Lecture Notes in Empirical Finance (MSc, PhD

Lecture Notes in Empirical Finance (MSc, PhD)
Paul Sderlind1
16 January 2015
1 Universityof St. Gallen. Address: s/bf-HSG, Rosenbergstrasse 52, CH-9000 St. Gallen,
Switzerland. E-mail: Paul.Soderlind@unisg.ch. Document name: EmpFinPhDAll.TeX.
Contents
1 Econometrics Cheat Sheet 5

1.1 The Variance of a Sample Mean . . . . . . . . . . . . . . . . . . . . 5
1.2 GMM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.3 MLE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1.4 Testing (Linear) Joint Hypotheses . . . . . . . . . . . . . . . . . . . 19
1.5 Testing (Nonlinear) Joint Hypotheses: The Delta Method . . . . . . . 20
A Statistical Tables 24
B Data Sources 24
2 Basic Asset Pricing Theory 26

2.1 Three Pricing Principles . . . . . . . . . . . . . . . . . . . . . . . . 26
2.2 Stochastic Discount Factors . . . . . . . . . . . . . . . . . . . . . . . 28
2.3 Beta Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . . 34
2.4 Risk Neutral Distributions . . . . . . . . . . . . . . . . . . . . . . . 42
3 Simulating the Finite Sample Properties 50

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
3.2 Monte Carlo Simulations . . . . . . . . . . . . . . . . . . . . . . . . 51
3.3 Bootstrapping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
4 Return Distributions 61
4.1 Estimating and Testing Distributions . . . . . . . . . . . . . . . . . . 61
4.2 Estimating Risk-neutral Distributions from Options . . . . . . . . . . 78
4.3 Threshold Exceedance and Tail Distribution . . . . . . . . . . . . . 84
4.4 Exceedance Correlations . . . . . . . . . . . . . . . . . . . . . . . . 92
4.5 Beyond (Linear) Correlations . . . . . . . . . . . . . . . . . . . . . 92
1
4.6 Copulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
4.7 Joint Tail Distribution . . . . . . . . . . . . . . . . . . . . . . . . . 106
5 Predicting Asset Returns 112

5.1 A Little Financial Theory and Predictability . . . . . . . . . . . . . . 112
5.2 Autocorrelations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
5.3 Multivariate (Auto-)correlations . . . . . . . . . . . . . . . . . . . . 124
5.4 Other Predictors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
5.5 Maximally Predictable Portfolio . . . . . . . . . . . . . . . . . . . . 133
5.6 Spurious Regressions and In-Sample Overfitting . . . . . . . . . . . . 134
5.7 Model Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
5.8 Out-of-Sample Forecasting Performance . . . . . . . . . . . . . . . . 142
5.9 Evaluating Forecasting Performance . . . . . . . . . . . . . . . . . . 143
6 Predicting Asset Returns: Nonparametric Estimation 150

6.1 Basics of Kernel Regressions . . . . . . . . . . . . . . . . . . . . . . 150
6.2 Distribution of the Kernel Regression and Choice of Bandwidth . . . 155
6.3 Applications of Kernel Regressions . . . . . . . . . . . . . . . . . . 160
7 Predicting and Modelling Volatility 163

7.1 Heteroskedasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
7.2 ARCH Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
7.3 GARCH Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
7.4 Value at Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
7.5 Non-Linear Extensions . . . . . . . . . . . . . . . . . . . . . . . . . 187
7.6 GARCH Models with Exogenous Variables . . . . . . . . . . . . . . 189
7.7 Stochastic Volatility Models . . . . . . . . . . . . . . . . . . . . . . 189
7.8 (G)ARCH-M . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
7.9 Multivariate (G)ARCH . . . . . . . . . . . . . . . . . . . . . . . . . 192
7.10 LAD and Quantile Regressions . . . . . . . . . . . . . . . . . . . . . 198
7.11 A Closed-Form GARCH Option Valuation Model by Heston and
Nandi . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
7.12 Fundamental Values and Asset Returns in Global Equity Markets,
by Bansal and Lundblad . . . . . . . . . . . . . . . . . . . . . . . . 212
2
A Using an FFT to Calculate the PDF from the Characteristic Function 216
A.1 Characteristic Function . . . . . . . . . . . . . . . . . . . . . . . . . 216
A.2 Invert the Characteristic Function . . . . . . . . . . . . . . . . . . . . 216
8 Factor Models 220

8.1 CAPM Tests: Overview . . . . . . . . . . . . . . . . . . . . . . . . . 220
8.2 Testing CAPM: Traditional LS Approach . . . . . . . . . . . . . . . 220
8.3 Testing CAPM: GMM . . . . . . . . . . . . . . . . . . . . . . . . . 225
8.4 Testing Multi-Factor Models (Factors are Excess Returns) . . . . . . 235
8.5 Testing Multi-Factor Models (General Factors) . . . . . . . . . . . . 241
8.6 Linear SDF Models . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
8.7 Conditional Factor Models . . . . . . . . . . . . . . . . . . . . . . . 256
8.8 Conditional Models with Regimes . . . . . . . . . . . . . . . . . . 257
8.9 Fama-MacBeth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
A Details of SURE Systems 262
B Calculating GMM Estimator 265

B.1 Coding of the GMM Estimation of a Linear Factor Model . . . . . . . 265
B.2 Coding of the GMM Estimation of a Linear SDF Model . . . . . . . . 267
9 Consumption-Based Asset Pricing 272

9.1 Consumption-Based Asset Pricing . . . . . . . . . . . . . . . . . . . 272
9.2 Asset Pricing Puzzles . . . . . . . . . . . . . . . . . . . . . . . . . . 275
9.3 The Cross-Section of Returns: Unconditional Models . . . . . . . . . 280
9.4 The Cross-Section of Returns: Conditional Models . . . . . . . . . . 283
9.5 Ultimate Consumption . . . . . . . . . . . . . . . . . . . . . . . . . 286
10 Alphas /Betas and Investor Characteristics 290

10.1 Basic Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
10.2 Calendar Time and Cross Sectional Regression . . . . . . . . . . . . 290
10.3 Panel Regressions, Driscoll-Kraay and Cluster Methods . . . . . . . . 291
10.4 From CalTime To a Panel Regression . . . . . . . . . . . . . . . . . 299
10.5 The Results in Hoechle, Schmid and Zimmermann . . . . . . . . . . 299
10.6 Monte Carlo Experiment . . . . . . . . . . . . . . . . . . . . . . . . 301
10.7 An Empirical Illustration . . . . . . . . . . . . . . . . . . . . . . . . 305
3
11 Expectations Hypothesis of Interest Rates 308
11.1 Term (Risk) Premia . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
11.2 Testing the Expectations Hypothesis of Interest Rates . . . . . . . . . 310
11.3 The Properties of Spread-Based EH Tests . . . . . . . . . . . . . . . 315
11 Yield Curve Models: MLE and GMM 318

11.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
11.2 Risk Premia on Fixed Income Markets . . . . . . . . . . . . . . . . . 323
11.3 Summary of the Solutions of Some Affine Yield Curve Models . . . . 325
11.4 MLE of Affine Yield Curve Models . . . . . . . . . . . . . . . . . . 334
11.5 Summary of Some Empirical Findings . . . . . . . . . . . . . . . . . 347
12 Yield Curve Models: Nonparametric Estimation 353

12.1 Nonparametric Regression . . . . . . . . . . . . . . . . . . . . . . . 353
12.2 Approximating Non-Linear Regression Functions . . . . . . . . . . . 355
4
1 Econometrics Cheat Sheet
Sections denoted by a star ( ) is not required reading.
Reference: Cochrane (2005) 11 and 14; Singleton (2006) 24; DeMiguel, Garlappi,
and Uppal (2009)
1.1 The Variance of a Sample Mean
Many estimators (including GMM) are based on some sort of sample average. Unless we
are sure that the series in the average is iid, we need an estimator of the variance (of the
sample average) that takes serial correlation into account. The Newey-West estimator is
probably the most popular.
Consider a sample mean, x, N of a K 1 vector x t
T
1X
xN D xt : (1.1)
T t D1
If x t is iid, then
p
Cov. T x/
N D Cov.x t /: (1.2)
Instead, if x t is autocorrelated, then

T
X1
p jsj

Cov. T x/
N D 1 R.s/, where R.s/ D Cov.x t ; x t s /: (1.3)
T
sD .T 1/
Proof. (of (1.3)) Notice that for T D 3, we have
Var .x1 C x2 C x3 / D 3 Var.x t / C 2 Cov.x t ; x t C1 / C 2 Cov.x t ; x t 1 /C
Cov.x t ; x t C2 / C Cov.x t ; x t 2 /:
The general pattern is

T T
X1
!
X
Var xt D .T jsj/ R.s/:
tD1 sD .T 1/
Divide both sides by T to get (1.3).
5

Var( T x)
Var(xt )
20
15
10 Data process: xt = xt1 + ut
0
0.8 0.6 0.4 0.2 0 0.2 0.4 0.6 0.8

p
Figure 1.1: Variance of T sample average of an AR(1) series
Example 1.1 (Variance of sample mean of AR(1).) Let x t D x t 1 Cu t , where Var .u t / D

2 . Let R.s/ denote the sth autocovariance and notice that R .s/ D jsj 2 = 1 2 . The

asymptotic (as T ! 1 so jsj =T ! 0 in (1.3)) variance can be written

p 1 1
X 2 X jsj 2 1 C
Var T xN D R.s/ D D ;
sD 1
1 2 sD 1 1 2 1
which is increasing in (provided jj < 1, as required for stationarity). The variance
p
of T xN is much larger for close to one than for close to zero: the high autocorrela-
tion create long swings, so the mean cannot be estimated with good precision in a small
sample. If we disregard all autocovariances, then we would conclude that the variance of
p
T xN is 2 = 1 2 , that is, the variance of x t . This is much smaller (larger) than the

true value when > 0 ( < 0). For instance, with D 0:9, it is 19 times too small. See
p
Figure 1.1 for an illustration. Notice that Var. T x/= N Var.x t / D Var.x/=Var.x
N t /=T , so
the ratio also shows the relation between the true variance of xN and the classical estimator
of it (based of the iid assumption).
p
The Newey-West estimator of the variance-covariance matrix of T xN is
bov pT xN D X b
n
jsj

C 1 Cov .x t ; x t s / ; (1.4)
sD n
nC1
6
where n is a finite bandwidth parameter. The weights, 1 jsj =.nC1/, are clearly tent-
shaped: 1 at the zero lagand lower as the lags become longer. This is similar to (1.3),
but the weights decrease quicker (assuming n < T 1). This suggests that n should be
somewhat larger than last lag with significant autocorrelation. However, a common rule
of thumb is to use round n D floor.0:75T 1=3 /, where floor./ means rounding down to
nearest integer (an alternative rule is n D floor.4.T =100/2=9 /).
Example 1.2 (Newey-West estimator) With n D 1 in (1.4) the Newey-West estimator be-
comes
b
Cov
p 1
b b 1 b
T xN D Cov .x t ; x t C1 / C Cov .x t ; x t / C Cov .x t ; x t 1 / :
2 2
Remark 1.3 (VARHAC) The VARHAC estimator of the covariance matrix (see Andrews
and Monahan (1992)) is to first fit a VAR(p) to x t
Xp
x t D A0 C Ai x t i C "t
i D1
p
N D D 1S D 1,
Pp
and then calculate D D I i D1 Ai . Finally, the estimated Cov. T x/
p
where S is Newey-West estimate of Cov. T "N/. As an example, let x t be a scalar that
p
follows an AR(1) process, x t D x t 1 C " t . If " t is iid, then Cov. T "N/ D 2 where 2
p
is the variance of " t . D D 1 , so Cov. T x/ N D 2 =.1 /2 which is the same as the
variance in Example 1.1 (since .1 2 /=.1 C / D 1 ). See Tables 1.11.2.
: 0 0.375 0.75
Simulated 5:8 9:3 23:1
OLS formula 5:8 6:2 8:6
Newey-West 5:7 8:4 16:3
VARHAC 5:7 9:1 22:4
Bootstrapped 5:5 8:6 19:7
Table 1.1: Standard error of OLS intercept (%) under autocorrelation (simulation evi-
dence). Model: y t D 1 C 0:9x t C t , where t D t 1 C t ; t is iid N(). NW uses 5
lags. VARHAC uses 5 lags and a VAR(1). The bootstrap uses blocks of size 20. Sample
length: 300. Number of simulations: 10000.
7
D0 D 0:75
: 0 0.375 0.75 0 0.375 0.75
Simulated 5:8 6:2 8:7 3:9 5:5 10:9
OLS formula 5:8 6:2 8:6 3:9 4:2 5:8
Newey-West 5:7 6:1 8:4 3:8 5:1 8:9
VARHAC 5:7 6:1 8:5 3:8 5:4 10:5
Bootstrapped 5:8 6:2 8:6 3:8 5:4 10:1
Table 1.2: Standard error of OLS slope (%) under autocorrelation (simulation evidence).
Model: y t D 1 C 0:9x t C t , where t D t 1 C t ; t is iid N(). x t D x t 1 C t ; t is
iid N(). NW uses 5 lags. VARHAC uses 5 lags and a VAR(1). The bootstrap uses blocks
of size 20. Sample length: 300. Number of simulations: 10000.
1.2 GMM
1.2.1 The Basic GMM
In general, the q 1 sample moment conditions in GMM are written

1 XT
N
g./ D g t ./ D 0q1 ; (1.5)
T t D1
where g./
N is short hand notation for the sample average. The notation g t .) is meant to
show that moments conditions depend on the parameter vector () and on data for period
t . We let 0 denote the true value of the k 1 parameter vector.
The GMM estimator is
Ok1 D arg min g./

N 0 W g./;
N (1.6)
where W is some symmetric positive definite q q weighting matrix. When the model is
exactly identified (q D k), then we do not have to perform an explicit minimization, since
all sample moment conditions can be set equal to zero (as many parameters as moment
conditions).
Example 1.4 (Moment condition for a mean) To estimate the mean of x t , use
gt D xt :
There is one parameter and one moment condition: exactly identified.
8
Example 1.5 (Moments conditions for OLS) Consider the linear model y t D x t0 0 C u t ,
where x t and are k 1 vectors. The k moments are
g t D x t .y t x t0 /:
There are as many parameters as moment conditions: exactly identified.
Example 1.6 (Moment conditions for estimating a normal distribution) Suppose you spec-
ify four moments for estimating the mean and variance of a normal distribution
2 3
xt
6 .x t /2 2 7
6 7
gt D 66 .x 3
7
4 t /
7
5
4 4
.x t / 3
This case is overidentified (q D 4 and k D 2), so a weighting matrix is needed.
GMM estimators are typically asymptotically normally distributed, with a covariance

matrix that depends on the covariance matrix of the moment conditions and the mapping
from the parameters to the moment conditions.
p
Let S0 be the (q q) covariance matrix of T g.
N 0 /, evaluated at the true parameter
values, hp i
S0 D Cov N 0/ ;
T g. (1.7)
where Cov./ is a matrix of covariances. When there is no autocorrelation of the moments,

then (1.7) becomes
S0 D Cov g t .0 / , if g t is not autocorrelated. (1.8)
When there is autocorrelation, then we may use the Newey-West approach to estimate S0 .
In practice, S0 is estimated by using the estimated coefficients in the moments to get
O a T q matrix, from which we estimate the covariances needed for
the data series g t ./,
(1.7) or (1.8).
Example 1.7 (Estimating a mean, variance) The moment in Example 1.4 (assuming iid
data, so we can use (1.8)) gives
S0 D Var.x t / D 2 :
9
In practice, we replace the variance by a sample estimate. If we suspect that x t is auto-
p
correlated, then we may use the NW estimator of Var. T g/.
N
Example 1.8 (OLS, covariance) For the moments in Example 1.5, using u t D y t x t0 ,
we have "p T #
T X
S0 D Cov xt ut
T t D1
It can be shown that under the Gauss-Markov assumptions S0 D 2 xx . In practice,

replace u t by the fitted residuals and calculate a sample covariance. If we suspect that g t
p
is autocorrelated, then we may use the NW estimator of Var. T g/. N
Example 1.9 (Estimating/testing a normal distribution, covariance) For the moments in

Example 1.6 (assuming iid normally distributed data, so we can use (1.8)), it can be
shown that we have 2 3
2 0 3 4 0
2 4 12 6 7
6 7
6 0 0
S0 D 6 6
4 6
7:
4 3 0 15 0 7
5
6 8
0 12 0 96
In practice, we would use the point estimates in the moments and calculate the sample
covariance matrix. If we suspect that g t is autocorrelated, then we may use the NW
p
estimator of Var. T g/.
N
Let D0 be the (qk) probability limit of the gradient (Jacobian) of the sample moment
conditions with respect to the parameters (also evaluated at the true parameters)
N 0/
@g.
D0 D plim : (1.9)
@ 0
Remark 1.10 (Jacobian) The Jacobian is of the following format
2 3
@gN 1 . / @gN 1 . /

6 : @1 :
@k
7
N 0/ 6 :
@g. 6 : :
: 7
D6 : 7 (evaluated at 0 ).
7
@ 0 6 :: :
:: 7
4 5
@gN q . / @gN q . /
@1
@k
Example 1.11 (Estimating a mean, Jacobian) For the moment in Example 1.4
T
@ 1X
D0 D .x t / D 1;
@ T t D1
10
which is just a constantand does not involve any parameter values.
Example 1.12 (OLS, Jacobian) For the moments in Example 1.5

T
!
1X
D0 D plim x t x t0 D xx :
T tD1
This does not contain any parameters either, but includes data. In practice, we replace
xx by a sample estimate.
Example 1.13 (Estimating/testing a normal distribution, covariance) For the moments in

Example 1.6 (assuming iid normally distributed data) we have (the rows are for the four
different moment conditions, the columns for the parameters: and 2 )
2 3
1 0
T 6 7
1 X6 2.x t / 1 7
D0 D plim 6
2
7
T tD1 64 3.x t / 0 7
5
3 2
4.x t / 6
2 3
1 0
6 7
6 0 1 7
D6 6
2
7:
4 3 0 7
5
2
0 6
The second equality holds only if the data is indeed normally distributed. In practice,
we would use the point estimates in the matrix on the first line and calculate the sample
average.
Combining the previous results, we have that

p d
T .O 0 / ! N.0; V / if W D S0 1 , where
1
V D D00 S0 1 D0 (1.10)

;
which assumes that we have used S0 1 as the weighting matrix. This gives the most effi-
cient GMM estimatorfor a given set of moment conditions. The choice of the weighting
matrix is irrelevant if the model is exactly identified, so (1.10) can be applied to this case
(even if we did not specify any weighting matrix at all).
In practice, the gradient D0 is approximated by using the point estimates and the
available sample of data. The Newey-West estimator is commonly used to estimate the
11
covariance matrix S0 . When the model is exactly identified, then we can typically rewrite
the covariance matrix as V D D0 1 S0 .D0 1 /0 , which might be easier to calculate.
To implement W D S0 1 , an iterative procedure is often used: start with W D Iq ,
estimate the parameters, estimate S0 , then (in a second step) use W D SO0 1 and reesti-
mate. In most cases this iteration is stopped at this stage, but other researchers choose to
continue iterating until the point estimates converge.
Example 1.14 (Estimating a mean, distribution) For the moment condition in Example
1.4 we have (assuming iid data)
p d
T .O 0 / ! N.0; 2 /, so O N.0 ; 2 =T /:
Example 1.15 (OLS, distribution) For the moment conditions in Example 1.5
1
V D xx S0 1 xx

:
Under the Gauss-Markov assumptions S0 D 2 xx , so

h
1
i 1
V D xx 2 xx D 2 xx1 :

xx
Example 1.16 (Estimating/testing a normal distribution, distribution) For the moment

conditions in Example 1.6 (assuming iid normally distributed data) we have that the
asymptotic covariance matrix of the estimated mean and variance is then (.D00 S0 1 D0 / 1 )
02 30 2 3 1 2 31 1
1 0 2 0 3 4 0 1 0 " # 1
1
2 4 12 6 7
B6 7 6 7 6 7C
B6 0 1 7 6 0 0 6 0 1 7C
2
0
B6 7 6 7 6 7C D 1
B6
@4 3 2 0 7
5
6
4 3 4 0 15 6 0 7 5
6
4 3 2 0 7C
5A 0 2 4
0 6 2 0 12 6
0 96 8
0 6 2
" #
2 0
D :
0 2 4
In an overidentified model (k < q), we can test if the k parameters make all q mo-
ment conditions hold. Notice that under the null hypothesis (that the model is correctly
specified)
p d
T gN .0 / ! N 0q1 ; S0 ; (1.11)

where q is the number of moment conditions. Since O chosen is such a way that k linear
combinations of the moment conditions always (in every sample) are zero, we get that
12
there are effectively only q k non-degenerate random variables. We can therefore test
the hypothesis that gN .0 / D 0 by the J test
O 0 S 1 g.
N / O d 2 if W D S0 1 : (1.12)
T g. 0 N / ! q k;
The left hand side equals T times of value of the loss function in (1.6) evaluated at the
point estimates. With no overidentifying restrictions (q D k) there are no restrictions to
test. Indeed, the loss function value is then always zero at the point estimates.
Example 1.17 (Estimating/testing a normal distribution, testing) After having estimated

the mean and the variance, we can test if all four moment conditions in Example 1.6 hold.
If data is drawn from a normal distribution, they should (give and take some randomness).
1.2.2 GMM with a Suboptimal Weighting Matrix
The distribution of the GMM estimates when we use a sub-optimal weighting matrix is
similar to (1.10), but the variance-covariance matrix is different (basically, reflecting the
fact that the approach does not produce the lowest possible variances anymore).
Example 1.18 (Estimating/testing a normal distribution) Example 1.6 is overidentified

since there are four moment conditions but only two parameters. Instead of using the
optimal weighting matrix (the inverse of S0 from Example 1.9, assuming the data is iid
normally distributed), we could use any other (positive definite) 44 matrix. For instance,
W D I4 or a matrix that puts almost all weight on the first two moment conditions.
It can be shown that if we use another weighting matrix than W D S0 1 , then the
variance-covariance matrix in (1.10) should be changed to
V2 D VA2 D00 W S0 W 0 D0 VA2

0
, where (1.13)
1
VA2 D D00 WD0

:
Similarly, the test of overidentifying restrictions becomes
O 0 C g.
N / O d 2 (1.14)
T g. 2 N / ! q k;
where 2C is a generalized inverse of
0
2 D A2 S0 A2 , where (1.15)
1
A2 D Iq D0 D00 WD0 D00 W:

13
Remark 1.19 (Quadratic form with degenerate covariance matrix) If the n 1 vector
X N.0; /, where has rank r n then Y D X 0 C X 2r where C is the
pseudo inverse of .
Example 1.20 (Pseudo inverse of a square matrix) For the matrix

" # " #
1 2 0:02 0:06
AD , we have AC D :
3 6 0:04 0:12
1.2.3 GMM without a Loss Function
Suppose we sidestep the whole optimization issue and instead specify k linear combina-
tions of the q moment conditions directly
0k1 D
A g. O ;
N / (1.16)

kq q1
where the matrix A is chosen by the researcher.
Example 1.21 (Overidentified example: estimating/testing a normal distribution) Exam-

ple 1.6 is overidentified since there are four moment conditions but only two parameters.
One possible A matrix would put all weight on the first two moment conditions
" #
1 0 0 0
AD :
0 1 0 0
It is straightforward to show that the variance-covariance matrix in (1.10) should be

changed to
V3 D VA3 A0 S0 A00 VA3

0
, where (1.17)
1
VA3 D .A0 D0 / ;
where A0 is the probability limit of A (if it is random).

Similarly, in the test of overidentifying restrictions (1.14), we should replace 2 by
0
3 D A3 S0 A3 , where (1.18)
1
A3 D Iq D0 .A0 D0 / A0 :
14
Example 1.22 (Estimating/testing a normal distribution) Continuing Example 1.21, we
have that A0 D0 in (1.17) is
0 1 1
B 2 3C
B
B" #6 1 0 C
C " #
B 1 0 0 0 6 0 7
1 7 C 1 0
VA3 D B D :
B 6 7C
B 0 1 0 0 6 2 7C
B 4 3 0 5 C
C 0 1
2
B
@ A0 0 6 C
A

D0
Example 1.23 (Estimating/testing a normal distribution) Continuing the previous exam-

ple, A3 in (1.18) is
2 3 2 30 1 1
1 0 0 0 1 0
6 7 6 7 B" #C " #
6 0 1 0 0 7 6 0 1 7B 1 0 C 1 0 0 0
A3 D6 7 6 7B C
6
4 0 0 1 0 7
5
6
4 3 2 0 7B 0
5@ 1 C
A 0 1 0 0
6 2

0 0 0 1 0 A0 D0 A0

I4 D0
2 3
0 0 0 0
6 7
6 0 0 0 0 7
D6 7:
6
4 3 2 0 1 0 7
5
0 6 2 0 1
3 in (1.18) is therefore
2 32 32 30
0 0 0 0 2 0 3 4 0 0 0 0 0
2 4 12 6 7
6 76 76 7
6 0 0 0 0 7 6 0 0 6 0 0 0 0 7
3 D 66 3 2
76 76 7
4 0 1 0 7
54
6 3 4 0 15 6 0 7 54
6 3 2 0 1 0 7
5
0 6 2 0 1 0 12 6 0 96 8 0 6 2 0 1
2 3
0 0 0 0
6 7
6 0 0 0 0 7
D6 6 0 0 6 6
7
4 0 7
5
0 0 0 24 8
Example 1.24 (Estimating/testing a normal distribution) Continuing the previous exam-

ple, we have that the test of the overidentifying restrictions (1.14) (assuming iid normally
15
distributed data to calculate S0 ) is (notice the generalized inverse of 3 )
2 30 2 32 3
0 0 0 0 0 0
6 7 6 76 7
6 0 7 6 0 0 0 0 76 0 7
DT6 T6
3
7 6
6
76
T
7
4 tD1 .x t / =T 5 4 0 0 1=.6 /
7 6 0 76
54 tD1 .x t /3 =T 7
5
T 4 4 8 T
tD1 .x t / 3 =T 0 0 0 1=.24 / tD1 .x t /4 3 4 =T
T 2 2
T t D1 .x t /3 =T T tTD1 .x t /4 3 4 =T

D C :
6 6 24 8
When we replace and by their estimates, then this is the same as the Jarque-Bera test
of normality.
1.2.4 GMM Example: The Means and Second Moments of Returns
Let R t be a vector of net returns of N assets. We want to estimate the mean vector and
the covariance matrix. The moment conditions for the mean vector are
E Rt D 0N 1 ; (1.19)
and the moment conditions for the unique elements of the second moment matrix are
E vech.R t R0t / vech. / D 0N.N C1/=21 : (1.20)
Remark 1.25 (The vech operator) vech(A) where A is m m gives an m.m C 1/=2 1
vector with the elements on and below the principal diagonal
2 A3stacked on top of each
" # a11
a11 a12
other (column wise). For instance, vech D 4 a21 5.
6 7
a21 a22
a22
Stack (1.19) and (1.20) and substitute the sample mean for the population expectation
to get the GMM estimator
T
" # " # " #
1X Rt O 0N 1
D : (1.21)
T t D1 vech.R t R0t / vech. O / 0N.N C1/=21
O vech. O /) is
In this case, D0 D I , so the covariance matrix of the parameter vector (;
just S0 (defined in (1.7)), which is straightforward to estimate.
16
1.3 MLE
1.3.1 Basic MLE
Let L be the likelihood function of a sample, defined as the joint density of the sample
L D pdf.x1 ; x2 ; : : : xT I / (1.22)
D L1 L2 : : : LT ; (1.23)
where are the parameters of the density function. In the second line, we define the
likelihood function as the product of the likelihood contributions of the different obser-
vations. For notational convenience, their dependence on the data and the parameters are
suppressed.
The idea of MLE is to pick parameters to make the likelihood (or its log) value as
large as possible
O D arg max ln L: (1.24)
MLE is typically asymptotically normally distributed

p
N .O / !d N.0; V /, where V D I./ 1
with (1.25)
@2 ln L
I./ D E =T or
@@ 0
@2 ln L t
D E ;
@@ 0
where I./ is the information matrix. In the second line, the derivative is of the whole
log likelihood function (1.22), while in the third line the derivative is of the likelihood
contribution of observation t.
Alternatively, we can use the outer product of the gradients to calculate the informa-
tion matrix as
@ ln L t @ ln L t

J./ D E : (1.26)
@ @ 0
A key strength of MLE is that it is asymptotically efficient, that is, any linear combi-
nation of the parameters will have a smaller asymptotic variance than if we had used any
other estimation method.
17
1.3.2 QMLE
A MLE based on the wrong likelihood function (distribution) may still be useful. Suppose
we use the likelihood function L, so the estimator is defined by
@ ln L
D 0: (1.27)
@
If this is the wrong likelihood function, but the expected value (under the true distribution)
of @ ln L=@ is indeed zero (at the true parameter values), then we can think of (1.27) as
a set of GMM moment conditionsand the usual GMM results apply. The result is that
this quasi-MLE (or pseudo-MLE) has the same sort of distribution as in (1.25), but with
the variance-covariance matrix
V D I./ 1 J./I./ 1
(1.28)
Example 1.26 (LS and QMLE) In a linear regression, y t D x t0 C " t , the first order
T
condition for MLE based on the assumption that " t N.0; 2 / is tD1 O t D 0.
.y t x t0 /x
This has an expected value of zero (at the true parameters), even if the shocks have a, say,
t22 distribution.
1.3.3 MLE Example: Estimate the Variance
Suppose x t is iid N.0; 2 /. The pdf of x t is
1 x t2

1
pdf .x t / D p exp : (1.29)
2 2 2 2
Since x t and x t C1 are independent,
L D pdf .x1 / pdf .x2 / ::: pdf .xT /

1 PT x t2

2 T =2
D .2 / exp , so (1.30)
2 t D1 2
T 1 PT
ln L D ln.2 2 / x2: (1.31)
2 2 2 t D1 t
The first order condition for optimum is
@ ln L T 1 1 PT
D 2 C x 2 D 0 so
@ 2 2 2 2 2. 2 /2 t D1 t
O 2 D TtD1 x t2 =T: (1.32)
P
18
Differentiate the log likelihood once again to get
@2 ln L T 1 1 PT
t D1 x t , so
2
2 2
D (1.33)
@ @ 2 4 2
. /3
@2 ln L T 1 T T
E 2 2 D 2 D (1.34)
@ @ 2 4 2
. /3 2 4
The information matrix is therefore
@2 ln L 1
I./ D E 2 2
=T D ; (1.35)
@ @ 2 4
so we have
p
T .O 2 2 / !d N.0; 2 4 /: (1.36)
1.4 Testing (Linear) Joint Hypotheses
Consider an estimator Ok1 which satisfies

p d
T .O 0 / ! N .0; Vkk / ; (1.37)
and suppose we want the asymptotic distribution of a linear transformation of
q1 D R: (1.38)
Under that null hypothesis (that D 0 )

p d
0 / ! N 0; qq ; where

T .R
D RVR0 : (1.39)
Example 1.27 (Testing 2 slope coefficients) Suppose we have estimated a model with
three coefficients and the null hypothesis is
H0 W 1 D 1 and 3 D 0:
We can write this as 2 3

" # 1 " # " #
1 0 0 6 7 1 0
4 2 5 D :
0 0 1 0 0
3
19
The test of the joint hypothesis is based on
d
T .R 0 /0 1 .R 0 / ! 2q : (1.40)
1.5 Testing (Nonlinear) Joint Hypotheses: The Delta Method
Consider an estimator Ok1 which satisfies

p d
T .O 0 / ! N .0; Vkk / ; (1.41)
and suppose we want the asymptotic distribution of a transformation of
q1 D f ./; (1.42)
where f .:/ has continuous first derivatives. Under that null hypothesis (that D 0 )
p d
O 0 / ! N 0; qq ; where

T .f ./
@f .0 / @f .0 /0
D V , where (1.43)
@ 0 @
2 3
@f1 . / @f1 . /
@1
@k
@f ./ 6 :: : :: 7
D 6 : : : : 7
@ 0 4
@fq . / @fq . /
5
@1
@k
qk
The derivatives can sometimes be found analytically, otherwise numerical differentiation

can be used. Now, a test can be done as in the same way as in (1.40).
Example 1.28 (Testing a Sharpe ratio) Stack the mean ( D E x t ) and second moment
(2 D E x t2 ) as D ; 2 0 . The Sharpe ratio is calculated as a function of
E.x/ @f ./ h 2
i
D f ./ D , so D :
.x/ .2 2 /1=2 @ 0 .2 2 /3=2 2.2 2 /3=2
If O is distributed as in (1.41), then (1.43) is straightforward to apply.
@f . /
Example 1.29 (Linear function) When f ./ D R, then the Jacobian is @ 0
D R, so
D RVR0 , just like in (1.39).
Example 1.30 (Testing a correlation of x t and y t , .x t ; y t /) For expositional simplicity,

assume that both variables have zero means. The variances and the covariance can then
20
be estimated by the moment conditions
2 3 2 3
x t2 xx xx
PT
t D1 g t ./=T D 031 where g t D 4 y t yy 5 and D 4 yy 5 :
6 2 7 6 7
x t y t xy xy
The covariance matrix of these estimators is estimated as usual in GMM, making sure
to account for autocorrelation of the data. The correlation is a simple function of these
parameters
xy @f ./ h 1 xy 1 xy 1

i
.x; y/ D f ./ D , so D 3=2 1=2
2 xx 1=2 3=2
2 xx 1=2 1=2 :
1=2
xx 1=2
yy @ 0 yy yy xx yy
It is then straightforward to apply the delta method (1.43).
Remark 1.31 (Numerical derivatives) A crude way to calculate a numerical derivative

is a forward difference
2 3
@f1 . /
@j
:: Q
7 f ./ f ./
, where Q D except that Qj D j C :
6
6 : 7D
4
@fq . /
5
@j
It is sometimes better to use a central difference

