 143. 145, 150. 184, '213, 216,
Pnold, ,.07 '2:~!I, 240. 243, :~66
Pt'non, :~Iio, :ln, 472 ROIlla, 379
Pt'salall, ,17,. Rom.lIlo, 17
Plkid,'rN,!)!) ROIlier. 27H. 2H!l
Phillip.~, 1',,277 Rosenfeld. I'll, 123-125, 143
Phillips, S., 100 Ross, D., 110
Pi"'Tt', '17 Ross. S., 31.156, l!l::\, 196,206,216.
Pills, ,. I '2 219.220,2::\9.240,245, 246, ~II,
Plau'II, :17') ::\IH,::\41.355.3HO,::\82,414,429.
Poggio, :l~(), :l!l'2, 510,512,516,517, 433,435,436,440.441,443.444.
51!l, :1'22 44!l, 451l, 458, 463, 508. 509 i
POISOII,4!)() Rossi,490
1'011,7, :l41i Roth. 84 I
!
1'011,'1', '27:', '271i, '2RO Rothschild, 92, 238. 4!11
POlit'US, :~ I!) Roy, :15
POlniJa, ,IH, 4!), 7H, 79, 'loll, ::\17 Rozell,I7
POlltT, ·175 Ruhack,I79
Poulst'u, 167, 17H Rubin, 2::\4
1'0wt'II, :>1 Ii, 517 Rubinstein, :l10, ::\41. ::\49. 351. 370,
I'lahhaIa, 17:1 :l81. 461, 507,509 ~
I'It'kc. :n,\ Rudehusch, 423
Pn'smll, '2!):~, :~O'2, 303, 307, 3::\2, 3::\4 Ruiz, 190. 493
Plic'Slley, ,170,471 Runkle, 423, 486, 488. 497
I'I()caccia, 476.....47H RUlld.501

Ib<l'I<'r, :IOH Salandro, 102

R;l(h', ,,07 <;<lIIIIIt'ison. 17.20.23, 30', 251l, 321
Ramaswamy, 216, ::\!B. 445. 446, 455 Sanders, 449
Rt'ady, I:~t, Sayers, 474
Rt·,hlingl(}n. 405 Schaefer, 412, 430, 441, 443. 452, 455
Rt'dt'l". :~:~'2 Scheinkman. 359-361. 392. 470, 475,
Rt'insch. 522 478.479
Rich,ml, '2!I:1 Schipper, I1l7. IHO
Rkil;ml\on, ·17~1!l, "H, 7!l. 1M. 210. Schot'llholu., 40H, 421, 422
27·1.4'2'2 S,·ho!t·s, H5, HH. 177,211, 3:>'9. :>'50.
Ri"I/, :110, :111 :V,i, :~54, ::\56. ::\67, 462. 510
Rillt'l, 1:,6 Schull/.I07
Robhin-, :1 I!l Schuss. 346
Rohn<is, 4'2:~ Schwam. E .• 429, 438, 439. 441, 442.
Roberts, 2'2, :lO, (,5 144.449,455
Rohills,1!1,\ Schwam., R., H4. R5, RR, 104. 107
l{ohins(}II,I'.. 171 Schwei7.er, 379
Rogalski. :~Ii!l Schwer!. G .• 149. 4R5. 497
Role),. 1·1!1 Sclovt'.472
 '\IIt/WI' /I/,["x

Scoll, :176, 37!1 Slill .. hco'III11·. ;)'22 •

SEC, H4, IIIH Slock. 'IH, ·I!I. [,H, 7ll, :17-1, ·122
Scnlana, oJ!!7 Sloker, ;,0·1. ;,0:,
Shankt'Il, H5, 1!13, 1!lIi, 19!I, 200, :101;, Stoll, 10:1-10;,. 107. 110. 1:1:,
212,21[,-217, :12(), :122, 221;, :1:n. SWill'. 7. :1,lIi
2·15, 241i, :1[, I Str.IIlI(, Ii
Shallllo,37!1 Sll'Oo"k. :\·IH
Shapim,,J.,107 SII,an, 7. 17
Shapi..." M., :17H, :1H!I, :117, :120, 12:! SIIIl'II.Io-. :)IH
Sharpc, 14, 15[" 1[,Ii, IHI SlIhha Ibo. ,17'2
Sh~\.~tri, 10:1 SlIi". ·1111
Shea,412 SlIIlIml'rs. ·IH. -1\1. 7H, 7\1, 21iO. 2Ii:,.
Shephard, 4!10, 4!1:I 2lili. :117. :I:tl
Shiller, :1[)[" :157, 2[,H, :1(il-:1(j:l. 2(i[), SIIII, '12!I, ,\:1:,. -I:IH, +11
:1(;7, :17[), :17C" :17H, 2H I, :1H:I, :1(0), SII'lIlall'San, M., 9:1
:lOli, 30H, 317, 31 H, :Ililj, :1%-:llI7, SUndarl''<III, S,. :12ti. :1'27. :1:10. :I!IIi
·IOH, ·119, 121,122, 11:1, -14:) SlIllil.... 'I\J.I
Shimko, :170, :,77 SlIt .. h. 'IIH
Shkifcr. 2·IH, 21!1. 317. :1:1:1 S""IISS01l. -11:1
Sias. 1:14
Siegel, A.• 413 'Eo'l'lu.li:1
Sit·gt'i,.J., :11 I ·\iI)·lor. II.. 17
SiC)!;III111HI.4n bylor,M,,'I'1
Sil\'l')'. 7, 12:1. 35H 'E'yl",. S" 'IW,
Simkowill., 17 'li·r;i,wirta.170
Simonds. H:, Thain, '212. :1:1:1

.....s•Sims. !I!)
Sillgl"',:HH
Sillglcllill, :lOti. :III, :11-1, 3:11;, :127,
Thayer. 2:1-1
Thisl('d.I'2:1
Thomhs. ·17

...
332. :41 H. 4:1!! TI1Il1llpson . .J..17'1
Ske1toll,;406 TholllpsoII, It, \(i7, 17:., 1110
Sloan, 2~:1, 2[, I Tilli\', 10:1, 107, %9
Jt Smidl,l;07 Timk, '2:)9, :1(;0
Smilh, 1.. 2:1 Titmall. 21'2. 221

..*•....
..., Smilh, (r" 1110
Smilh,J,. 110
Smith. ~.. '17.7\1
Soriano" 107
Sosill. :I/![" :1!1I
St"lllh~nlgh. 100, 17H, '2 H, '21 :). '217,
Tj0sthl'im, '170
'li'l'vs.40Ii
To"g. ,\711. ,172
'Ii) .... "" 107-10\1, 177, :1!12
'Ii»" +1'2, ·I:,e,. '1:)7. ,IIi-!
Tr,lIll1, :',HH

: :11)7, In:l, 2HI;. 30l'. :110. '121, ,122.

·Hli, :11H. ,m
T'I·y"o,.-I,1
'L-;'),.,171;
. . . Slarks. 1M '1:-.. ho('gl,I07-IOD
~
_ SI.Ill/., :11:1, :1'21; TII(\<."". Ii
- SIl'il(cn"hld, :17!1 TuEII"',507

-
..--
: : Stewart, 474
Sliglilz, I;), :1·1
'1'111'1,111111. ·11i:1. -IH\I, -11111
TVI'rsk y. :1:1:1

...•
.. I Ill/Ill)" {IIf/,·,\'

I 'Il,d, !tit< Whil<', '\, :\ ,,'i-:IH I ,IIi I

Whi,,', II .. :, I. 171. ,IX!I,:>I:!, :>l r"
\'.llIlk"'IIIIT, ,III .r,'.!'.!, :1~7, :,:H •. :):\~t
\'",ilt'k, '\ \:2, 'I~~I, -1:r.!. ·\:\·1. ·\·11. \\'hi"'\.I\\', 1:1 I
,1,1'1
\\'hil"II',III, -I~:I
\'aY,lIlI>s. :1 Iii \\'hill", k, :'.x7
\'i,hll)', :'1-I.'i, ~'I!I. :I:tl \\'id"'III,17
\',,\tnr,I, ,\71
\\"i"II<'I, :1 \H
\\,iggill', :1'7;;--:1;; I ,IK~I, ,Pltl
\\',dd"" ',:!:! II'dn", :llti
\\',"lilll'''II', :11 7, :1:1:1
Willi.II"',I .. W" KH, \ 7:" \ 77
1\',"li'.,I" :,~I, li:1
Williams, IC, "
\\',lIlg,j., ~I:.!. ~I'I, :171, :17:1-:17:" :n7 Willig, \ III
\\"lIlg, y" :IH7, :IHH
1I'(lotll", tI, 17 I, ,17:,
1\',lIlg, I .. , :lI,I, ,1%
\\'o(Jllt. idg",\XK, '\1'1',1, '\'11, 'I~H. ·1~17
1\';lIlll'I', 1:,0, I,d, \71, 177
II'," killg, Ii',
II',Lskl', 17:1
\\'.\\:-'(H\. ~:l~1