2 3
@f1 . /
Q Qj D j C =2
@j
" #
:: 7 f ./ f . /
, where Q D D except that
6
6 : 7D
4
@fq . /
5 j D j =2:
@j
1.5.1 GMM & Delta Method Example 1: Confidence Bands around a Mean-Variance
Frontier
A point on the mean-variance frontier at a given expected return is a non-linear function

of the means and the second moment matrix estimated by (1.21). It is therefore straight-
forward to apply the delta method to calculate a confidence band around the estimate.
Figure 1.2 shows some empirical results. The uncertainty is lowest for the minimum
variance portfolio (in a normal distribution, the uncertainty about an estimated variance is
p
increasing in the true variance, Var. T O 2 / D 2 4 ).
21
Mean-Std frontier US industry portfolios, 1947:12013:12
20
Mean Std
A 12.59 14.06
15
HD B 12.53 20.87
Mean, %
A CGJ BE
I F C 12.38 16.64
10 D 13.96 18.06
E 13.27 21.46
5 F 10.68 14.81
G 12.51 16.78
0 H 13.50 16.90
0 5 10 15 20 25 I 10.84 13.20
J 11.62 17.45
Std, %
Mean-Std frontier one Std

20 1/N?
15 SR(tangency) 0.75
Mean, %
SR(EW) 0.59
10 t-stat of difference 1.87
0
0 5 10 15 20 25
Std, %
Figure 1.2: Mean-Variancepfrontier of US industry portfolios. Monthly returns are used

in the calculations, but 100 12Variance is plotted against 100 12mean.
1.5.2 GMM & Delta Method Example 2: Testing the 1=N vs the Tangency Portfolio
Reference: DeMiguel, Garlappi, and Uppal (2009)

It has been argued that the (naive) 1=N diversification gives a portfolio performance
which is not worse than an optimal portfolio. One way of testing this is to compare the
the Sharpe ratios of the tangency and equally weighted portfolios. Both are functions of
the first and second moments of the basic assets, so a delta method approach similar to
the one for the MV frontier (see above) can be applied. Notice that this approach should
incorporate the way (and hence the associated uncertainty) the first and second moments
affect the portfolio weights of the tangency portfolio.
Figure 1.2 shows some empirical results.
22
Bibliography
Andrews, D. W. K., and J. C. Monahan, 1992, An Improved Heteroskedasticity and
Autocorrelation Consistent Covariance Matrix Estimator, Econometrica, 60, 953966.
Cochrane, J. H., 2005, Asset pricing, Princeton University Press, Princeton, New Jersey,
revised edn.
DeMiguel, V., L. Garlappi, and R. Uppal, 2009, Optimal Versus Naive Diversification:
How Inefficient is the 1/N Portfolio Strategy?, Review of Financial Studies, 22, 1915
1953.
Singleton, K. J., 2006, Empirical dynamic asset pricing, Princeton University Press.
23
A Statistical Tables
n Critical values
10% 5% 1%
10 1:81 2:23 3:17
20 1:72 2:09 2:85
30 1:70 2:04 2:75
40 1:68 2:02 2:70
50 1:68 2:01 2:68
60 1:67 2:00 2:66
70 1:67 1:99 2:65
80 1:66 1:99 2:64
90 1:66 1:99 2:63
100 1:66 1:98 2:63
Normal 1:64 1:96 2:58
Table A.1: Critical values (two-sided test) of t distribution (different degrees of freedom)
and normal distribution.
n Critical values
10% 5% 1%
1 2:71 3:84 6:63
2 4:61 5:99 9:21
3 6:25 7:81 11:34
4 7:78 9:49 13:28
5 9:24 11:07 15:09
6 10:64 12:59 16:81
7 12:02 14:07 18:48
8 13:36 15:51 20:09
9 14:68 16:92 21:67
10 15:99 18:31 23:21
Table A.2: Critical values of chisquare distribution (different degrees of freedom, n).
B Data Sources
The data used in these lecture notes are from the following sources:
1. website of Kenneth French,
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
24
2. Datastream
3. Federal Reserve Bank of St. Louis (FRED), http://research.stlouisfed.org/fred2/
4. website of Robert Shiller, http://www.econ.yale.edu/~shiller/data.htm
5. yahoo! finance, http://finance.yahoo.com/
6. OlsenData, http://www.olsendata.com
25
2 Basic Asset Pricing Theory
References: Back (2010), Cochrane (2005) and Pennacchi (2008)
2.1 Three Pricing Principles
The following definitions will be useful later.
Remark 2.1 (Complete markets) Markets are complete if there are sufficiently many as-
sets so you could hedge against any possible outcome. For instance, in a binomial model
(where the stock price can take a jump up or down), then two assets are required: a stock
and a bond (or a stock and an option, or...)
Remark 2.2 (Law of one price) The price of portfolio is the portfolio of the prices. This
rules out trivial arbitrage.
Remark 2.3 (No arbitrage) Every asset whose payoff is always nonnegative and some-
times positive, has a positive price. This rules out a free lunch: you cannot get something
for nothing.
Remark 2.4 (Law of iterated expectations) The law of iterated expectations implies that
(using subscripts to denote time)
E t .x tC1 E t C1 y t C2 / D E t x t C1 y t C2
To see why, let y t C2 D E t C1 y t C2 C " t C2 , so " t C2 is the surprise. The left hand side can
then be written
E t x t C1 .y t C2 " t C2 /:
Rationality of the expectation requires that E t .x t C1 " t C2 / D 0, that is, " t C2 is not corre-
lated with x tC1 : information in t C 1 cannot predict a surprise in t C 2. As a special case,
x t C1 could be a (known) constant.
26
2.1.1 Three Asset Pricing Principles
There are three main ways of pricing financial assets. First, by replication. If the payoff
of asset i (xi ) is a portfolio (linear combination) of the payoffs of assets a and b
xi D xa C xb ; (2.1)
then the law of one price requires that
Pi D Pa C Pb : (2.2)
Example 2.5 (Binomial model) Assume a stock will be worth either 9:5 (low state) or 11
(high state), and that there is a bond that always pays off 1. A call option (with strike
price 10) on the stock will be worth either 0 or 1. You can replicate this option by holding
2=3 of the stock and 19=3 of the bonds, since it gives 0 in the low state and 1 in the high
state.
The second way is by a stochastic discount factor (SDF, also called pricing kernel),
which is a variable (m) such that
Pi D E mxi , for all assets (i ), (2.3)
where xi is the (future) payoff and Pi is todays price. All time subscripts are dropped
in order to save ink. The expectation should be interpreted as being conditional on the
information available today. Notice that it is the same m that prices all assets.
The third way is by using the discounted riskneutral expected payoff
1
Pi D E xi ; (2.4)
Rf
where Rf is the riskfree gross rate and E xi is the expected value of xi according to the
riskneutral distribution. This distribution is best thought of as a theoretical construction,
which cannot be directly observed from data (more details later).
Remark 2.6 (Black-Scholes) Consider a European call option with a strike price K. The
payoff at expiration is max.0; Pi;1 K/, where Pi;1 is the price of the underlying asset
at expiration. If the return of the underlying asset follows a continuous time random
walk with normally distributed shocks, then a dynamically rebalanced portfolio of the
underlying and a safe asset replicates the call optionso the call option price must equal
27
the price of the portfolio. Alternatively, the call option price equals Em max.0; Pi;1 K/
and E max.0; Pi;1 K/=Rf . In each case, the explicit solution of the call option price
is the Black-Scholes formula.
Remark 2.7 (Bond pricing) The price of an n-period zero-coupon bond equals the cross-
moment between the pricing kernel (m) and the value of the same bond next period (then
an n 1-period bond)
1
Pn;0 D E mPn 1;1 D E Pn 1;1 :
Rf
2.2 Stochastic Discount Factors
Dividing both sides of (2.3) by the known price gives
E mRi D 1, where Ri D xi =Pi : (2.5)
Here Ri is the gross return. (Another way to think about this: Ri is the payoff of an asset
whose price today is 1.)
For a riskfree asset (which is not correlated with the SDF) we get
E m E Rf D 1, so Rf D 1= E m: (2.6)
Remark 2.8 (Risk and asset prices) Using (2.6) in (2.3) gives
E xi
Pi D C Cov.m; xi /:
Rf
This says that the price equals the expected present value of payoff + risk adjustment.
Idiosyncratic risk is not compensated (priced). For instance, E xi D 25; Rf D 1:1 and
Cov.m; xi / D 2
25
Pi D 2 22:7 2 D 20:7:
1:1
The investor is only willing to pay 20.7 for an asset with expected present value of 22.7:
this is considered to be a risky asset.
Combining (2.5) and (2.6) gives that an excess return should satisfy
E mRie D 0: (2.7)
28
Rewrite (2.7) get the risk premium
E Rie D Rf Cov m; Rie (2.8)

Risk premium is driven by the systematic risk (covariance with SDF). Idiosyncratic volatil-
ity does not matter for pricing (it can be diversified away).
Example 2.9 Using Rf D 1:1 and Cov.m; Rie / D 0:1 in (2.8) gives the risk premium
E Rie D 0:11, that is 11%:
Equation (2.8) together with E m D 1=Rf gives
E Rie
Corr.m; Rie /.m/ D Em : (2.9)
.Rie /
Since 1 Corr.m; Rie / 1, this means (take the absolute value of both sides, notice
that Corr.m; Rie / 1, and rearrange)
.m/ j E Rie j
: (2.10)
E.m/ .Rie /
Remark 2.10 (A simple test of an SDF model) Find the highest E Rie = Rie from a

set of assets, and check if .m/ = E m (from your model) is higher. See Figure 2.1.
Remark 2.11 (How the SDF defines a MV frontier) Reshuffle (2.10) as

(
Rf C E.m/
.m/
.Ri / if E Ri Rf
E Ri is .m/
Rf E.m/
.Ri / if E Ri Rf
which gives the two lines in Figure 2.2 (draw E Ri as a function of .Ri /). Use 1= E.m/ D
Rf .
2.2.1 Where Do SDFs Come from? Version 1: Optimization
Consider the two-period optimization problem
maxfC0 ;i g u .C0 / C E u .C1 / subject to (2.11)

C0 C niD1 i Pi D W0 and (2.12)
P
C1 D y1 C niD1 i xi : (2.13)
P
29
Comparison of (m)/Em and max SR
1
Model of m : 0.99(Ct /Ct1 )
(m)/Em
US data 1970:12013:12,
max SR
0.8 monthly returns
Max SR are from returns of 10 industry portfolios

0.6
0.4
0.2
0
0 50 100 150 200

Figure 2.1: Comparison of SDF model with max SR from data on returns
ER
slope: .m/=Em
Rf assets
.R/
Figure 2.2: MV frontier (from SDF)
The first line defines expected utility from consuming now (period 0) and later (period
1). Notice: the subscripts on (C0 ; C1 ; y1 ; W0 ) are here used to indicate time. However,
following the previous analysis we take it for granted that the price of asset i (Pi ) refer to
period 0 and the payoff (xi ) to period 1. The second line is the budget restriction today:
consumption plus asset purchases (i assets of type i, each at the price Pi ) equals todays
wealth. The third line defines what consumption in period 1 will be: any income y1 plus
the payoffs from the assets (xi from asset i , of which we own i ).
30
To solve the optimization problem, substitute for C1 and define the Lagrangian
max u .C0 / C E u.y1 C niD1 i xi / C0 C niD1 i Pi (2.14)

P P
W0 :

C1
The first order conditions are
wrt C0 : u0 .C0 / D (2.15)

wrt i : E u0 .C1 / xi D Pi for i D 1 : : : n: (2.16)
Combine to get
E u0 .C1 / xi D Pi for i D 1:::n (2.17)

0
u .C1 /
E m1 xi D Pi , where m1 D : (2.18)
u0 .C0 /
Apply to a riskfree asset, xi;1 D 1 and Pi D 1=Rf , where Rf is the gross interest rate
u0 .C1 / 1 1 u0 .C0 /
E 1 D so Rf D : (2.19)
u0 .C0 / Rf E u0 .C1 /
With a CRRA utility function, u0 .C / D C , so the SDF in (2.18) is

C1
m1 D : (2.20)
C0
Example 2.12 (Riskfree rate) With CRRA as in (2.20) with D 3 and D 0:95, and
.C0 ; C1 / D .1:95; 2/ we get (assuming no uncertainty)
3
1 2
Rf D 1:14;
0:95 1:95
so the net interest rate is approximately 14%. Instead, with C1 D 2:1 we get
3
1 2:1
Rf D 1:31;
0:95 1:95
so the net rate is approximately 31%. The reason is that if the future is bright, then
investors want a large compensation for saving (rather, they would like to borrow).
Example 2.13 (The SDF as a function of consumption) With CRRA as in (2.20) with
31
Utility function with tangents Marginal utility
Consumption Consumption
Figure 2.3: Utility function
D 3 and D 0:95, and (C0 ; C1 / D .1:95; 2/ we get

3
2
m1 D 0:95 0:88
1:95
Instead, with C1 D 2:1 we get
3
2:1
m1 D 0:95 0:76;
1:95
so the ratio is random (since C1 is)and moves inversely with C1 .
Notice that u0 .C1 /, and therefore m in (2.18), moves inversely with C1 , see Figure
2.3. Approximate m1 a bC1 , where b > 0. Use in (2.8)
E Rie D Rf Cov a bC1 ; Rie

D bRf Cov C1 ; Rie : (2.21)

Procyclical assets have high expected returns (as they pay off when marginal utility is
low). The reason why risky assets have high risk premia is, of course, that otherwise no
one would like to buy those assets.
Example 2.14 (From a consumption-based model to CAPM) Suppose marginal utility is

an affine function of the market excess return
e
mDa bRm , with b > 0:
This would, for instance, be the case in a Lucas model where consumption equals the
market return and the utility function is quadratic.
32
Remark 2.15 (Deriving CAPM from marginal utility) If utility depends on the portfolio
return Rp and is of CARA form, u.Rp / D exp. Rp k/ where k is a measure of risk
aversion, then the optimal portfolio will be on the mean-variance frontier. In equilibrium,
CAPM holds.
Remark 2.16 (The equity premium puzzle, log-normal version) With CRRA (2.20), equa-
tion (2.5) says that the average gross return of an asset should be determined by

C1
E Ri D 1:
C0
Let c D ln.C1 =C0 / and ri D ln Ri and write the expression as
E exp. c C ri / D 1:
Recall that if x N.; 2 /, then E exp.x/ D exp. C 2 =2/. Assume c C ri is

indeed normally distributed, then the previous equation can be written
exp. E c C E ri C 2 c2 =2 C r2 =2 cr / D 1:
Take logs to get
E c C E ri C 2 c2 =2 C r2 =2 cr D 0, or

E ri D C E c . 2 c2 =2 C r2 =2 cr /:
Apply to a riskfree return to get
rf D C E c 2 c2 =2:
Combine to have the risk premium
E ri rf D cr r2 =2:
The equity premium puzzle (Mehra and Prescott (1985)) is that the covariance is too small
to explain the historical average risk premium on US equity.
2.2.2 Where Do SDFs Come from? Version 2: Law of One Price or No Arbitrage
We can (although it is a bit involved) prove the following result. In comparison with the
optimization approach, they are very general: they rely on weak assumptions and tells us
33
about whether there is an SDF. On the other hand, the results say very little about what
the SDF is.
If markets are complete, then there is only one SDF. You may derive it from MV
assets or macro series or whatever, but you get the same SDF.
Instead, if markets are incomplete (the more realistic case), then we can still prove
something about the existence of an SDF:
The law of one price and incomplete markets imply that there exists an SDFand it
can be written as linear function of available assets. However, there may be several
alternative SDFs, for instance, written in terms of macro variables. They need not
be the same, but they should deliver the same asset prices.
No arbitrage and incomplete markets imply that there exists at least one positive
SDF. There may be other SDFs, and some of them can take on negative values (in
some states of the world).
(SDFs that can have negative realizations are problematic, since they can assign neg-
ative prices to some derivativeswhich we want to avoid. Notice that the optimization
based approach creates SDFs that are always positiveprovided marginal utilities are.)
2.3 Beta Pricing Models
2.3.1 Definition of a Beta Pricing Model
A beta pricing model says that the average returns for any asset are
E Ri D Rf C i0 ; (2.22)
where are factor risk premia and i are the regression coefficients from
Ri;t D i C i0 f t C ui;t : (2.23)
See Figure 2.4 for an example.

When there is a single factor which is an excess return, then we can apply (2.22) to
f t and notice that i D 1 (regressing f t on itself gives a slope coefficient equal to one).
34
Fit of CAPM Fit of 2-factor model
18 18
16 16
Mean excess return, %

14 14
12 12
= 0.67 = 0.63 -11.27
10 b = -13.1 10 b = -299 15520
8 pval: 0.00 8 pval: 0.00
6 6
4 4
5 10 15 5 10 15
Predicted mean excess return, % Predicted mean excess return, %
US data 1957:12013:12 CAPM:

25 FF portfolios (B/M and size) Ri = i + i Rm and ERi = i
SDF: Coskewness model:

m = 1 + b (f Ef) Ri = i + i1 Rm + i2 R2m and
ERi = i1 1 + i2 2
Figure 2.4: CAPM and quadratic model
MV frontiers from 10 US industry portfolios 1970:12013:12

1.02
The market return is marked by *
1.015 The returns are monthly gross returns
A D
1.01 HC G
*F
Mean
I J BE
1.005
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08

Std
Figure 2.5: MV frontier from US industry indices
35
Therefore,
E f D Rf C ; so
D Ef Rf : (2.24)
This is a way to identify the factor risk premia and it also holds when there are several
factors. CAPM is a one-factor model, while the Fama-French model is a three-factor
model. In CAPM the factor is an excess return since it is the return of a long-short
portfolio, that is, the difference between the returns of the market portfolio and another
portfolio (a risk free asset). In the Fama and French (1993) model, the factors are also
excess returns since they are also based on long-short portfolios (market minus risk free,
value stock minus growth stocks, large stocks minus small stocks). Carhart (1997) adds a
momentum factor and Pastor and Stambaugh (2003) a liquidity factor.
However, the approach in (2.24) only works when the factors are returns. If not, the
factor risk premia must be estimated.
If the factor is indeed a (single) return, then
the beta pricing model (2.22) hold if and only if the factor is on the MV frontier
(and is not equal to the minimum variance return or the riskfree return).
The empirical implication is that
testing a beta pricing model is the same as testing if the return factor (e.g. the
market return) is MV efficient.
This can be done in several ways, but the easiest approach is run the regression
e
Ri;t D i C i0 f t C ui;t ; (2.25)
and to test if D 0. Notice that this works also with several factors, provided all of them
are excess returns.
Example 2.17 (CAPM) when f D Rm (the market return), then we have CAPM. Testing
CAPM is the same as testing if the market portfolio is MV efficient. See Figure 2.5 for an
empirical example.
Remark 2.18 (Typical results from testing CAPM) It is often found that > 0 for small
stocks and value stocks (and the opposite for growth stocks). Dynamic portfolios that
bet on short-run reversal, medium-run momentum and long-run reversion also tend to
36
have > 0. Finally, firms with unexpectedly high earnings growth tend to have returns
also after the surprise, but that firms with high uncertainty or high asset growth tend to
underperform. The average mutual fund has a negative alphaand it seems as if alphas
are not particularly correlated over time.
2.3.2 Factor Mimicking Portfolios
Pricing factors need not be returns (e.g. inflation or market volatility). In principle, that
does not change much: the beta pricing model (2.22)(2.23) would still be true, although
we need another method to identify the factor risk premia than (2.24).
In practice, it is often convenient to work with factor mimicking portfolios instead.
To construct such a portfolio, regress the factor on a constant and a vector of asset ex-
cess returns. Then use, the fitted values (minus the intercept) as the return of a factor
mimicking portfolio.
Instead of using a regression, factor mimicking portfolios are often approximated by
long-short based on asset sorts (for instance, small minus big firms).
Example 2.19 (Fama-French) The Fama and French (1993) (see also Fama and French
(1996)) SMB and HML portfolios can be thought of as factor mimicking portfolios
perhaps mimicking the credit cycle and the degree of optimism/pessimism on the market.
See Figure 2.6.
Example 2.20 (Carry trade factor) Lustig, Roussanov, and Verdelhan (2011) use a carry
trade risk factor mimicking portfolio (labelled HMLF X ) which is (almost) a portfolio of
exchange rates where high-minus-low refers to the interest rate level. This turns out to be
an important factor for explaining the cross-section of exchange rate returns. It is argued
that HMLF X is strongly related to macro economic risk.
2.3.3 SDFs versus Beta Pricing Models
We can always think of the SDF as the factor in a beta pricing model. To see this,
rewrite (2.8) as
Cov m; Rie

E Ri D
e
. Rf / Var.m/: (2.26)
Var.m/

i
However, we often want to go beyond this by providing more information about what is
behind the SDF.
37
Cumulated excess returns on FF factors
market
15 SMB
HML
index level
10
0
1960 1970 1980 1990 2000 2010
Figure 2.6: Cumulated excess returns on FF factors
Example 2.21 ((2.26) with a utility based SDF) If the SDF is the ratio of marginal CRRA
utilities as in (2.20), then (2.26) explains the expected average return as a function of the
returns regression coefficient from Rie D C i .C1 =C0 / C u.
Remark 2.22 (Empirical performance of consumption based models) Standard consump-

tion based asset pricing models (like the CRRA discussed above) have a problem with
explaining the historical average returns on equity. It is perhaps somewhat better at ex-
plaining the cross-section of different equity returns. More sophisticated consumption
based models that incorporate habits (Campbell and Cochrane (1999)) or that focus on
longer horizons (Parker and Julliard (2005)) or allow for (a small) long-run movements
in growth (Bansal and Yaron (2004)) do a bit better.
Given a beta pricing model against an SDF like (2.26), it is straightforward to show
that
there is always (another) beta representationagainst a return on the MV frontier:
E Rie D i;mv mv ; (2.27)
where i;mv is the regression coefficient of asset i against that return on the MV frontier.
This result says that MV frontiers are crucial for all asset pricing. However, it remains
to be tested whether your favourite factor is really on the frontier. For instance, if the
market return happens to be on the MV frontier, then CAPM holdsotherwise not.
38
Proof. (Proof of (2.26))(2.27) ) Recall from (2.9)(2.10) that an asset that is per-
fectly correlated (positively or negatively) with the SDF has the highest possible jSharpe
ratioj, which means that it is on the MV frontier. The perfect correlation also means that
the return of this asset (Rmv ) must be such that m D C Rmv , where and are two
constants. Using this in (2.26) gives the result.
Cov C e

R mv ; Ri
E Rie D . Rf / Var. C Rmv /
Var. C Rmv /
Cov Rmv ; Rie

D . Rf / Var.Rmv /:
Var.Rmv /
mv
i;mv
It can also be show that an SDF that is a linear function of same factors (f ) is the
same thing as having linear factor model. To be precise,
there is a beta pricing model with the factors f if and only if there is an SDF that
is linear (affine) in those factors, m D a C b 0 f .
This implies that if we know (a; b) in the model
m D a C b 0 .f E f /; 0 D E mRie ; (2.28)
then we can find an such that the beta pricing model (2.22) holds. Conversely, given
in (2.22) we can find b such that (2.28) holds. (Notice: i can be estimated and a is only
important if we use some returns, not just excess returns. In that case, a D 1=Rf .) See
Figure 2.7 for a numerical example and Figure 2.4 for an empirical illustration.
Example 2.23 (From consumption to other factors) If the ratio of marginal utility (con-
sumption) in Example 2.21 depends on a vector of factors in a linear way, then we have
an SDF like in (2.28). For instance, the macro-economic equilibrium might imply that
marginal utility is a linear function of some key macroeconomic variables like output,
interest rates and inflation
m D Output C Interest rate C Inflation;
where ( ; ; ) are constants. The factor model for the asset prices then include the same
macro factors.
The empirical implication of (2.28) is that
39
MV frontiers Means 0.090 0.060
Cov 0.026 0.005

0.1 matrix 0.005 0.014
Riskfree 0.010
Mean
0.05 Rm : w1 0.506
w2 0.494
mean 0.075
std 0.112
0
0 0.05 0.1 0.15
Std
Pricing with the SDF (m):

m = 0.9901 5.134 (Rm ERm )
Pricing with CAPM (Rm ): Em(R Rf ) = 0.000 0.000
= ERm Rf = 0.065
= 1.227 0.767 Beta representation against m:
= 0.080 0.050 m = Var(m)/Em = -0.335
m = -0.239 -0.149
m m = 0.080 0.050
Figure 2.7: Calculations of SDF, beta representation against both SDF and Rm
estimating/testing a linear SDF model is the same as estimating/testing an old-

fashioned linear factor model.
The choice between a linear SDF model or a beta pricing model is therefore based on
what is more convenient (or already established in the literature). For most asset classes
this means a beta pricing model, although studies of bonds and derivatives often work
with SDFs. What is more important is the assumption of linearityand the choice of the
factors.
Proof. (Proof of (2.28) ) Combine (2.28) and (2.22) to get
1
D Var.f /b or b D a Var.f / 1 ;
a
where Var.f / is the variance-covariance matrix of f . By definition, the betas are multiple
regression coefficients, so they are
i D Var.f / 1
Cov.f; Rie /:
Example 2.24 (CAPM)SDF) Suppose we know that (2.22) is E Rie D i with D

0:08 and where i is the regression coefficient in Rie D i C i Rm
e e
C ui , where Rm is
40
e
the market excess return (f D Rm ). Suppose Var.Rme
/ D 0:162 . From the proof of (2.28)
and using E m D a D 1 (which is not important since we are dealing with excess returns),
we have
D b Var.Rm
e
/, or
0:08 D b0:162 ) b D 3:125:
Use in (2.28)
e
mD1 3:125 .Rm E Rm
e
/
Notice the sign: m proxies marginal utility. In terms of risk premia, recall (2.8) and
combine with the equation for m
E Rie D Rf 3:125 Cov.Rm

e
; Rie /;
which shows that a procyclical asset has a positive risk premium.
Example 2.25 (SDF)CAPM) Suppose we know that
e
mD1 3:125 .Rm E Rm
e
/
and that Var.f / D Var.Rm

e
/ D 0:162 . The proof of 2.28 gives
D b 0 Var.f / D 0:162 . 3:125/ D 0:08;
so the beta (CAPM) representation (2.22) is E Re D i 0:08.
2.3.4 Conditional Asset Pricing
(In this section I use time subscripts, since it is needed to clarify the concepts)
Most asset pricing theories are conditional
1 D E0 m1 Ri;1 ; (2.29)
where E0 are the expectations at time of the portfolio formation and Ri;1 is the gross
return of asset i in period 1. However, we typically want an expression in terms of an un-
conditional expectationsince that can be approximated by a sample average of available
data.
41
Use iterated expectations to get
1 D E m1 Ri;1 : (2.30)
This is correct, but explores only a very limited set of the model properties. Instead, notice
that for any z0 known in 0
z0 D z0 E0 m1 Ri;1 )
E z0 D E m1 Ri;1 z0 ; (2.31)
where the second line follows from the law of iterated expectations. Notice that z0 must
be correlated with m1 Ri;1 for this expression to differ from (2.30). Otherwise, the expec-
tation can be factored as E z0 D E z0 E m1 Ri;1 . This suggests that z0 must be able to
predict m1 Ri;1 for it to matter. For this reason empirical conditional asset pricing often
checks if the proposed state variable z0 has any predictive power.
Interpretation 1: (2.31) captures more of the conditional model than just conditioning
down (z0 D 1 is a special case).
Interpretation 2: Ri;1 z0 is payoff of a managed portfolio; z0 its price. See Figure 2.8
for an example where the return distribution is different in different time periods (driven
by a state variable) and Figure 2.9 for an empirical illustration.
MVF of basic assets in different states MVF from unconditional moments

8 state -1 8 of basic assets
state 1 of managed portfolios
7 7
Mean, %
Mean, %
optimal
constant
6 6
5 5
0 5 10 15 20 0 5 10 15 20
Std, % Std, %
Figure 2.8: MV frontiers
2.4 Risk Neutral Distributions
To simplify the analysis, assume that there are k different states of the world and that
state j has the probability j . The asset pricing model (2.3) can then be written (for asset
42
Fit of CAPM Fit of CAPM-LSTAR
Mean excess return, % 14 14

12 12
10 10
8 8
6 6
4 4
5 10 15 5 10 15
Rie = + [1 G(z)]1 Rm
e
+
Rie = + Rm
e
+ G(z)2 Rme
+
Monthly US data 1957:12013:12
G(z) is a logistic function
25 FF portfolios (B/M, size)
z: lagged momentum return
Figure 2.9: Test of 1 and 2-factor models, 25 FF portfolios
i)
Xk
Pi D E mxi D j mj xij ; (2.32)
j D1
where xij is the payoff of asset i in state j (next period).

Define the risk neutral probabilities as
j D Rf mj j ; (2.33)
where Rf is the gross riskfree rate. Then rewrite (2.32) as

Xk
Pi D j mj xij
j D1
.j /=Rf
Xk
D j xij =Rf
j D1
D E xi =Rf ; (2.34)
which says that the asset price equals the discounted risk neutral expected value. Once
we have the risk neutral distribution of asset i for a given investment horizon, we can price
any European derivative (whose expiration is at the investment horizon) on that asset. For
instance, if we have the risk neutral distribution for the bond price 3 months from now,
43
we can price also a European put option on that bond.
Clearly, this expression can be rearranged as
E xi
D Rf ; (2.35)
Pi
which says that the risk neutral expected (gross) return on any asset equals the (gross)
riskfree rate.
Recall that a forward contract has a zero price and a payoff xi;1 D Pi;1 Fi , where
Pi;1 is the price of the underlying asset i next period and Fi the contracted forward price.
Apply (2.34) to get
0 D E .Pi;1 Fi / =Rf , so Fi D E Pi;1 : (2.36)
This shows that the mean of the risk-neutral distribution (of asset i) equals the forward
price.
Remark 2.26 (Binomial model) Consider the process for the underlying asset i
(
Pi;0 u with probability
Pi;1 D
Pi;0 d with probability 1 ;
where Pi;0 is todays price and Pi;1 is the price next period. For simplicity, we assume no
dividends. We know from basic option pricing that a derivative that is worth Cu in the up
state and Cd in the down state must have the current price C0
1 Rf d
C0 D Cu C .1 / Cd with D ;
Rf u d
where is the risk neutral probability. From (2.33) we know that j =Rf D mj j , so
=Rf D mu
.1 /=Rf D md .1 /:
We can therefore write the price of the derivative also as
C0 D mu Cu C md .1 /Cd ;
which is just C0 D E.mpayoff of derivative).
Example 2.27 (Binomial model) If u D 1:1; d D 0:95; D 2=3; Rf D 1; Cu D 1 and
44
Cd D 0, then we get
1 0:95 1
C0 D 1 with D D :
1:1 0:95 3
It follows that mu D 1=2 and md D 2. Notice that E m D 2=3 1=2 C 1=3 2 D 1 so
the gross riskfree rate is indeed 1. Also, notice that using m to price the derivative gives
C0 D 2=3 1=2 1 D 1=3.
2.4.1 Special Case: Lognormal Distribution (the Log Asset Price)
Suppose log asset price is a univariate normal (we call this is physical distribution)
ln Pi;1 D pi;1 N.p ; pp /; (2.37)
and also that the distribution of the log SDF is also normal
ln m1 N.m ; mm /: (2.38)
Direct calculations then give that todays gross interest rate is (recall if x N.; 2 /,
then E exp.x/ D exp. C 2 =2/)
1
D E m1 D exp.m C mm =2/: (2.39)
Rf
Similarly, todays price of the underlying asset is (assuming no dividends, so the future
price is the payoff)
Pi;0 D E m1 Pi;1
D E exp.ln m1 C pi;1 /
D exp m C p C mm =2 C pp =2 C mp

D exp .m C mm =2/ exp p C pp =2 C mp

1=Rf
1
D exp p C pp =2 C mp : (2.40)

Rf
Suppose the risk neutral distribution of the future log asset price is also normal
pi;1 N.p ; pp /, with p D p C mp : (2.41)
This distribution has the same variance as the physical distribution of pi;1 in (2.37), but
45
a different mean. This simple result is due to the assumption of lognormally distributed
variables. See Figure 2.10 for an example.
To illustrate that this works, notice that
1
Pi;0 D E Pi;1 (2.42)
Rf
1
D E exp.pi;1 /
Rf
1
D exp.p C mp C pp =2/;
Rf
which is the same as the SDF approach (2.40) gives.

To apply the risk neutral distribution, we could, for instance, price a European put
option with strike price K as
1
Put0 D E max.0; K Pi;1 /
Rf
1 RK
D 1 K exp.p/ .pI p ; pp /dp; (2.43)
Rf
where .pI p ; pp / is notation for the pdf for a N.p ; pp / distribution evaluated at p.
Example 2.28 (Asset price under lognormality.) If m D 0:04; mm D 0:04; p D

0:03; pp D 0:01 and mp D 0:015, then (2.39)(2.40) give
1
D exp. 0:04 C 0:04=2/ 0:98 so ln Rf D 0:02
Rf
Pi;0 D exp. 0:04 C 0:04=2/ exp.0:03 0:015 C 0:01=2/ D 1:
Since Pi;0 D 1, the payoff is actually a gross return.
Example 2.29 (Risk neutral lognormal distribution) In Example 2.28, the physical dis-
tribution of the log payoff (pi;1 ) is N.0:03; 0:01/, while the risk neutral distribution (2.41)
is N.0:03 0:015; 0:01/, that is, N.0:015; 0:01/. See Figure 2.10.
To interpret the risk neutral pdf in (2.41), notice that an asset with a negative covari-
ance with the pricing kernel tends to pay off in the wrong states (for instance, in booms),
so it is considered a risky asset and will have a low price. For a risk-neutral investor to
make an equally low valuation, he must be more pessimistic about the future payoff: the
distribution is shifted down (to the left).
46
Physical and risk-neutral pdfs (lognormal)
4
physical
risk-neutral
1 mean std
physical 0.030 0.100
risk-neutral 0.015 0.100
0
0.25 0.2 0.15 0.1 0.05 0 0.05 0.1 0.15 0.2
log payoff (return)
Figure 2.10: Physical and risk-neutral distributions
Joint distribution: ln m N, Re mixN
0.1
0.05 4
2
0
0
3
2
1 2
0
1
2 4 Re
ln M 3
Figures 2.112.12 illustrate a case where the distribution is more complicatedand

the transformation from the physical to the risk neutral distribution involves much more
than just a horizontal shift.
47
Physical and riskneutral pdfs
physical ln m N
rn Re mix N
0.25
0.2
0.15
0.1
mean std
0.05 physical 0.340 1.800
risk-neutral 0.000 2.110
0
4 3 2 1 0 1 2 3 4
Re
Bibliography
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Oxford.
Bansal, R., and A. Yaron, 2004, Risks for the Long Run: A Potential Resolution of Asset
Pricing Puzzles, The Journal of Finance, 59, 14811509.
Campbell, J. Y., and J. H. Cochrane, 1999, By force of habit: a consumption-based

explanation of aggregate stock market behavior, Journal of Political Economy, 107,
205251.
Carhart, M., 1997, On persistence in mutual fund performance, 52, 5782.
revised edn.
Fama, E. F., and K. R. French, 1993, Common risk factors in the returns on stocks and
bonds, Journal of Financial Economics, 33, 356.
Fama, E. F., and K. R. French, 1996, Multifactor explanations of asset pricing anoma-
lies, Journal of Finance, 51, 5584.
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Lustig, H. N., N. L. Roussanov, and A. Verdelhan, 2011, Common risk factors in cur-
rency markets, Review of Financial Studies, 24, 37313777.
Mehra, R., and E. Prescott, 1985, The equity premium: a puzzle, Journal of Monetary
Economics, 15, 145161.
Parker, J., and C. Julliard, 2005, Consumption risk and the cross section of expected
returns, Journal of Political Economy, 113, 185222.
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nal of Political Economy, 111, 642685.
Pennacchi, G., 2008, Theory of Asset Pricing, Pearson Education.
49
3 Simulating the Finite Sample Properties
Reference: Greene (2000) 5.3 and Horowitz (2001)
3.1 Introduction
Additional references: Cochrane (2001) 15.2; Davidson and MacKinnon (1993) 21; Davi-
son and Hinkley (1997); Efron and Tibshirani (1993) (bootstrapping, chap 9 in particular);
and Berkowitz and Kilian (2000) (bootstrapping in time series models)
We know the small sample properties of regression coefficients in linear models with
fixed regressors and iid normal error terms. When these conditions are not satisfied, then
we may use Monte Carlo simulations and bootstrapping to understand the small sample
properties.
How they should be implemented depends crucially on the properties of the model
and data: if the residuals are autocorrelated, heteroskedastic, or perhaps correlated across
regressions equations. These notes summarize a few typical cases.
The need for using Monte Carlos or bootstraps varies across applications and data
sets. For a case where it is not needed, see Figure 3.1, and for a case where it matters,
compare the traditional and bootstrapped t-stats in Tables 3.13.2.
2y 3y 4y 5y
factor 1:00 1:87 2:69 3:47
.6:59/ .6:77/ .6:97/ .7:17/
constant 0:00 0:00 0:00 0:00
.0:00/ . 0:44/ . 0:83/ . 1:21/
R2 0:14 0:15 0:16 0:17
obs 591:00 591:00 591:00 591:00
Table 3.1: Regression of different excess (1-year) holding period returns (in columns, in-
dicating the maturity of the respective bond) on a single forecasting factor and a constant.
Numbers in parentheses are t-stats. U.S. data for 1964:12014:3.
50
alpha t LS t NW t boot
US industry portfolios, 1970:12013:12 all NaN NaN NaN NaN
15 A (NoDur) 3.56 2.71 2.52 2.24
Mean excess return
B (Durbl) -1.09 -0.53 -0.54 -0.52

C (Manuf ) 0.71 0.75 0.71 0.64
10 D (Enrgy) 3.92 1.77 1.76 1.85
D
A
GC E (HiTec) -2.00 -1.11 -1.12 -1.00
I FH JB E 1.93 1.15 1.12 0.97
F (Telcm)
5 G (Shops) 1.35 0.94 0.90 0.89
H (Hlth ) 2.31 1.35 1.38 1.37
0 I (Utils) 2.80 1.58 1.53 1.58
0 0.5 1 1.5 J (Other) -0.61 -0.58 -0.56 -0.47
(against the market)
NW uses 1 lag
The bootstrap samples (yt , xt ) in blocks of 10
3000 simulations
Figure 3.1: CAPM, US industry portfolios, different t-stats
2y 3y 4y 5y
factor 1:00 1:87 2:69 3:47
.3:83/ .4:00/ .4:16/ .4:32/
constant 0:00 0:00 0:00 0:00
.0:00/ . 0:21/ . 0:39/ . 0:56/
R2 0:14 0:15 0:16 0:17
obs 591:00 591:00 591:00 591:00
U.S. data for 1964:12014:3. Numbers in parentheses are t-stats. Bootstrapped standard
errors, with blocks of 10 observations.
3.2 Monte Carlo Simulations
3.2.1 Monte Carlo Simulations in the Simplest Case
Monte Carlo simulations is essentially a way to generate many artificial (small) samples
from a parameterised model and then estimate the statistic (for instance, a slope coeffi-
cient) on each of those samples. The distribution of the statistic is then used as the small
sample distribution of the estimator.
The following is an example of how Monte Carlo simulations could be done in the
51
special case of a linear model with a scalar dependent variable
y t D x t0 C u t ; (3.1)
where u t is iid N.0; 2 / and x t is stochastic but independent of u t s for all s. This means
that x t cannot include lags of y t .
Suppose we want to find the small sample distribution of a function of the estimate,
O To do a Monte Carlo experiment, we need information on (i) the coefficients ; (ii)
g./.
the variance of u t ; 2 ; (iii) and a process for x t .
The process for x t is typically estimated from the data on x t (for instance, a VAR
system x t D A1 x t 1 C A2 x t 2 C e t ). Alternatively, we could simply use the actual
sample of x t and repeat it.
The values of and 2 are often a mix of estimation results and theory. In some case,
we simply take the point estimates. In other cases, we adjust the point estimates so that
g./ D 0 holds, that is, so you simulate the model under the null hypothesis in order to
study the size of tests and to find valid critical values for small samples. Alternatively,
you may simulate the model under an alternative hypothesis in order to study the power
of the test using either critical values from either the asymptotic distribution or from a
(perhaps simulated) small sample distribution.
To make it a bit concrete, suppose you want to use these simulations to get a 5%
critical value for testing the null hypothesis g./ D 0. The Monte Carlo experiment
follows these steps.
1. Construct an artificial sample of the regressors (see above), xQ t for t D 1; : : : ; T .

Draw random numbers uQ t for t D 1; : : : ; T from a prespecified distribution (eg.
multivariate normal) and use those together with the artificial sample of xQ t to cal-
culate an artificial sample yQ t for t D 1; : : : ; T from
yQ t D xQ t0 C uQ t ; (3.2)
by using the prespecified values of the coefficients (perhaps your point estimates).
2. Calculate an estimate O and record it along with the value of g./

O and perhaps also
the test statistic of the hypothesis that g./ D 0.
3. Repeat the previous steps N (3000, say) times. The more times you repeat, the
better is the approximation of the small sample distribution.
52
4. Sort your simulated , O g./,
O and the test statistic in ascending order. For a one-
sided test (for instance, a chi-square test), take the (0:95N )th observations in these
sorted vector as your 5% critical values. For a two-sided test (for instance, a t-
test), take the (0:025N )th and (0:975N )th observations as the 5% critical values.
You may also record how many times the 5% critical values from the asymptotic
distribution would reject a true null hypothesis.
O g./,
5. You may also want to plot a histogram of , O and the test statistic to see if there
is a small sample bias, and how the distribution looks like. Is it close to normal?
How wide is it?
We have the same basic procedure when y t is a vector, except that we might have
to consider correlations across the elements of the vector of residuals u t . For instance,
we might want to generate the vector uQ t from a N.0; / distributionwhere is the
variance-covariance matrix of u t .
Remark 3.1 (Generating N.; / random numbers) Suppose you want to draw an n 1
vector " t of N.; / variables. Use the Cholesky decomposition of to calculate the
lower triangular P such that D PP 0 . Draw u t from an N.0; In / distribution, and
define " t D C P u t . Note that Cov." t / D E P u t u0t P 0 D PIP 0 D .
It is straightforward to sample the errors from other distributions than the normal,
for instance, a student-t distribution. Equipped with uniformly distributed random num-
bers, you can always (numerically) invert the cumulative distribution function (cdf) of any
distribution to generate random variables from any distribution by using the probability
transformation method. See Figure 3.2 for an example.
Remark 3.2 Let X U.0; 1/ and consider the transformation Y D F 1 .X/, where
F 1 ./ is the inverse of a strictly increasing cumulative distribution function F , then Y
has the cdf F .
Example 3.3 The exponential cdf is x D 1 exp. y/ with inverse y D ln .1 x/ =.
Draw x from U.0; 1/ and transform to y to get an exponentially distributed variable.
3.2.2 Monte Carlo Simulations when x t Includes Lags of y t
If x t contains lags of y t , then we must set up the simulations so that feature is preserved in
every artificial sample that we create. For instance, suppose x t includes y t 1 and another
53
Distribution of LS t-stat, T = 5 Distribution of LS t-stat, T = 100
t = (b 0.9)/Std(b)
0.4 0.4
0.3 0.3
0.2 0.2
0.1 0.1
0 0
4 2 0 2 4 4 2 0 2 4
Model: Rt = 0.9ft + t , t = vt 2,
where vt has a 22 distribution Probability density functions
Estimated model: yt = a + bft + ut N(0,1)

0.4
Number of simulations: 25000 22 2
0.3
T = 5 T = 100 0.2
Kurtosis of t-stat: 46.75 3.05
Frequency of |t-stat| > 1.64 0.29 0.11 0.1
Frequency of |t-stat| > 1.96 0.23 0.05 0
4 2 0 2 4
Figure 3.2: Results from a Monte Carlo experiment with thick-tailed errors.
vector z t of variables which are independent of u t s for all s
y t D x t0 C u t (3.3)
D y t 1 C 0zt C ut
We can then generate an artificial sample as follows. First, create a sample zQ t for t D
1; : : : ; T by some time series model (for instance, a VAR) or by taking the observed
sample itself. Second, observation t of .xQ t ; yQ t / is generated recursively as
" #
yQ t 1
xQ t D and yQ t D xQ t0 C uQ t for t D 1; : : : ; T (3.4)
zQ t
We clearly need the initial value yQ0 to start up the artificial sampleand then the rest of
the sample (t D 1; 2; :::) is calculated recursively. See Figures 3.43.5 for an example.
For instance, for a VAR(2) model (where there is no z t )
y t D A1 y t 1 C A2 y t 2 C ut ; (3.5)
54
Freq of rejecting randomness, = 0.75 Freq of rejecting randomness, = 0.5
1 1
0.5 0.5
Autocorr
runs test
0 0
0 50 100 150 200 250 0 50 100 150 200 250
Sample size, T Sample size, T
True model: yt = yt1 + t ,

Freq of rejecting randomness, = 0.25 where t is iid N(0,2)
1
Rejecting randomness if |t-stat| > 1.96
0.5 Number of simulations: 25000
0
0 50 100 150 200 250
Sample size, T
Figure 3.3: Results from a Monte Carlo experiment on two methods of testing for ran-
domness.
the procedure is straightforward. First, estimate the model on data and record the esti-
mates (A1 ; A2 ; Var.u t /). Second, draw a new time series of residuals, uQ t for t D 1; : : : ; T
and construct an artificial sample recursively (first t D 1, then t D 2 and so forth) as
yQ t D A1 yQ t 1 C A2 yQ t 2 C uQ t : (3.6)
(This requires some starting values for y 1 and y0 .) Third, re-estimate the model on the
artificial sample, yQ t for t D 1; : : : ; T .
3.2.3 Monte Carlo Simulations with non-iid Errors
It is more difficult to handle non-iid errors, like those with autocorrelation and het-
eroskedasticity. We then need to model the error process and generate the errors from
that model.
If the errors are autocorrelated, then we could estimate that process from the fitted
55
Average LS estimate of Std of LS estimate of
simulation
0.9 asymptotic
0.1
0.85
0.8
0.05
0.75
0.7 0
0 100 200 300 400 500 0 100 200 300 400 500
Sample size, T Sample size, T

T Std of LS estimate of True model: yt = 0.9yt1 + t ,
0.8 where t is iid N(0,2)
0.7 Estimated model: yt = a + yt1 + ut
0.6 Number of simulations: 25000
0.5
0.4
0 100 200 300 400 500
Sample size, T
Figure 3.4: Results from a Monte Carlo experiment of LS estimation of the AR coeffi-
cient.
errors and then generate artificial samples of errors (here by an AR(2))
uQ t D a1 uQ t 1 C a2 uQ t 2 C "Q t : (3.7)
Alternatively, heteroskedastic errors can be generated by, for instance, a GARCH(1,1)

model
u t N.0; t2 /, where t2 D ! C u2t 1 C t2 1 : (3.8)
However, this specification does not account for any link between the volatility and the
regressors (squared)as tested for by Whites test. This would invalidate the usual OLS
standard errors and therefore deserves to be taken seriously. A simple, but crude, approach
is to generate residuals from a N.0; t2 ) process, but where t2 is approximated by the
fitted values from
"2t D c 0 w t C t ; (3.9)
where w t include the squares and cross product of all the regressors.
56
Distribution of LS estimator, T = 25 Distribution of LS estimator, T = 100
Mean and std: Mean and std:
0.1 0.74 0.16 0.1 0.86 0.06
0.05 0.05
0 0
0.2 0.4 0.6 0.8 1 0.2 0.4 0.6 0.8 1
True model: yt = 0.9yt1 + t , t is iid N(0,2)

Estimated model: yt = a + yt1 + ut
Number of simulations: 25000
Figure 3.5: Results from a Monte Carlo experiment of LS estimation of the AR coeffi-
cient.
3.3 Bootstrapping
3.3.1 Bootstrapping in the Simplest Case
Bootstrapping is another way to do simulations, where we construct artificial samples by

sampling from the actual data. The advantage of the bootstrap is then that we do not
have to try to estimate the process of the errors and regressors (as we do in a Monte Carlo
experiment). The real benefit of this is that we do not have to make any strong assumption
about the distribution of the errors.
The bootstrap approach works particularly well when the errors are iid and indepen-
dent of x t s for all s. This means that x t cannot include lags of y t . We here consider
bootstrapping the linear model (3.1), for which we have point estimates (perhaps from
LS) and fitted residuals. The procedure is similar to the Monte Carlo approach, except
that the artificial sample is generated differently. In particular, Step 1 in the Monte Carlo
simulation is replaced by the following:
1. Construct an artificial sample yQ t for t D 1; : : : ; T by
yQ t D x t0 C uQ t ; (3.10)
where uQ t is drawn (with replacement) from the fitted residual and where is the
point estimate.
57
Example 3.4 With T D 3, the artificial sample could be
2 3 2 0 3
.yQ1 ; xQ 1 / .x1 0 C u2 ; x1 /
4 .yQ2 ; xQ 2 / 5 D 4 .x20 0 C u1 ; x2 / 5 :
6 7 6 7
.yQ3 ; xQ 3 / .x30 0 C u2 ; x3 /
The approach in (3.10) works also when y t is a vector of dependent variablesand

will then help retain the cross-sectional correlation of the residuals.
3.3.2 Bootstrapping when x t Includes Lags of y t
When x t contains lagged values of y t , then we have to modify the approach in (3.10)
since uQ t can become correlated with x t . For instance, if x t includes y t 1 and we happen
to sample uQ t D u t 1 , then we get a non-zero correlation. The easiest way to handle this
is as in the Monte Carlo simulations in (3.4), but where uQ t are drawn (with replacement)
from the sample of fitted residuals. The same carries over to the VAR model in (3.5)(3.6).
3.3.3 Bootstrapping when Errors Are Heteroskedastic
Suppose now that the errors are heteroskedastic, but serially uncorrelated. If the het-
eroskedasticity is unrelated to the regressors, then we can still use (3.10).
On contrast, if the heteroskedasticity is related to the regressors, then the traditional LS
covariance matrix is not correct (this is the case that Whites test for heteroskedasticity
tries to identify). It would then be wrong to pair x t with just any uQ t D us since that
destroys the relation between x t and the variance of the residual.
An alternative way of bootstrapping can then be used: generate the artificial sample
by drawing (with replacement) pairs .ys ; xs /, that is, we let the artificial pair in t be
.yQ t ; xQ t / D .ys ; xs / D .xs0 0 C us ; xs / for some random draw of s so we are always
pairing the residual, us , with the contemporaneous regressors, xs . Note that we are always
sampling with replacementotherwise the approach of drawing pairs would be to just re-
create the original data set.
This approach works also when y t is a vector of dependent variables.
Example 3.5 With T D 3, the artificial sample could be

2 3 2 3 2 0 3
.yQ1 ; xQ 1 / .y2 ; x2 / .x2 0 C u2 ; x2 /
4 .yQ2 ; xQ 2 / 5 D 4 .y3 ; x3 / 5 D 4 .x30 0 C u3 ; x3 / 5
6 7 6 7 6 7
.yQ3 ; xQ 3 / .y3 ; x3 / .x30 0 C u3 ; x3 /
58
It could be argued (see, for instance, Davidson and MacKinnon (1993)) that bootstrap-
ping the pairs .ys ; xs / makes little sense when xs contains lags of ys , since the random
sampling of the pair .ys ; xs / destroys the autocorrelation pattern on the regressors.
3.3.4 Bootstrapping when Errors Are Autocorrelated
It is quite hard to handle the case when the errors are serially dependent, since we must
sample in such a way that we do not destroy the autocorrelation structure of the data. A
common approach is to fit a model for the residuals, for instance, an AR(1), and then
bootstrap the (hopefully iid) innovations to that process.
Another approach amounts to resampling blocks of data. For instance, suppose the
sample has 10 observations, and we decide to create blocks of 3 observations. The first
block is .uO 1 ; uO 2 ; uO 3 /, the second block is .uO 2 ; uO 3 ; uO 4 /, and so forth until the last block,
.uO 8 ; uO 9 ; uO 10 /. If we need a sample of length 3 , say, then we simply draw of those
block randomly (with replacement) and stack them to form a longer series. To handle end
point effects (so that all data points have the same probability to be drawn), we also create
blocks by wrapping the data around a circle. In practice, this means that we add the
following blocks: .uO 10 ; uO 1 ; uO 2 / and .uO 9 ; uO 10 ; uO 1 /. The length of the blocks should clearly
depend on the degree of autocorrelation, but T 1=3 is sometimes recommended as a rough
guide. An alternative approach is to have non-overlapping blocks. See Berkowitz and
Kilian (2000) for some other approaches.
Example 3.6 With T D 9 and a block size of 3, the artificial sample could be
u2 ; u3 ; u4 ; u7 ; u8 ; u9 ; u4 ; u5 ; u6 :

block 2 block 7 block 4
See Table 3.3 for an illustration.
3.3.5 Other Approaches
There are many other ways to do bootstrapping. For instance, we could sample the re-
gressors and residuals independently of each other and construct an artificial sample of
the dependent variable yQ t D xQ t0 O C uQ t . This clearly makes sense if the residuals and
regressors are independent of each other and errors are iid. In that case, the advantage of
this approach is that we do not keep the regressors fixed.
59
: 0 0.375 0.75
Simulated 5:8 8:0 10:2
OLS formula 5:8 6:2 7:2
Newey-West 5:7 7:5 9:5
VARHAC 5:7 8:1 11:0
Bootstrapped 5:5 7:5 9:5
Table 3.3: Standard error of OLS intercept (%) under autocorrelation (simulation evi-
dence). Model: y t D 1 C 0:9x t C t , where t D t C t 1 ; t is iid N(). NW uses 5
lags. VARHAC uses 5 lags and a VAR(1). The bootstrap uses blocks of size 20. Sample
length: 300. Number of simulations: 10000.
Bibliography
Berkowitz, J., and L. Kilian, 2000, Recent developments in bootstrapping time series,
Econometric-Reviews, 19, 148.
Cochrane, J. H., 2001, Asset pricing, Princeton University Press, Princeton, New Jersey.
Davidson, R., and J. G. MacKinnon, 1993, Estimation and inference in econometrics,

Oxford University Press, Oxford.
Davison, A. C., and D. V. Hinkley, 1997, Bootstrap methods and their applications, Cam-
bridge University Press.
Efron, B., and R. J. Tibshirani, 1993, An introduction to the bootstrap, Chapman and Hall,
New York.
Greene, W. H., 2000, Econometric analysis, Prentice-Hall, Upper Saddle River, New
Jersey, 4th edn.
Horowitz, J. L., 2001, The Bootstrap, in J.J. Heckman, and E. Leamer (ed.), Handbook
of Econometrics . , vol. 5, Elsevier.
60
4 Return Distributions
4.1 Estimating and Testing Distributions
Reference: Harvey (1989) 260, Davidson and MacKinnon (1993) 267, Silverman (1986);
Mittelhammer (1996), DeGroot (1986)
4.1.1 A Quick Recap of a Univariate Distribution
The cdf (cumulative distribution function) measures the probability that the random vari-
able Xi is below or at some numerical value xi ,
Fi .xi / D Pr.Xi xi /: (4.1)
For instance, with an N.0; 1/ distribution, F . 1:64/ D 0:05. Clearly, the cdf values
are between (and including) 0 and 1. The distribution of Xi is often called the marginal
distribution of Xi to distinguish it from the joint distribution of Xi and Xj . (See below
for more information on joint distributions.)
The pdf (probability density function) fi .xi / is the height of the distribution in the
sense that the cdf F .xi / is the integral of the pdf from minus infinity to xi
Z xi
Fi .xi / D fi .s/ds: (4.2)
sD 1
(Conversely, the pdf is the derivative of the cdf, fi .xi / D @Fi .xi /=@xi .) The Gaussian
pdf (the normal distribution) is bell shaped.
Remark 4.1 (Quantile of a distribution) The quantile of a distribution ( ) is the value

of x such that there is a probability of of a lower value. We can solve for the quantile by
inverting the cdf, D F . / as D F 1 ./. For instance, the 5% quantile of a N.0; 1/
distribution is 1:64 D 1 .0:05/, where 1 ./ denotes the inverse of an N.0; 1/ cdf,
also called the quantile function. See Figure 4.1 for an illustration.
61
Pdf of N(0,1) Pdf of N(0,1)
0.4 Pr(x 1) = 0.4 Pr(x 0.5) =
0.16 0.69
0.3 0.3
0.2 0.2
0.1 0.1
0 0
2 0 2 2 0 2
x x
Cdf of N(0,1) Inverse of cdf of N(0,1)

1
2
cdf value
0.5 0
x
2
0
2 0 2 0 0.5 1
x cdf value
Figure 4.1: Finding quantiles of a N(, 2 ) distribution
4.1.2 QQ Plots
Are returns normally distributed? Mostly not, but it depends on the asset type and on the
data frequency. Options returns typically have very non-normal distributions (in partic-
ular, since the return is 100% on many expiration days). Stock returns are typically
distinctly non-linear at short horizons, but can look somewhat normal at longer horizons.
To assess the normality of returns, the usual econometric techniques (BeraJarque
and Kolmogorov-Smirnov tests) are useful, but a visual inspection of the histogram and a
QQ-plot also give useful clues. See Figures 4.24.5 for illustrations.
Remark 4.2 (Reading a QQ plot) A QQ plot is a way to assess if the empirical distri-
bution conforms reasonably well to a prespecified theoretical distribution, for instance,
a normal distribution where the mean and variance have been estimated from the data.
Each point in the QQ plot shows a specific percentile (quantile) according to the empiri-
cal as well as according to the theoretical distribution. For instance, if the 2th percentile
(0.02 percentile) is at -10 in the empirical distribution, but at only -3 in the theoretical
62
distribution, then this indicates that the two distributions have very different left tails.
There is one caveat to this way of studying data: it only provides evidence on the
unconditional distribution. Suppose instead that we have estimated a model for time-
variation in the mean and variance (denoted t and t2 , respectively), then it makes more
sense to study the distribution (QQ plot) of the standardised return
Rt t
RQ t D : (4.3)
t
As a simple example, the mean could be estimated by an AR(1) model (so we would
have t D a C R t 1 ) and the variance by a GARCH model (so we would have t2 D
! C u2t 1 C t2 1 where u t 1 is the surprise to the return in t 1). See Figure 4.6 for
an illustration.
Daily returns Daily returns, zoomed vertically

25
8000
Number of days
Number of days
20
6000
15
4000 10
2000 5
0 0
20 10 0 10 20 10 0 10
Daily excess return, % Daily excess return, %
Daily returns, zoomed horizontally

8000 Daily S&P 500 returns, 1957:12014:3
Number of days
Solid line: estimated normal distribution

6000
4000
2000
0
2 0 2
Daily excess return, %
Figure 4.2: Distribution of daily S&P returns
63
QQ plot of daily S&P 500 returns
6
0.1st to 99.9th percentiles
2
Empirical quantiles
Daily S&P 500 returns

6 1957:12014:3
6 4 2 0 2 4 6
Quantiles from estimated N(, 2 ), %
Figure 4.3: Quantiles of daily S&P returns
4.1.3 Parametric Tests of Normal Distribution
The skewness, kurtosis and Bera-Jarque test for normality are useful diagnostic tools.
They are
Test statistic Distribution

3
skewness D T1 TtD1 xt
P
N .0; 6=T /
4 (4.4)
kurtosis D T1 TtD1 xt
P
N .3; 24=T /
Bera-Jarque D T6 skewness2 C 24
T
.kurtosis 3/2 22 :
This is implemented by using the estimated mean and standard deviation. The distribu-
tions stated on the right hand side of (4.4) are under the null hypothesis that x t is iid
N.; 2 /. The excess kurtosis is defined as the kurtosis minus 3.
The intuition for the 22 distribution of the Bera-Jarque test is that both the skewness
and kurtosis are, if properly scaled, N.0; 1/ variables. It can also be shown that they,
under the null hypothesis, are uncorrelated. The Bera-Jarque test statistic is therefore a
sum of the square of two uncorrelated N.0; 1/ variables, which has a 22 distribution.
64
QQ plot of daily returns QQ plot of weekly returns
10
5
Empirical quantiles
Empirical quantiles
5
0 0
5
5
10
5 0 5 10 5 0 5 10
2 2
Quantiles from N(, ), % Quantiles from N(, ), %
QQ plot of monthly returns Circles denote 0.1th to 99.9th percentiles

Empirical quantiles
10 Daily S&P 500 returns, 1957:12014:3
10
20
20 10 0 10
Quantiles from N(, 2 ), %
Figure 4.4: Distribution of S&P returns (different horizons)
The Bera-Jarque test can also be implemented as a test of overidentifying restrictions

in GMM. The moment conditions
2 3
xt
T 6 2 2 7
7
1 X .x t /
g.; 2 / D (4.5)
6
6 7;
T t D1 6 3
.x
4 t / 7
5
.x t /4 3 4
should all be zero if x t is N.; 2 /. We can estimate the two parameters, and 2 , by
using the first two moment conditions only, and then test if all four moment conditions
are satisfied. It can be shown that this is the same as the Bera-Jarque test if x t is indeed
iid N.; 2 /.
65
QQ plot of 5-min returns QQ plot of hourly returns
0.2 1
Empirical quantiles
Empirical quantiles
0.1 0.5
0 0
0.1 0.5
0.2 1
0.2 0.1 0 0.1 0.2 1 0.5 0 0.5 1
2
Quantiles from N(, ), % Quantiles from N(, 2 ), %
QQ plot of daily returns Circles denote 0.1th to 99.9th percentiles

Empirical quantiles
EUR/USD, based on 5-minute data,

2
1998:12013:11
2 0 2
Quantiles from N(, 2 ), %
Figure 4.5: Distribution of exchange rate returns (different horizons)

QQ plot of AR residuals QQ plot of AR&GARCH residuals
6 6
S&P 500 returns (daily)
4 1954:12014:3 4
Empirical quantiles
Empirical quantiles
2 0.1th to 99.9th 2
percentile
0 0
-2 AR(1) -2 AR(1)&GARCH(1,1)
-4 Stand. residuals: -4 Stand. residuals:
ut / ut /t
-6 -6
-6 -4 -2 0 2 4 6 -6 -4 -2 0 2 4 6
Quantiles from N(0,1), % Quantiles from N(0,1), %
Figure 4.6: QQ-plot of residuals
4.1.4 Nonparametric Tests of General Distributions
The Kolmogorov-Smirnov test is designed to test if an empirical distribution function,

EDF.x/, conforms with a theoretical cdf, F .x/. The empirical distribution function is
66
Empirical distribution function and theoretical cdf
1 When the plot of EDF takes a jump up,

the correct EDF value is the higher one
0.8
0.6
0.4
data
0.2 cdf of N(4,1)
EDF
0
3 3.5 4 4.5 5 5.5 6

x
Figure 4.7: Example of empirical distribution function
defined as the fraction of observations which are less or equal to x, that is,
T
1X
EDF .x/ D .x t x/; where (4.6)
T t D1
(
1 if q is true
.q/ D
0 else.
The EDF.x t / and F .x t / are often plotted against the sorted (in ascending order) sample
fx t gTtD1 .
See Figure 4.7 for an illustration.
Example 4.3 (EDF) Suppose we have a sample with three data points: x1 ; x2 ; x3 D
5; 3:5; 4. The empirical distribution function is then as in Figure 4.7.
Define the absolute value of the maximum distance
DT D max jEDF .x t / F .x t /j : (4.7)

xt
Example 4.4 (Kolmogorov-Smirnov test statistic) Figure 4.7 also shows the cumulative
distribution function (cdf) of a normally distributed variable. The test statistic (4.7) is then
67
Kolmogorov-Smirnov test
1 The
K-S test statistic is
T the length of the longest arrow
0.8
0.6
0.4
data
0.2 cdf of N(4,1)
EDF
0
3 3.5 4 4.5 5 5.5 6

x
Figure 4.8: K-S test
the largest difference (in absolute terms) of the EDF and the cdfamong the observed
values of x t . See Figure 4.8.
p
We reject the null hypothesis that EDF.x/ D F .x/ if T D t > c, where c is a critical
value which can be calculated from
p 1
2i 2 c 2
X
lim Pr T DT c D 1 2 . 1/i 1
e : (4.8)
T !1
i D1
It can be approximated by replacing 1 with a large number (for instance, 100). For
instance, c D 1:35 provides a 5% critical value. See Figure 4.9. There is a corresponding
test for comparing two empirical cdfs.
Pearsons 2 test does the same thing as the K-S test but for a discrete distribution.
Suppose you have K categories with Ni values in category i. The theoretical distribution
predicts that the fraction pi should be in category i , with Ki D1 pi D 1. Then
P
K
X .Ni Tpi /2 2
K 1: (4.9)
i D1
Tpi
68

Cdf of K-S test stat, T DT
1
0.95
cdf
p-value Critical value

0.150 1.138
0.9 0.100 1.224
0.050 1.358
0.025 1.480
0.010 1.628
0.85
1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9
c
p
Figure 4.9: Distribution of the Kolmogorov-Smirnov test statistics, T DT
There is a corresponding test for comparing two empirical distributions.
4.1.5 Fitting a Mixture Normal Distribution to Data
Reference: Hastie, Tibshirani, and Friedman (2001) 8.5

A normal distribution often fits return data poorly. If we need a distribution, then a
mixture of two normals is typically much better, and still fairly simple.
The pdf of this distribution is just a weighted average of two different (bell shaped)
pdfs of normal distributions (also called mixture components)
f .x t I 1 ; 2 ; 12 ; 22 ; / D .1 /.x t I 1 ; 12 / C .x t I 2 ; 22 /; (4.10)
where .xI i ; i2 / is the pdf of a normal distribution with mean i and variance i2 . It
thus contains five parameters: the means and the variances of the two components and
their relative weight ().
See Figures 4.104.12 for an illustration.
Remark 4.5 (Estimation of the mixture normal pdf) With 2 mixture components, the log
likelihood is just
XT
LL D ln f .x t I 1 ; 2 ; 12 ; 22 ; /;
t D1
where f ./ is the pdf in (4.10) A numerical optimization method could be used to maximize
69
Distribution of daily S&P500 returns
normal pdf
0.6
0.5
0.4
0.3
0.2 Daily S&P 500 returns

1957:12014:3
0.1
0
5 4 3 2 1 0 1 2 3 4 5
Figure 4.10: Histogram of returns and a fitted normal distribution
this likelihood function. However, this is tricky so an alternative approach is often used.
This is an iterative approach in three steps:
(1) Guess values of 1 ; 2 ; 12 ; 22 and . For instance, pick 1 D x1 , 2 D x2 , 12 D
22 D Var.x t / and D 0:5.
(2) Calculate
.x t I 2 ; 22 /
t D for t D 1; : : : ; T:
.1 /.x t I 1 ; 12 / C .x t I 2 ; 22 /
(3) Calculate (in this order)

PT PT
.1 /x tD1 .1 t /.x t 1 /2
1 D Pt D1
t t 2
T
, 1 D P T
;
t D1 .1 t / t D1 .1 t /
PT PT
t D1 t x t t .x t 2 /2
2 D PT , 2 D t D1PT
2
, and
t D1 t tD1 t
XT
D t =T .
t D1
Iterate over (2) and (3) until the parameter values converge. (This is an example of the
EM algorithm.) Notice that the calculation of i2 uses i from the same (not the previous)
70
Distribution of daily S&P500 returns
Mixture pdf 1
0.6 Mixture pdf 2
pdf 1 pdf 2
mean 0.03 -0.04 Total pdf
0.5 std 0.66 2.01
weight 0.84 0.16
0.4
0.3

1957:12014:3
0.1
0
5 4 3 2 1 0 1 2 3 4 5
Figure 4.11: Histogram of returns and a fitted mixture normal distribution
iteration.
4.1.6 Kernel Density Estimation
Reference: Silverman (1986)

A histogram is just a count of the relative number of observations that fall in (pre-
specified) non-overlapping intervals. If we also divide by the width of the interval, then
the area under the histogram is unity, so the scaled histogram can be interpreted as a
density function. If the intervals (bins) are h wide around a point x: x h=2 to x Ch=2.
The scaled histogram at the point x (say, x D 2:3) can be defined as
T
O 1 X 1 x t x
f .x/ D 1=2 ; where (4.11)
T t D1 h h
(
1 if q is true
.q/ D
0 else.
Note that the area under fO .x/ indeed integrates to unity.