\\'<"'1,1'.. :10'" :110, :11:" :II~I, :I:!O

I\'ei!. R., 'Iilli Znkh,tlI.st'r. :i(iO
\\"'II':;I<'ill, 1:,7 Z('III.a, :1(i7
\1''''1, :"", I :\Il, :!:IX, :!W, no, n:l, hid"" :\ 17
:!7X, :!HO, :!K~I, r,:I,'>, r,:lli ZIIiIiI. C .. :!17
I \'h,d(')" 107 ZhOll, I ... :1:1',
\\'11(','11<-)" :117 Zill. :10:>, :1 \ :', :1 \ \1. :\:!o, :1:\01 •. I:\!""
\\'hil('(lII.I>, H,I, W" xx, !tH, 107 ·1:0-1, r,'., -1:,7, ,IIi'>
 I
•
Subject Index

ahsolllie vallie GARCH Illodel, 'IR5 option pricing, 3RI

arlivatioll funnioll, :) 13 arithmetic Brownian motion, :~2,
arlillc-yield 1Il0dds of the term 311. Sre also Brownian motion
stl"llClllre, 12H, 441, 44:. Arrow-Dehreu securities, :,07
aggrq~att' consluilptioll artificial neural network, 512. Sfe also
aggrl'gatioll,305 learning networks
(:OIlSIIIIIPlioll (~lpital A,sl't A~ian options, 382
Pricing Model, :~\(i ask price, 83
'\lIlni("all oplion, :149 aSYlllptotic distribution
:t1l11)litIHit--dl'pendent eX(l(JIll'lltial GMM eSlimalOr, 533
autoregressioll (EXPAR) m()dd~, IV estimator, 529
470 ML estimator, 350, 538
;lIlIipnsisll'nn', nO asymptotic order, 343
alllillll'tir variates lIlethod, 3HH asymptotically efficient estimator,
arhitrage opportunities, 339 358,530
,1;lIt' price vector, 29" autocorrelation coefficients, 44, 66,
hond excess relUrllS, 4 H 145
Merton's approach !O option autocorrelation malrices, 75, 76,
pricing, :l51 I:~ I . .'Ire abo cross-aulOcorrelation
arhil ragl' portfolios, :l!'i I allwcovariance coeflicients, 45
Mhilrag(' Pricing Theory (APT), R, alllOcoV'driance matrices, 74
W., ~)2, 21 ~). Srr also Capital Asset Alltoregressive Conditionally ,
Pricillg Modd, IIIl1ltil;lctor Ileteroskedastic models, 469,
Ill<)(kl.s 4H2. Sff allo GARCH model~
,'xaCl bnm pricing, 221 avt'l'age clerivative estimators, 505
Llnor risk exposure, 221 ;<wrage rate options, 3R2, 3R6
p<Tv;!sive fanors, 221
riskln't' relllrn, 220 hackpropagation,515 \1

I>'l'll·divt'rsilied market port")lio, bandwidth, !'i00

221 optimal bandwidth selection, rOll
AR( :11 1l1Odels, 41i9, 4H2, Sff film barrier models, 121 :
(;;\R( :11 Illodels barrin options, 391
 SlIbi('(/ 'lId,'.\"

Ba}'('sian inl'cn'nn', 7 ('slilllalor 101 ,,'!. :llil

BDS It'sl, -17\1 geonll·lric. :1-17
BEKK llIodel, 4!J1 I'ropnlil's. :1,1,1
henchmark portfolio, 2\IH huhhl<-s, 2"H
Ik'rkelt'}' Oplions Dalahast', 107 hllllish ""rtilal spr('ad, ,.O!I
Bernoulli dislrihuliou. I H lIullnlly Erkel, ,17:1
hela, I!"" I H2, ·J!lli
hia.< .. all oplioll. :1,1(1
linilt'-samplt' hias in long-hurizoll ("allahle hond. :~!I:.
rellrt'ssions. 27:1 Capilal AsscIl'ricitlll ~Iodl'l (C;\I':o.I).
hid pri<"t'.!\:{ \01. IHI. .\/,(,,,1.\(11\1 hinOlll" 1'1 it·illil
hid-ask hounct', 101. 13,1 Thl'ory. Inlcrtl'mporal {;"I'il;"
hid-ask spread, !l!l, 111i. 117 AsSt'1 Pricinll Mod!'l.
all\'erse-sell'clion cost n>lllpOIH'nl, dala-'I",opinll hiasl's.
10:1 Inl'all-Variallcc ('flicit'III-"'1
('slilllatilllllhe efl'cetivc hid·ask malill'lIIalics. IIIII\(if"nor IlIodl'ls,
sprcad, 13,1 S;llIIl'll' sel<-ni(\l1 hiasl's
iI1\"(~l\lory cosl compollcnl. 10:1 allOlll;,li!'s, 21 I
o!'dcr-proccssinll cost cOlllpont'nt, appli(:alions. IItl
, 103 lIIa("k vnsion. IH2, I!l(i
hilil\car model. "71 hook-lIIarkel clkn rOlldilion;",
hin.lr)' Ihreshold lIIodel, ,,12 4%
hin()mi.1I tree for the short-Icrm cross-sectional rl'J4rt'ssioll h'SlS,
i)IlI'r!'sl rale, 412 21 :). Spt' Ill\(} en ors-in-\',u i.d)it-s
hinl~ and dcalh oplions, :I!l\ h,,\<, ....,k,·ltJ,lirily.20H
\II"flk-SdlOlt's and Merton oplion illll'IWlllp(lral l"I'Iilillrilllli
I~ricinll model. 339, 3[,0. S"P ,d.,,, Illodels. :12:~
dplion pricinllmodels .lanll.,,}' I'Ill-n. 100
!'s\im<llOl' I()!' a, 31i'1 lIoll-nonnalil)'.20H
'1!lillstinlllhc UI<lck-Scholes nonsytH"hrollolls Iradinll, W,
I 1()J"Jllllla I()!' pr!'dkl"hiliIY, :~7" ol'lion I'rieillll, :1:11
ast'lInpliollS. :I,,() I'0w!'r of Icsls, 204
IIlack-Seholl's \()J"Jllllla, :1,,2, :171, pric!'-l'arnings-ralio l'Ilt-n, :! II
i :l7:I,!",(!1 Shall'l'-l.inlnet" \"l'lSioll, I H2, I WI
CAPM,3,>1 silt, elien. 211, 'I!Hi
ddlt'rllliniSlie volalilily, :17!1 si,,' of I('sl.<, 203
eSlimalor for ,,', :lli\, :17,1, :17" 1<'lllporal dep""d!'I" ... , 20H
swchaslic \"Olalilil)" :11\0 IIl1ohst'rl'ahilily of Ihe """ kcl
implied volatilily, 377 pontolio. 2\:1, 211i.
oplion scnsilivilies. 3:,1 CAI'IvI. S('(' {:apilal Ass!'1 PI i<illil
horrowinll ("onslraillls. 31:, :o.lodl'l
Box·Cox lransl()JJnalion, 1,10 (,II(hing III' wilh Ih!' .I01H'W', :1:!7,
lIox-Pinfc Q'SI<llislic, li7 :12H. S,.,'''I.\O hahil lilllllalioll
llrork-lkrhcrt-Schl'inklllan ICst, ,17K IllOdl'ls
Brownian mOlion, 3,101 {;awhy dislrihulion, I H
.uithml'tic, :12. :1"" {:{ :AI'M. Sn' {:OIlSllllll'lioll (:"l'il,II
!'slimalor I(,r a, 31i,I A,S!' I Pri";nlllvlodd
"'ilill).; 11111111(111,11,1 ("lld,llllllI IlIlq~l.t1. ·177
rli.II's 1111'''11', ,17:1, s/'/' 1//.11/ (0 .... 1 III I ,'pil.d (· .... Iilll.lllnil. IX:~
(kt('nllilli~tic IIOlllilll'ar '"111"'" 1"",<1,, :1'lIi, ·101
dy1\~\1l\iL\l syst('I\\S tu\\\(.'-:...it\·, ·lUb
dll'lIll'k ",,,,,Is, ,II:! (OllIHJII 1;111', ·101
dO\(·IH· ........ intiir.ltol", ·177 dllLllilili. lin
(:"hi>-lloll).;la,' IIlilil)', :1:!li die, 11\"(' dlll.HiOll, ·10(.
C(){'IJ'ICit.'lIt IUllnion:-o. :F',r) 101 \\'.11 (I, ah". ,IOH
C1Jilllt'gl;lliulI. '2:,7 illlllltllli/;llil Ill. ·It):,
111 .. 11'1111 ,'slrlldlln' "r illll'n'si Iliglilll'.II' IIIII,h'l, ,lOti
ral,'s, ,11\1 ~1;I"'IIILoI''.s ,ltllalillll, '1Il:!
CllllIpll'«' asset luark('ts. :!W-) IIH,dili,'" ,It II ,II ilill , ,IW,
"oIIlIH'IIIHI "l'li,,"S, :1\)1 I" in', 101, ,10\1
'''lldilioll.Ii I'olalilil), Illod"'s, .'In' \·i"l<I III 11I;)III,il)" 1111
,\IH :11 Ill"d .. ", (;AI{CII 1II001"'s ("( )\',11 i~"IlT sl.lli1 m.1I il),. ·IH·I
(1JIIIWt"lioll stll'lIgth. :)l:~ (;O\\·1c .... :!Olll·;., r.lIin. :\:, . .\I'r til",
«()I\ ... i.\t('111
oIl1d 1I1lilnl"ully R;)II<111111 \\',IIk I IIllll"'l
,\S\'IlII'\lIliCIIII' 1I11\'11lal «:ll/\N) (:"", I I\g,"',oll , ;)IHI Ross I\HlIlt-I, ,I:\(i
C.~titH;lI()rs. :\!'"lH (:IIx-R",,, IIplilll\ I" itillg It'('lilliqlll',
1"IIIl .... lallt-(·ollcl.lIioll IlHHld, ·I~)L :~~)(). SI'I' (1"0 I j .... k-!I('tllral
(1)11",I;ult-<':>"IH'rtt'<i-r('ttlrll hypC)filt.'sis. opiion-pi iriltg 1IH'lhod
~:-):) ('1 O\ ..... -all!o("orr('!;tlioll. 7,1, jrj. H't. I :l~J.
.Illd HT1()1" .ltitol"l'gr('ssin' S"I' a/\lI.l1lto('ol"l('laliol1 InalritTS
11ll'lhuds. LXI nc" ..... ,,(·clitHI.lIIIICHkb. 17:~
.IIHl \'(,Ltlthty lc.·"t~. ~7(1 ("10;., .... • .... ('( tiul\,\l H.'slli(:ti(11\~ Oil lht'
(:OIl.'1I1l1ptiol1 (:apital As;o..l'1 Pricing 1('111l .... lrtlrlllIC. ·I:,~

\llIdt'l (U:/\I'M), :\0,1 l I'O,..... -\·.dHI.lliul1. !'"lO~

:l~grl').~,II" IIlIISlIlIll'lioll alld, :llh ,\11111' ,\111111" Lillo, :IHli
1-:1"1"ill-I,ill-\\'l'il n'rm,il''' IIlilil)' (111' .... (· til diIlU·I1 .... ltJII.tlil\, :,()·I

1111,,"'1, :11\1, SI'I'I/flll

FI'.ql'ill-l.ill-W,'illlllldcl d.II,I-"")( 'I""g, ~ I~, :!·IO, :!·Ih, :!·I\l,
II "I 1'111 1II'II1al \'," iahl,', (IV) '2:d, :)'2:~
n·gn·'\sioll. :\ II <ld.lIdl li,k, ,lllIi
i 11\ (';.,1111' hell" og-t·IICiIY. :~ 17 ([('gll·t' .... ()111('('dolll. :)~:)
[HJ\\'('I IItility, :~()!'"). s",' (I/.\O 1>I'It.I or .\11 optiOIl. :\:',:~. :)1~
IlIglIlIllll.d .I;., . . t·( pricing IIludels d('It.I.lIll'liltJei. :11.:) 10
'\Ji>.-.tilillillg nlll;"1I1l1pli()1\ 0111 clr ,"'II,I-h('(lgill~, r,l:!, :.:l:!
Iii,' IlIodl'!, :I:!O <ll'l i\,lIi\t' 'l'{ III iiit· ..... :\:~~l. ·1:1!'"1. S"f'
i 1)\\ .... \I\\\plion ).!,ro\\'lh, :\ \ \ .. \:\.., tlhfl liM'd·inronH.' dc.·, iVf.\\i\"c.·
I (1I1 .... llIllplioll of \luckhold('rs ;IIHI ... c'("lIlilit· ..... "ption pi iring
IIOIl.\(' II kli"ld,'I.'s, :117 IOI\\,lld (tl1ll1.1( t. ·I:,X
«(lIlllIlIIOll";-I(·( ()nl.t. . yllq>tolics. :~ti·1 IUIIII t· ... c ulIll.1t 1. ·1:J~l
lIJlIl:.lli;IIl illn'sIIlH'1l1 ~Ir;llcgi(.'s. 71l dc·lc·llllini . . llt llolllillc·;tI chll;lIl1i(".ti
'"llIml \';111,11,' 1111'1 I",d , :I:n \\·"'('111...... 17:~
, II II \ ,.:\ i I ~. ·11)( i lo~i ... llt 111.11'. ~,'.!.:,
, III 1I'l.lIillll l'IlI'llil'i"lIl. ,1,1 :--('Il~ili\ it\ 10 illtli.d (otulilioll ..... ·J7:\
(Ill I "i;tlillll diIlH·lI . . iClIl. ·17K 11'111 111.11'. 171. 17fl, :,:!;)
 It-,till!!. . .\',.,. h-'llll~!tll dli .. il'IlCl'. S," ;1~1·1II111'lli .. I'lIi .. il'llt'l'
d,'h'IJujui"" 'UHl1iIH·.1I Flli, i"11I ~bl \..1'" I "'p"lltl',is
(1\ 1I.lIlIicti,JlO( ,.",., (EI\III), :!I)
tllIl"Il'11l (. ,l.lIillll.lI \ IJiIIt ,'''. ft;,. S"llIis" IIII~-F"IIII I-:lIiril'lIl'1', ~'.!, :\11
:\7'2. s,',. ill,,, un" I",), p1IH·t· ........ Slmll~-Forlll Elliril'lIn, '.!~, :111
dillt"ioll hilI< lioll, :F,ji \\"':Ik-lill'lll Ellieil'I"\', :!:!, :111
cii" ,111111 "olllh, :1'lIi, :l'li' H ;,\R(:I ( 1II0dd, ·tHli, ·I~X
''',lllll.tling 'he I,')(H oll))(,n h'nu 1':11. .'i"" I'XI""I:Ilill'" Itl'polllI',i,
slnl.-III"', ,10'1 ,'Iasli .. ily, ·IO!',
101 w:lld I :111', :I~I~I ,,/asl iri I)' 01' i II It'I'II''' 'I " " •.1
hotd'I\!!.~pl." \ud ''''tUIIt. :~t.I~ ,"hSlilllioll, :111',
i III Illll II i/:1I iOll, ,10', hl'pl'rholic' discOHlllillg :t 11<1 , :I:',.j
Inlll slrllnll'" "I illl,'n"1 1:11"" s"paral illg ri"k al'l'rsio" 1'1'0111
:1~17 illl<'I't"lIIplII'al slIhslillllioll. :1 I"
I il'l<I nil 1'1' , :1~1i' Iht' riskll'ss illll'l\'SI LIII' :11111. :',I)~I
lil'l(1 spll':\(I, :1~17 1'llIhcdditl)!; <lilll(,IISioll, '171i
rid<l 10 111:11111 ill, :1'lj EI\IJ I. .\;'1' E,.,i..;.'11I I\lad... 'I'
<Ii" 011111 IlIlInioll, 110, .'in' '1'Ii,,<, IIY)lollll'sis
('sl illl:llioll Epst,'ill-Zill-\\'t'il lI'I'II1"il'l' IIlilill'
<li''''IIIIIII,d 1':Ihl<' 11111.11'1, :1 I~I
of hillin' <lil'i<lI'II'''. ~r,1i .. onSlllllplioll-",,'alth r:lli .. , :I~ I
,,!, Ihl' ,10, \.. 1'1 in', ~'.'. (To"'."i-s('niollal ;".,('1 pricing-
eli" n,,(,-tillle' I1I0dc+.. Ii 11'111 III", :I~~
01 ol'lioll 1'1 i('ill~. :I.'H I'qllity I'n'''lilllll 1'"111." :I'!:I
"I '''>l'h'',li. "o!:\lilill, I~~I brlill as,,'1 III i.. illg ""lIkl, :I~ I
dj,( It'lil.llillll, :~x:\. :\X:. ,"""Iillllill~ '"I""ll1plio" 0111 "I
<lhlrilllilioll, .'in' :"\'JlIl'loli.- II", 1110<11'1, :I~O
<li'lriIHllillll, 1t'1lI11" "'Illitl' prl'lIIilltll 1'"1111'
<lil'i(I"lId'l'l in' r'llill, ~Ii I. ~Ii~ ell.-hillg lip ",ilh Ih".l"""""
didd,'"d·r"lio "IIIdd, ~Ii:\ "IIl<lI'l, :I:!H
dl\idt"lIch. I:!. '..!:. I 11'IIISt'''Jag'''''':lIh,1I1 \'ol;lIilill
clo,,"'" "0110"". Sf',' I.. , IIIli. "I 1"'"IHI, :\Il~
:1I1,11",i, logllorlllal ;IS\l" I" i.. illg 111111",1
dowlI alld 11111 ol'lio"" :1'11 wilh Fpslt'ill-Zill-\\'t-illililill'.
cllill, :11, Y.li :I'.!:I
,111,11'1'11111'111'1 "1'1 ill"" :.... 1\ Io'glllll'l,,;l1 ;",.. , pli. ill)!; 11I,"1c1
<l1I,,1'I''I"ill' "I"ilill', :','11 wiill P"W('I' Illilill', :107
clllr"I.I,' ~",,,h, :1~li, TI~ ""lIiIV lI'IIIII.-IIa'I", ~r'li, ~H7
dur~,tiu". ·10:\. \'1'1' ,If, .. , onl H ,,, hnn,{.... t'qui\·;,!t'lll luaI11Hg-;,h· HU';\"iUn', :),~):).