In fact, that h1 .jx t xj h=2/ is the pdf value of a uniformly distributed variable
71
QQ plot of daily S&P 500 returns
6
0.1th to 99.9th percentiles
2
Empirical quantiles
4 Daily S&P 500 returns

1957:12014:3
6 4 2 0 2 4 6
Quantiles from estimated mixture normal, %
Figure 4.12: Quantiles of daily S&P returns
(over the interval x h=2 to x C h=2). This shows that our estimate of the pdf (here:
the histogram) can be thought of as a average of hypothetical pdf values of the data in
the neighbourhood of x. However, we can gain efficiency and get a smoother (across x
values) estimate by using another density function that the uniform. In particular, using a
density function that tapers off continuously instead of suddenly dropping to zero (as the
uniform density does) improves the properties. In fact, the N.0; h2 / is often used. The
kernel density estimator of the pdf at some point x is then
2
1 XT 1 1 x x
fO .x/ D
t
p exp : (4.12)
T t D1 h 2 2 h
Notice that the function in the summation is the density function of a N.x; h2 / distribu-
tion.
See Figure 4.13 for an example of the weights.
The value h D 1:06 Std.x t /T 1=5 is sometimes recommended, since it can be shown
to be the optimal choice (in MSE sense) if data is normally distributed and the Gaussian
kernel is used.(See below for a proof.) The bandwidth h could also be chosen by a leave-
72
Weights for histogram (at x = 4) Weights for kernel density (at x = 4)
2 2
1.5 1.5
1 data 1
weights
0.5 Bin: 4 0.25 0.5
0 0
3 3.5 4 4.5 5 3 3.5 4 4.5 5
x x
Weights for kernel density (at x = 4), larger h

2
1.5
1
0.5
0
3 3.5 4 4.5 5
x
Figure 4.13: Calculation of the pdf at x D 4
one-out cross-validation technique.

See Figure 4.14 for an example and Figure 4.15 for a cross-validation approach to
determine the bandwidth.
It can be shown (see Silverman (1986) 3.3) that under the assumption that x t is iid, the
mean squared error, variance and bias of the estimator at the value x are approximately
(for general kernel functions)
MSE.x/ D VarfO.x/ C BiasfO.x/2 , with

1 R1
VarfO.x/ D f .x/ 1 K.u/2 du
Th
1 d 2 f .x/ R 1
BiasfO.x/ D h2 1 K.u/u2 du: (4.13)
2 dx 2
In these expressions, f .x/ is the true density of x and K.u/ the kernel (pdf) used as a
weighting function for u D .x t x/= h. With an N.0; 1/ kernel these expressions can be
73
simplified to
1 1
VarfO.x/ D f .x/ p
Th 2
2
1 d f .x/
BiasfO.x/ D h2 : (4.14)
2 dx 2
Proof. (of (4.14)) We know that
R1 2 1 R1
1 K.u/ du D p and 1 K.u/u2 du D 1;
2
if K.u/ is the density function of a standard normal distribution. (We are effectively using
the N.0; 1/ pdf for the variable .x t x/= h.) Use in (4.13).
Proof. (Best bandwidth if f .x/ N ) Use (4.14) to write the mean integrated squared
error (MISE) as
2
d 2 f .x/
Z
1 1 1
Z Z
MISE.x/ D MSE.x/dx D f .x/dx p C h4 dx:
Th 2 4 dx 2
Notice that f .x/dx D 1 and if f .x/ is the pdf of N.0; 2 /, then the last integral is
R
p
3=.8 5 /. Combining gives
1 1 1 3
MISE.x/ D p C h4 5
p :
Th2 4 8
The first order condition with respect to h is

1 3
0D 2
C h3 5 , or
Th 4
4 5
D h5 , so
3T
1=5
4 1=5
hD T :
3
The term .4=3/1=5 1:06.

It can then be shown that (with iid data and a Gaussian kernel) the asymptotic distri-
bution is
p
1

O d
T hf .x/ f .x/ ! N 0; p f .x/ ; (4.15)
2
provided h is decreased (as T increases) slightly faster than T 1=5 (for instance, suppose
p
h D T 1:1=5 h0 , where h0 is a constant). Notice the T h term on left hand side (the usual
74
p
expression in parametric models include only T ).
Remark 4.6 (Asymptotic bias) The condition that h decreases faster than T 1=5 ensures
p
O
that the bias of T hb.x/ vanishes as T ! 1. This is seen by noticing that the bias in
p
O
(4.14) is proportional to h2 . Combining gives the bias of T hb.x/ as being proportional
1=2 5=2 1:1=5
to T h . If indeed h D T h0 , then we have
0:05 5=2
T 1=2 h5=2 D T h0
which is decreasing to zero as T increases.
Remark 4.7 (Cross-validation to choose h) If x t is iid, then the following cross-validation

approach is perhaps the easiest way to find the best bandwidth. Define the integrated
squared error (ISE) as f .x/ fO.x/2 dx. (ISE is specific for a sample, while the MISE
R
discussed above is the expected value of ISE across all samples. The difference is small
in large samples.) Expand as ISE D f .x/2 C fO.x/2 2f .x/fO.x/dx. For the first
R
term, notice that f .x/2 dx does not depend on the bandwidth, so we can treat is as a
R
constant, . If we use an N.0; 1/ kernel, then it can be shown that the middle term is
O 2 1 XT 1 XT 1 x t xs
f .x/ dx D O t /; where g.x
O t/ D
R
g.x :
T t D1 T sD1 h h
where .x/ is the pdf of a N.0; 2/. The last term is the same as 2 Ex fO.x/, where Ex
denotes that the expectation is over which x value that is realized. If we had access to
another sample (xQ i ), then we could plug in those values in the (already estimated) fO./
function to estimate Ex fO.x/ as the average fO.xQ i / value. Instead, we use a leave-one-out
approach which preserves the property that fO./ does not depend on the xi value: estimate
fO t .x/ by excluding data point t from the sample, and then evaluate it at x D x t , fO t .x t /.
(The alternative of using the the same sample for both estimation and evaluation would
lead to a classical overfitting, driving the h value towards zero.) Then, estimate Ex fO.x/
by the average fO t .x t / value. To sum up, pick h to minimize ISE.h/, where
1 XT h O
i
ISE.h/ D C O t / 2f t .x t / :
g.x
T tD1
The easiest way to handle a bounded support of x is to transform the variable into one
with an unbounded support, estimate the pdf for this variable, and then use the change
of variable technique to transform to the pdf of the original variable.
We can also estimate multivariate pdfs. Let x t be a d 1 matrix and O be the estimated
covariance matrix of x t . We can then estimate the pdf at a point x by using a multivariate
75
Kernel density estimate of daily S&P500 returns
optimal bandwith
0.6 higher bandwidth
0.5
0.4
0.3

1957:12014:3
0.1
0
5 4 3 2 1 0 1 2 3 4 5
Figure 4.14: Stock returns
Cross validation simulations

2.5
integrated squared error (ISE)
2 Daily S&P 500 returns

1957:12014:3
1.5
rule-of-thumb
1
0.5
0.5
1
0.05 0.1 0.15 0.2 0.25
bandwidth (h)
Figure 4.15: Stock returns
Gaussian kernel as

1 XT 1 1
fO .x/ D exp .x t 0 O
x/ .H / 2
.x t 1
x/ : (4.16)
T O 1=2
t D1 .2/d=2 jH 2 j 2
76
Notice that the function in the summation is the (multivariate) density function of a
O distribution. The value H D 1:06T 1=.d C4/ is sometimes recommended.
N.x; H 2 /
Remark 4.8 ((4.16) with d D 1) With just one variable, (4.16) becomes
" 2 #
1 XT 1 1 x x
fO .x/ D
t
p exp ;
T t D1 H Std.x / 2
t 2 H Std.x t /
which is the same as (4.12) if h D H Std.x t /.
4.1.7 Foundations of Technical Analysis... by Lo, Mamaysky and Wang (2000)
Reference: Lo, Mamaysky, and Wang (2000)

Topic: is the distribution of the return different after a signal?. This paper uses
kernel regressions to identify and implement some technical trading rules, and then tests
if the distribution (of the return) after a signal is the same as the unconditional distribution
(using Pearsons 2 test and the Kolmogorov-Smirnov test). They reject that hypothesis
in many cases, using daily data (1962-1996) for around 50 (randomly selected) stocks.
Inverted MA rule, S&P 500

1350
MA(3) and MA(25), bandwidth 0.01
Circles at the bottom (top) margin indicates buys (sells)
1300
1250
1200
Long MA (-)
Long MA (+)
Short MA
1150
Jan Feb Mar Apr
1999
Figure 4.16: Examples of trading rules
77
Distribution of returns for all days Inverted MA rule: after buy signal
Mean Std Mean Std dashed: 95%
0.6 0.03 1.16 0.6 0.06 1.71 confidence band
0.4 0.4
0.2 0.2
0 0
2 0 2 2 0 2
Return Return
Daily S&P 500 data 1990:12014:3
Inverted MA rule: after neutral signal Inverted MA rule: after sell signal
Mean Std Mean Std
0.6 0.04 0.96 0.6 0.02 0.88
0.4 0.4
0.2 0.2
0 0
2 0 2 2 0 2
Return Return
Figure 4.17: Distribution of returns after different trading signals
4.2 Estimating Risk-neutral Distributions from Options
Reference: Breeden and Litzenberger (1978); Cox and Ross (1976), Taylor (2005) 16,
Jackwerth (2000), Sderlind and Svensson (1997a) and Sderlind (2000)
4.2.1 The Breeden-Litzenberger Approach
A European call option price with strike price X has the price
C D E M max .0; S X/ ; (4.17)
where M is the nominal discount factor and S is the price of the underlying asset at the
expiration date of the option k periods from now.
We have seen that the price of a derivative is a discounted risk-neutral expectation of
78
the derivative payoff. For the option it is
C D exp. ik/ E max .0; S X/ ; (4.18)
where E is the risk-neutral expectation.
Example 4.9 (Call prices, three states) Suppose that S only can take three values: 90,
100, and 110; and that the risk-neutral probabilities for these events are: 0.5, 0.4, and
0.1, respectively. We consider three European call option contracts with the strike prices
89, 99, and 109. From (4.18) their prices are (if B D 1)
C .X D 89/ D 0:5.90 89/ C 0:4.100 89/ C 0:1.110 89/ D 7

C .X D 99/ D 0:5 0 C 0:4.100 99/ C 0:1.110 99/ D 1: 5
C .X D 109/ D 0:5 0 C 0:4 0 C 0:1.110 109/ D 0:1:
Clearly, with information on the option prices, we could in this case back out what the
probabilities are.
(4.18) can also be written as

Z 1
C D exp. ik/ .S X/ h .S / dS; (4.19)
X
where i is the per period (annualized) interest rate so exp. ik/ D Bk and h .S / is the
(univariate) risk-neutral probability density function of the underlying price (not its log).
Differentiating (4.19) with respect to the strike price and rearranging gives the risk-neutral
distribution function
@C .X /
Pr .S X/ D 1 C exp.ik/ : (4.20)
@X
Proof. Differentiating the call price with respect to the strike price gives
Z 1
@C
D exp . ik/ h .S / dS D exp . ik/ Pr .S > X/ :
@X X
Use Pr .S > X/ D 1 Pr .S X/.

Differentiating once more gives the risk-neutral probability density function of S at
S DX
@2 C.X/
pdf .X/ D exp.ik/ : (4.21)
@X 2
Figure 4.18 shows some data and results for German bond options on one trading date.
(A change of variable approach is used to show the distribution of the log asset price.)
79
Bond options, approximate cdf Bond options, approximate pdf
1
20
0.5 10
Options on German gov
bonds, traded on LIFFE
25-Mar-1994 0
0
95 100 105 95 100 105
Strike price Strike price
Figure 4.18: Bund options 6 April 1994. Options expiring in June 1994.
A difference quotient approximation of the derivative in (4.20)

@C 1 C .Xi C1 / C .Xi / C .Xi / C .Xi 1/
C (4.22)
@X 2 Xi C1 Xi Xi Xi 1
gives the approximate distribution function. The approximate probability density func-
tion, obtained by a second-order difference quotient
@2 C

C .Xi C1 / C .Xi / C .Xi / C .Xi 1 / 1
= .Xi C1 Xi 1 / (4.23)
@X 2 Xi C1 Xi Xi Xi 1 2
is also shown. The approximate distribution function is decreasing in some intervals,
and the approximate density function has some negative values and is very jagged. This
could possibly be explained by some aberrations of the option prices, but more likely
by the approximation of the derivatives: changing approximation method (for instance,
from centred to forward difference quotient) can have a strong effect on the results, but
all methods seem to generate strange results in some interval. This suggests that it might
be important to estimate an explicit distribution. That is, to impose enough restrictions on
the results to guarantee that they are well behaved.
4.2.2 Mixture of Normals
A flexible way of estimating an explicit distribution is to assume that the distribution of

the logs of M and S, conditional on the information today, is a mixture of n bivariate
normal distributions (see Sderlind and Svensson (1997b)). Let .xI ; / denote a
normal multivariate density function over x with mean vector and covariance matrix
. The weight of the j t h normal distribution is .j / , so the probability density function,
80
Bond options, implied volatility Bond options, pdf
0.1
Options on German gov 25-Mar-1994 N
bonds, traded on LIFFE 1 mix N
25-Mar-1994
0.09
0.5
0.08
0
5.5 6 6.5 7 7.5 5.5 6 6.5 7 7.5
Strike price (yield to maturity, %) Yield to maturity, %
Bond options, fitted iv Bond options, pdfs on 2 dates

0.1
25-Mar-1994 23-Feb-1994
1 03-Mar-1994
0.09
0.5
0.08
0
5.5 6 6.5 7 7.5 5.5 6 6.5 7 7.5
Strike price (yield to maturity, %) Yield to maturity, %
Figure 4.19: Bund options 23 February and 3 March 1994. Options expiring in June 1994.
pdf, of ln M and ln S is assumed to be

n
" #! " # " # " #!
.j / .j / .j /
ln M X ln M m mm ms
pdf D .j / I .j / ; .j / .j / ; (4.24)
ln S j D1
ln S s ms ss
with jnD1 .j / D 1 and .j / 0. One interpretation of mixing normal distributions is

P
that they represent different macro economic states, where the weight is interpreted as
the probability of state j .
Let .:/ be the standardized (univariate) normal distribution function. If .j /
m D m
.j /
and mm D mm in (4.24), then the marginal distribution of the log SDF is Gaussian
(while that of the underlying asset price is not). In this case the European call option price
(4.17) has a closed form solution in terms of the spot interest rate, strike price, and the
81
parameters of the bivariate distribution1
2 0 1
n .j / .j / .j /
B s C ms C ss ln X C

X 1 .j /
C D exp. ik/ .j / 4exp .j /
C .j /
C
6
s ms
2 ss
@ q A
.j /
j D1 ss
0 13
.j / .j /
B s C ms ln X C7
X @ q A5 : (4.25)
.j /
ss
(For a proof, see Sderlind and Svensson (1997b).) Notice that this is like using the
physical distribution, but with .j / .j /
s C ms instead of s .
.j /
Notice also that this is a weighted average of the option price that would hold in each
state
X n
C D .j / C .j / : (4.26)
j D1
(See Ritchey (1990) and Melick and Thomas (1997).)

A forward contract written in t stipulates that, in period , the holder of the contract
gets one asset and pays F . This can be thought of as an option with a zero strike price
and no discountingand it is also the mean of the riskneutral distribution. The forward
price then follows directly from (4.25) as
n
!
.j /
X ss
F D exp s C ms C
.j / .j / .j /
: (4.27)
j D1
2
There are several reasons for assuming a mixture of normal distributions. First, non-
parametric methods often generate strange results, so we need to assume some parametric
distribution. Second, it gives closed form solutions for the option and forward prices,
which is very useful in the estimation of the parameters. Third, it gives the Black-Scholes
model as a special case when n D 1.
To see the latter, let n D 1 and use the forward price from (4.27), F D exp .s C ms C ss =2/,
in the option price (4.25) to get
ln F=X C ss =2 ln F=X ss =2

C D exp. ik/F p exp. ik/X p ; (4.28)
ss ss
1
Without these restrictions, .j / in (4.25) is replaced by Q .j / D .j / exp.m N .j / C
.j / .j / .j /
=2/= jnD1 .j / exp.m C mm =2/. In this case, Q .j / , not .j / , will be estimated from option
P
mm
data.
82
02-Mar-2009 16-Mar-2009
From CHF/EUR options 6
6
4 4
pdf
pdf
2 2
0 0
1.3 1.4 1.5 1.6 1.3 1.4 1.5 1.6
CHF/EUR CHF/EUR
16-Nov-2009 17-May-2010
8
15
6
pdf
10 pdf
4
5 2
0 0
1.3 1.4 1.5 1.6 1.3 1.4 1.5 1.6
CHF/EUR CHF/EUR
Figure 4.20: Riskneutral distribution of the CHF/EUR exchange rate
which is indeed Blacks formula.

We want to estimate the marginal distribution of the future asset price, S. From (4.24),
it is a mixture of univariate normal distributions with weights .j / , means .j /
s , and vari-
.j /
ances ss . The basic approach is to back out these parameters from data on option and
forward prices by exploiting the pricing relations (4.25)(4.27). For that we need data on
at least at many different strike prices as there are parameters to estimate.
Remark 4.10 Figures 4.184.19 show some data and results (assuming a mixture of two
normal distributions) for German bond options around the announcement of the very high
money growth rate on 2 March 1994..
Remark 4.11 Figures 4.204.22 show results for the CHF/EUR exchange rate around
the period of active (Swiss) central bank interventions on the currency market.
Remark 4.12 (Robust measures of the standard deviation and skewness) Let P be the
th quantile (for instance, quantile 0.1) of a distribution. A simple robust measure of the
83
CHF/EUR 3m, 80% conf band and forward
1.6
1.55
1.5
1.45
1.4
1.35
1.3
1.25
1.2
200901 200904 200907 200910 201001 201004
standard deviation is just the difference between two symmetric quantile,
Std D P1 P ;
where it is assumed that < 0:5. Sometimes this measure is scaled so it would give the
right answer for a normal distribution. For instance, with D 0:1, the measure would be
divided by 2.56 and for D 0:25 by 1.35.
One of the classical robust skewness measures was suggested by Hinkley
.P1 P0:5 / .P0:5 P /

Skew D :
P1 P
This skewness measure can only take on values between 1 (when P1 D P0:5 ) and
1 (when P D P0:5 ). When the median is just between the two percentiles (P0:5 D
.P1 C P /=2), then it is zero.
4.3 Threshold Exceedance and Tail Distribution
Reference: McNeil, Frey, and Embrechts (2005) 7
84
Robust variance (10/90 perc) Robust skewness (10/90 perc)
From CHF/EUR options
0.1 0
0.2
0.05
0.4
0
200901 201001 2009 2010
iv atm 25 risk reversal/iv(atm)
0.1 0
0.2
0.05
0.4
0
2009 2010 2009 2010
In risk control, the focus is on the distribution of losses beyond some threshold level.
This has three direct implications. First, the object under study is the loss
XD R; (4.29)
that is, the negative of the return. Second, the attention is on how the distribution looks
like beyond a threshold and also on the probability of exceeding this threshold. In con-
trast, the exact shape of the distribution below that point is typically disregarded. Third,
modelling the tail of the distribution is best done by using a distribution that allows for a
much heavier tail that suggested by a normal distribution. The generalized Pareto (GP)
distribution is often used. See Figure 4.23 for an illustration.
Remark 4.13 (Cdf and pdf of the generalized Pareto distribution) The generalized Pareto
distribution is described by a scale parameter ( > 0) and a shape parameter (). The
85
unknown shape
90% probability mass (Pu D 0:9) generalized Pareto dist
u Loss
Figure 4.23: Loss distribution
cdf (Pr.Z z/, where Z is the random variable and z is a value) is

(
1 .1 C z=/ 1= if 0
G.z/ D
1 exp. z=/ D 0;
for 0 z if 0 and z = in case < 0. The pdf is therefore

(

1
.1 C z=/ 1= 1 if 0
g.z/ D

1
exp. z=/ D 0:
The mean is defined (finite) if < 1 and is then E.Z/ D =.1 /. Similarly, the variance
is finite if < 1=2 and is then Var.Z/ D 2 =.1 /2 .1 2/. See Figure 4.24 for an
illustration.
Remark 4.14 (Random number from a generalized Pareto distribution ) By inverting

the Cdf, we can notice that if u is uniformly distributed on .0; 1, then we can construct
random variables with a GPD by
z D .1 u/
1 if 0
zD ln.1 u/ D 0:
Consider the loss X (the negative of the return) and let u be a threshold. Assume
that the threshold exceedance (X u) has a generalized Pareto distribution. Let Pu be
probability of X u, that is, Pu D Pr.X u/. Then, the cdf of the loss for values
greater than the threshold (Pr.X x/ for x > u) can be written
F .x/ D Pu C G.x u/.1 Pu /, for x > u; (4.30)
86
Pdf of generalized Pareto distribution ( = 0.15)
7
=0
6 = 0.25
= 0.45
5
0
0 0.1 0.2 0.3 0.4 0.5
Outcome of random variable
Figure 4.24: Generalized Pareto distributions
where G.z/ is the cdf of the generalized Pareto distribution. Noticed that, the cdf value is
Pu at at x D u (or just slightly above u), and that it becomes one as x goes to infinity.
Clearly, the pdf is
f .x/ D g.x u/.1 Pu /, for x > u; (4.31)
where g.z/ is the pdf of the generalized Pareto distribution. Notice that integrating the
pdf from x D u to infinity shows that the probability mass of X above u is 1 Pu . Since
the probability mass below u is Pu , it adds up to unity (as it should). See Figure 4.26 for
an illustration.
It is often to calculate the tail probability Pr.X > x/, which in the case of the cdf in
(4.30) is
1 F .x/ D .1 Pu /1 G.x u/; (4.32)
where G.z/ is the cdf of the generalized Pareto distribution.

The VaR (say, D 95%) is the -th quantile of the loss distribution
VaR D cdfX 1 ./; (4.33)
where cdfX 1 ./ is the inverse cumulative distribution function of the losses. That is, VaR
is the quantile of the loss distribution. For instance, VaR95% is the 0:95 quantile of the
87
Loss distributions for loss > 12, Pr(loss > 12) = 10%
1 N(0.08, 0.162 )
generalized Pareto ( = 0.22, = 0.16)
0.8
VaR(95%) ES(95%)
0.6
Normal dist 18.2 25.3
GP dist 24.5 48.4
0.4
0.2
0
15 20 25 30 35 40 45 50 55 60
Loss, %
Figure 4.25: Comparison of a normal and a generalized Pareto distribution for the tail of
losses
loss distribution. This clearly means that the probability of the loss to be less than VaR
equals
Pr.X VaR / D : (4.34)
(Equivalently, the Pr.X >VaR / D 1 :)

Assuming VaR u (that is, Pu ), the cdf (4.30) together with the form of the
generalized Pareto distribution give
8

< uC 1
1 if 0

1 Pu
VaR D , for Pu : (4.35)
u ln 1 Pu1
D0

:
Proof. (of (4.35)) Set F .x/ D in (4.30) and use z D x u in the cdf from Remark
4.13 and solve for x.
If we assume < 1 (to make sure that the mean is finite), then straightforward inte-
gration using (4.31) shows that the expected shortfall is
ES D E.XjX VaR /
VaR u
D C , for > Pu and < 1: (4.36)
1 1
88
The expected exceedance of a GP distribution (with < 1) for any threshold > u is
e./ D E .X jX > /

u
D C , for > u and < 1. (4.37)
1 1
Proof. (of (4.37)) Substitute for VaR in the expected shortfall (4.36)
u
E.XjX / D C
1 1
and subtract from both sides to get (4.37).
The expected exceedance of a generalized Pareto distribution (with 0 < < 1) is
increasing with the threshold level . This indicates that the tail of the distribution is
very long. In contrast, a normal distribution would typically show a negative relation (see
Figure 4.26 for an illustration). This provides a way of assessing which distribution that
best fits the tail of the historical histogram.
Remark 4.15 (Expected exceedance from a normal distribution) If X N.; 2 /, then
.0 /
E.X jX > / D C ;
1 .0 /
with 0 D . /=
where ./ and are the pdf and cdf of a N.0; 1/ variable respectively.
The expected exceedance over is often compared with an empirical estimate of the
same thing: the mean of X t for those observations where X t >
PT
t D1 .X t /.X t > /
O
e./ D PT ; where (4.38)
t D1 .X t > /
(
1 if q is true
.q/ D
0 else.
If it is found that e./

O is increasing (more or less) linearly with the threshold level ()
as in (4.37), then it is reasonable to model the tail of the distribution from that point as a
generalized Pareto distribution.
The estimation of the parameters of the distribution ( and ) is typically done by
maximum likelihood. Alternatively, A comparison of the empirical exceedance (4.38)
with the theoretical (4.37) can help. Suppose we calculate the empirical exceedance for
89
different values of the threshold level (denoted i all large enough so the relation looks
linear), then we can estimate (by LS)
O i / D a C bi C "i :
e. (4.39)
Then, the theoretical exceedance (4.37) for a given starting point of the GPD u is related
to this regression according to
u
aD and b D , or
1 1
b
D and D a.1 / C u: (4.40)
1Cb
Expected exeedance (loss minus threshold, v)

30
25
20
N(0.08, 0.162 )
15
generalized Pareto ( = 0.22, = 0.16, u = 12)
10
0
15 20 25 30 35 40
Threshold v, %
Figure 4.26: Expected exceedance, normal and generalized Pareto distribution
Remark 4.16 (Log likelihood function of the loss distribution) Since we have assumed
that the threshold exceedance (X u) has a generalized Pareto distribution, Remark 4.13
shows that the log likelihood for the observation of the loss above the threshold (X t > u)
90
is
X
LD Lt
t st. X t >u
(
ln .1= C 1/ ln 1 C .X t u/ = if 0
ln L t D
ln .X t u/ = D 0:
This allows us to estimate and by maximum likelihood. Typically, u is not estimated,

but imposed a priori (based on the expected exceedance).
Expected exceedance Estimated loss distribution (pdf)

Loss minus threshold, v
(50th to 99th percentiles) u = 1.3, Pr(loss > u) = 6.8%

1.2 u = 1.3, = 0.29, = 0.52 0.1
= 0.24, = 0.57
1
0.05
0.8
0.6
0
0 0.5 1 1.5 2 2.5 1.5 2 2.5 3 3.5 4
Threshold v, % Loss, %
QQ plot
Daily S&P 500 returns, 1957:12013:12
Empirical quantiles
(94th to 99th percentiles)

2.5
1.5
1.5 2 2.5
Quantiles from estimated GPD, %
Figure 4.27: Results from S&P 500 data
Example 4.17 (Estimation of the generalized Pareto distribution on S&P daily returns).
Figure 4.27 (upper left panel) shows that it may be reasonable to fit a GP distribution
with a threshold u D 1:3. The upper right panel illustrates the estimated distribution,
while the lower left panel shows that the highest quantiles are well captured by estimated
distribution.
91
4.4 Exceedance Correlations
Reference: Ang and Chen (2002)

It is often argued that most assets are more strongly correlated in down markets than
in up markets. If so, diversification may not be such a powerful tool as what we would
otherwise believe.
A straightforward way of examining this is to calculate the correlation of two returns
(x and y, say) for specific intervals. For instance, we could specify that x t should be
between h1 and h2 and y t between k1 and k2
Corr.x t ; y t jh1 < x t h2 ; k1 < y t k2 /: (4.41)
For instance, by setting the lower boundaries (h1 and k1 ) to 1 and the upper boundaries
(h2 and k2 ) to 0, we get the correlation in down markets.
A (bivariate) normal distribution has little probability mass at very low returns, which
leads to the correlation being squeezed towards zero as we only consider data far out in
the tail. In short, the tail correlation of a normal distribution is always closer to zero than
the correlation for all data points. This is illustrated in Figure 4.28.
In contrast, Figures 4.294.30 suggest (for two US portfolios) that the correlation in
the lower tail is almost as high as for all the data and considerably higher than for the
upper tail. This suggests that the relation between the two returns in the tails is not well
described by a normal distribution. In particular, we need to use a distribution that allows
for much stronger dependence in the lower tail. Otherwise, the diversification benefits (in
down markets) are likely to be exaggerated.
4.5 Beyond (Linear) Correlations
Reference: Alexander (2008) 6, McNeil, Frey, and Embrechts (2005)

The standard correlation (also called Pearsons correlation) measures the linear rela-
tion between two variables, that is, to what extent one variable can be explained by a
linear function of the other variable (and a constant). That is adequate for most issues
in finance, but we sometimes need to capture non-linear relations. It also turns out to be
easier to calibrate/estimate copulas (see below) by using other measures of dependency.
Spearmans rank correlation (called Spearmans rho and often denoted S ) measures
to what degree two variables have a monotonic relation: it is the correlation of their
92
Correlation in lower tail, bivariate N(0,1) distribution
0.7 corr = 0.75

corr = 0.5 corr is the correlation of the
corr = 0.25
0.6 full bivariate distribution
0.5
0.4
0.3
0.2
0.1
0
0 0.1 0.2 0.3 0.4 0.5
Upper boundary (prob of lower value)
Figure 4.28: Correlation in lower tail when data is drawn from a normal distribution with
correlation
respective ranks. It measures if one variable tends to be high when the other also is
without imposing the restriction that this relation must be linear.
It is computed in two steps. First, the data is ranked from the smallest (rank 1) to
the largest (ranked T , where T is the sample size). Ties (when two or more observations
have the same values) are handled by averaging the ranks. The following illustrates this
for two variables
x t rank.x t / y t rank.y t /
2 2:5 7 2
10 4 8 3 (4.42)
3 1 2 1
2 2:5 10 4
In the second step, simply estimate the correlation of the ranks of two variables
Spearmans D Corrrank.x t /; rank.y t /: (4.43)
Clearly, this correlation is between 1 and 1. (There is an alternative way of calculating

the rank correlation based on the difference of the ranks, d t Drank.x t / rank.y t /, D
1 6 tTD1 d t2 =.T 3 T /. It gives the same result if there are no tied ranks.) See Figure
4.31 for an illustration.
93
Extreme returns of two portfolios
Daily US data 1979:12013:12

10
Lines mark 5th and 95th percentiles
5
Returns of large stocks, %
10
Corr freq
All 0.69 1.00
15 Low 0.76 0.02

Mid 0.52 0.84
High 0.50 0.02
20
20 15 10 5 0 5 10
Returns of small stocks, %
Figure 4.29: Correlation of two portfolios
The rank correlation can be tested by using the fact that under the null hypothesis the
rank correlation is zero. We then get
p
T 1 Spearmans !d N.0; 1/: (4.44)
q
(For samples of 20 to 40 observations, it is often recommended to use .T 2/=.1 OS2 /OS
where OS denotes Spearmans . This has a tT 2 distribution.)
Remark 4.18 (Spearmans for a distribution ) If we have specified the joint distribu-
tion of the random variables X and Y , then we can also calculate the implied Spearmans
(sometimes only numerically) as CorrFX .X/; FY .Y / where FX .X/ is the cdf of X and
FY .Y / of Y .
Kendalls rank correlation (called Kendalls ) is similar, but is based on compar-

ing changes of x t (compared to x1 ; : : : x t 1 ) with the corresponding changes of y t . For
94
Lower tail correlation Upper tail correlation
0.8 0.8
0.7 0.7
0.6 0.6
0.5 0.5
0.4 0.4
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Upper boundary (quantile level) Lower boundary (quantile level)
small stocks and large stocks

from 10 size deciles
Figure 4.30: Correlation in the tails for two portfolios

Corr = 0.90 Corr = 0.03
2 2
1 1
0 0
y
1 1
Spearmans = 0.88 Spearmans = 0.03
2 Kendalls = 0.69 2 Kendalls = 0.01
5 0 5 5 0 5
x x
Corr = 0.88 Corr = 0.49

2 2
1 1
0 0
y
1 1
Spearmans = 0.84 Spearmans = 1.00
2 Kendalls = 0.65 2 Kendalls = 1.00
5 0 5 5 0 5
x x
Figure 4.31: Illustration of correlation and rank correlation
instance, with three data points (.x1 ; y1 /; .x2 ; y2 /; .x3 ; y3 /) we first calculate
Changes of x Changes of y
x2 x1 y2 y1
(4.45)
95
x3 x1 y3 y1
x3 x2 y3 y2 ;
which gives T .T 1/=2 (here 3) pairs. Then, we investigate if the pairs are concordant
(same sign of the change of x and y) or discordant (different signs) pairs
ij is concordant if .xj xi /.yj yi / > 0 (4.46)

ij is discordant if .xj xi /.yj yi / < 0:
Finally, we count the number of concordant (Tc ) and discordant (Td ) pairs and calculate
Kendalls tau as
Tc Td
Kendalls D : (4.47)
T .T 1/=2
It can be shown that
4T C 10

Kendalls ! N 0;
d
; (4.48)
9T .T 1/
so it is straightforward to test by a t-test.
Example 4.19 (Kendalls tau) Suppose the data is
x y
2 7
10 9
3 10:
We then get the following changes
Changes of x Changes of y
x2 x1 D 10 2 D 8 y2 y1 D 9 7 D 2 concordant
x3 x1 D 3 2 D 5 y3 y1 D 10 7 D 3 discordant
x3 x2 D 3 10 D 13 y3 y2 D 10 9 D 1; discordant.
Kendalls tau is therefore

1 2 1
D D :
3.3 1/=2 3
If x and y actually has bivariate normal distribution with correlation , then it can be
shown that on average we have
6
Spearmans rho = arcsin.=2/ (4.49)

2
Kendalls tau D arcsin./: (4.50)

In this case, all three measures give similar messages (although the Kendalls tau tends to
96
be lower than the linear correlation and Spearmans rho). This is illustrated in Figure 4.32.
Clearly, when data is not normally distributed, then these measures can give distinctly
different answers.
Spearmans and Kendalls as functions of linear corr

1
Spearmans
Kendalls
0.8 The variables have joint normal
distributions with correlations
according to the horizontal axis
0.6
0.4
0.2
0
0 0.2 0.4 0.6 0.8 1
Correlation
Figure 4.32: Spearmans rho and Kendalls tau if data has a bivariate normal distribution
A joint -quantile exceedance probability measures how often two random variables
(x and y, say) are both above their quantile. Similarly, we can also define the probability
that they are both below their quantile
G D Pr.x x; ; y y; /; (4.51)
x; and y; are -quantile of the x- and y-distribution respectively.