d'II.llion or IHII)II;ullllg, ~7 :IX:I, r.ox

tI\'JI,lIl1i, h"dgillg 'lo.lI'·gl. :,~ I {'II o""i~ill-\·:II'i;,hh's. ~ I ti
d\II,lIl1ir 1I.lIlill~~ 'ILllc'~i("', :·'~I'.!, :'lll 1·.IIle-r 1''1 1I:lli" " , ~'.l:I, r.ox. St'" 11/'"
I h"\"i,, "1"'1,11,,1. :11;11 ,11l,'h:"lir <li"""1I111 1';lrlllr
(:"hh-llollgl:1S 1I1ilill' 11111''''1. :1~li
..!11'('lil'· dlll,llill". lilli, S",' 11/'" I ;llio 1IH1<1.'I, 01 hahil IIIl'IlIalill" .
~ nupoH luulll, :I'.!H
..!I," Ii,,· '1"";111. iiI:! FlIl'Opl'all IIplioll, :I·I~I
 ","".,4.""'\
tiOI

"\"t'llt-study'analysis, 149, Sff fll.lII exmic securilies, 391

lIollparallll'lric tests expansion of lhe slales, 357
ahnorlllal r<,turn, I :>0, 1:>1 EXPAR models, 470
Arhitr;lge Pricing Theory, 151i expectations hypothesis (EH), 413,
Capital Assel Pricing Model. I:>() 41 Il, 419, See also pure I
clustering, ttiti expectations hypothesis, term
(oJ}stant-mean-return lIIodel, 151, slruclUre of inlerest r.lIes
1:,,1 empirical evidence, 418
<Toss-sectional IlIodels, 17? log expectations hypothesi. 432,
Clllllldativ(' abnormal return, I fiO 4:17
l'arllings-announcement eX<lmple, preferred habitats, 418
1:)2 yield spreads, 418
(,stimation window, 1:)2 expected discounted value, See
('v('nt window, 151 discounted value
('v('nt-date uncertainlY, 17G expont>lltial GARCI-I model, 486.
factor lIlodel, 15:) 4HH -
g(,lIerali/,('d method of moments, exponential spline, 412
Ir)4, 174
inft-rl'nce with changing variances, face value, 396
Hi7 factor analysis. 234
law and econolllics, 14~1 factor model, I:):'. Su aLso
kgalliahility, 149, 179 multifactor models
lIlarkl'tlllodel, 1:>1,1:/:/, I:>H f;lir ganlt>. Sef martingale
,narket-a(ljusted-returll lTlodel, rat tail, 16, 4HO. See also kurtosis
I !)l; finite-dimt>lISional distributions
nons)'llchronous trading, 177 (FDDs), 344, 364
Ilormal return, 151 Fisher inromlation matrix, See
p"st-evellt window, 157 information matrix
sampling illlel>'al, 175 fixed-income derivative securities,
SkC:\\fIH'SS of rt~tll .. nSJ 172 4:,5
,standardized cumulative abnormal Black-Scholes formula, 462
return, 160 IIt>ath:larrow-Mor!on model, 457
t('st pOWt'r, I (ill Ilo-Lee model, 456
(');al'l factor pricing, 221 hOllloskedastic single-factor
illtl'rpr('ting deviations. 242 model,463
llu';llI-variance effiri('1l1 set option pricing. 461
Inathematics, 243 term struclUre of implied volatililY,
ll(lIlrisk-haSl'd alternatives. 24H 41i3
optilllal orthogonal portfolio, 24:~, fixl'd-income securitit>s, 395
2-\:',21H floor function, 114
I i,k-lJas('d alterllatiV(", 247 Fokker-Planck eCJuation, 359
Sh;tlp(' ratio, 245. 247. 24H, 2')2 foreign currency, 5, 3H2, 386, 390
t;lllp;ency pOllfolio, 24:>, 2,17 forw,lr<l equation, 359
exn'"s kurtosis 17, 4HH, :> 12. S,'" fI!.1I1 fOr>vard ratt>, 399, 438, 440, See qlso
kurtosis, returns term structure of interest rates
('xcess n'ttlrllS, 12, I H2, 2f}l{, 2~1l coupon-bearing term structurrl ,
('X('ITis(' III in' , :H9 4011
 Su/Jjnl/I/I/"":

liu-war<i-ratc curvc, 4()O, 41 \! g('lIerali/.cd illwrS(~ of a 1II.ltriX, :l+I,

log ")nvard ratc, -lOU, 40H \!·I:,
pltrl' t~xJ>cclaliolls h),pothl'sis, ,11,1, (;cll('r.tlil.l'd Ml'thod of MOllI<'lIls
417 «;MM), 174. :lOH, \!:l\!, :IH, :I:,~I,
yield to maturity, 400 'HH, <1-1\1, 4:,:), 4H!.l, 4~H, :,:12
forward trading, :\99 asymptotic disirilllllioll, ,,:1:1
franiotlally dillcrctlced lilll(, sni,'s, as}'rnptotic \'ariann... :-l:\:\
til'J Nl·Wt..·)'~\\'t'SI (· ... tirnator, !",:\;,

franiJ>nall)' illtegraled limc scri('s. SIDcilasli .. dilI,-,r(,lllial <''1l1alioll,

St'f frauiollally dillcrellced lillle :I:,~)

S('r ics wl'iglHillg malrix, ,,:I:~

hllltL\mcntal asset, :{,)() g('()III"ll'ic IIrOWlliall lIIolioll, :IH:I.
hlllti'\III(·lIlal vall1l', \!:,H, \!HH SI'" 0/.," Browlliall 11101 i()11
risk-IH·lIlralil.Cd pro('t-''', :V,;" :170
Ci\IM. S"t' CeIlClali!.('" ~lt-Iho" 01
(;all1l,la of all OptiOll, :\:,:\
!'v101l11'1l1S
(;Mt(l;ll 1II0dds, 'IH~, ,IHIi, ·IH7
(~oldll1<lIl-S()sin-(;;lllo oplioll pi it ('
allsi,llIle \'aille (;ARCII IlIodl'l, ·IH;,
101'111111.1, :IH", :{!).I
,"It\ilional cxplanalDI)' variahles,
(;01 dOll growlh IIH"kl, ~:,ti
tlHH d),lIalllic (;orcloll glowlh moth-I.
I\E~K IIlDdcl, 49 I
~Ii:\
ftll\diliollallll'lIkcl IllOllel, 'I~I:\ gOV{'I'III1H'1I1 sp('luling in lh(' nlilily
t'tllidiliollallloIlIJtH"lIIalil)" 'IHH rlillnioll, :t!(i
t'tlIl~lalll-ft'lTt'lalioll modd, 'I~I~ (;rallger-('ausalil)', \11
.1 •
('slll11alloll,' 1H7,4H\)
(;r(' .. ks, :1:,:1
('X(,\,SS kurlosis ill stalldardi/.(·(1

l-t'sidllals,4HH h.lhil form,llioll, :W.7

(;ARCH (1,1) lIIodel, 'IH:\, ·1\17 Ah .. IIII<"I .. I, :W7
(;ARCIi-M model, ·\!J·I C.lIl1plll'II-Codlrall(' 1II0tl<-I, :1:10
](;ARCII lIIodel, 4M (:oll.,lalll;lIid('s 1110<1 .. 1. :1:10
illl<'l'('S\ ralC volatilit)" <1,,~ l'xlnllal-hahil models, :1:!7
lIIultivariate, 490 illlnll"l-h"hil lIlod,'ls, :1:0
p('rsistl'lIft', 4H:\ dirkl .. II ... • modeL" :l\!~1
Q( ;ARCII 1II0tlel, 4~17 ral io lIlodels, :{\!7.
sillglc-lilftOl' (;ARCII (1,1) lIIodd, Ilallliltoll Markov-swilchillg Illodel,
491 ·In
slationar), distributioll, ·IH·I 1!aIlS"II'S I,·S! or oVI·tidt·IHifyillg
liS stock r<'tllrns, 4HH 1'(·.,1 rin iOIl', :,:11
VE(:II lIIodel, '1\11 11'11I"'II~Jag;lIl11alh"lI "olalilil),
(;,\R(:I l-ill-lIl<'all Illotlel, '1\).1 bOlllld, ~\)(i. S,'" 0/.'" .'It)(·h'''li.
(;ARCIl-~1 lIIodd, ·I~)'\ discouill r"nor
(;'III"iall knlH'I, "II I 1lt'IIt'hmark jlonlo\i(), '2tlK
(;(,IH'raliled AUlon'gressiw blll;l)' 1'1<'lIIilllll I'lIl.1k, :\O~
(:ollditiollall), 1iel<'l'oskedaslic gl'OIlIt'11 ic illlerprelalioll. \!\)H
modd" ·IH:I. S"t' (//.III (;AIH :11 logl1orlnal ass('1 pricing 1I)()(1c'1
models ,,,ilh pow('r IIlilil)' alld, :10\)
(;('II('''lli/('1I En 01 Di"l ihutioll, ·IH\I 111.11\..,'1 1', iniolls alH\, :11:,
 11I.I~ill)l1l1l (Ont'i.llioll porll(,lio. ill( nilit' 11 ... 1..., :\ I:;
:!\IH lilt01111''''1(' 11I;lIkl'h, :1\l(i, :I'I:!
11I",I1I-\'al ;;III1T <"Ili(,;(,II(,)" :1\IH IIldt'jH'lIdt'1I1 ,11111 ;<lI'lIli,'al
1It)IIII('g.lIi\'ill' Ct)IISllailils. :IO! d;sl.i""IIOII (11Il), I:., :1:1, ,17:.
I k.1I h;l;IITO\\,-f>lollon llIodel, ,1:.7, illd('~('d 111"1(1-, :1\1,.
"1'(' al.\CI prl( in~ tn.:.<.'d-ltl("(HlU' Itldlll.'C( !'ool(l)lt.' ('~(ilt\ato .., :,O:l
ckri\'alin' st','11I itil'~ IlIlilli('"illl;ti g('IH'I~lI(1I, :\tiO
I k.l\·i~idc: ani\'.lIioll rtlnnioll,;) 1:\ illlorlll;)li,," III;)I,;~, I!II, :1,.1', :.:IH
II('elg(' !,on!"olios, :1:1:! IIIfI '111I,1t il III-IU;III i~ ('qll.dity. :l:~!'
111·t\g{· r~l\io, :\:l'!, :\:,:t .\1'1' fll.\CJ Illjlllll,l\'('I, ,>1:1
,1"II;t-!II',lgi'lg i",IIIIIII<'II\.(\ \',lIi,l"k, (1\')
11l'(l'l"og('IU'Olis ill\·(·.,\{, 'J"~. :{ I H, :~:\:, • ('gn""';tllI, :'.11, :11 :1, ,1\).\, '.'27,
1,,'1(', ",k('daslicil),- alld :':~:1
;111( )("H"I"('I"I i( 1I1-("()J ISi~t('111 1I1 .. lnlllH'lIh,·117. :'~N
"';1111\;11,1 ('I'I'OI'S, 1:111, 17·1, :!liH, illlt'gLII('(\ l ;i\i{l :11 III1Hll'1. ,11',1
:~I: ~·1 inh'u"t I,'t~', .'·n· cuupon hOlld ....
I It 'It '111"'1...,·( 1.1,,1 it i1\.( Illbi:-.h'll t cli"t)!llI! 1,,,"cl ... luln-;lId ra(('.
(·.'I:III.IIIH', :) I inh'l ( ..... , 1.11(' II InT.,sls, ~horl·It'rnl
ill,lel"1I 1;11('1, ,11,1 illicit, .. , I.\lt·. 1(,lln SIIIU:III1(' 01
Ilid k11 nllil.', ,>\,1 ililert'S1 1;11('" \ i('ltl 'IHI';III,
i",I,lIie,tl \'"L!lilily, :17H I i,kk" ;111<'1,"1 rail'
1/0-1,(,(, 1111 Hlel, ,\:.(i, ,lli,l. SI'I' 111,/1 illlt'I('~I·I.II(' IOI(T~I."I .... , ·IIN
I" ieill).: li,('d-ill(,(IIIII' d('rivati\'!' 11111'111;" 1'.11(' 01 1'('111111, ,101
.... (Tlll"ili('s 1I1lt'Ipol.llillii plllhlt-IIIS. ;)If;
1I"ldill).:-I"'1 ioel "'IIIi'll, :\\17 1111"11('1111"" ,il (:,ll'il.ll ;\",'1 1'. irin).:
1\1 ~I\\\ )~~\,t 1.\:,\ if ~\ng\c·L;\\"tt)\" ~lo,k\ (ll::\1't>.I), '21\1, '2:11, :!\IL
11'[ 11l-\1I"tlct 1I11' Iliodel, '1~~J. ·If,!!, ,'iI'(' (//.\(1 { :.Ipil~" :\~S('I PI it iug
-i:",1 ~llIdl·1. 1I11t1lil.u lUI" IlIud('l..;