In practice, this can be estimated from data by first finding the empirical -quantiles
(x; and Oy; ) by simply sorting the data and then picking out the value of observation
O
T of this sorted list (do this individually for x and y). Then, calculate the estimate
1 XT
GO D t ; where (4.52)
T t D1
1 if x t Ox; and y t Oy;

(
t D
0 otherwise.
See Figure 4.33 for an illustration based on a joint normal distribution.
97
Pr(x < Q(x, q), y < Q(y, q)), Gauss Pr(x < Q(x, q), y < Q(y, q)), Gauss
100 5
corr = 0.25
corr = 0.5 4
3
%
%
50
2
1
0 0
0 50 100 0 5 10
Quantile level (q), % Quantile level (q), %
Figure 4.33: Probability of joint low returns, bivariate normal distribution
4.6 Copulas
Reference: McNeil, Frey, and Embrechts (2005), Alexander (2008) 6, Jondeau, Poon, and
Rockinger (2007) 6
Portfolio choice and risk analysis depend crucially on the joint distribution of asset
returns. Empirical evidence suggest that many returns have non-normal distribution, es-
pecially when we focus on the tails. There are several ways of estimating complicated
joint (non-normal) distributions: using copulas is one. This approach has the advantage
that it proceeds in two steps: first we estimate the marginal distribution of each return
separately, then we model the comovements by a copula.
4.6.1 Multivariate Distributions and Copulas
Any pdf can also be written as
f1;2 .x1 ; x2 / D c.u1 ; u2 /f1 .x1 /f2 .x2 /; with (4.53)

ui D Fi .xi /;
where c./ is a copula density function and ui D Fi .xi / is short-hand notation for the cdf
value as in (4.1). The extension to three or more random variables is straightforward.
Equation (4.53) means that if we know the joint pdf f1;2 .x1 ; x2 /and thus also the
cdfs F1 .x1 / and F2 .x2 /then we can figure out what the copula density function must
be. Alternatively, if we know the marginal (univariate) pdfs f1 .x1 / and f2 .x2 /and thus
also the cdfs F1 .x1 / and F2 .x2 /and the copula function, then we can construct the joint
distribution. (This is called Sklars theorem.) This latter approach will turn out to be
98
useful.
The correlation of x1 and x2 depends on both the copula and the marginal distribu-
tions. In contrast, both Spearmans rho and Kendalls tau are determined by the copula
only. They therefore provide a way of calibrating/estimating the copula without having to
involve the marginal distributions directly.
Example 4.20 (Independent X and Y ) If X and Y are independent, then we know that
f1;2 .x1 ; x2 / D f1 .x1 /f2 .x2 /, so the copula density function is just a constant equal to
one.
Remark 4.21 (Joint cdf) A joint cdf of two random variables (X1 and X2 ) is defined as
F1;2 .x1 ; x2 / D Pr.X1 x1 and X2 x2 /:
This cdf is obtained by integrating the joint pdf f1;2 .x1 ; x2 / over both variables
Z x1 Z x2
F1;2 .x1 ; x2 / D f1;2 .s; t/dsdt:
sD 1 tD 1
(Conversely, the pdf is the mixed derivative of the cdf, f1;2 .x1 ; x2 / D @2 F1;2 .x1 ; x2 /=@x1 @x2 .)
Remark 4.22 (From joint to univariate pdf) The pdf of x1 (also called the marginal pdf
R1
of x1 ) can be calculate from the joint pdf as f1 .x1 / D x2 D 1 f1;2 .x1 ; x2 /dx2 .
pdf of bivariate N() distribution, corr = 0.8 cdf of bivariate N() distribution, corr = 0.8
0.2 1
0.1 0.5
2 2
0 0
2 0 2 0
0 x 0 x
y 2 2 y 2 2
Figure 4.34: Bivariate normal distributions
99
Remark 4.23 (Joint pdf and copula density, n variables) For n variables (4.53) general-
izes to
f1;2;:::;n .x1 ; x2 ; : : : ; xn / D c.u1 ; u2 ; : : : ; un /f1 .x1 /f2 .x2 / : : : fn .xn /; with

ui D Fi .xi /;
Remark 4.24 (Cdfs and copulas ) The joint cdf can be written as
F1;2 .x1 ; x2 / D C F1 .x1 /; F2 .x2 /;
where C./ is the unique copula function. Taking derivatives gives (4.53) where
@2 C.u1 ; u2 /
c.u1 ; u2 / D :
@u1 @u2
Notice the derivatives are with respect to ui D Fi .xi /, not xi . Conversely, integrating the
density over both u1 and u2 gives the copula function C./.
4.6.2 The Gaussian and Other Copula Densities
The bivariate Gaussian copula density function is

2 2
1 21 2 C 2 22

1
c.u1 ; u2 / D p exp , with (4.54)
1 2 2.1 2 /
1
i D .ui /;
where 1 ./ is the inverse of an N.0; 1/ distribution.

Notice that when using this function in (4.53) to construct the joint pdf, we have to
first calculate the cdf values ui D Fi .xi / from the univariate distribution of xi (which
may be non-normal) and then calculate the quantiles of those according to a standard
normal distribution i D 1 .ui / D 1 Fi .xi /. This is used in (4.54) (and finally in
(4.53)). See Figure 4.35 for an illustration.
It can be shown that assuming that the marginal pdfs (f1 .x1 / and f2 .x2 /) are normal
and then combining with the Gaussian copula density recovers a bivariate normal dis-
tribution. However, the way we typically use copulas is to assume (and estimate) some
other type of univariate distribution, for instance, with fat tailsand then combine with a
(Gaussian) copula density to create the joint distribution.
A zero correlation ( D 0) makes the copula density (4.54) equal to unityso the
joint density is just the product of the marginal densities. A positive correlation makes the
100
copula density high when both x1 and x2 deviate from their means in the same direction.
The easiest way to calibrate a Gaussian copula is therefore to set
D Spearmans rho, (4.55)
as suggested by (4.49).
Alternatively, the parameter can be calibrated to give a joint probability of both x1
and x2 being lower than some quantileto match the properties of data: see (4.52). The
value of this probability (according to a copula) is easily calculated by finding the copula
function (essentially the cdf) corresponding to a copula density. Some results are given in
remarks below. See Figure 4.33 for results from a Gaussian copula. This figure shows that
a higher correlation implies a larger probability that both variables are very lowbut that
the probabilities quickly become very small as we move towards lower quantiles (lower
returns).
Remark 4.25 (The Gaussian copula function ) The distribution function corresponding
to the Gaussian copula density (4.54) is obtained by integrating over both u1 and u2 and
the value is C.u1 ; u"2 I #
/ D" .1 ; 2 / where i is defined in (4.54) and is the bivariate
#!
0 1
normal cdf for N ; . Most statistical software contains numerical routines
0 1
for calculating this cdf.
Remark 4.26 (Multivariate Gaussian copula density ) The Gaussian copula density for
n variables is
1 1 0
c.u/ D p exp .R 1
In / ;
jRj 2
where R is the correlation matrix with determinant jRj and is a column vector with
i D 1 .ui / as the i th element.
The Gaussian copula is useful, but it has the drawback that it is symmetricso the
downside and the upside look the same. This is at odds with evidence from many financial
markets that show higher correlations across assets in down markets. The Clayton copula
density is therefore an interesting alternative
c.u1 ; u2 / D . 1 C u1 C u2 / 2 1=
.u1 u2 / 1
.1 C /; (4.56)
where 0. When > 0, then correlation on the downside is much higher than on the
upside (where it goes to zero as we move further out the tail).
101
For the Clayton copula we have

Kendalls D , so (4.57)
C2
2K
D ; (4.58)
1 K
where K denotes Kendalls . The easiest way to calibrate a Clayton copula is therefore
to set the parameter according to (4.58).
Figure 4.36 illustrates how the probability of both variables to be below their respec-
tive quantiles depend on the parameter. These parameters are comparable to the those
for the correlations in Figure 4.33 for the Gaussian copula, see (4.49)(4.50). The figure
are therefore comparableand the main point is that Claytons copula gives probabilities
of joint low values (both variables being low) that do not decay as quickly as according to
the Gaussian copulas. Intuitively, this means that the Clayton copula exhibits much higher
correlations in the lower tail than the Gaussian copula doesalthough they imply the
same overall correlation. That is, according to the Clayton copula more of the overall
correlation of data is driven by synchronized movements in the left tail. This could be
interpreted as if the correlation is higher in market crashes than during normal times.
Remark 4.27 (Multivariate Clayton copula density ) The Clayton copula density for n
variables is
Pn n 1= Qn 1 Qn
c.u/ D 1 nC C .i

i D1 ui i D1 ui i D1 1 1/ :
Remark 4.28 (Clayton copula function ) The copula function (the cdf) corresponding to
(4.56) is
C.u1 ; u2 / D . 1 C u1 C u2 / 1= :
The following steps summarize how the copula is used to construct the multivariate
distribution.
1. Construct the marginal pdfs fi .xi / and thus also the marginal cdfs Fi .xi /. For in-
stance, this could be done by fitting a distribution with a fat tail. With this, calculate
the cdf values for the data ui D Fi .xi / as in (4.1).
2. Calculate the copula density as follows (for the Gaussian or Clayton copulas, re-
spectively):
102
Gaussian copula density, corr = -0.5 Gaussian copula density, corr = 0
5 5
0 0
2 2
0 0
x2 2 0 2 x2 2 2
2 x1 2 x1 0
Gaussian copula density, corr = 0.5 Clayton copula density, = 1.5 ( = 0.43)
5 5
0 0
2 2
0 0
x2 2 0 2 x2 2 2
2 x1 2 x1 0
Figure 4.35: Copula densities (as functions of xi )
Pr(x < Q(x, q), y < Q(y, q)), Gauss Pr(x < Q(x, q), y < Q(y, q)), Clayton
5 5
corr = 0.25 = 0.38
4 corr = 0.5 4 = 1.00
3 3
%
2 2
1 1
0 0
0 5 10 0 5 10
Quantile level (q), % Quantile level (q), %
The values are calibrated
to give correlations of
0.25 and 0.5
Figure 4.36: Probability of joint low returns, Clayton copula
(a) for the Gaussian copula (4.54)

i. assume (or estimate/calibrate) a correlation to use in the Gaussian cop-
ula
103
ii. calculate i D 1
.ui /, where 1
./ is the inverse of a N.0; 1/ distribu-
tion
iii. combine to get the copula density value c.u1 ; u2 /
(b) for the Clayton copula (4.56)
i. assume (or estimate/calibrate) an to use in the Clayton copula (typically
based on Kendalls as in (4.58))
ii. calculate the copula density value c.u1 ; u2 /
3. Combine the marginal pdfs and the copula density as in (4.53), f1;2 .x1 ; x2 / D
c.u1 ; u2 /f1 .x1 /f2 .x2 /, where ui D Fi .xi / is the cdf value according to the marginal
distribution of variable i .
See Figures 4.374.38 for illustrations.
Joint pdf, Gaussian copula, corr = -0.5 Joint pdf, Gaussian copula, corr = 0
2 2
1 1
x2
x2
0 0
1 1
2 2
2 1 0 1 2 2 1 0 1 2
x1 x1
Notice: marginal distributions are N(0,1)
Joint pdf, Gaussian copula, corr = 0.5 Joint pdf, Clayton copula, = 1.5
2 2
1 1
x2
x2
0 0
1 1
2 2
2 1 0 1 2 2 1 0 1 2
x1 x1
Figure 4.37: Contours of bivariate pdfs
104
Joint pdf, Gaussian copula, corr = -0.5 Joint pdf, Gaussian copula, corr = 0
2 2
1 1
x2
x2
0 0
1 1
2 2
2 1 0 1 2 2 1 0 1 2
x1 x1
Notice: marginal distributions are t5
Joint pdf, Gaussian copula, corr = 0.5 Joint pdf, Clayton copula, = 1.5
2 2
1 1
x2
x2
0 0
1 1
2 2
2 1 0 1 2 2 1 0 1 2
x1 x1
Figure 4.38: Contours of bivariate pdfs
Remark 4.29 (Tail Dependence ) The measure of lower tail dependence starts by finding
the probability that X1 is lower than its qth quantile (X1 F1 1 .q/) given that X2 is
lower than its qth quantile (X2 F2 1 .q/)
l D PrX1 F1 1 .q/jX2 F2 1 .q/;
and then takes the limit as the quantile goes to zero
l D limq!0 PrX1 F1 1 .q/jX2 F2 1 .q/:
It can be shown that a Gaussian copula gives zero or very weak tail dependence,
unless the correlation is 1. It can also be shown that the lower tail dependence of the
Clayton copula is
l D 2 1= if > 0
and zero otherwise.
105
4.7 Joint Tail Distribution
The methods for estimating the (marginal) distribution of the lower tail for each return can
be combined with a copula to model the joint tail distribution. In particular, combining the
generalized Pareto distribution (GPD) with the Clayton copula provides a flexible way.
This can be done by first modelling the loss (X t D R t ) beyond some threshold (u),
that is, the variable X t u with the GDP. To get a distribution of the return, we simply use
the fact that pdfR . z/ D pdfX .z/ for any value z. Then, in a second step we calibrate the
copula by using Kendalls for the subsample when both returns are less than u. Figures
4.394.41 provide an illustration.
Remark 4.30 Figure 4.39 suggests that the joint occurrence (of these two assets) of re-
ally negative returns happens more often than the estimated normal distribution would
suggest. For that reason, the joint distribution is estimated by first fitting generalized
Pareto distributions to each of the series and then these are combined with a copula as in
(4.41) to generate the joint distribution. In particular, the Clayton copula seems to give a
long joint negative tail.
Prob(both returns < quantile) Prob(both returns < quantile), zoomed in

100 5
Data
estimated N() 4
3
%
50
2
1
0 0
0 50 100 0 5 10
Quantile level, % Quantile level, %

small stocks and large stocks
Figure 4.39: Probability of joint low returns
To find the implication for a portfolio of several assets with a given joint tail distribu-
tion, we often resort to simulations. That is, we draw random numbers (returns for each
of the assets) from the joint tail distribution and then study the properties of the portfolio
(with say, equal weights or whatever). The reason we simulate is that it is very hard to
106
Loss distribution, small stocks Loss distribution, large stocks
u = 0.5, Pr(loss > u) = 17.8% u = 0.5, Pr(loss > u) = 24.6%
0.2 = 0.20, = 0.61 0.2 = 0.12, = 0.67
0.15 Daily US data 1979:12013:12 0.15
0.1 0.1
0.05 0.05
0 0
1 2 3 4 5 1 2 3 4 5
Loss, % Loss, %
Return distribution, small stocks Return distribution, large stocks

(Only lower tail is shown) (Only lower tail is shown)
0.2 0.2
0.15 GP 0.15
0.1 Normal 0.1
0.05 0.05
0 0
5 4 3 2 1 5 4 3 2 1
Return, % Return, %
Figure 4.40: Estimation of marginal loss distributions
actually calculate the distribution of the portfolio by using mathematics, so we have to

rely on raw number crunching.
The approach proceeds in two steps. First, draw n values for the copula (ui ; i D
1; : : : ; n). Second, calculate the random number (return) by inverting the cdf ui D
Fi .xi / in (4.53) as
xi D Fi 1 .ui /; (4.59)
where Fi 1 ./ is the inverse of the cdf.
Remark 4.31 (To draw n random numbers from a Gaussian copula) First, draw n num-
bers from an N.0; R/ distribution, where R is the correlations matrix. Second, calculate
ui D .xi /, where is the cdf of a standard normal distribution.
Remark 4.32 (To draw n random numbers from a Clayton copula) First, draw xi for
i D 1; : : : ; n from a uniform distribution (between 0 and 1). Second, draw v from a
gamma(1=; 1) distribution. Third, calculate ui D 1 ln.xi /=v 1= for i D 1; : : : ; n.
107
Joint pdf, independent copula Joint pdf, Gaussian copula
1 1
large stocks
large stocks
2 2
3 3
Spearmans = 0.44
4 4
4 3 2 1 4 3 2 1
small stocks small stocks
Joint pdf, Clayton copula

1 The marginal distributions of the losses
large stocks
are estimated GP distributions

2
3
Kendalls = 0.30, = 0.87
4
4 3 2 1
small stocks
Figure 4.41: Joint pdfs with different copulas
These ui values are the marginal cdf values.
Remark 4.33 (Inverting a normal and a generalised Pareto cdf) Must numerical soft-
ware packages contain a routine for inverting a normal cdf. Remark 4.13 shows how to
generate random numbers for a generalised Pareto distribution.
Such simulations can be used to quickly calculate the VaR and other risk measures
for different portfolios. A Clayton copula with a high parameter (and hence a high
Kendalls ) has long lower tail with highly correlated returns: when asset takes a dive,
other assets are also likely to decrease. That is, the correlation in the lower tail of the
return distribution is high, which will make the VaR high.
Figures 4.424.43 give an illustration of how the movements in the lower get more
synchronised as the parameter in the Clayton copula increases.
108
Gaussian copula, = 0.49 Clayton copula, = 0.56
4 4
= 0.22
2 2
Asset 2
Asset 2
0 0
2 2
marginal pdf:
normal
4 4
4 2 0 2 4 4 2 0 2 4
Asset 1 Asset 1
Clayton copula, = 1.06 Clayton copula, = 2.06
4 4
= 0.35 = 0.51
2 2
Asset 2
0 Asset 2 0
2 2
4 4
4 2 0 2 4 4 2 0 2 4
Asset 1 Asset 1
Figure 4.42: Example of scatter plots of two asset returns drawn from different copulas
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109
Quantile of equally weighted portfolio, different copulas
0.8
Notice: VaR95% = (the 5% quantile)
1
1.2
1.4
1.6
1.8
N
2 Clayton, = 0.56
Clayton, = 1.06
Clayton, = 2.06
2.2
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
Prob of lower outcome
Figure 4.43: Quantiles of an equally weighted portfolio of two asset returns drawn from
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111
5 Predicting Asset Returns
Reference: Cochrane (2005) 20.1; Campbell, Lo, and MacKinlay (1997) 2 and 7;
Taylor (2005) 57
5.1 A Little Financial Theory and Predictability
The traditional interpretation of autocorrelation in asset returns is that there are some
irrational traders. For instance, feedback trading would create positive short term au-
tocorrelation in returns. If there are non-trivial market imperfections, then predictability
can be used to generate economic profits. If there are no important market imperfections,
then predictability of excess returns should be thought of as predictable movements in
risk premia.
To see the latter, let RetC1 be the excess return on an asset. The canonical asset pricing
equation then says
E t m t C1 RetC1 D 0; (5.1)
where m t C1 is the stochastic discount factor.
Remark 5.1 (A consumption-based model) Suppose we want to maximize the expected

1
discounted sum of utility E t sD0 s u.c t Cs /. Let Q t be the consumer price index in t.
Then, we have 8
< u0 .ct C1 / Qt if returns are nominal
u0 .c t / Q t C1
m t C1 D
: . t C1 / if returns are real.
u 0 c
u0 .c t /
We can rewrite (5.1) (using Cov.x; y/ D E xy E x E y) as
E t RetC1 D Cov t .m t C1 ; RetC1 /= E t m t C1 : (5.2)
This says that the expected excess return will vary if risk (the covariance) does. If there is
some sort of reasonable relation between beliefs and the properties of actual returns (not
necessarily full rationality), then we should not be too surprised to find predictability.
112
Example 5.2 (Epstein-Zin utility function) Epstein and Zin (1991) define a certainty
equivalent of future utility as Z t D E t .U t1C1 /1=.1 / where is the risk aversionand
then use a CES aggregator function to govern the intertemporal trade-off between current
consumption and the certainty equivalent: U t D .1 /C t1 1= C Z t1 1= 1=.1 1= /
where is the elasticity of intertemporal substitution. If returns are iid (so the consumption-
wealth ratio is constant), then it can be shown that this utility function has the same
pricing implications as the CRRA utility, that is,
E.C t =C t 1/

R t D constant.
(See Sderlind (2006) for a simple proof.)
Example 5.3 (Portfolio choice with predictable returns) Campbell and Viceira (1999)
specify a model where the log return of the only risky asset follows the time series process
r t C1 D rf C x t C u t C1 ;
where rf is a constant riskfree rate, u t C1 is unpredictable, and the state variable follows
(constant suppressed)
x tC1 D x t C t C1 ;
where t C1 is also unpredictable. Clearly, E t .r t C1 rf / D x t . Cov t .u t C1 ; t C1 / can

be non-zero. For instance, with Cov t .u tC1 ; t C1 / < 0, a high return (u t C1 > 0) is
typically associated with an expected low future return (x tC1 is low since t C1 < 0) With
Epstein-Zin preferences, the portfolio weight on the risky asset is (approximately) of the
form
v t D a0 C a1 x t ;
where a0 and a1 are complicated expression (in terms of the model parameterscan be
calculated numerically). There are several interesting results. First, if returns are not
predictable (x t is constant since t C1 is), then the portfolio choice is constant. Second,
when returns are predictable, but the relative risk aversion is unity (no intertemporal
hedging), then v t D 1=.2 / C x t = Var t .u t C1 /. Third, with a higher risk aversion and
Cov t .u t C1 ; tC1 / < 0, there is a positive hedging demand for the risky asset: it pays off
(today) when the future investment opportunities are poor.
Example 5.4 (Habit persistence) The habit persistence model of Campbell and Cochrane
(1999) has a CRRA utility function, but the argument is the difference between consump-
tion and a habit level, C t X t , instead of just consumption. The habit is parametrised in
113
terms of the surplus ratio S t D .C t X t /=C t . The log surplus ratio.(s t )is assumed to
be a non-linear AR(1)
s t D s t 1 C .s t 1 /c t :
It can be shown (see Sderlind (2006)) that if .s t 1 / is a constant and the excess return
is unpredictable (by s t ) then the habit persistence model is virtually the same as the CRRA
model, but with .1 C / as the effective risk aversion.
Example 5.5 (Reaction to news and the autocorrelation of returns) Let the log asset
price, p t , be the sum of a random walk and a temporary component (with perfectly cor-
related innovations, to make things simple)
p t D u t C " t , where u t D u t 1 C "t

D ut 1 C .1 C /" t :
Let r t D p t pt 1 be the log return. It is straightforward to calculate that
Cov.r t C1 ; r t / D .1 C / Var." t /;
so 0 < < 1 (initial overreaction of the price) gives a negative autocorrelation. In short,
mean reversion in the price level means negative autocorrelation of the returnsand vice
versa. See Figure 5.1 for the impulse responses with respect to a piece of news, " t .
5.2 Autocorrelations
Reference: Campbell, Lo, and MacKinlay (1997) 2
5.2.1 Autocorrelation Coefficients and the Box-Pierce Test
The sampling properties of autocorrelations (Os ) are complicated, but there are several
useful large sample results for Gaussian processes (these results typically carry over to
processes which are similar to the Gaussiana homoskedastic process with finite 6th
moment is typically enough, see Priestley (1981) 5.3 or Brockwell and Davis (1991) 7.2
7.3). When the true autocorrelations are all zero (not 0 , of course), then for any i and j
different from zero
p
" # " # " #!
Oi 0 1 0
T !d N ; : (5.3)
Oj 0 0 1
114
Impulse response, = 0.4 Impulse response, = 0.4
1 1
0 0
1 Price 1
Return
0 1 2 3 4 5 0 1 2 3 4 5
period period
Price is random walk + temporary component Result:

pt = ut + t , where ut = ut1 + t mean reversion (momentum) in the price
implies negative (positive) autocorrelation
The figure traces out the response to of the returns
1 = 1, starting from u0 = 0
Figure 5.1: Impulse responses when price is random walk plus temporary component
This result can be used to construct tests for both single autocorrelations (t-test or 2 test)
and several autocorrelations at once (2 test). To apply this on returns, the return horizon
can be whatever (seconds, years,...), but it is important that the returns are non-overlapping
(time aggregation can easily introduce spurious serial correlation).
Example 5.6 (t-test) We want to test the hypothesis that 1 D 0. Since the N.0; 1/ dis-
tribution has 5% of the probability mass below -1.64 and another 5% above 1.64, we
p
can reject the null hypothesis at the 10% level if T jO1 j > 1:64. With T D 100, we
p
therefore need jO1 j > 1:64= 100 D 0:165 for rejection, and with T D 1000 we need
p
jO1 j > 1:64= 1000 0:053.
p
The Box-Pierce test follows directly from the result in (5.3), since it shows that T Oi
p
and T Oj are iid N(0,1) variables. Therefore, the sum of the square of them is distributed
as an 2 variable. The test statistic typically used is
L
X
QL D T Os2 !d L
2
: (5.4)
sD1
Example 5.7 (Box-Pierce) Let O1 D 0:165, and T D 100, so Q1 D 100 0:1652 D
2:72. The 10% critical value of the 21 distribution is 2.71, so the null hypothesis of no
autocorrelation is rejected.
115
SMI SMI daily excess returns, %
6 10
SMI
bill portfolio 5
4
0
2
-5
0 -10
1995 2000 2005 2010 1995 2000 2005 2010
Daily SMI data, 1993:52014:2
1st order autocorrelations:

daily weekly monthly
returns 0.03 -0.10 0.02
|returns| 0.29 0.31 0.19
Figure 5.2: Time series properties of SMI
The choice of lag order in (5.4), L, should be guided by theoretical considerations, but
it may also be wise to try different values. There is clearly a trade off: too few lags may
miss a significant high-order autocorrelation, but too many lags can destroy the power of
the test (as the test statistic is not affected much by increasing L, but the critical values
increase).
See Figures 5.25.3.
The main problem with these tests is that the assumptions behind the results in (5.3)
may not be reasonable. For instance, data may be heteroskedastic. One way of handling
these issues is to make use of the GMM framework. (Alternatively, the results in Taylor
(2005) are useful.)
Remark 5.8 (Runs test ) A runs test is a non-parametric test of randomness. Let d t
be an indicator variable (
0 if y t q
dt D
1 if y t > q
where q typically (but not necessarily) is the mean of y t . Let T1 D TtD1 d t , that is the
P
number of occasions when y t > q, and T2 D T T1 (the number of occasions when

y t q). Also define the numbers of runs (r), that is, the number of changes in the d t
116
Autocorr, daily excess returns Autocorr, weekly excess returns
Autocorr with 90% conf band around 0
0.2 S&P 500, 1979:12014:2 0.2
0.1 0.1
0 0
0.1 0.1
1 2 3 4 5 1 2 3 4 5
lag (days) lag (weeks)
Autocorr, daily abs(excess returns) Autocorr, weekly abs(excess returns)
0.2 0.2
0.1 0.1
0 0
0.1 0.1
1 2 3 4 5 1 2 3 4 5
lag (days) lag (weeks)
Figure 5.3: Predictability of US stock returns
series (where the first observation is counted as a change)

PT
r D1C t D2 jd t dt 1 j:
(Warning: r indicates runs, not returns.) It is straightforward (but tedious) to show

that, under the null hypothesis of randomness,
T1 T2
Er D 2 C 1 and
T
.E r 1/.E r 2/
Var.r/ D :
T 1
We can therefore test the null hypothesis of randomness by a t-stat
r Er
!d N.0; 1/:
Var.r/
p
The basic intuition of the test is that a positive autocorrelation would lead to too few runs
117
1st autocorrelation 2nd autocorrelation
0.1 0.1
0.05 0.05
0 0
0.05 0.05
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
size decile size decile
3rd autocorrelation
Autocorrelations of excess returns
on size sorted equity portfolios
0.1
Decile 1 contains the 10% smallest firms,
0.05
while decile 10 the 10% largest firms
0
US daily data 1979:12014:2
0.05
1 2 3 4 5 6 7 8 9 10
size decile
Figure 5.4: Predictability of US stock returns, size deciles
(r < E r): the y t variable would stay on one side of the threshold q for long spells of
timeand hence there would be few changes in x t . Negative autocorrelation is just the
opposite, since it tends to give a zigzag pattern around the mean. See Figure 5.5 for an
example.
5.2.2 GMM Test of Autocorrelation
This section discusses how GMM can be used to test if a series is autocorrelated. The
analysis focuses on first-order autocorrelation, but it is straightforward to extend it to
higher-order autocorrelation.
Consider a scalar random variable x t with a zero mean (it is easy to extend the analysis
to allow for a non-zero mean). Consider the moment conditions
T
" # " # " #
x t2 2 1 X x t2 2 2
g t ./ D ; so g./
N D , with D :
x t x t 1 2 T tD1 x t x t 1 2
(5.5)
118
t-stat for runs test of returns
10
A negative t-stat indicates too

few runs (positive autocorrelation)
15 US daily excess returns 1979:12014:2
1 2 3 4 5 6 7 8 9 10
size decile
Figure 5.5: Runs test
2 is the variance and the first-order autocorrelation so 2 is the first-order autocovari-

ance. We want to test if D 0. We could proceed along two different routes: estimate
and test if it is different from zero or set to zero and then test overidentifying restrictions.
We are able to arrive at simple expressions for these testsprovided we are willing
to make strong assumptions about the data generating process. (These tests then typically
coincide with classical tests like the Box-Pierce test.) One of the strong points of GMM
is that we could perform similar tests without making strong assumptionsprovided we
use a correct estimator of the asymptotic covariance matrix of the moment conditions.
Remark 5.9 (Box-Pierce as an Application of GMM) (5.5) is an exactly identified system

so the weight matrix does not matter, so the asymptotic distribution is
p d
T .O
1
0 / ! N.0; V /, where V D D00 S0 1 D0

;
where D0 is the Jacobian of the moment conditions and S0 the covariance matrix of the
moment conditions (at the true parameter values). We have
" # " # " #
@gN 1 .0 /=@ 2 @gN 1 .0 /=@ 1 0 1 0
D0 D plim D D ;
@gN 2 .0 /=@ 2 @gN 2 .0 /=@ 2 0 2
119
since D 0 (the true value). The definition of the covariance matrix is
"p T
# "p T #0
T X T X
S0 D E g t .0 / g t .0 / :
T t D1 T t D1
Assume that there is no autocorrelation in g t .0 / (which means, among other things, that
volatility, x t2 ; is not autocorrelated). We can then simplify as
S0 D E g t .0 /g t .0 /0 :
This assumption is stronger than assuming that D 0, but we make it here in order to
illustrate the asymptotic distribution. Moreover, assume that x t is iid N.0; 2 /. In this
case (and with D 0 imposed) we get
" #" #0 " #
x t2 2 x t2 2 .x t2 2 /2 .x t2 2 /x t x t 1
S0 D E DE
xt xt 1 xt xt 1 .x t2 2 /x t x t 1 .x t x t 1 /2
" # " #
E x t4 2 2 E x t2 C 4 0 2 4 0
D D :
0 E x t2 x t2 1 0 4
To make the simplification in the second line we use the facts that E x t4 D 3 4 if x t
N.0; 2 /, and that the normality and the iid properties of x t together imply E x t2 x t2 1 D
E x t2 E x t2 1 and E x t3 x t 1 D E 2 x t x t 1 D 0. Combining gives
p
" #!
O 2 0 1
Cov T D D0 S0 D0 1
O
0" #0 " # 1" #1 1
4
1 0 2 0 1 0
D@ 2 4
A
0 0 0 2
" #
2 4 0
D :
0 1
p
This shows that T O !d N.0; 1/.
5.2.3 Autoregressions
An alternative way of testing autocorrelations is to estimate an AR model
r t D c C a1 r t 1 C a2 r t 2 C ::: C ap r t p C "t ; (5.6)
120
and then test if all the slope coefficients are zero with a 2 test. The return horizon can
be whatever (seconds, years,...), but it is important that the returns are non-overlapping.
See Figures 5.65.7 for illustrations. Notice that the results can be sensitive to the sample
period.
This approach is somewhat less general than the Box-Pierce test, but most stationary
time series processes can be well approximated by an AR of relatively low order. To
account for heteroskedasticity and other problems, it can make sense to estimate the co-
variance matrix of the parameters by an estimator like Newey-West. It can be noticed that
when r t D c C a1 r t 1 C " t , then a1 D 1 .
Slope coefficient (b) R2
0.5 Slope with 90% conf band

0.1
0
0.05
0.5
0
0 20 40 60 0 20 40 60
Return horizon (months) Return horizon (months)
Scatter plot, 36 month returns Monthly US stock excess returns,