11"'('liillf! Fe ,'I,lli,'II', :1:1:1 illlcrtt'lIlpt)l.d 11l;II"gillal r;lI(' 01

Ilsi .. h It',sl or nOlllill!'al'ily, ·17 r• ~lIh"tillllioll, ~~H
111111 ,IIHI Whil(' ,11I('h,ISI;" \'ol.tlilily 1111('11('111\,01,11 "1("lillll;1I1I dk<t,
IIltHld, :IHO :1:1 I, .\"1' f//III ('iaslil'ily of
111Ir.,I-,\i;,lIddhl'Ol r('sc,lied rang(, illl(""'llI!,oral,"h'lilttlioll
:-ot;llbtic ,)"('1' Il' .... ctlied LlIlgc: iliH'slol 11('1('J'ogl'ttl'ilY and, :117
";I.!listie III ('gllbll\' "'lIIl'k,1 ,Lila, :Iti:\
l\\lH.',h.I:-ois 111l\( 1io\\:-.. :)\7 {SF. \'stin\'\lol, :,0;1
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II~ sl:1I isl i('s, ~71
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likelihood fltlKlioll, :lli:!, ',:17 . .\1'1' ii/II' I""khack opliollS, :N I
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o lik.-lih"",1 ratill It'sl, I ~I:I
I li'l"i,Iil\' dr"(',,, .lIl r • 1I1:I('allla(s dllralioll, -10:1
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log ri('hl, :1!/7, :I!I'I, IIIX. S,',' ,till' lil'ld hid-ask hOlillce, IIl1l1sYII('hroliolis
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('slilllalioll nllHlilioll:11, 'I!I:I
l"gi.'li.- !'tIIlClioll, 'd:1 lI,ark"1 I'ortfillio, 1:1", IHI, :I:!:I, ·I!I:.
IIJ~i'lk 111"1'. :,'.!;. '11.1I\..o\,l'loaill, :IH, HI, 1,1:.
M~lIko\'process, 3:,7 Monte Carlo simulation methods,
Markov-switl'hillV; modds, '!7'2 :HO, 382, 386
martinv;ale, 2H, '2:,() antithetic variates method, 388
martinv;ale convergellce thcorem, comparisons with closed-form
.Ill-! solutions, 384
ilia I tingall' pric"ing t(·chniqul'. :,:,.! computational cost, 386
In~lIurity, 3!1(, control variate method, 3R7
ltIaXillllllll ('orn:latioll portf,.lio, 29H. nude Monte Carlo, 3R6
.'iff aLI" IlanscnJav;ann<lthan discretiJation, 383, 3R5
mlatility bound efficiency, 386
II.axinllllll likelihood, 7 importance sampling, 3H8
In~lxinlllm likelihood estimatioll, limitations, 390
:\:.H, :,:~6 IlIl1llher-theorelic method, 38H
;ls)'IIl)llOtic distrihutioll, :.:,H path-dependent option pricing,
('"ltinuous-record asymptotics, 3H2
:-\Ii.! stratifird samplinv;, 3HH
factor analysis, 2:H variallce-reduction techniques,
(;AR( :11 lIlodels, 487 387
illfOfltl:tlioll matrix, 53H mortv;age-backed securities, 406
illf •• nllatioll-matfix cquality, ,.:-\!I lIlultifactor models, 219, 324. !Su (Ill"
I
inq~ularly sampled data. 3(,:, Arhitrage Pricing Theory, exact
oplion prict', 3li7 factor pricing, Intertempor.tl
'I'""i-maximllm likdihoo<l Capital Asset Pricing Model,
l'stimation, :.39 selection of factors
st<lChastic difTerentialeqllation, Hlack version of the CAPM"1224,
:~:.7 229 I

Whitt' specification test, :,:-\!} cross-sectional regression

lIll'all reversion, R9 approach, 222, 233 \
llll'all-V;lriance (:fficient-s<'t empirical studies, 240
1lI;ltlll'matics, IH4, 2·B, '2!lH Epstein-Zin-Weil recursive utility
gl()ballninill1Ull1-\'f.\riance model,324
portfolio, I W" '217 eSlimation of expected returns,
Ilansell:Jagannathan volatility 231
houlld,2'JH estimation of risk premia, 2~1
minilllum-variancc frontier, I Wi factor portfolios spanning tile
Sharpe ralio, IHH mean-variance frontier, 22R
tangcncy portfolio, I HH, I !JG, 21 H Generalized Method of Mor'enL~,
{('ro-Ilt'ta portfolio, 18'2, IW., 21 H 222
m-historil's, 112 Ilotelling 'rl statistic, 232
mixe(1 distribution, .JHI macroeconomic variables as
mixture of normal distrihutions, 'IHI factors, 226
MI. estimation. Sf' maximum portfolios as factors, 223
likelihood estimation term-strttrture models, 440
M1.1'. SI'I' multilayer perceptron multilayer perceptfOn (Ml.P), 512
modified duration, 40!l_ Srr al.l{) multiplicative linear congruential
duration generators (MLCG), ~'2:)
nIOIII('IIt conditions, 3:,9 multipoint moment conditions, 361
(j(}!j ,'iubj,.,.t 11II1t'.'(

~
IIIlIltiqlladrit-s. !i 17 l'llIpiril'allimli.i).:,. 12H
IIIlIlti\'ariatl~ (;ARCII n\(ull'ls. -1\10 nontrading prOl'l'''. I,I!',
llIultlvariate st"r!l;Istir-v"latility nonlraclin~, S"" nons),'lI'hronolls
ll!o!ll'lS, 4\,:1 tradin~
11 ....111,,1
distribution, 1;,
1
Nadara}'a-Wal,oll kernl'l estilliatur. 'llnnher-tilcorctic nll,thod. :IHH
51)!)
olh-r, S",' ask price
IIl'\\\,\,rk lUpolo),'Y, ~, H
optilllal ortho~ollal portlolio, 2,1:1.
Il<'t"'I'l'ks, f, Il!. S"" tllw learnin);
~-I;), :!'HI . .'i,'" ilL\/) l'xan i'ano,.
Ilf(\vorks
pricin).:
nCllqllnclworks. ;,Il! . .'iPl'IIL",
option pricing, :I'I!I
Idarnill)( networks
al!jllstillg tIl(' lIIark-Srholt-s
Nl'wqy-Wcstestilllator, [,:{!i
li,,.lI\ula lill' prcelit-tahilit),. :Ii!',
1It'\\,s:i"'pact CIIrvc, 4X!i
111;II'k-Sch(lk~ ancll\ll'rtoll option
II-hi'lmit's, 47(i
pril"i ng- modd. :\;,0
nO-oll!hitraKl' collditioll, :\:19
Black-Scholcs formllla, :171, :17:1
'lOisl' traders. 317
disnl'lc-tilllt, lIIodl'ls, :IHI
lIominal bonds, 442
estimator for (J~, :n'l
lIominal stochastic discolIlII factor,
illcompkte markt·ts, :1!I2
'1-13. Spr tlllO sto(\lastic disl'ount
martingale approach, :1!'l'I
lac lOr
lIlaximllm likdihood estimatioll.
nonlille"r ARMA nlodc1s, 471
:lIi7
nonlincar ,autorq~rcssi\'c models,
1I0nparalllctric lIIl'thods. :1!I2
471 1'''lh-<lepl'lItll'1I1 oplions, :IH:!
nonlilll'ar dynamical S)'S'l'IJlS, -17:t risk-IIl'lItral pricill); 1Ilt'.hocl. :\H~
S" tiL", dctertllillislic lIonli'l<'ar statl'-priet· dt'nsitics, ;,O!I
d)'lIamical s}'stellls option scnsitlV\(ics, :\!):\
nonlinear-in-mean time-series onlt-reel pmhit modd, 122, I :lli
Illodels, 41i9
maxillHlm likc:lihood estin.ation,
nonlilll~alcin-variance timc-snies
127, 141
lIIodels, 4(i!1
Ornstl'il\-l1hlcllhl~(k Ilion'". :lliO,
nonlinear least sqllares estilllation. :17I,4:H
:,1:" ;,IH onho).:onality condition, !',2H
nonlinear llloving-m'l'raKI' Illolkls. OItllO~ol1ality tests, 271i
,lti!!
O-U process. S"I'
l1onlinl'ar tirnc·st'ric"s analysis. '1(iH
()nlStl·in-Uhll·nh,'ck I"'"''''
lIolllinearity h"till)(. S,'p testill): h,r o'lIp"tla),l'r, :,1:1
nonlincar strllelllrl' "\'l'rlillin~. ,1!lH, ;,2:\
nonparametric cstimation, 4!'H. ~,I"
IInivcrsal appn,ximatioll propl'rty. par. -101
;,1;, parallel prorl'ssin~, ;, I!',
nOllparanll'trir option f'ricin~ paraml'tric 0l'tion-pril'ill~ lI11llld.
mcthods, :HO. :192. [II 0 :1-10, :1;,li
nOllparamcllic lesL<, 172 path-dl'JH'IlI\cllt dni\'ali\'l's, :\-Ill
nonpcriodic cycles, li3 l"'th-c1qH'I\(\cllt optiolls, :1,10. :IH2
nonseparabilit), in utilit}" :{2Ii I'EII. S,'" I'lIrl' "xpl~rtatiom
nOlls},lIchronolls tr,((ling, H,I. 177 hYl'othl'sis
 li07