2 1926:12013:12
1 Regression: Ret = a + bRt1

e
+ t
Return
2
2 1 0 1 2
lagged return
The autoregression can easily allow for the coefficients to depend on the market situ-
ation. For instance, consider an AR(1), but where the autoregression coefficient may be
121
Slope with 90% conf band
0.5
0.1
0
0.05
0.5
0
0 20 40 60 0 20 40 60
Monthly US stock excess returns,

1957:12013:12
Regression: Ret = a + bRt1

e
+ t
different depending on the sign of last periods return
r t D c C a.r t 1 0/r t 1 C b.r t 1 > 0/r t 1, where (5.7)

(
1 if q is true
.q/ D
0 else.
Remark 5.10 (Pitfall I in testing long-run returns) Let r t in (5.6) be a two period return,
r t D rQt C rQt 1 , where rQt is a one-period (log) return. An AR(1) on overlapping data
would then be
rQt C rQt 1 D c C a.rQt 1 C rQt 2 / C " t :
Even if the one-period returns are uncorrelated, a would tend to be positive and significant
since rQt 1 shows up on both the left and right hand sides: the returns are overlapping.
Instead, the correct specification is
rQt C rQt 1 D c C a.rQt 2 C rQt 3/ C "t :
Remark 5.11 (Pitfall 2 in testing long-run returns) A less serious pitfall is to use all
available returns on the left hand side, for instance, all daily two-day returns. Two suc-
122
Autoregression coeff, after negative returns Autoregression coeff, after positive returns
0.1 0.1
with 90% conf band around 0
0.05 S&P 500 (daily), 1979:12014:2 0.05
0 0
0.05 0.05
0.1 0.1
1 2 3 4 5 1 2 3 4 5
lag (days) lag (days)
Based on the following regression:
Ret = + (1 Qt1 )Rt1

e e
+ Qt1 Rt1 + t
Qt1 = 1 if rt1 > 0, and zero otherwise
Figure 5.8: Predictability of US stock returns, results from a regression with interactive
dummies
cessive observations are then
rQt C rQt 1 D c C a.rQt 2 C rQt 3/ C "t

rQt C1 C rQt D c C a.rQt 1 C rQt 2/ C " t C1
There is no problem with the point estimate of a, since the left and right hand side returns
do not overlap. However, the residuals (" t and " t C1 ) are likely to be correlated which has
to be handled in order to make correct inference. To see this, suppose rQt D c=2 C u t
where u t is iid. Clearly, the left and right hand sides are uncorrelated, so D 0. With
this we have
rQt C rQt 1 D c C " t , where " t D u t C u t 1
rQt C1 C rQt D c C " t C1 , where " t C1 D u t C1 C u t :
Since u t shows up in both " t and " t C1 , the latter are correlated. See Figure 5.9. This can
be solved by using a Newey-West approach (or something similar), or by skipping every
second observation (there is then no overlap of the residuals).
123
e
Slope (b) in Rte = a + bRt 1 + t Autocorrelation of residual
0.5 1
0 0.5
0.5 0
0 5 10 15 20 0 5 10 15 20
Slope with two different 90% conf band, OLS and NW std
Monthly US stock excess returns 1926:12013:12, overlapping data
Figure 5.9: Slope coefficient, LS vs Newey-West standard errors
5.3 Multivariate (Auto-)correlations
There is no reason to restrict the prediction model to only use the lagged returns of the
same asset. See Figure 5.10 for an illustration.
Coefficient on self (lagged), Coefficient on decile 10 (lagged),

0.1 0.1
0.05 0.05
0 0
0.05 0.05
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
size decile size decile
Multiple regression with lagged excess Decile 1 contains the 10% smallest firms,
return on self and largest decile as while decile 10 the 10% largest firms
regressors:
e e e
Ri,t = + Ri,t1 + R10,t1 + t US daily excess returns 1979:12014:2
Figure 5.10: Coefficients from multiple prediction regressions
124
5.3.1 Momentum or Contrarian Strategy?
A momentum strategy invests in assets that have performed well recentlyand often goes
short in those that have underperformed. The performance is driven by both autocorrela-
tion and spill-over effects from other assets.
See 5.11 for an empirical illustration.
Buy winners and sell losers
excess return
alpha
8
6
Buy (sell) the 5 assets with highest
(lowest) return over the last month
4
2
25 FF portfolios
0
0 2 4 6 8 10 12
Evaluation horizon, days
Figure 5.11: Performance of momentum investing
To formalize this, let there be N assets with returns R, with means and autocovariance
matrix
E R D and (5.8)
.k/ D E.R t /.R t k /0 :
Example 5.12 ( .k/ with two assets) We have

" #
Cov.R1;t ; R1;t k / Cov.R1;t ; R2;t k/
.k/ D :
Cov.R2;t ; R1;t k / Cov.R2;t ; R2;t k/
Define the equal weighted market portfolio return as simply

N
1 X
Rmt D Ri t D 10 R t =N (5.9)
N i D1
125
with the corresponding mean return
N
1 X
m D i D 10 =N: (5.10)
N i D1
A momentum strategy could (for instance) use the portfolio weights

Rt k Rmt k
w t .k/ D ; (5.11)
N
which basically says that wi t .k/ is positive for assets with an above average return k pe-
riods back. Notice that the weights sum to zero, so this is a zero cost portfolio. However,
the weights differ from fixed weights (for instance, put 1=5 into the best 5 assets, and
1=5 into the 5 worst assets) since the overall size of the exposure (10 jw t j) changes over
time. A large dispersion of the past returns means large positions and vice versa. To
analyse a contrarian strategy, reverse the sign of (5.11).
The profit from this strategy is
N N
X Ri t k Rmt k
X Ri t k Ri t
t .k/ D Ri t D Rmt k Rmt ; (5.12)
i D1 N
i D1
N
wit
where the last term uses the fact that iND1 Rmt k Ri t =N D Rmt k Rmt .
The expected value is

N
1 0 N 1 1 X
E t .k/ D 1 .k/1 tr .k/ C tr .k/ C .i m /2 ; (5.13)
N2 N2 N i D1
where the 10 .k/1 sums all the elements of .k/ and tr .k/ sums the elements along
the main diagonal. (See below for a proof.) To analyse a contrarian strategy, reverse the
sign of (5.13).
With a random walk, .k/ D 0, then (5.13) shows that the momentum strategy wins
money: the first two terms are zero, while the third term contributes to a positive perfor-
mance. The reason is that the momentum strategy (on average) invests in assets with high
average returns (i > m ).
The first term of (5.13) sums all elements in the autocovariance matrix and then sub-
tracts the sum of the diagonal elementsso it only depends on the sum of the cross-
covariances, that is, how a return is correlated with the lagged return of other assets. In
general, negative cross-covariances benefit a momentum strategy. To see why, suppose a
126
high lagged return on asset 1 predicts a low return on asset 2, but asset 2 cannot predict
asset 1 (Cov.R2;t ; R1;t k / < 0 and Cov.R1;t ; R2;t k / D 0). This helps the momentum
strategy since we have a negative portfolio weight of asset 2 (since it performed relatively
poorly in the previous period).
Example 5.13 ((5.13) with 2 assets) Suppose we have

" # " #
Cov.R1;t ; R1;t k / Cov.R1;t ; R2;t k / 0 0
.k/ D D :
Cov.R2;t ; R1;t k / Cov.R2;t ; R2;t k/ 0:1 0
Then
1 0 1
1 .k/1 tr .k/ D 0:1 0 D 0:025, and

N 2 22
N 1 2 1
tr .k/ D 0 D 0;
N2 2
so the sum of the first two terms of (5.13) is positive (good for a momentum strategy).
For instance, suppose R1;t k > 0, then R2;t tends to be low which is good (we have a
negative portfolio weight on asset 2).
The second term of (5.13) depends only on own autocovariances, that is, how a return
is correlated with the lagged return of the same asset. If these own autocovariances are
(on average) positive, then a strongly performing asset in t k tends to perform well in
t , which helps a momentum strategy (as the strongly performing asset is overweighted).
See Figure 5.13 for an illustration based on Figure 5.12.
Example 5.14 Figure 5.13 shows that a momentum strategy works reasonably well on
daily data on the 25 FF portfolios. While the cross-covariances have a negative influence
(because they are mostly positive), they are dominated by the (on average) positive auto-
correlations. The correlation matrix is illustrated in Figure 5.12. In short, the small firms
(asset 1-5) are correlated with the lagged returns of most assets, while large firms are not.
Example 5.15 ((5.13) with 2 assets) With

" #
0:1 0
.k/ D ;
0 0:1
127
(Auto-)correlation matrix, daily FF returns 1979:12014:2
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
1 0.12 0.10 0.08 0.07 0.06 0.15 0.11 0.08 0.07 0.07 0.15 0.11 0.07 0.07 0.07 0.16 0.10 0.08 0.05 0.05 0.14 0.10 0.07 0.06 0.05
2 0.09 0.08 0.06 0.05 0.04 0.11 0.08 0.06 0.05 0.05 0.12 0.09 0.06 0.05 0.05 0.13 0.08 0.07 0.04 0.04 0.11 0.09 0.06 0.05 0.04
3 0.05 0.05 0.03 0.02 0.02 0.08 0.05 0.03 0.03 0.03 0.09 0.06 0.03 0.03 0.03 0.09 0.06 0.04 0.02 0.02 0.09 0.07 0.04 0.03 0.03
4 0.04 0.04 0.02 0.01 0.01 0.07 0.04 0.02 0.02 0.02 0.08 0.06 0.03 0.03 0.03 0.08 0.05 0.04 0.02 0.02 0.08 0.06 0.03 0.03 0.02
5 0.08 0.08 0.07 0.06 0.06 0.10 0.08 0.07 0.07 0.07 0.11 0.09 0.07 0.07 0.07 0.11 0.09 0.08 0.06 0.06 0.10 0.08 0.06 0.06 0.06
6 0.07 0.07 0.05 0.04 0.04 0.11 0.08 0.06 0.06 0.05 0.13 0.10 0.07 0.06 0.06 0.14 0.10 0.08 0.06 0.05 0.14 0.11 0.08 0.07 0.06
7 0.03 0.03 0.02 0.01 0.01 0.06 0.04 0.02 0.02 0.02 0.07 0.06 0.03 0.03 0.03 0.08 0.06 0.05 0.02 0.02 0.08 0.07 0.04 0.03 0.03
8 0.01 0.01 0.00 -0.00 -0.00 0.04 0.02 0.01 0.01 0.01 0.05 0.04 0.02 0.02 0.02 0.06 0.04 0.03 0.01 0.01 0.06 0.05 0.03 0.02 0.02
9 0.01 0.01 -0.00 -0.01 -0.01 0.04 0.02 0.00 0.00 0.01 0.05 0.04 0.01 0.02 0.01 0.06 0.04 0.03 0.01 0.01 0.06 0.05 0.02 0.02 0.02
10 0.03 0.02 0.02 0.01 0.02 0.05 0.03 0.02 0.02 0.03 0.05 0.05 0.03 0.03 0.03 0.06 0.05 0.04 0.03 0.03 0.06 0.05 0.03 0.03 0.03
11 0.05 0.05 0.04 0.04 0.03 0.10 0.08 0.06 0.06 0.05 0.11 0.09 0.07 0.06 0.06 0.12 0.09 0.08 0.06 0.05 0.13 0.11 0.08 0.07 0.07
12 0.04 0.04 0.04 0.03 0.03 0.07 0.06 0.05 0.05 0.05 0.09 0.08 0.06 0.06 0.05 0.10 0.08 0.07 0.05 0.05 0.11 0.10 0.07 0.07 0.06
13 0.03 0.03 0.03 0.02 0.02 0.06 0.05 0.04 0.04 0.04 0.07 0.07 0.05 0.05 0.05 0.08 0.07 0.07 0.05 0.05 0.09 0.08 0.06 0.06 0.06
14 0.02 0.03 0.02 0.02 0.02 0.05 0.04 0.03 0.03 0.04 0.05 0.05 0.04 0.04 0.04 0.06 0.06 0.05 0.04 0.04 0.07 0.06 0.05 0.05 0.04
15 0.02 0.03 0.02 0.02 0.02 0.04 0.04 0.03 0.04 0.04 0.05 0.06 0.04 0.05 0.05 0.06 0.06 0.06 0.04 0.04 0.07 0.07 0.05 0.05 0.06
16 0.02 0.03 0.02 0.02 0.01 0.06 0.05 0.04 0.04 0.04 0.08 0.07 0.04 0.05 0.04 0.09 0.06 0.05 0.03 0.03 0.10 0.09 0.06 0.06 0.05
17 0.04 0.04 0.04 0.03 0.03 0.07 0.06 0.06 0.05 0.06 0.08 0.08 0.06 0.06 0.06 0.09 0.08 0.07 0.05 0.05 0.11 0.10 0.08 0.07 0.06
18 0.03 0.04 0.03 0.03 0.03 0.06 0.06 0.05 0.05 0.05 0.07 0.07 0.05 0.06 0.05 0.08 0.07 0.07 0.05 0.05 0.09 0.09 0.07 0.07 0.06
19 0.03 0.03 0.03 0.02 0.02 0.05 0.05 0.04 0.04 0.05 0.06 0.06 0.05 0.06 0.05 0.07 0.06 0.06 0.04 0.04 0.08 0.07 0.06 0.06 0.06
20 0.02 0.03 0.02 0.02 0.02 0.04 0.04 0.03 0.04 0.05 0.05 0.05 0.04 0.05 0.04 0.06 0.06 0.05 0.04 0.04 0.06 0.06 0.05 0.05 0.05
21 -0.05 -0.05 -0.05 -0.05 -0.05 -0.03 -0.03 -0.04 -0.04 -0.03 -0.02 -0.03 -0.04 -0.04 -0.04 -0.02 -0.03 -0.04 -0.05 -0.05 -0.00 -0.02 -0.04 -0.03 -0.04
22 -0.04 -0.04 -0.04 -0.04 -0.04 -0.02 -0.02 -0.03 -0.03 -0.03 -0.01 -0.01 -0.03 -0.02 -0.03 -0.01 -0.02 -0.03 -0.04 -0.04 -0.00 -0.01 -0.03 -0.03 -0.03
23 -0.02 -0.02 -0.02 -0.02 -0.03 -0.01 -0.01 -0.01 -0.01 -0.01 -0.00 0.00 -0.01 -0.01 -0.01 0.00 0.00 -0.01 -0.02 -0.02 0.01 0.01 -0.00 -0.00 -0.01
24 -0.05 -0.04 -0.05 -0.05 -0.05 -0.03 -0.03 -0.04 -0.03 -0.02 -0.02 -0.02 -0.03 -0.02 -0.03 -0.02 -0.02 -0.03 -0.04 -0.04 -0.01 -0.02 -0.03 -0.02 -0.02
25 -0.03 -0.03 -0.03 -0.03 -0.03 -0.02 -0.02 -0.02 -0.02 -0.01 -0.02 -0.02 -0.02 -0.02 -0.02 -0.02 -0.02 -0.02 -0.03 -0.03 -0.02 -0.02 -0.03 -0.02 -0.02
Figure 5.12: Illustration of the cross-autocorrelations, Corr.R t ; R t k /, daily FF data.

Dark colours indicate high correlations, light colours indicate low correlations.
Decomposition of momentum return (1-day horizon)
Daily US data 1979:12014:2 14.31

20 25 FF portfolios (B/M and size)
10
0.02
0
10
20 -11.56
Crosscov Autocov means
Figure 5.13: Decomposition of return from momentum strategy based on daily FF data
then
1 0 1
D .0:2 0:2/ D 0, and

2
1 .k/1 tr .k/
N 22
N 1 2 1
2
tr .k/ D .0:1 C 0:1/ D 0:05;
N 2
128
so the sum of the first two terms of (5.13) is positive (good for a momentum strategy).
Proof. (of (5.13)) Take expectations of (5.12) and use the fact that E xy D Cov.x; y/C
E x E y to get
N
1 X
E t .k/ D Cov.Ri t C 2i Cov.Rmt C 2m :

k ; Ri t / k ; Rmt /
N i D1
Notice that N1 N
i D1 Cov.Ri t D tr .k/=N , where tr denotes the trace. Also, let
P
k ; Ri t /
RQ D R and notice that
1 h 0Q 0Q 0 i 1 0 Q Q0 10 .k/1
Cov.Rmt k ; Rmt / D E 2 1 R t 1 Ri t k D E 2 1 R t Ri t k 1 D :
N N N2
Finally, we note that N1 N 2

2m D N1 N m /2 . Together, these results
P P
i D1 i i D1 .i
give
N
10 .k/1 1 1 X
E t .k/ D C tr .k/ C .i m /2 ;
N2 N N i D1
which can be rearranged as (5.13).
5.4 Other Predictors
There are many other, perhaps more economically plausible, possible predictors of future
stock returns. For instance, both the dividend-price ratio and nominal interest rates have
been used to predict long-run returns, and lagged short-run returns on other assets have
been used to predict short-run returns.
5.4.1 Prices and Dividends
The Accounting Identity
Reference: Campbell, Lo, and MacKinlay (1997) 7 and Cochrane (2005) 20.1.
The gross return, R t C1 , is defined as
D t C1 C P t C1 D t C1 C P tC1
R tC1 D , so P t D : (5.14)
Pt R tC1
129
Substituting for P t C1 (and then P t C2 ; :::) gives
D t C1 D t C2 D t C3
Pt D C C C ::: (5.15)
R t C1 R t C1 R t C2 R t C1 R t C2 R tC3
1
X D t Cj
D Qj ; (5.16)
j D1 kD1 R t Ck
provided the discounted value of P t Cj goes to zero as j ! 1. This is simply an ac-

counting identity. It is clear that a high price in t must lead to low future returns and/or
high future dividendswhich (by rational expectations) also carry over to expectations
of future returns and dividends.
It is sometimes more convenient to analyze the price-dividend ratio. Dividing (5.15)
and (5.16) by D t gives
Pt 1 D t C1 1 D t C2 D t C1 1 D t C3 D t C2 D t C1
D C C C :::
Dt R t C1 D t R t C1 R tC2 D t C1 D t R t C1 R t C2 R t C3 D t C2 D t C1 D t
(5.17)
1 Y j
X D t Ck =D tCk 1
D : (5.18)
j D1
R t Ck
kD1
As with (5.16) it is just an accounting identity. It must therefore also hold in expectations.
Since expectations are good (the best?) predictors of future values, we have the impli-
cation that the asset price should predict a discounted sum of future dividends, (5.16),
and that the price-dividend ratio should predict a discounted sum of future changes in
dividends.
Linearizing the Accounting Identity
We now log-linearize the accounting identity (5.18) in order to tie it more closely to the
(typically linear) econometrics methods for detecting predictability The result is
1
X
pt dt s .d t C1Cs d t Cs / rQt C1Cs ; (5.19)
sD0
where D 1=.1CD=P / where D=P is a steady state dividend-price ratio ( D 1=1:04

0:96 if D=P is 4%) and where rQtC1Cs is a one-period log return.
As before, a high price-dividend ratio must imply future dividend growth and/or low
future returns. In the exact solution (5.17), dividends and returns which are closer to the
130
present show up more times than dividends and returns far in the future. In the approxi-
mation (5.19), this is captured by giving a higher weight (higher s ).
Proof. (of (5.19)slow version) Rewrite (5.14) as
D t C1 C P t C1

P tC1 D t C1
R t C1 D D 1C or in logs
Pt Pt P t C1
rQt C1 D p tC1 p t C ln 1 C exp.d t C1 p t C1 / :
Make a first order Taylor approximation of the last term around a steady state value of
d t C1 p t C1 , denoted d p,
h i exp.d p/ h i
ln 1 C exp.d t C1 p t C1 / ln 1 C exp.d p/ C d tC1 p tC1 d p
1 C exp.d p/
constant C .1 / .d t C1 p t C1 / ;
where D 1=1 C exp.d p/ D 1=.1 C D=P /. Combine and forget about the constant.
The result is
rQt C1 p t C1 p t C .1 / .d t C1 p t C1 /
D p t C1 p t C .1 / d t C1 ;
where 0 < < 1. Add and subtract d t from the right hand side and rearrange
rQt C1 .p t C1 d t C1 / .p t d t / C .d t C1 d t / , or
pt d t .p t C1 d t C1 / C .d t C1 dt / rQt C1
This is a (forward looking, unstable) difference equation, which we can solve recursively
forward. Provided lims!1 s .p t Cs d t Cs / D 0, the solution is (5.19). (Trying to solve
for the log price level instead of the log price-dividend ratio is problematic since the
condition lims!1 s p t Cs D 0 may not be satisfied.)
Dividend-Price Ratio as a Predictor
One of the most successful attempts to forecast long-run return is by using the dividend-
price ratio
r t Cq D C q .d t p t / C " t Cq ; (5.20)
where r t Cq is the log return between t and t C q. For instance, CLM Table 7.1, report R2
values from this regression which are close to zero for monthly returns, but they increase
131
to 0.4 for 4-year returns (US, value weighted index, mid 1920s to mid 1990s). See also
Figure 5.14 for an illustration.
By comparing with (5.19), we see that the dividend-ratio in (5.20) is only asked to
predict a finite (unweighted) sum of future returnsdividend growth is disregarded. We
should therefore expect (5.20) to work particularly well if the horizon is long (high q) and
if dividends are stable over time.
From (5.19) we get (from using Cov.x; y z/ D Cov.x; y/ Cov.x; z/) that
1 1
! !
X X
Var.p t d t / Cov p t d t ; s .d tC1Cs d tCs / Cov p t d t ; s r t C1Cs ;
sD0 sD0
(5.21)
which shows that the variance of the price-dividend ratio can be decomposed into the
covariance of price-dividend ratio with future dividend change minus the covariance of
price-dividend ratio with future returns. This expression highlights that if p t d t is not
constant, then it must forecast dividend growth and/or returns.
The evidence in Cochrane suggests that p t d t does not forecast future dividend
growth, so that predictability of future returns explains the variability in the dividend-
price ratio. This fits very well into the findings of the R2 of (5.20). To see that, recall the
following fact.
Remark 5.16 (R2 from a least squares regression) Let the least squares estimate of in
O The fitted values yO t D x 0 .
y t D x t0 0 C u t be . O If the regression equation includes a
b
t
constant, then R2 D Corr .y t ; yO t /2 . In a simple regression where y t D a C bx t C u t ,
b
where x t is a scalar, R2 D Corr .y t ; x t /2 .
5.4.2 Predictability but No Autocorrelation
The evidence for US stock returns is that long-run returns may perhaps be predicted
by using dividend-price ratio or interest rates, but that the long-run autocorrelations are
weak (long run US stock returns appear to be weak-form efficient but not semi-strong
efficient). Both CLM 7.1.4 and Cochrane 20.1 use small models for discussing this
case. The key in these discussions is to make changes in dividends unforecastable, but
let the return be forecastable by some state variable (E t d t C1Cs E t d t Cs D 0 and
E t r t C1 D r C x t ), but in such a way that there is little autocorrelation in returns. By
taking expectations of (5.19) we see that price-dividend will then reflect expected future
returns and therefore be useful for forecasting.
132
Slope with 90% conf band

0.4 0.1
0.2 0.05
0 0
0 20 40 60 0 20 40 60
Monthly US stock excess returns,

Scatter plot, 36 month returns 1926:12013:12
2
Regression:
1 Rte = a + b log(E/P)t1 + t
Return
2
4 3 2 1
lagged log(E/P)
5.5 Maximally Predictable Portfolio
As a way to calculate an upper bound on predictability, Lo and MacKinlay (1997) con-

struct maximally predictable portfolios. The weights on the different assets in this portfo-
lio can also help us to understand more about how the predictability works.
Let Z t be an n 1 vector of demeaned returns
Zt D Rt E Rt ; (5.22)
and suppose that we (somehow) have constructed rational forecasts E t 1 Z t such that
0
Zt D Et 1 Z t C " t , where E t 1 " t D 0, Var t 1 ." t " t / D : (5.23)
Consider a portfolio 0 Z t . The R2 from predicting the return on this portfolio is (as
133
usual) the fraction of the variability of 0 Z t that is explained by 0 E t 1 Zt
R2 . / D 1 Var. 0 " t /= Var. 0 Z t /

D Var. 0 Z t / Var. 0 " t /= Var. 0 Z t /
D Var. 0 E t 1 Z t /= Var. 0 Z t /
D 0 Cov.E t 1 Z t / = 0 Cov.Z t / : (5.24)
The covariance in the denominator can be calculated directly from data, but the covari-
ance matrix in the numerator clearly depends on the forecasting model we use (to create
E t 1 Z t ).
The portfolio ( vector) that gives the highest R2 is the eigenvector (normalized to
sum to unity) associated with the largest eigenvalue (also the value of R2 ) of Cov.Z t / 1 Cov.E t 1 Z t /.
Example 5.17 (One forecasting variable) Suppose there is only one predictor, x t 1,
Z t D x t 1 C "t ;
0
where is n 1. This means that E t 1 Z t D x t 1 , so Cov.E t 1 Z t / D Var.x t 1 /
and that Cov.Z t / D Var.x t 1 / 0 C . We can therefore write (5.24) as
0 Var.x t 1 / 0
R2 . / D :
0 Var.x t 1 / 0 C 0
The first order conditions for maximum then gives (this is very similar to the calculations
of the minimum variance portfolio in mean-variance analysis)
D 1
=10 1
;
where 1 is an n 1 vector of ones. In particular, if (and therefore 1 ) is diagonal,

then the portfolio weight of asset i is i divided by the variance of the forecast error of
asset i: assets which are hard to predict get smaller weights. We also see that if the sign
of i is different from the sign of 10 1 , then it gets a negative weight. For instance, if
10 1 > 0, so that most assets move in the same direction as x t 1 , then asset i gets a
negative weight if it moves in the opposite direction (i < 0).
5.6 Spurious Regressions and In-Sample Overfitting
References: Ferson, Sarkissian, and Simin (2003)
134
5.6.1 Spurious Regressions
Ferson, Sarkissian, and Simin (2003) argue that many prediction equations suffer from
spurious regression featuresand that data mining tends to make things even worse.
Their simulation experiment is based on a simple model where the return predictions
are
r t C1 D C Z t C v t C1 ; (5.25)
where Z t is a regressor (predictor). The true model is that returns follow the process
r t C1 D C Z t C u t C1 ; (5.26)
where the residual is white noise. In this equation, Z t represents movements in expected
returns. The predictors follow a diagonal VAR(1)
" # " #" # " # " #!
Zt 0 Zt 1 "t "t
D C , with Cov D : (5.27)
Z t 0 Z t 1 "t "t
In the case of a pure spurious regression, the innovations to the predictors are uncor-
related ( is diagonal). In this case, ought to be zeroand their simulations show that
the estimates are almost unbiased. Instead, there is a problem with the standard deviation
O If is high, then the returns will be autocorrelated.
of .
See Table 5.1 for an illustration.
D0 D 0:75
: 0 0.375 0.75 0 0.375 0.75
Simulated 5:8 6:2 8:7 3:9 5:5 10:9
OLS formula 5:8 6:2 8:6 3:9 4:2 5:8
Newey-West 5:7 6:1 8:4 3:8 5:1 8:9
VARHAC 5:7 6:1 8:5 3:8 5:4 10:5
Bootstrapped 5:8 6:2 8:6 3:8 5:4 10:1
Table 5.1: Standard error of OLS slope (%) under autocorrelation (simulation evidence).
Model: y t D 1 C 0:9x t C t , where t D t 1 C t ; t is iid N(). x t D x t 1 C t ; t is
iid N(). NW uses 5 lags. VARHAC uses 5 lags and a VAR(1). The bootstrap uses blocks
of size 20. Sample length: 300. Number of simulations: 10000.
Under the null hypothesis of D 0, this autocorrelation is loaded onto the residuals.
For that reason, the simulations use a Newey-West estimator of the covariance matrix
(with an automatic choice of lag order). This should, ideally, solve the problem with the
135
inferencebut the simulations show that it doesnt: when Z t is very autocorrelated (0.95
or higher) and reasonably important (so an R2 from running (5.26), if we could, would be
0.05 or higher), then the 5% critical value (for a t-test of the hypothesis D 0) would be
2.7 (to be compared with the nominal value of 1.96). Since the point estimates are almost
unbiased, the interpretation is that the standard deviations are underestimated. In contrast,
with low autocorrelation and/or low importance of Z t , the standard deviations are much
more in line with nominal values.
See Table 5.1 for an illustration. They show that we need a combination of an auto-
correlated residuals and an autocorrelated regressor to create a problem for the usual LS
formula for the standard deviation of a slope coefficient. When the autocorrelation is very
high, even the Newey-West estimator is likely to underestimate the true uncertainty.
To study the interaction between spurious regressions and data mining, Ferson, Sarkissian,
and Simin (2003) let Z t be chosen from a vector of L possible predictorswhich all are
generated by a diagonal VAR(1) system as in (5.27) with uncorrelated errors. It is as-
sumed that the researchers choose Z t by running L regressions, and then picks the one
with the highest R2 . When D 0:15 and the researcher chooses between L D 10
predictors, the simulated 5% critical value is 3.5. Since this does not depend on the im-
portance of Z t , it is interpreted as a typical feature of data mining, which is bad enough.
When the autocorrelation is 0.95, then the importance of Z t start to become important
spurious regressions interact with the data mining to create extremely high simulated
critical values. A possible explanation is that the data mining exercise is likely to pick out
the most autocorrelated predictor, and that a highly autocorrelated predictor exacerbates
the spurious regression problem.
5.7 Model Selection
5.7.1 Traditional Model Selection
Excluding a relevant regressor will cause a bias of all coefficients (unless those regres-
sors are uncorrelated with the excluded regressor). In contrast, including an irrelevant
regressor is not really dangerous, but is likely to decrease the precision. In particular,
forecasting models with many regressors typically perform very poorly out of sample.
To select the regressors, apply the following rules: rule 1: use economic theory; rule 2:
avoid data mining and mechanical searches for the right regressors; rule 3: maybe use a
general-to-specific approachstart with a general regression and test restrictions,..., keep
136
making it simpler until restrictions are rejected; rule 4: always include a constant.
Remember that R2 can never decrease by adding more regressorsnot really a good
guide. To avoid overfitting, punish models with too many parameters. Perhaps consider
RN 2 instead
T 1
RN 2 D 1 .1 R2 / ; (5.28)
T k
where T is the sample size and k is the number of regressors (including the constant).
This measure includes trade-off between fit and the number of regressors (per data point).
Notice that RN 2 can be negative (while 0 R2 1). Clearly, the model must include a
constant for R2 (and therefore RN 2 ) to make sense. Alternatively, apply Akaikes Informa-
tion Criterion (AIC) and the Bayesian information criterion (BIC). They are
k
AIC D ln 2 C 2 (5.29)
T
k
BIC D ln 2 C ln T; (5.30)
T
where 2 is the variance of the fitted residuals.
These measures also involve trade-offs between fit (low 2 ) and number of parameters
(k, including the intercept). Choose the model with the highest RN 2 or lowest AIC or BIC.
It can be shown (by using R2 D 1 2 = Var.y t / so 2 D Var.y t /.1 R2 /) that AIC and
BIC can be rewritten as
k
AIC D ln Var.y t / C ln.1 R2 / C 2 (5.31)
T
k
BIC D ln Var.y t / C ln.1 R2 / C ln T: (5.32)
T
This shows that both are decreasing in R2 (which is good), but increasing in the number
of regressors per data point (k=T ). It therefore leads to a similar trade-off as in RN 2 . Recall
that the model should always include a constant.
Example 5.18 (Empirical application of model selection) See Table 5.2 for an empirical
example showing a number of possible model specifications. The dependent variable is
the monthly realized variance of S&P 500 returns (calculated from daily returns). The
possible regressors are lags of the dependent variable, the VIX index and the S&P 500
returns. Similarly, Table 5.3 for the the best specification according to AIC. Notice that
AIC tend to favour fairly large models with many regressors.
137
1 2 3 4 5 6 7
RV t 1 0:73 0:33
.10:86/ .1:90/
RV t 2 0:57 0:04
.10:49/ .0:34/
VIX t 1 0:91 0:71
.11:69/ .4:49/
VIX t 2 0:68 0:25
.12:14/ . 1:30/
Rt 1 0:86 0:17
. 3:26/ . 1:37/
Rt 2 0:48 0:06
. 2:77/ .0:67/
constant 4:24 6:86 2:44 2:16 16:45 16:20 0:94
.4:58/ .7:97/ . 1:96/ .2:27/ .16:02/ .15:42/ .1:01/
R2 0:54 0:32 0:56 0:31 0:16 0:05 0:61
obs 277:00 277:00 277:00 277:00 277:00 277:00 277:00
Table 5.2: Regression of monthly realized S&P 500 return volatility 1990:12013:5.
Numbers in parentheses are t-stats, based on Newey-West with 4 lags.
5.7.2 Sequential Model Selection
Reference: Hastie, Tibshirani, and Friedman (2001) 3

In some cases, even good economic theory leaves us with too many potential regres-
sors. This is often the case when developing forecasting modelswhere it is often noticed
models with many predictors tend to fail out of sample. It then becomes crucial to apply
some model selection technique, that is, a method that sets some regression coefficients
to zero.
If there are K potential regressors, then there are 2K different models. If the list of
models is not too long, then the AIC and BIC in (5.29)(5.30) can be used, see Table 5.3.
Otherwise, we need some sort of sequential approach.
Example 5.19 (3 potential regressors) If the three potential regressors are 1; x1 and x2 ,
then the list of models has 23 1 D 7 possibilities: .1/I .x1 /I .x2 /I .1; x1 /I .1; x2 /I .x1 ; x2 /I .1; x1 ; x2 /.
138
1 2 3 4
RV t 1 0:31 0:31 0:33 0:30
.2:03/ .1:96/ .1:94/ .1:93/
RV t 2 0:05
.0:45/
VIX t 1 0:74 0:88 0:71 0:87
.4:76/ .6:04/ .4:46/ .6:18/
VIX t 2 0:24 0:35 0:22 0:39
. 1:17/ . 2:42/ . 1:15/ . 2:41/
Rt 1 0:16 0:17
. 1:24/ . 1:37/
Rt 2 0:06
.0:71/
constant 0:90 0:39 0:73 0:67
.0:94/ .0:35/ .0:87/ .0:63/
R2 0:61 0:61 0:61 0:61
obs 277:00 277:00 277:00 277:00
Table 5.3: Best four regressions of monthly realized S&P 500 return volatility according
to AIC, 1990:12013:5. Ordered from best (1) to fourth best (4). Numbers in parentheses
are t-stats, based on Newey-West with 4 lags.
A forward stepwise selection is as follows
.1/ start with an intercept (5.33)

.2/ add the variable that improves the fit the most
.3/ repeat .2/ until the fit does not improve much
To specify a stopping rule, first define the residual sum of squares (for a given vector of
coefficients, ) as
RSS./ D TtD1 .y t x t0 /2 : (5.34)
P
In step (2) we would then add the variable that gives the lowest RSS (when added to the
previous selection). In step (3), it is often recommended that we stop adding regressors
when
RSS.Oold / RSS.Onew /
< c1;T k 1 ; (5.35)
RSS.Onew /=.T k 1/
where k is the number of coefficients in Oold (including the intercept) so there are k C 1
coefficients in Onew and c1;T k 1 is the 90% or 95% critical value of an F1;T k 1 distri-
139
1 2 3 4
RV t 1 0:31 0:31
.1:96/ .2:03/
RV t 2
VIX t 1 0:91 1:22 0:88 0:74

.11:69/ .6:15/ .6:04/ .4:76/
VIX t 2 0:36 0:35 0:24
. 2:11/ . 2:42/ . 1:17/
Rt 1 0:16
. 1:24/
Rt 2
constant 2:44 1:36 0:39 0:90

. 1:96/ . 1:64/ .0:35/ .0:94/
R2 0:56 0:59 0:61 0:61
obs 277:00 277:00 277:00 277:00
Table 5.4: Best four regression of monthly realized S&P 500 return volatility according
to a forward step selection (based on t-stats), 1990:12013:5. Ordered from smallest (1)
to fourth smallest (4). Numbers in parentheses are t-stats, based on Newey-West with 4
lags.
bution. For instance, the 90% critical value of F1;100 equals 2:76.
As an alternative to the RSS based rule in (5.34)(5.35), we could instead use t-stats:
in step (2) add the variable with the highest jt-statj and in step (3) stop adding variables
when that jt-statj is lower than 1.64 (or 1.96).
Example 5.20 (Forward stepwise selection) Applying the forward step selection approach
(based on t-stats) to the regression discussed in Example 5.18 gives a sequence of larger
and larger models shown in Table 5.4.
An alternative approach to model selection is the lasso method, which minimizes the
sum of squared residuals (just like OLS), but under a restriction that the sum of the ab-
solute value of the coefficients should not exceed a threshold t . In short, it solves the
following constrained optimization problem
x t0 b/2 subject to
PT PK
minb t D1 .y t i D1 jbi j t; (5.36)
where the value of t is chosen a priori. (This problem can be solved by brute force
140
1 2 3 4
RV t 1 0:32 0:32 0:35
.1:69/ .1:88/ .1:80/
RV t 2
VIX t 1 0:91 0:57 0:49 0:48

.11:69/ .3:25/ .2:98/ .2:76/
VIX t 2
Rt 1 0:32 0:31
. 3:65/ . 3:61/
Rt 2 0:11
.0:88/
constant 2:44 0:58 1:00 0:71
. 1:96/ . 0:58/ .0:93/ .0:82/
R2 0:56 0:58 0:60 0:61
obs 277:00 277:00 277:00 277:00
Table 5.5: Regression of monthly realized S&P 500 return volatility with model selection
done by lasso, but then estimated with OLS, 1990:12013:5. Ordered from smallest (1)
to fourth smallest (4). Numbers in parentheses are t-stats, based on Newey-West with 4
lags.
minimization if there are few regressors. Otherwise, the lars algorithm by Efron, Hasti,
Johnstone, and Tibshirani (2004) is very efficient and can handle large problems.)
Clearly, when t K O O
i D1 jbi j where bi are the OLS estimates, then the lasso approach
P
reproduces the OLS estimates. For smaller values of t , the lasso will give smaller coeffi-
cients: some bi will be zero and others tend to be closer to zero than OLS would suggest
(like other shrinkage methods like a ridge estimation).
The lasso method can be used as a model selection technique by estimating a sequence
of models with increasingly higher t values. With a sufficiently low t , only one coefficient
is non-zerofor a somewhat higher t value, two coefficients are non-zero and so on. (If
we solve (5.36) with brute force, then this might involve some tweaking of the sequence
of the t values. However, the lars algorithm does this automatically.) Once the L (five,
say) smallest specifications are found, we could re-estimate each of them with OLS. (This
is the lars-OLS hybrid discussed in Efron, Hasti, Johnstone, and Tibshirani (2004).)
Example 5.21 (lasso regression) Applying the lasso approach to the regression discussed
in Example 5.18 gives a sequence of larger and larger models. Re-estimating the four
141
smallest of those models with OLS gives the results in Table 5.5.
Remark 5.22 (Ridge regression ) The ridge regression solves minb TtD1 .y t x t0 b/2 C
P
K 2
P
i D1 bi ;where > 0, so it forms a compromise between OLS and zero coefficients. This
is easiest to see if y t and x t are demeaned so D 0. Then, the first order conditions for
minimization are TtD1 x t .y t x t0 b/
P Q bQ D 0, so bQ D . 1 PT x t x 0 C / 1 1 PT x t y t :
T t D1 t T t D1
Notice that D 0 gives OLS, while D 1 gives b D 0.Q
Remark 5.23 (Application of the lasso/lars algorithms) These algorithms often stan-
dardize x t to have zero means and unit standard deviations, and y t to have zero means.
p
In some cases, they also calculate bi T instead of bi .
5.8 Out-of-Sample Forecasting Performance
References: Goyal and Welch (2008), and Campbell and Thompson (2008)
create et D
rOt r t rOt
1 t 1 t t C1
sample
create e t C1 D
rOt C1 r t C1 rOt C1
1 t t C1
longer sample
Figure 5.15: Out-of-sample forecasting
The idea of out-of-sample forecasting is to replicate real life forecasting. The predic-
tion equation is estimated on data up to and including t 1, and then a forecast is made
for period t. The forecasting performance of the equation is then compared with using
some benchmark prediction model (also estimated on data up to and including t 1). See
Figure 5.15 for an illustration. Then, the sample is extended with one period (t) and a
forecast is made for t C 1. This continuous until the sample is exhausted. The Mariano-
Diebold tests of the forecasting performance based on (5.45) can clearly be used in this
setting.
142
Goyal and Welch (2008) find that the evidence of predictability of equity returns dis-
appears when out-of-sample forecasts are considered. Campbell and Thompson (2008)
claim that there is still some out-of-sample predictability, provided we put restrictions on
the estimated models.
Campbell and Thompson (2008) first report that only few variables (earnings price
ratio, T-bill rate and the inflation rate) have significant predictive power for one-month
stock returns in the full sample (18712003 or early 1920s2003, depending on predictor).
The comparison is done in terms of the MSE and an out-of-sample R2
1 XT 1 XT
2
ROS D1 .r t rOt /2 = .r t rQt /2 ; (5.37)
T t Ds T t Ds
where s is the first period with an out-of-sample forecast, rOt is the forecast based on the
prediction model (estimated on data up to and including t 1) and rQt is the prediction
from some benchmark model (also estimated on data up to and including t 1). In
practice, the paper uses the historical average (also estimated on data up to and including
t 1) as the benchmark prediction. Comparing the MSE is an application of the Mariano-
Diebold approach, while out-of-sample R2 is non-linear transformation of linear moment
conditions (5.41) that define the MSE. We can therefore apply the delta method to test it.
The evidence shows that the out-of-sample forecasting performance is very weakas
claimed by Goyal and Welch (2008).
It is argued that forecasting equations can easily give strange results when they are
estimated on a small data set (as they are early in the sample). They therefore try different
restrictions: setting the slope coefficient to zero whenever the sign is wrong, setting
the prediction (or the historical average) to zero whenever the value is negative. This
improves the results a bitalthough the predictive performance is still weak.
See Figures 5.165.17 for an illustrations. The evidence suggests that the in-sample
long-run predictability vanishes out-of-sample. It also suggests that there is still some
short-run predictability for small firm stocks.
5.9 Evaluating Forecasting Performance
Further reading: Diebold (2001) 11; Stekler (1991); Diebold and Mariano (1995)
To do a solid evaluation of the forecast performance (of some forecaster/forecast
method/forecast institute), we need a sample (history) of the forecasts and the resulting
forecast errors. The reason is that the forecasting performance for a single period is likely
143
Out-of-sample R2 , excess returns predicted by E/P
Monthly US stock excess returns

0.05
Estimation on data window of 240 months
0 Forecasts for 1957:12013:12
0.05 The out-of-sample R2 measures the fit

of E/P regression relative to the
0.1 historical average
0.15
0.2
0.25
10 20 30 40 50 60
Return horizon (months)
Figure 5.16: Predictability of US stock returns, out-of-sample
Out-of-sample R2 , AR model
0.05
Out-of-sample R2 from AR(1) of excess
0.04 returns on size sorted equity portfolios
Decile 1 contains the 10% smallest firms,

0.03 while decile 10 the 10% largest firms
0.02 US daily data 1979:12013:12
0.01
0.01
1 2 3 4 5 6 7 8 9 10
size decile
Figure 5.17: Short-run predictability of US stock returns, out-of-sample.
to be dominated by luck, so we can only expect to find systematic patterns by looking at

results for several periods.
Let e t be the forecast error in period t
et D rt rOt ; (5.38)
144
where rOt is the forecast (made in t h) and r t the actual outcome. (Warning: some authors
prefer to work with rOt r t as the forecast error instead.)
Quite often, we compare a forecast method (or forecasting institute) with some kind
of naive forecast like a no change or a random walk. The idea of such a comparison
is to study if the resources employed in creating the forecast really bring value added
compared to a very simple (and inexpensive) forecast.
Ultimately, the ranking of forecasting methods should ideally be done based on the
true benefits/costs of forecast errorswhich may differ between organizations. For in-
stance, a forecasting agency has a reputation (and eventually customers) to lose, while
an investor has more immediate pecuniary losses. Unless the relation between the fore-
cast error and the losses are immediately understood, the ranking of two forecast methods
is typically done based on a number of different criteria. Several of those criteria are
inspired by basic statistics.
Most statistical forecasting methods are based on the idea of minimizing the sum of
squared forecast errors, tTD1 e t2 . For instance, the least squares (LS) method picks the
regression coefficient in
r t D 0 C 1 x t h C t (5.39)
to minimize the sum of squared residuals. This will, among other things, give a zero
mean of the fitted residuals and also a zero correlation between the fitted residual and the
regressor. As usual, rational forecasts should have forecast errors that cannot be predicted
(by past regressors or forecast errors).
Evaluation of a forecast often involve extending these ideas to the forecast method,
irrespective of whether a LS regression has been used or not. In practice, this means
studying (i) whether the forecast error, e t , has a zero mean; (ii) the mean squared (or
absolute value) of the forecast error ; (iii) the fraction of times the squared (or absolute
value) of the forecast error is lower than some threshold; (iv) the profit from investing by
following a forecasting model; (v) if the forecast errors are autocorrelated or correlated
with past information.
Remark 5.24 (Autocorrelation of forecast errors ) An efficient h-step-ahead forecast er-

ror has a zero correlation with the forecast error h (and more) periods earlier. For in-
stance, with h D 2, let e t C2;t D y t C2 E t y t C2 be the error of forecasting y t C2 using the
information in period t. It should be uncorrelated with e t;t 2 D y t E t 2 y t , since the
latter is known when the forecast E t y t C2 is formed.
To perform formal tests of forecasting performance a Diebold and Mariano (1995)
145
test is typically performedand it is an application of GMM. To implement it, consider
two different forecasts. For instance, the first forecast could be your estimated model and
the other one might be a naive forecasting model (for instance, no change) that you hope
to beat. To test the different aspects discussed before, let e t and " t denote the forecast
errors, .x/ be an indicator function that is one if x is true and zero otherwise, and let
r te and r t" denote the returns from following the different forecasts. Then, define moment
conditions
gt D et " t , or (5.40)
g t D e t2 "2t or g t D je t j j" t j, or (5.41)
g t D .e t2 < "2t /, or (5.42)
g t D r te r t" , or (5.43)
gt D et et 1 "t "t 1 or g t D e t x t h "t xt h: (5.44)
The different moment conditions correspond to the different aspects of the forecasts dis-
cussed above. For instance, (5.40) is for testing if the two methods have the same average
forecast error. From the usual properties of GMM, we then have
p
T gN !d N.0; S0 /; (5.45)
PT p
where gN D t D1 g t =T is the average moment condition and S 0 D Var. N is the
T g/
variance. The latter can be estimated by, for instance, a Newey-West approach. This can
be used to construct a t-test. However, when models a and b are nested (say, a is a special
case of b), then the asymptotic distribution is non-normal so other critical values must be
applied (see Clark and McCracken (2001)).
Remark 5.25 (Empirical results on predicting annual S&P 500 returns) Table 5.6 com-
pares the out-of-sample predictive performance of an E/P regression estimated recursively
(e) and the historical average return also estimated recursively ("). The historical aver-
age seems to overestimate the returns, but the difference to the E/P regression (which is
almost unbiased) is not significant. In contrast, the regression creates more volatile errors
(although again not significant), as measured by both the squared and the absolute value
of the residuals. Finally, the last line shows that the larger volatility of the regression
errors is partly driven by a higher frequency of large (in absolute terms) residuals (and
this result is significant).
Example 5.26 We want to compare the performance of the two forecast methods a and
146
mean std t-stat
2
Roos 0:11
e 0:23 2:08 0:11
" 1:65 1:91 0:86
e " 1:88 0:86 2:18
e2 334:11 59:66 5:60
2
" 301:91 51:52 5:86
e 2 "2 32:20 27:61 1:17
jej j"j 0:85 0:62 1:36
jej < j"j 0:46 0:05 10:21
Table 5.6: Mariano-Diebold tests of forecasting 1-year S&P returns, 1957:12013:12.

The e forecasts are out-of-sample and based on E/P regressions, while the " forecasts
are the historical average returns. Estimation is done on a moving data window of 240
observations.
b. We have the following forecast errors .e1 ; e2 ; e3 / D . 1; 1; 2/ and ."1 ; "2 ; "3 / D
. 1:9; 0; 1:9/. Both have zero means, so there is (in this very short sample) no constant
bias. The mean squared errors are
MSEe D . 1/2 C . 1/2 C 22 =3 D 2

MSE" D . 1:9/2 C 02 C 1:92 =3 2:41;
so the first forecast a is better according to the mean squared errors criterion. The mean
absolute errors are
MAEe D j 1j C j 1j C j2j=3 1:33

MAE" D j 1:9j C j0j C j1:9j=3 1:27;
so the second forecast is better according to the mean absolute errors criterion. The
reason for the difference between these criteria is that the second forecast has fewer but
larger errorsand the quadratic loss function punishes large errors very heavily. Count-
ing the number of times the absolute error (or the squared error) is smaller, we see that
the first forecast is better one time (first period), and the second forecast is better two
times.
As an example, Leitch and Tanner (1991) analyse the profits from selling 3-month
T-bill futures when the forecasted interest rate is above futures rate (forecasted bill price
is below futures price). The profit from this strategy is (not surprisingly) strongly related
147
to measures of correct direction of change (see above), but (perhaps more surprisingly)
not very strongly related to mean squared error, or absolute errors.
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Campbell, J. Y., and L. M. Viceira, 1999, Consumption and portfolio decisions when
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149
6 Predicting Asset Returns: Nonparametric Estimation
6.1 Basics of Kernel Regressions
Reference: Campbell, Lo, and MacKinlay (1997) 12.3; Hrdle (1990); Pagan and Ullah
(1999); Mittelhammer, Judge, and Miller (2000) 21
6.1.1 Introduction
Nonparametric regressions are used when we are unwilling to impose a parametric form
on the regression equationand we have a lot of data.
Let the scalars y t and x t be related as
y t D b.x t / C " t ; (6.1)
where " t is uncorrelated over time and where E " t D 0 and E." t jx t / D 0. The function
b./ is unknown and possibly non-linear.
One possibility of estimating such a function is to approximate b.x t / by a polynomial
(or some other basis). This will give quick estimates, but the results are global in the
sense that the value of b.x t / at a particular x t value (x t D 1:9, say) will depend on all
the data pointsand potentially very strongly so. The approach in this section is more
local by down weighting information from data points where xs is far from x t .
Suppose the sample had 3 observations (say, t D 3, 27, and 99) with exactly the same
value of x t , say 1:9. A natural way of estimating b.x/ at x D 1:9 would then be to
average over these 3 observations as we can expect average of the error terms to be close
to zero (iid and zero mean).
Unfortunately, we seldom have repeated observations of this type. Instead, we may
try to approximate the value of b.x/ (x is a single value, 1.9, say) by averaging over (y)
observations where x t is close to x. The general form of this type of estimator is
PT
Ob.x/ D PtD1 w t .x/y t ; (6.2)
T
t D1 w t .x/
where w t .x/= tTD1 w t .x/ is the weight on observation t, which his non-negative and
150
(weakly) decreasing in the the distance of x t from x. Note that the denominator makes
the weights sum to unity. The basic assumption behind (6.2) is that the b.x/ function is
smooth so local averaging (around x) makes sense.
Remark 6.1 (Local constant estimator ) Notice that (6.2) solves the problem min TtD1 w t .x/.y t
P
O
x /2 for each value of x. (The result is b.x/ D x .) This is (for each value of x) like a
weighted regression of x t on a constant. This immediately suggests that the method could
be extended to solving a problem like min TtD1 w t .x/y t x bx .x t x/2 , which
P
defines the local linear estimator.
As an example of a w.:/ function, it could give equal weight to the k values of x t

which are closest to x and zero weight to all other observations (this is the k-nearest
neighbor estimator, see Hrdle (1990) 3.2). As another example, the weight function
O
could be defined so that it trades off the expected squared errors, Ey t b.x/ 2
, and the
2O
expected squared acceleration, Ed b.x/=dx . This defines a cubic spline (often used
2 2
in macroeconomics when x t D t , and is then called the Hodrick-Prescott filter).
Remark 6.2 (Easy way to calculate the nearest neighbor estimator, univariate case)
Create a matrix Z where row t is .y t ; x t /. Sort the rows of Z according to the second
column (x). Calculate an equally weighted centred moving average of the first column
(y).
6.1.2 Kernel Regression
A Kernel regression uses a pdf as the weight function, w t .x/ D K .x t x/= h, where
the choice of h (also called bandwidth) allows us to easily vary the relative weights of
different observations. The perhaps simplest choice is a uniform density function for x t
over x h=2 to x C h=2 (and zero outside this interval). In this case, the weighting
function is
1 x t x
w t .x/ D 1=2 ; where (6.3)
h
( h
1 if q is true
.q/ D
0 else.
This weighting function puts the weight 1= h on all data point in the interval x h=2 and
zero on all other data points.
151
Kernel regression of AR(1) for returns
6
Uniform kernel, interval width: 1
4 Daily S&P 500 returns 1979:12014:3
2
Return
2
Evaluated at -9.5, -8.5,...
Evaluated at more points
4
10 5 0 5 10
Lagged return
Figure 6.1: Non-parametric regression with uniform kernel
However, we can gain efficiency and get a smoother (across x values) estimate by
using a density function that puts more weight to very local information, but also tapers
off more smoothly. The pdf of N.x; h2 / is often used. This weighting function is positive,
so all observations get a positive weight, but the weights are highest for observations close
to x and then taper off in a bell-shaped way. A low value of h means that the weights taper
off fast. See Figure 6.2 for an example.
With the N.x; h2 / kernel, we get the following weights at a point x
h i
xt x 2
exp

h
=2
w t .x/ D p : (6.4)
h 2
Remark 6.3 (Kernel as a pdf of N.x; h2 /) If K.z/ is the pdf of an N.0; 1/ variable, then
K .x t x/= h = h is the same as using an N.x; h2 / pdf of x t . Clearly, the 1= h term
would cancel in (6.2).
Effectively, we can think of these weights as being calculated from an N .0; 1/ density
function, but where we use .x t x/= h as the argument.
When h ! 0, then b.x/ O evaluated at x D x t becomes just y t , so no averaging is
O
done. In contrast, as h ! 1, b.x/ becomes the sample average of y t , so we have global
averaging. Clearly, some value of h in between is needed.
152
Data and weights for b(1.7) Data and weights for b(1.9)
5 5
wt (1.7) wt (1.9)

weights
weights
1 1
yt
yt

4 4
0 0
1.5 2 2.5 1.5 2 2.5
xt xt
Data on xt : 1.5 2.0 2.5

Data and weights for b(2.1) Data on yt : 5.0 4.0 3.5
5 N(x, h2 ) kernel, h = 0.25

wt (2.1) . denotes the data
denotes the fitted b(x)
weights
1
Left y-axis: data; right y-axis: weights
yt
0
1.5 2 2.5
xt
Figure 6.2: Example of kernel regression with three data points
O
In practice we have to estimate b.x/ at a finite number of points x. This could, for
instance, be 100 evenly spread points in the interval between the minimum and the max-
imum values observed in the sample. Special corrections might be needed if there are a
lot of observations stacked close to the boundary of the support of x (see Hrdle (1990)
4.4). See Figure 6.3 for an illustration.
Example 6.4 (Kernel regression) Suppose the sample has three data points x1 ; x2 ; x3 D
1:5; 2; 2:5 and y1 ; y2 ; y3 D 5; 4; 3:5. Consider the estimation of b.x/ at x D 1:9.
With h D 1, the numerator in (6.4) is
XT 2 2 2
p
w t .x/y t D e .1:5 1:9/ =2 5 C e .2 1:9/ =2 4 C e .2:5 1:9/ =2 3:5 = 2
t D1
p
.0:92 5 C 1:0 4 C 0:84 3:5/ = 2
p
D 11:52= 2:
153
Kernel regression, effect of bandwidth (h)
Data
5 h = 0.25
h = 0.2
4.5
y
3.5
1.4 1.6 1.8 2 2.2 2.4
x
Figure 6.3: Example of kernel regression with three data points
The denominator is
XT p
.1:5 1:9/2 =2 .2 1:9/2 =2 .2:5 1:9/2 =2
w t .x/ D e Ce Ce = 2
t D1
p
2:75= 2:
The estimate at x D 1:9 is therefore
O
b.1:9/ 11:52=2:75 4:19:
6.1.3 Multivariate Kernel Regression
Suppose that y t depends on two variables (x t and z t )
y t D b.x t ; z t / C " t ; (6.5)
where " t is uncorrelated over time and where E " t D 0 and E." t jx t ; z t / D 0.
This makes the estimation problem more data demanding. To see why, suppose we
use a uniform density function as weighting function (see in (6.3)). However, with two
regressors, the interval becomes a rectangle. With as little as a 20 intervals of each of
x and z, we get 400 bins, so we need a large sample to have a reasonable number of
observations in every bin.
154
5
Gaussian kernel
Daily S&P 500 returns 1979:12014:3
Return
Small bandwidth
Optimal bandwitdh
Large bandwidth
5
10 5 0 5 10
Lagged return
Figure 6.4: Non-parametric regression, importance of bandwidth
In any case, the most common way to implement the kernel regressor is to let
PT
O z/ D Pt D1 w t .x/w t .z/y t ;
b.x; (6.6)
T
tD1 w t .x/w t .z/
where w t .x/ and w t .z/ are two kernels like in (6.4) and where we may allow the band-
width (h) to be different for x t and z t (and depend on the variance of x t and y t ). In this
case. the weight of the observation (x t ; z t ) is proportional to w t .x/w t .z/, which is high
if both x t and z t are close to x and z respectively.
6.2 Distribution of the Kernel Regression and Choice of Bandwidth
Kernel regressions are typically consistent, provided longer samples are accompanied by
smaller values of h, so the weighting function becomes more and more local as the sample
size increases. It can be shown (see Hrdle (1990) 3.1 and Pagan and Ullah (1999) 3.34)
that under the assumption that x t is iid, the mean squared error, variance and bias of the
155
4
Gaussian kernel
6 Daily S&P 500 returns 1979:12014:3 10
5
10 0
5
0 5
5 10
10
Return lagged twice
Return lagged once
Figure 6.5: Non-parametric regression with two regressors
estimator at the value x are approximately (for general kernel functions)
O
MSE.x/ D Varb.x/ O
C Biasb.x/ 2
, with
2
O 1 .x/ R 1
Varb.x/ D 1 K.u/2 du
T h f .x/
2
O 1 d b.x/ df .x/ 1 db.x/ R1
Biasb.x/ 2
Dh 2
C 2
1 K.u/u du: (6.7)
2 dx dx f .x/ dx
In these expressions, 2 .x/ is the variance of the residuals in (6.1), f .x/ the marginal
density of x and K.u/ the kernel (pdf) used as a weighting function for u D .x t x/= h.
The remaining terms are functions of the true regression function.
With a Gaussian kernel these expressions can be simplified to
O 1 2 .x/ 1
Varb.x/ D p
T h f .x/ 2
2
O 1 d b.x/ df .x/ 1 db.x/
Biasb.x/ 2
Dh C : (6.8)
2 dx 2 dx f .x/ dx
156
Proof. (of (6.8)) We know that
R1 2 1 R1
1 K.u/ du D p and 1 K.u/u2 du D 1;
2
if K.u/ is the density function of a standard normal distribution. (We are effectively using
the N.0; 1/ pdf for the variable .x t x/= h.) Use in (6.7).
A smaller h increases the variance (we effectively use fewer data points to estimate
b.x/) but decreases the bias of the estimator (it becomes more local to x). If h decreases
less than proportionally with the sample size (so hT in the denominator of the first term
increases with T ), then the variance goes to zero and the estimator is consistent (since the
bias in the second term decreases as h does).
The variance is a function of the variance of the residuals and the peakedness of the
kernel, but not of the b.x/ function. The more concentrated the kernel is (s K.u/2 du
large) around x (for a given h), the less information is used in forming the average around
x, and the uncertainty is therefore largerwhich is similar to using a small h. A low
density of the regressors (f .x/ low) means that we have little data at x which drives up
the uncertainty of the estimator.
The bias increases (in magnitude) with the curvature of the b.x/ function (that is,
.d b.x/=dx 2 /2 ). This makes sense, since rapid changes of the slope of b.x/ make it hard
2
to get b.x/ right by averaging at nearby x values. It also increases with the variance of
the kernel since a large kernel variance is similar to a large h.
It is clear that the choice of h has a major importance on the estimation results. A
lower value of h means a more local averaging, which has the potential of picking up
sharp changes in the regression functionat the cost of being more affected by random-
ness.
See Figures 6.16.4 for an example.
Remark 6.5 (Rule of thumb value of h) In a simplified case, we case find the h value
that minimizes the MSE. Use (6.8) to construct the MSE D Var.b/Cbias.b/2 . To simplify,
assume the distribution of x is uniform, so f .x/ D 1=.xmax xmin / and df .x/=dx D 0.
In addition, run the regression y D C x C x 2 C " as an approximation of b.x/.
With this we have d 2 b.x/=dx 2 2 and we approximate 2 by the variance of the fitted
residuals, "2 . Combining, we have
1 2 1
MSE D .xmax xmin / p C h4 2 :
Th " 2
157
Minimizing with respect to h gives the first order condition
1 2 1
" .xmax x min / p C 4h3 2 D 0, so
T h2 2
1 2 1
2
" .xmax xmin / p D h5 , or
T 8
1=5 2=5
T j j "2=5 .xmax xmin /1=5 0:6 D h:
In practice, replace xmax xmin by the difference between the 90th and 10th percentiles of
x.
A good (but computationally intensive) approach to choose h is by the leave-one-out

cross-validation technique. This approach would, for instance, choose h to minimize the
expected (or average) prediction error
XT h i2
EPE.h/ D yt bO t .x t ; h/ =T; (6.9)
t D1
where bO t .x t ; h/ is the fitted value at x t when we use a regression function estimated on

a sample that excludes observation t , and a bandwidth h. This means that each prediction
is out-of-sample. To calculate (6.9) we clearly need to make T estimations (for each
x t )and then repeat this for different values of h to find the minimum.
Remark 6.6 (EPE calculations) Step 1: pick a value for h

Step 2: estimate the b.x/ function on all data, but exclude t D 1, then calculate bO 1 .x1 /
and the error y1 bO 1 .x1 /
Step 3: redo Step 2, but now exclude t D 2 and. calculate the error y2 bO 2 .x2 /. Repeat
this for t D 3; 4; :::; T . Calculate the EPE as in (6.9).
Step 4: redo Steps 23, but for another value of h. Keep doing this until you find the best
h (the one that gives the lowest EPE)
Remark 6.7 (Speed and fast Fourier transforms) The calculation of the kernel estimator
can often be speeded up by the use of a fast Fourier transform.
If the observations are independent, then it can be shown (see Hrdle (1990) 4.2,
Pagan and Ullah (1999) 3.36, and also (6.8)) that, with a Gaussian kernel, the estimator
at point x is asymptotically normally distributed
p h i
1 2 .x/

O
T h b.x/ b.x/ ! N 0; pd
; (6.10)
2 f .x/
158
Cross validation, kernel regression
1.015
Avg prediction error, relative to min

Gaussian kernel
1.01 rule-of-thumb
1.005
1
0.5 1 1.5 2 2.5
Bandwidth
Figure 6.6: Cross-validation
where 2 .x/ is the variance of the residuals in (6.1) and f .x/ the marginal density of x.
(A similar expression holds for other choices of the kernel.) This expression assumes that
the asymptotic bias is zero, which is guaranteed if h is decreased (as T increases) slightly
faster than T 1=5 (for instance, suppose h D T 1:1=5 h0 , where h0 is a constant). To
estimate the density of x, we can apply a standard method, for instance using a Gaussian
kernel and the bandwidth (for the density estimate only) of 1:06 Std.x t /T 1=5 .
Remark 6.8 (Asymptotic bias) The condition that h decreases faster than T 1=5 ensures
p
O
that the bias of T hb.x/ vanishes as T ! 1. This is seen by noticing that the bias in
p
O
(6.8) is proportional to h2 . Combining gives the bias of T hb.x/ as being proportional
1=2 5=2 1:1=5
to T h . If indeed h D T h0 , then we have
0:05 5=2
T 1=2 h5=2 D T h0
which is decreasing to zero as T increases.
To estimate 2 .x/ in (6.10), we use a non-parametric regression of the squared fitted

residuals on x t
O t /;
"O2t D 2 .x t /, where "O t D y t b.x (6.11)
O t / are the fitted values from the non-parametric regression (6.1). Notice that the
where b.x
O
estimation of 2 .x/ is quite computationally intensive since it requires estimating b.x/ at
159
Kernel regression of AR(1) for returns, with 90% conf band
5
Gaussian kernel
Return
5
10 5 0 5 10
Lagged return
Figure 6.7: Non-parametric regression with confidence bands
every point x D x t in the sample, not just a small grid of x values. To draw confidence
O
bands, it is typically assumed that the asymptotic bias is zero (E b.x/ D b.x/).
See Figure 6.7 for an example where the width of the confidence band varies across
x valuesmostly because the sample contains few observations close to some x values.
(However, the assumption of independent observations can be questioned in this case.)
6.3 Applications of Kernel Regressions
6.3.1 Nonparametric Estimation of State-Price Densities Implicit in Financial As-

set Prices, by Ait-Sahalia and Lo (1998)
Reference: Ait-Sahalia and Lo (1998)

There seem to be systematic deviations from the Black-Scholes model. For instance,
implied volatilities are often higher for options far from the current spot (or forward)
pricethe volatility smile. This is sometimes interpreted as if the beliefs about the future
log asset price put larger probabilities on very large movements than what is compatible
with the normal distribution (fat tails).
This has spurred many efforts to both describe the distribution of the underlying asset
price and to amend the Black-Scholes formula by adding various adjustment terms. One
strand of this literature uses nonparametric regressions to fit observed option prices to the
160
variables that also show up in the Black-Scholes formula (spot price of underlying asset,
strike price, time to expiry, interest rate, and dividends). For instance, Ait-Sahalia and
Lo (1998) applies this to daily data for Jan 1993 to Dec 1993 on S&P 500 index options
(14,000 observations).
This paper estimates nonparametric option price functions and calculates the implicit
risk-neutral distribution as the second partial derivative of this function with respect to the
strike price.
1. First, the call option price, Hi t , is estimated as a multivariate kernel regression
Hi t D b.S t ; X; ; r t ; t / C "i t ; (6.12)
where S t is the price of the underlying asset, X is the strike price, is time to
expiry, r t is the interest rate between t and t C , and t is the dividend yield
(if any) between t and t C . It is very hard to estimate a five-dimensional kernel
regression, so various ways of reducing the dimensionality are tried. For instance,
by making b./ a function of the forward price, S t exp.r t t /, instead of S t ,
r t , and t separably.
2. Second, the implicit risk-neutral pdf of the future asset price is calculated as
@2 b.S t ; X; ; r t ; t /=@X 2 , properly scaled so it integrates to unity.
3. This approach is used on daily data for Jan 1993 to Dec 1993 on S&P 500 index op-
tions (14,000 observations). They find interesting patterns of the implied moments
(mean, volatility, skewness, and kurtosis) as the time to expiry changes. In par-
ticular, the nonparametric estimates suggest that distributions for longer horizons
have increasingly larger skewness and kurtosis: whereas the distributions for short
horizons are not too different from normal distributions, this is not true for longer
horizons. (See their Fig 7.)
4. They also argue that there is little evidence of instability in the implicit pdf over
their sample.
Bibliography
Ait-Sahalia, Y., and A. W. Lo, 1998, Nonparametric estimation of state-price densities
implicit in financial asset prices, Journal of Finance, 53, 499547.
161
Hrdle, W., 1990, Applied nonparametric regression, Cambridge University Press, Cam-
bridge.
Mittelhammer, R. C., G. J. Judge, and D. J. Miller, 2000, Econometric foundations, Cam-

bridge University Press, Cambridge.
Pagan, A., and A. Ullah, 1999, Nonparametric econometrics, Cambridge University

Press.
162
7 Predicting and Modelling Volatility
Reference: Campbell, Lo, and MacKinlay (1997) 12.2; Taylor (2005) 811; Hamil-
ton (1994) 21; Hentschel (1995); Franses and van Dijk (2000); Andersen, Bollerslev,
Christoffersen, and Diebold (2005)
7.1 Heteroskedasticity
7.1.1 Descriptive Statistics of Heteroskedasticity (Realized Volatility)
Time-variation in volatility (heteroskedasticity) is a common feature of macroeconomic

and financial data.
The perhaps most straightforward way to gauge heteroskedasticity is to estimate a
time-series of realized variances from rolling samples. For a zero-mean variable, u t ,
this could be
q
2 1X 2
t D u D .u2t 1 C u2t 2 C : : : C u2t q /=q: (7.1)
q sD1 t s
Notice that t2 depends on lagged information, and could therefore be thought of as the
prediction (made in t 1) of the volatility in t . Unfortunately, this method can produce
quite abrupt changes in the estimate.
An alternative is to apply an exponentially weighted moving average (EWMA) es-
timator of volatility, which uses all data points since the beginning of the samplebut
where recent observations carry larger weights. Let the weight for lag s be .1 /s
where 0 < < 1, so
1
X
t2 D .1 / s 1 u2t s D .1 /.u2t 1 C u2t 2 C 2 u2t 3 C : : :/; (7.2)
sD1
which can also be calculated in a recursive fashion as
t2 D .1 /u2t 1 C t2 1 : (7.3)
163
Realized std (44 days), annualized EWMA std, annualized, = 0.99
50 50
40 40
30 30
20 20
10 10
0 0
1980 1990 2000 2010 1980 1990 2000 2010
S&P 500 (daily) 1954:12014:3

AR(1) of excess returns, the figures
show std of residual
EWMA std, annualized, = 0.9
50
40
30
20
10
0
1980 1990 2000 2010
Figure 7.1: Standard deviation
The initial value (before the sample) could be assumed to be zero or (better) the uncondi-
tional variance in a historical sample. The EWMA is commonly used by practitioners. For
instance, the RISK Metrics (formerly part of JP Morgan) uses this method with D 0:94
for use on daily data. Alternatively, can be chosen to minimize some criterion function
like tTD1 .u2t t2 /2 .
See Figure 7.2 for an illustration of the weights. (They clearly sum to one.)
Remark 7.1 (VIX) Although VIX is based on option prices, it is calculated in a way
that makes it (an estimate of) the risk-neutral expected variance until expiration, not the
implied volatility, see Britten-Jones and Neuberger (2000) and Jiang and Tian (2005).