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11/.\/1 (kli,,-h("d~ill~ slral!').,')" illll'l-"-"lilll'" -117
IWI C"nll,lIl<-" ",-;lIl1,\\iotl, {H:I l\l~ 1"111' n'I'I"' 1"lioIlS hYl'ollwsis.
1H'IIIl'lIJ('1I1.,hurk, (;:). ,""n' u/.\O lInil -II-I
nH.1 pl't'''''", I"d,·",-d 1t •• hil .• I,. -IIX
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p"'" I'rohkll', :110 (2-Sl.lIisl;" \i
"i .. ( l'wi",·li,I" .... Illodds. ·172 'I" ... I.-.. Ii .. 101"1. :,:!H
pbill '-;II,ill" opliollS, :1-1\1 'I" .• dl,'li( (;,\({( :lllIIodl"l, -1~17
i'lliIIClI(" .~l·( lioll. ·Ii:, '1'1.lSi.",."i""111 lik,'liituod
"o\\"lIo'lIi,,1 II lOd <"is , 47 ( ,·slilll.,lio", -\H\I, :,:\\1
"o'lli,lio " .... Ionllall("" n-;tillalioll,
I WI /(' '1 .. 1i_,"(. '271
1'''''-''' IIlilill-, :10:" -t:\-( , .. dL" t. .. si, I 11111"1 iOlls (RHFs), :>I(i
i'I'R_ .\,." p"'i"ni\lll l'"r'";1 r .. illt.ow ol'liollS, :\\11
rl').~n·.,;..i('11 ralidolH 1It1luht'r ~l·lIt'ralors. :)!![,
1""Lllllioll;lI)" s'lI-ill~S, :110, :1:11 1;111<10111 walk, 27 . .\", II/.I<I
I" .. <iin;lhilil\" or _,lock r"llIrIls. '27. long.hori/on 1l'ltlrns. lon~·"lllgl"
'2lli d"l"'III\("II"I'. Random W.llk {
IIIa .. k-S .. h"lt-, Ii .... II lila, :171, :17" "."clel. Ib,"lo", Walk '2 lIludd,
(:.lIl1pb,",I·( ;ochralil' ,,",,11'1. :1:1'2 Itlllcl"lII Walk :1 lIlodei. I{'chllical
dilj,klld-I'rin' ralio. '2(;H .\1\;\ly~is. uHit root pl'(}n.·ss('~s.
r;lIio"al hllhhks. '2(;0 \'"ri;IIlCt' c1iff<,'n'lIu.', variance
lill"'.\" .. rri"~ risk·av"rsio". :1:1'2 lalio
I'r"kn('d hahilals, ·11)-\ , 0111 illllolls-I ill,,' limil. :\-\·1
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,itl.,l("l"illg, 10\1. I-I:. '·IIl!'i. i, .. 1 ("Vid('11t (', (i;.
di,,-O\-(·r)". 107 R.. lldolll Walk I IIIU(kl, 2H, :1 I. :I:~
distT"I"lll'SS, 1m), 1-1:1 II-slalislics. :\.\
,,~·di\"idend, 1'2 , .. lIo"i.-.. 1 ,01 rl"lalioll, :1·1
illll"" 1.107,1-1:1 (:owlcs:)ol1('S ratio, :\.r,
lirk,. IIIX l·ig<'IIV.dul· .... of IIH' ("ova.-ianc<'
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pi ir('-l"ulIil1g-S-IOIlio ('H<.'ci. ~II KI""d .. 11 r "0' rl"lalioll Il'sl, :\·1
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prillriplt- or illl"'l1 i,III("(', :lIi7 '"'1' 1\'_'1. :IH
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\';11 iall ... · dill""'11I ".1.11 idl" ,. I i.,k avt'l'sioll
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,,()IIIII;IIlII',1I1 'Llli'li, '. Ii Illoel.·h, :I:!'I
I;IlIk I\'sl, '7~ F'I"il), 1'1"llIilllll I'll II Ie , :101'. :'.~:',
I'atiollal """hll'S, ~r.H :I:!~I
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l't'glll.lIi/al iOIl. rd Ii, r.~~ loss ;I\'(TSioll. :\:1:1
l('pli(,;llill).: portlolio. :1'.:1. :IHII. :I~II s",.aralillg ri"k an'r,ioll fro II I
n'pli"alioll ill \10111<' (:.1.-1" illtt'l'l"lIlpor;aI ,"I"titllti,,". :11
sillllalatioll. :IH:I tiI1H"\'ar\'ing, :1:10. :1:1'.
rc'IJI ('S('J1I;11 i\"(, .tgc'lIl IIloch·I..;. :?~):? I isk paiel's, :I:!:.
:10:1 I isk'III'lIlraloplioll pi i('illg IIWilllld.
,,(',\calcd range SI.lli"i,. (i~ :VI·I, :170, :IH:!, :111'1
I'(·tll ... I', :!:.I I i,k'III'\ltr;1I prit'illg 1lt-II,it\', :IOX
aIl11ll;llill'd, 10 ris"'IH'''tralil)" :I:"!
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(:.III('h\' di,,, illlilioll. IH li,k'I('llInilradl'tlll, 1·1, IHI
<"<lIl\pol\l\d, 10 ri,k·s"aril\~, :1 I H
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di""""I<·III'.", 1111 :11 11, :I:!H, :rll
dis"",'I<'III'" hi",. I IIi rollill).: standard dl'\'iatioll, ·11' I
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fUl'l'Clstillg I ('lUI U"'. '.!tiX RIS stalistil' . .\"" 1("St'",,-, l 1 ~l1\~t'
gn ',". ~) s1a1i . . tic
holdi1lg-pl'l ioell "111111, :I'IH RWI IIlud.·1. S,·,· R.llldllill W,IIk I
i1l1l<,\)(,lId"11I1r .11111 idt'1IIi, ;111\- lIIudel
di,,,i!.I1I1·" (1I1l). I:. R\\".! lIIo.k!. 'il'l' R;lIIdlllll \\';alk '~

ioilll .li,,, illillioll, 1:1 lIullleI

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'Ia"'" di'll illlllioli. I', "tile.' \'C.'('tol", ;,:\7
IIIII'OIl<lilioll;a! di'll iI1111 i,,". I'. SI )~1. .'i/'" st""'-dq"'lIdl'lIt 1II0.kl,
IIm'xp,,('\t'" "",,·k It· II II ",. '2til. "'1'\11 it\' III;Irk.'1 \illt .. 1·1
:!KI ,"','('tioll 0' bn"rs. :!:l:1
 uv~

cross-sectional ~eneraliJ.ed IC<lst stable distribution. 17

squares (Gl.S) , 23!) standard Brownian mOlion, :H4. S«
data-snooping. 240, 24(), 251 tllw Brownian motion
bctor analysis. 2:H statc prices, 295, 507
principal components. 236 state-i.lependent models (SDM), 470
IOtOltion'll incietcrrninacy, 234 state-price density (SPD), 507
strict factor structure. 234, 2:19 slationary time-senes process, 484.
st'lI~t'xciting threshold Su also unit root process
'llllOJ"egression (SETAR) models, stochastic approximation, 515
470 stochastic differential equation, 346,
sell~lillancing portfolio, 339, 351 356
s"qlU'nces and reversals, 35 GM M estimation. 359'
st'l"ial con-dation, 44 lto's Lemma, 348
SETAl{ models. Spp self-i.~xcitin~ maximum likelihood estimation,
threshold autoregrcssion 3!)7
(SETAR) models multiplication rules, 347
Sharpe ratio. IHH, 24:).247. :lOO stochastic discount factor. 294, 427,
short-term intercst rate, 430, 44~l. Sft 429. 8't also Euler equation
11/.\1/ discollnt bonels. riskless erJllity premium punle. 302
illl(·ft·st rate habit-formation difference
(;t\R( :11 d'f(ons on mlalilily. 4:)2 models. 331
re).\illw-switching-.4:11 Hansen-Jag-annathan volatility
sholbaks constr.lints, 31:. hound,296
'ign t('SI, 172 nominal, 443
,i,,- ('fI"n, 211. 4% non negativity. 295, 301
si,,'-sOlwci portfolio. 70, 7!i. 129 power utility, 309
sk,'wll('ss. 17. HI, 17'2. 49H. ,'iPf ilL\() state-price density, 508
I cturns un irJllencss, 296
SIOI'I' "stimators, 50!) stochastic trend. 65. See auo unit
slIlall ,tocks, :! I I. 4!)(, root process
"llOOI hillg, 4!l9, 517. Sa I//.m kernel stochastic-volatility models. 379,489.
rl'~n'ssion 4~1:{

,,,I\,I'llcy constr.lint, :~ I:. multiv'lriaH" 493

'p'lI\lIillg, :mo, 3~1l slratified sampling, 388
SI'D. Srr stale-pric(' ciellsity strict factor structure, 234, 239
specilicuioll tests strike price, 349
Ilallsl'll's tcst, 531 STRIPS, 39()
Whilt· I('st, 53!J slrohoscopic map. 475
sl'lill" ('slilllalioll, 410, '112. !) 17 slruclural hreak.~, 472
1'''I'OII<'llli,,1 splinc modt'!, '112 Stll<!t-n(-( distrihution, 210, 489 i
tax-;uljustetl spline model, 41:! substitution effect, 321, 331.Set aho
'pot rOlle, 414, 417 ela.~licily of inlertemporal \
spread. Sl'r hid-ask spreaci. yield sui>srillilion I
spr('ad supershares. !)()7 I
spn'ad-Iock illterest ratt~ swaps. 391 support and resistance levels, 4:l '
'«llan'-root single-factor surplus comumption ratio, 330 •
1,'J'In-Sll'llcture model, 435. 454 survivorship hias, 311. Sf'(, auo
 Ii 10 ,'illbi('('/ /111/(');

sample sdeclion hiases Iln)('k-lkchert-Sch('inklllall II'SI.

S)'II Ihelic com'erlible bonds, :m I -17H
Iisieh (('SI. ·17:,
'Isa), lest. 471i
lail Ihickness, 4HO
Theta. :If,:l
(aX .-ii('nll'll', -111[,
thn'shold, 472
lax-.u!;USl('cI spline modd "f Ihe
threshold aUloregression (TAR), ,172
(crill struclure, 41:1
lillie aggregation. !}1. 12!1
ledllliral anal),sis, 4:l, Spp IIllO
lillie inconsislcncy. :tH
Random Walk 2 moclel
tillle-nonseparabilily ill Ihe ulilit),
Il'mpnrary shock, !i!'" ,'i" (It.,O unil functioll, 327, :tm, Srp ullll hallil
rool process
"\\'Inalion modds
l('nlmOlp, 0174, 47(\, 52:,
. Iran' operator, 74
ll'rnl premia, 11 H Trades ancl Quotes (TAQ) dalaha,,,',
lerm strUclure of implied volalilily, 107
41i:l trai1\il\~ a It.'t\r1\in~ 'H.~twurk, !) I r,. r) I X
(('rill slrm:lurc ofillleresl ratt'S, :1!17, Irailling palh. [,I!I
St'P tllw yield curve, Icnll-strtl('Wn' Iransat'LioJls t'OSL"'I, 1t1!",
models, expectations h),potht'sis, lransanions dala. 107, 1:1fi
pure expectations hypothesis trallsitioll densit), fUllnioll, :I"H
(OiQlegralioll,419 Tr('asury S('curities, ~!I:,
((lI'~C<L~lin~ illlcrcsl rates, 'IIH STRIPS, :I!lIi
s!,lihe eslimalion, 4]() Trc;\s\ll)' bills, :I!)(i
tax CnCCl~, 111 Treasul)' nOles ,\tid 1I<IIIIls, :I'lli
\'e(,ior autore~ressiv(, (VAR) wh('II-i"\I('d lIIarkel. :I!I!I
~nethods, 42:1 /,no-('olll'0n yield nil \','. :1!17
(('nll-s,trut:lurc lIIoclds, -127, Sf(- (I/,W Irl'nd-stationaIY procl'ss. ti:J, :\i~ . ."i,',.
Iix~cI-i"comc derivativc securities (11m ullit root process
a/'lil\c-yicld models, 12H, -141, 1,1:, tr(,lIc1illg OnlSl('il,-Ullklll)('ck
1 ,
C()~, In~('rsol1, and Ross lIIodd, pro('ess. :171
f3!i 'Isay wsl of Ilolllinearit)', '171i
c1'<11s-seclional I'eslriniolls, -1:,2 tw,.-!;"'Ior I('nll-slr\l(lure 111<1(1<-1, ,I:IK
lixdl-income derivative secmilit's, Iwo-slage least squart's (:!SI.S)
4f,:, estimalioll, f,:10
II ..-~.ec modt'!, 4[,Ii, 4(i.1, St't' 11£111 var"i&\11Cl'-('(wariant:c Iltalfix, ;,:\ I
i)ricin~ fixcd-incOllle dnivati"c lognormal asset pricillg 1110<11"1
1l 't:lIrities with pow('r utility, :1 I !:!
~,
hOI~HlskecliL~lic singk-hlt'lor
,.~ unil root process, ().t. 1,257
~lIoclel,129,1f'2, 4f,7
;;. I.... m slrlll'lllre ofillien'si ra(('s,
la(('ill-variable \llodels, 'lolll
,II!)
LOII~sIOlI1:Schwanllllodcl, '1:11l
volalilil), profess, '11l'1
s'llIal,(,-l'IIol sillgl('-I;lI'lol' lI,o,kl,
volalilily I('sl.~, '277
4:1:1, ,1:"1
ulliversal approximation propenl"
stochaslic c.IiscounllilClor, '127
f>1 f,
IIv(.-filctor moclel, 4:lH
Vasicek mocld, 4:1-1 VAR IIII'lh"ds. Spt'venor
(('slillg for no"linl'ar sl 1'111'1 lin' alllorq.:n'ssi,,1' mel hods

t
I
SIII,jI'(/ flllit'x Iii I

"a,i.III"", I:" 17 '"C )l.llIlil~ ."fllil"s,:J I:!

"a,ianc('-i>""11<1s I,'sls, '277 \'(Ilalili,,' I('sl.', '27:,
,a,ian('(' dilkn'IICl', S",' "a,ialln' lillilc-s.lIllplt' ("(JlI . . ich·l".tlicJlIS. :!71'\
ratio Ma"il alld ~I('IIOII \lIodel, '277
\';I,i;IIIC(, iIlC'l".llil)" '27ti ortho~CHI,,\ity h·~\s. ~7t)
\'.11 i"I)("" .-;lIi", ,IK, liK uni\ \00\'\, '.!.77
lUl\g-hol If.(H\ l"l'gn.·~si()l\s,
272 \·~lli;'lIHT·htHttld..; It· .... IS. '277
Itllld"111 Walk I Illodcl, 'I!l V"it"11;1 s('ril's, ,171
Itllld"," Walk :IIllOd('l, :,:1
";I'i;IIICl'-I>""nds Il'sls, '277 W,dd 1(,,1, I~I:!, '2KI. :,:1\1
,'a,iallcl'-r('dllction I('rhniqlll's. :lH7 1I'('igill I 1111<"1 iOIl , :,00
Vasic('k Illodd, ,1:1'1 \\'('ighlillg tllallix
\'Eell Inoll('), ,)\)) (;~1\1 <'slilll;lIioll, ;.:1'2, :,:H
H'I" "1><'1;lIor, ,I\)() I\' :,'.!.K, ,,:I()
(',I i Illal iOIl,
"TIllr ;1Il\()H'gn'ssi\'(' (VAR) \'\'hilt· nOls\', :\.1(;
I1H.'thocis Whill' 'I'<'cilkalioll I('sl, :,:1\)
1I11i1tipc'riud Itu ('("a."its, ~H() "'il'lIe,'!" pron.'ss. :\·1,1. ,',;"" "lw
I" l'Sl'nt-\'altll' 1'C:I.ltiou . . , ~7~) arilhlllc,'lj(" BI oWl1ian 1l10lioll
I',i("(' H,lalilil)" '.!.KO I\'il<l card oplioll, 'I!i!)
Till .... n,l.lli)il)", '.!.~H Wi"han di,,,, ihlllio", 1!)2
\''':~,I, :1',:1 Wold Rq)H''''llt'lIiulI Tb,'un'Ill, ·lIiH
,,,l.llilil\'
Ikl(,llllilli,lic, :17'1 \'i"ld , III "', :\~17 ,t:I:!, ,I:\H, ·1-10, Sn'
hi,lmic;d, :17K ,,1\0 1('1111 sll tleilIl (0 "I" inll'rl'sl
illll'li,''', :177 I;ltt· ...

,IIl,'il;"'1 ic, :17K, :IKI), 'IK~I, ,HI:I I il'ld 'I" I'ad, :1!)7, ,11K
\O,I,IIi1ill' 1','lilllalioll, S"I' ARCII lid" III III.IIII1;ly, :1117, ,1111
1111,,1<-'" (;AI{( :11 \lIeldels,
,'I< H'h, .." ie-I'I ,I,ll ilil)' III< ,tid, Il'l 0-1,,'1;1 .1....... (·1. '.!~'·I
,,,I,llili\1 Ic('dh<ll''', ,1\17 It'ltl-fPllPi))\ IUHlIls. :\~H;

,.,