We can also estimate the realized covariance of two series (ui t and ujt ) by
q
1X
ij;t D ui;t s uj;t s ; (7.4)
q sD1
164
Weight on lagged data (u2ts ) in EWMA estimate of volatility
= 0.99
0.05 = 0.94
0.04
t2 = (1 )(u2t1 + u2t2 + 2 u2t3 + ...)
0.03
0.02
0.01
0
0 20 40 60 80 100
lag, s
Figure 7.2: Weights on old data in the EWMA approach to estimate volatility
Standard deviation, different weekdays Standard deviation, different hours
0.04 0.05
0.04
0.035 0.03
0.02
0.03
Mon Tue Wed Thu Fri 0 6 12 18
Hour
5-minute data on EUR/USD changes, 1998:12014:10
Sample size: 1264870
Figure 7.3: Standard deviation of EUR/USD exchange rate changes
as well as the EWMA
ij;t D .1 /ui;t 1 uj;t 1 C ij;t 1: (7.5)
By combining with the estimates of the variances, it is straightforward to estimate corre-

lations.
165
Monthly std, EUR/USD Monthly std, GBP/USD
based on 5-minute changes,
0.1 1998:12014:10 0.1
0.05 0.05
0 0
2000 2005 2010 2000 2005 2010
Monthly std, CHF/USD Monthly std, JPY/USD
0.1 0.1
0.05 0.05
0 0
2000 2005 2010 2000 2005 2010
Figure 7.4: Standard deviation of exchange rate changes

Std, EWMA estimate, = 0.9 CBOE volatility index (VIX)
50 50
40 40
30 30
20 20
10 10
0 0
1990 1995 2000 2005 2010 2015 1990 1995 2000 2005 2010 2015
S&P 500, daily data 1954:12014:3
Figure 7.5: Different estimates of US equity market volatility
7.1.2 Variance and Volatility Swaps
Instead of investing in straddles, it is also possible to invest in variance swaps. Such a

contract has a zero price in inception (in t ) and the payoff at expiration (in t C m) is
Variance swap payoff t Cm = realized variance t Cm variance swap rate t , (7.6)

166
Monthly corr, EUR/USD and GBP/USD Monthly corr, EUR/USD and CHF/USD
1 1
0.5 0.5
0 0
-0.5 -0.5
2000 2005 2010 2000 2005 2010
Monthly corr, EUR/USD and JPY/USD

1 based on 5-minute changes,
1998:12014:10
0.5
-0.5
2000 2005 2010
Figure 7.6: Correlation of exchange rate changes
Correlation of FTSE 100 and DAX 30 Correlation of FTSE 100 and DAX 30
1 1
Corr
Corr
0.5 0.5
EWMA ( = 0.99) 44-day window

0 0
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015
Sample (daily) 1991:12014:4
Figure 7.7: Time-varying correlations (EWMA and realized)
where the variance swap rate (also called the strike or forward price for ) is agreed on at
inception (t) and the realized volatility is just the sample variance for the swap period.
Both rates are typically annualized, for instance, if data is daily and includes only trading
167
days, then the variance is multiplied by 252 or so (as a proxy for the number of trading
days per year).
A volatility swap is similar, except that the payoff it is expressed as the difference
between the standard deviations instead of the variances
p
Volatility swap payoff t Cm = realized variance t Cm volatility swap rate t , (7.7)
If we use daily data to calculate the realized variance from t until the expiration(RV tCm ),
then
252 Pm 2
RV t Cm D sD1 R tCs ; (7.8)
m
where R t Cs is the net return on day t C s. (This formula assumes that the mean return is
zerowhich is typically a good approximation for high frequency data. In some cases,
the average is taken only over m 1 days.)
Notice that both variance and volatility swaps pays off if actual (realized) volatility
between t and t C m is higher than expected in t . In contrast, the futures on the VIX pays
off when the expected volatility (in t C m) is higher than what was thought in t. In a way,
we can think of the VIX futures as a futures on a volatility swap (between t C m and a
month later).
Since VIX2 is a good approximation of variance swap rate for a 30-day contract, the
return can be approximated as
Return of a variance swap t Cm D .RV t Cm V IX t2 /=V IX t2 : (7.9)
Figures 7.8 and 7.9 illustrate the properties for the VIX and realized volatility of the
S&P 500. It is clear that the mean return of a variance swap (with expiration of 30
days) would have been negative on average. (Notice: variance swaps were not traded
for the early part of the sample in the figure.) The excess return (over a riskfree rate)
would, of course, have been even more negative. This suggests that selling variance
swaps (which has been the speciality of some hedge funds) might be a good dealexcept
that it will incur some occasional really large losses (the return distribution has positive
skewness). Presumably, buyers of the variance swaps think that this negative average
return is a reasonable price to pay for the hedging properties of the contractsalthough
the data does not suggest a very strong negative correlation with S&P 500 returns.
168
VIX (solid) and realized volatility (dashed)
80 The realized volatility is

measured over the last 30 days
70
60
50
40
30
20
10
1990 1995 2000 2005 2010 2015
Figure 7.8: VIX and realized volatility (variance)
Histogram of return on (synthetic) variance swaps

1.5 Daily data on VIX and S&P 500 1990:22014:3
Correlation with S&P 500 returns: -0.12
0.5
0
1 0.5 0 0.5 1 1.5 2 2.5
Figure 7.9: Distribution of return from investing in variance swaps
169
7.1.3 Forecasting Realized Volatility
Implied volatility from options (iv) should contain information about future volatilityas
is therefore often used as a predictor. It is unclear, however, if the iv is more informative
than recent (actual) volatility, especially since they are so similarsee Figure 7.8.
Table 7.1 shows that the iv (here represented by VIX) is close to be an unbiased
predictor of future realized volatility since the slope coefficient is close to one. However,
the intercept is negative, which suggests that the iv overestimate future realized volatility.
This is consistent with the presence of risk premia in the iv, but also with subjective beliefs
(pdfs) that are far from looking like normal distributions. By using both iv and the recent
realized volatility, the forecast powers seems to improve.
Remark 7.2 (Restricting the predicted volatility to be positive) A linear regression (like
those in Table 7.1) can produce negative volatility forecasts. An easy way to get around
that is to specify the regression in terms on the log volatility.
Remark 7.3 (Restricting the predicted correlation to be between 1 and 1) The per-
haps easiest way to do that is to specify the regression equation in terms of the Fisher
transformation, z D 1=2 ln.1 C /=.1 /, where is the correlation coefficient.
The correlation coefficient can then be calculated by the inverse transformation D
exp.2z/ 1=exp.2z/ C 1.
(1) (2) (3)

lagged RV 0:75 0:24
.10:23/ .2:01/
lagged VIX 0:91 0:66
.12:09/ .8:05/
constant 3:99 2:63 1:34
.4:01/ . 1:98/ . 1:65/
R2 0:56 0:61 0:62
obs 5986:00 6006:00 5986:00
Table 7.1: Regression of 22-day realized S&P return volatility 1990:22014:3. All daily
observations are used, so the residuals are likely to be autocorrelated. Numbers in paren-
theses are t-stats, based on Newey-West with 30 lags.
170
Corr(EUR,GBP) Corr(EUR,CHF) Corr(EUR,JPY)
lagged Corr(EUR,GBP) 0:88
.27:50/
lagged Corr(EUR,CHF) 0:87
.13:38/
lagged Corr(EUR,JPY) 0:83
.19:31/
constant 0:06 0:10 0:05
.3:56/ .1:93/ .2:77/
R2 0:81 0:76 0:68
obs 190:00 190:00 190:00
Table 7.2: Regression of monthly realized correlations 1998:12013:11. All exchange

rates are against the USD. The monthly correlations are calculated from 5 minute data.
Numbers in parentheses are t-stats, based on Newey-West with 1 lag.
7.1.4 Heteroskedastic Residuals in a Regression
Suppose we have a regression model
y t D x t0 b C u t ; where (7.10)
E u t D 0 and Cov.xi t ; u t / D 0:
In the standard case we assume that u t is iid (independently and identically distributed),
which rules out heteroskedasticity.
In case the residuals actually are heteroskedasticity, least squares (LS) is nevertheless
a useful estimator: it is still consistent (we get the correct values as the sample becomes
really large)and it is reasonably efficient (in terms of the variance of the estimates).
However, the standard expression for the standard errors (of the coefficients) is (except in
a special case, see below) not correct. This is illustrated in Table 7.4.
There are two ways to handle this problem. First, we could use some other estimation
method than LS that incorporates the structure of the heteroskedasticity. For instance,
combining the regression model (7.10) with an ARCH structure of the residualsand
estimate the whole thing with maximum likelihood (MLE) is one way. As a by-product
we get the correct standard errors provided, of course, the assumed distribution is cor-
rect. Second, we could stick to OLS, but use another expression for the variance of the
coefficients: a heteroskedasticity consistent covariance matrix, among which Whites
covariance matrix is the most common.
171
RV(EUR) RV(GBP) RV(CHF) RV(JPY)
lagged RV(EUR) 0:64
.7:32/
lagged RV(GBP) 0:72
.10:40/
lagged RV(CHF) 0:34
.2:60/
lagged RV(JPY) 0:56
.5:07/
constant 0:06 0:04 0:22 0:12
.1:62/ .1:33/ .3:16/ .1:85/
D(Tue) 0:12 0:08 0:13 0:11
.11:47/ .6:82/ .4:41/ .3:77/
D(Wed) 0:11 0:09 0:09 0:13
.9:48/ .7:23/ .4:11/ .4:42/
D(Thu) 0:12 0:09 0:13 0:15
.9:98/ .5:80/ .7:01/ .3:81/
D(Fri) 0:12 0:07 0:13 0:13
.6:42/ .4:33/ .9:05/ .4:32/
R2 0:41 0:52 0:12 0:32
obs 4151:00 4151:00 4151:00 4151:00
Table 7.3: Regression of daily realized variance 1998:12013:11. All exchange rates are
against the USD. The daily variances are calculated from 5 minute data. Numbers in
parentheses are t-stats, based on Newey-West with 1 lag.
To test for heteroskedasticity, we can use Whites test of heteroskedasticity. The null
hypothesis is homoskedasticity, and the alternative hypothesis is the kind of heteroskedas-
ticity which can be explained by the levels, squares, and cross products of the regressors
(denoted w t )clearly a special form of heteroskedasticity. The reason for this specifica-
tion is that if the squared residual is uncorrelated with w t , then the usual LS covariance
matrix applieseven if the residuals have some other sort of heteroskedasticity.
To implement Whites test, let wi be the squares and cross products of the regressors.
The test is then to run a regression of squared fitted residuals on w t
uO 2t D w t0 C v t ; (7.11)
and to test if all the slope coefficients (not the intercept) in are zero. (This can be done
be using the fact that TR2 =.1 R2 / p2 , p D dim.wi / 1:)
172
Scatter plot, iid residuals Scatter plot, Var(residual) depends on x2
20 20
10 10
0 0
y
y
10 10
20 20
10 5 0 5 10 10 5 0 5 10
x x
y = 0.03 + 1.3x + u
Solid regression lines are based on all data,
dashed lines exclude the crossed out data point
Figure 7.10: Effect of heteroskedasticity on uncertainty about regression line
Example 7.4 (Whites test) If the regressors include .1; x1t ; x2t / then w t in (7.11) is the
2 2
vector (1; x1t ; x2t ; x1t ; x1t x2t ; x2t ).
D0 D1
: 0 0.5 1 0 0.5 1
Simulated 7:1 13:0 19:1 13:6 19:1 24:9
OLS formula 7:1 10:1 13:3 13:4 16:2 19:3
Whites 7:0 12:7 18:5 13:3 18:7 24:3
Bootstrapped 7:1 12:7 18:5 13:4 18:8 24:4
Table 7.4: Standard error of OLS slope (%) under heteroskedasticity (simulation evi-
dence). Model: y t D 1C0:9x t C t , where t N.0; t2 /, with t2 D .1C jz t jCjx t j/2 ,
where z t is iid N(0,1) and independent of x t . Sample length: 200. Number of simulations:
25000. The bootstrap draws pairs .ys ; xs / with replacement.
If we reject the null hypothesis in Whites test, then we either have to model both the
regression equation and the volatility process simultaneously (for instance, using MLE)
or adjust the OLS standard errors.
Remark 7.5 (Whites covariance matrix) Recall that the sample moment conditions for
OLS are
T
1X
gN ./ D x t .y t x t0 b/ D 0k1 ;
T t D1
173
where we have k regressors in x t . For the asymptotic distribution we need covariance
p
matrix of T gN ./ and the Jacobian of the moment conditions with respect to the param-
eters (b). Let u t D y t x t0 b and notice that
"p T
#
T X
S0 D Cov xt ut D Cov.x t u t /;
T t D1
where we have assumed that there is no autocorrelation, but we allow for heteroskedas-
ticity since we are using the covariance matrix of x t u t (not imposing that x t and u t are
unrelated). We can estimate this as
T
1
SO D x t x t0 uO 2t :
X
T tD1
Moreover, the Jacobian is

T
!
1X
D0 D plim x t x t0 D xx :
T tD1
Combining gives
p d
T .bO b0 / ! N.0; xx1 S0 xx1 /:
7.1.5 Autoregressive Conditional Heteroskedasticity (ARCH)
Autoregressive heteroskedasticity is a special form of heteroskedasticityand it is often

found in financial data which shows volatility clustering.
To test for ARCH features, Engles test of ARCH is perhaps the most straightforward.
It amounts to running an AR(q) regression of the squared zero-mean variable (here de-
noted u t )
u2t D ! C a1 u2t 1 C : : : C aq u2t q C v t ; (7.12)
Under the null hypothesis of no ARCH effects, all slope coefficients are zero and the
R2 of the regression is zero. (This can be tested by noting that, under the null hypothesis,
TR2 =.1 R2 / 2q .) This test can also be applied to the fitted residuals from a regression
like (7.10). However, in this case, it is not obvious that ARCH effects makes the standard
expression for the LS covariance matrix invalid (use Whites test (7.11) for this).
It is straightforward to phrase Engles test in terms of GMM moment conditions. We
simply use a first set of moment conditions to estimate the parameters of the regression
174
model, and then test if the following additional (ARCH related) moment conditions are
satisfied at those parameters
2 3
u2t 1
6 :
E6
7 2
4
::
5 t a0 / D 0q1 :
7 .u (7.13)
2
ut q
An alternative test (see Harvey (1989) 259260), is to apply a Box-Ljung test on uO 2t , to

see if the squared fitted residuals are autocorrelated. We just have to adjust the degrees of
freedom in the asymptotic chi-square distribution by subtracting the number of parameters
estimated in the regression equation. These tests for ARCH effects will typically capture
GARCH (see below) effects as well.
7.2 ARCH Models
Consider the regression model
y t D x t0 b C u t ; where (7.14)
E u t D 0 and Cov.xi t ; u t / D 0:
We will study different ways of modelling how the volatility of the residual is autocorre-
lated.
7.2.1 Properties of ARCH(1)
In the ARCH(1) model the residual in the regression equation (7.14) can be written
u t D v t t ; with (7.15)
v t iid with E v t D 0 and Var.v t / D 1;
and the conditional variance is generated by
t2 D ! C u2t 1 ; with (7.16)

! > 0 and 0 < 1:
Notice that t2 is the conditional variance of u t , and it is known already in t 1. (Warning:

some authors use a different convention for the time subscripts.) We also assume that v t
175
ARCH std, annualized GARCH std, annualized
50 50
40 40
30 30
20 20
10 10
0 0
1980 1990 2000 2010 1980 1990 2000 2010
S&P 500 (daily) 1954:12014:3
AR(1) of excess returns AR(1) of excess returns

with ARCH(1) errors with GARCH(1,1) errors
t2 = + u2t1 t2 = + u2t1 + t1
2
ARCH coefficient: GARCH coefficients:

0.31 0.08 0.91
Figure 7.11: ARCH and GARCH estimates
is truly random, and hence independent of t2 .

The non-negativity restrictions on ! and are needed in order to guarantee t2 > 0.
The upper bound < 1 is needed in order to make the conditional variance stationary. To
see the latter, notice that the forecast (made in t) of volatility in t C s is
!
E t t2Cs D N 2 C s 1
t2C1 N 2 , with N 2 D (7.17)

;
1
where N 2 is the unconditional variance and we recall that t2C1 is known in t . The forecast
of the variance is just like in an AR(1) process. A value of < 1 is needed to make the
difference equation stable.
The conditional variance of u t Cs is clearly equal to the expected value of t2Cs
Var t .u t Cs / D E t t2Cs : (7.18)
Proof. (of (7.17)(7.18)) Notice that E t t2C2 D ! C E t v t2C1 E t tC1 2

since v t is
independent of t . Morover, E t v t C1 D 1 and E t t C1 D t C1 (known in t). Combine to
2 2 2
get E t tC2
2
D ! C t2C1 . Similarly, E t t2C3 D ! C E t t2C2 . Substitute for E t t2C2 to
get E t t2C3 D ! C .! C t2C1 /, which can be written as (7.17). Further periods follow
176
the same pattern.
To prove (7.18), notice that Var t .u t Cs / D E t v t2Cs t2Cs D E t v t2Cs E t t2Cs since v tCs
and t Cs are independent. In addition, E t v t2Cs D 1, which proves (7.18).
If we assume that v t is iid N.0; 1/, then the distribution of u tC1 , conditional on the
information in t , is N.0; t2C1 /, where tC1
2
is known already in t . Therefore, the one-step
ahead distribution is normalwhich can be used for estimating the model with MLE.
However, the distribution of u t C2 (still conditional on the information in t ) is more com-
plicated. Notice that
q
u t C2 D v tC2 t C2 D v t C2 ! C v t2C1 t2C1 ; (7.19)
which is a nonlinear function of v t C2 and v t C1 (which are standard normal) and it depends
on t C2 which is not known in t. This makes u tC2 have a non-normal distribution. In
fact, it will have fatter tails than a normal distribution with the same variance (excess kur-
tosis). This spills over to the unconditional distribution which has the following kurtosis
(assuming > 0)
(
2
E u4t 3 11 3 2 > 3 if denominator is positive
2 2
D (7.20)
.E u t / 1 otherwise.
As a comparison, the kurtosis of a normal distribution is 3 (you also get this by setting
D 0). This means that we can expect u t to have fat tails, but that the standardized resid-
uals u t = t perhaps look more normally distributed. See Figure 7.13 for an illustration
(although based on a GARCH model).
Example 7.6 (Kurtosis) With D 1=3, the kurtosis is 4, at D 0:5 it is 9 and at D 0:6
it is infinite. With D 0, it is 3.
Proof. (of (7.20)) Since v t and t are independent, we have E.u2t / D E.v t2 t2 / D
E t2 and E.u4t / D E.v t4 t4 / D E. t4 / E.v t4 / D E. t4 /3, where the last equality follows
from E.v t4 / D 3 for a standard normal variable. To find E. t4 /, square (7.16) and take
expectations (and use E t2 D !=.1 /)
E t4 D ! 2 C 2 E u4t 1 C 2! E u2t 1
2 2
D! C E. t4 /3 2
C 2! =.1 /, so
2
1C !
E t4 D :
1 3 2 .1 /
177
Multiplying by 3 and dividing by .E u2t /2 D ! 2 =.1 /2 gives (7.20).
7.2.2 Estimation of the ARCH(1) Model
Suppose we want to estimate the ARCH modelperhaps because we are interested in

the heteroskedasticity or because we want a more efficient estimator of the regression
equation than LS. We therefore want to estimate the full model (7.14)(7.16) by ML or
GMM.
Remark 7.7 (Likelihood function of u t N.; 2 /) The pdf of an u t N.0; 2 / is
1 ut 2

1
pdf .x t / D p exp ;
2 2 2 2
so the log-likelihood is
1 1 1 u2t
ln L t D ln .2/ ln 2 :
2 2 2 2
If u t and us are independent (uncorrelated if normally distributed), then the joint pdf
is the product of the marginal pdfsand the joint log-likelihood is the sum of the two
likelihoods.
The most common way to estimate the model is to assume that v t is iid N.0; 1/ and
to set up the likelihood function. The log likelihood is easily found, since the model is
conditionally Gaussian. It is
T T
T 1X 1 X u2t
ln L D ln .2/ ln t2 , if (7.21)
2 2 tD1 2 t D1 t2
v t is iid N.0; 1/:
By plugging in (7.14) for u t and (7.16) for t2 , the likelihood function is written in terms
of the data and model parameters. The likelihood function is then maximized with respect
to the parameters. Note that we need a starting value of 12 D ! C u20 . The most
convenient (and common) way is to maximize the likelihood function conditional on a y0
and x0 . That is, we actually have a sample from (t D) 0 to T , but observation 0 is only
used to construct a starting value of 12 . The optimization should preferably impose the
constraints in (7.16). The MLE is consistent.
178
Remark 7.8 (Coding the ARCH(1) ML estimation) A straightforward way of coding the
estimation problem (7.14)(7.16) and (7.21) is as follows.
First, guess values of the parameters b (a vector), and !, and . The guess of b can be
taken from an LS estimation of (7.14), and the guess of ! and from an LS estimation of
uO 2t D ! C uO 2t 1 C " t where uO t are the fitted residuals from the LS estimation of (7.14).
Second, loop over the sample (first t D 1, then t D 2, etc.) and calculate uO t from (7.14)
and t2 from (7.16). Plug in these numbers in (7.21) to find the likelihood value.
Third, make better guesses of the parameters and do the second step again. Repeat until
the likelihood value converges (at a maximum).
Remark 7.9 (Imposing parameter constraints on ARCH(1)) To impose the restrictions in

(7.16), iterate over values of .b; !; Q and let ! D !Q 2 and D exp.a/=1
Q / Q C exp.a/.
Q
It is often found that the fitted normalized residuals, uO t = t , still have too fat tails
compared with N.0; 1/. Estimation using other likelihood functions, for instance, for
a t-distribution can then be used. Or the estimation can be interpreted as a quasi-ML
(is typically consistent, but requires different calculation of the covariance matrix of the
parameters).
Another possibility is to estimate the model by GMM using, for instance, the follow-
ing moment conditions
2 3
xt ut
E 4 u2t t2 5 D 0.kC2/1 ; (7.22)
6 7
u2t 1 .u2t t2 /
where u t and t2 are given by (7.14) and (7.16).

It is straightforward to add more lags to (7.16). For instance, an ARCH.p/ would be
t2 D ! C 1 u2t 1 C : : : C p u2t p: (7.23)
We then have to add more moment conditions to (7.22), but the form of the likelihood
function is the same except that we now need p starting values and that the upper bound-
ary constraint should now be jpD1 j 1.
7.3 GARCH Models
Instead of specifying an ARCH model with many lags, it is typically more convenient to
specify a low-order GARCH (Generalized ARCH) model. The GARCH(1,1) is a simple
179
GARCH std, annualized EWMA std, annualized, = 0.99
50 50
40 40
30 30
20 20
10 10
0 0
1980 1990 2000 2010 1980 1990 2000 2010
AR(1) of excess returns

with GARCH(1,1) errors
t2 = + u2t1 + t1
2 EWMA std, annualized, = 0.9
50
GARCH coefficients:
40

0.08 0.91 30
20
10
0
1980 1990 2000 2010
Figure 7.12: Conditional standard deviation, estimated by GARCH(1,1) model
and surprisingly general model where
t2 D ! C u2t 1 C t2 1 , with (7.24)

! > 0; ; 0; and C < 1;
combined with (7.14) and (7.15).

The non-negativity restrictions are needed in order to guarantee that t2 > 0 in all
periods. The upper bound C < 1 is needed in order to make the t2 stationary and
therefore the unconditional variance finite. To see the latter, notice that we in period t can
forecast the future conditional variance ( t2Cs ) as (since t2C1 is known in t )
!
E t t2Cs D N 2 C . C /s 1
t2C1 N 2 , with N 2 D (7.25)

;
1
where N 2 is the unconditional variance. This has the same form as in the ARCH(1) model
180
QQ plot of AR residuals QQ plot of AR&GARCH residuals
6 6
S&P 500 returns (daily)
4 1954:12014:3 4
Empirical quantiles
Empirical quantiles
2 0.1th to 99.9th 2
percentile
0 0
-2 AR(1) -2 AR(1)&GARCH(1,1)
-4 Stand. residuals: -4 Stand. residuals:
ut / ut /t
-6 -6
-6 -4 -2 0 2 4 6 -6 -4 -2 0 2 4 6
Quantiles from N(0,1), % Quantiles from N(0,1), %
Figure 7.13: QQ-plot of residuals
(7.17), but where the sum of and is like an AR(1) parameter. The restriction C < 1
must hold for this difference equation to be stable.
As for the ARCH model, the conditional variance of u t Cs is clearly equal to the ex-
pected value of tCs
2
Var t .u t Cs / D E t t2Cs : (7.26)
Assuming that u t has no autocorrelation, it follows directly from (7.25) that the ex-
pected variance of a longer time period (u t C1 C u t C2 C : : : C u t CK ) is
Var t . K
PK 2
sD1 u t Cs / D E t N2 C K
sD1 tCs D K sD1 . C /
s 1
t2C1 N 2
P P
1 . C /K 2
D K N 2 C N 2 : (7.27)

tC1
1 . C /
This is useful for portfolio choice and asset pricing when the horizon is longer than one
period (day, perhaps).
Proof. (of (7.25)(7.27)) Notice that E t tC2
2
D ! C E t v t2C1 E t t2C1 C t2C1 since
v t is independent of t . Moreover, E t v tC12
D 1 and E t t2C1 D tC1 2
(known in t).
Combine to get E t tC2 D ! C . C / t C1 . Similarly, E t t C3 D ! C . C / E t t2C2 .
2 2 2
Substitute for E t t2C2 to get E t t2C3 D ! C . C /! C . C / tC1 2

, which can be
written as (7.25). Further periods follow the same pattern.
To prove (7.27), use (7.25) and notice that K C s 1
D C K
= 1 . C /.
P
sD1 . / 1 . /
181
Remark 7.10 (EWMA) The GARCH(1,1) has many similarities with the exponential mov-
ing average estimator of volatility
t2 D .1 /u2t 1 C t2 1 :
This methods is commonly used by practitioners. For instance, the RISK Metrics uses
this method with D 0:94. Clearly, plays the same type of role as in (7.24) and
1 as . The main differences are that the exponential moving average does not have
a constant and volatility is non-stationary (the coefficients sum to unity). See Figure 7.12
for a comparison.
The kurtosis of the process is (assuming > 0)

/2
(
E u4t 3 1 122.C > 3 if denominator is positive
D .C /2
(7.28)
.E u2t /2 1 otherwise.
If D 0, then the variance becomes deterministic and the distribution normal (with a
kurtosis of 3).
Proof. (of (7.28)) Since v t and t are independent, we have E.u2t / D E.v t2 t2 / D E t2
and E.u4t / D E.v t4 t4 / D E. t4 / E.v t4 / D E. t4 /3, where the last equality follows from
E.v t4 / D 3 for a standard normal variable. We also have E.u2t t2 / D E t4
E t4 D E.! C u2t 1 C t2 1 /2
D ! 2 C 2 E u4t 1 C 2 E t4 1 C 2! E u2t 1 C 2! E t2 1 C 2 E.u2t 1 t2 1 /
D ! 2 C 2 E. t4 /3 C 2 E t4 C 2! E t2 C 2! E t2 C 2 E t4
! 2 C 2!. C / E t2
D :
1 2 2 . C 2 /2
Use E t2 D !=.1 a /, multiply by 3 and divide by .E u2t /2 D ! 2 =.1 /2 gives

(7.28).
The GARCH(1,1) corresponds to an ARCH.1/ with geometrically declining weights,
which is seen by solving (7.24) recursively by substituting for t2 1 (and then t2 2 , t2 3 ,
...)
1
2 ! X
t D C j u2t 1 j : (7.29)
1 j D0
This suggests that a GARCH(1,1) might be a reasonable approximation of a high-order

ARCH.
182
Proof. (of (7.29)) Substitute for t2 1 in (7.24), and then for t2 2 , etc
t 1 2

t2 D ! C u2t 1 C ! C u2t 2 C t2 2
D ! .1 C / C u2t 1 C u2t 2 C 2 t2 2
:
D ::
and we get (7.29).

To estimate the model consisting of (7.14), (7.15) and (7.24) we can still use the
likelihood function (7.21) and do a MLE. We typically create the starting value of u20 as
in the ARCH model (use y0 and x0 to create u0 ), but this time we also need a starting value
of 02 . It is often recommended that we use 02 D Var.uO t /, where uO t are the residuals from
a LS estimation of (7.14). It is also possible to assume another distribution than N.0; 1/.
Remark 7.11 (Imposing parameter constraints on GARCH(1,1)) To impose the restric-

Q ;
tions in (7.24), iterate over values of .b; !; Q and let ! D !Q 2 , D exp./=1
Q / Q C
exp./ Q and D exp./=1
Q C exp./; Q C exp./ Q
Q C exp./.
To estimate the GARCH(1,1) with GMM, we can, for instance, use the following
moment conditions (where t2 is given by (7.24))
2 3
xt ut
6 2
6 u t t2
7
0
E66 u2 .u2 2 / 7 D 0.kC3/1 ; where u t D y t x t b: (7.30)
7
7
4 t 1 t t 5
u2t 2 .u2t t2 /
7.4 Value at Risk
The value at risk (as fraction of the investment) at the level (say, D 0:95) is VaR D
cdf 1 .1 /, where cdf 1 ./ is the inverse of the cdfso cdf 1 .1 / is the 1
quantile of the return distribution. See Figure 7.14 for an illustration. When the return
has an N.; 2 / distribution, then VaR95% D . 1:64/. See Figures 7.157.17 for
an example of time-varying VaR, based on a GARCH model.
7.4.1 Backtesting a VaR Model
Backtesting a VaR model amounts to checking if (historical) data fits with the VaR num-
bers. For instance, we first find the VaR95% and then calculate what fraction of returns
183
Value at risk and distribution of returns
3
2.5 VaR 95% = (5% quantile)
1.5
0.5
0
40 -VaR 95% 0 40
Return, %
Figure 7.14: Value at risk
GARCH std, % Value at Risk95% (one day), %

5 10
S&P 500, daily data 1954:12014:3
4
The horizontal lines are from the
3 unconditional distribution 5
2
1
0 0
1980 1990 2000 2010 1980 1990 2000 2010
The VaR is based on N()
e
Rte = a + bRt1 + ut
with GARCH(1,1) errors VaRt = (t 1.64t )
t2 = + u2t1 + t1
2 e
where t = a + bRt1
Coefficient estimates:
b
0.09 0.08 0.91
Figure 7.15: Conditional volatility and VaR
that is actually below (the negative of ) this number. If the model is correct it should be
5%. We then repeat this for VaR96% : only 4% of the returns should be below (the negative
of ) this number. Figures 7.167.17 show results from backtesting a VaR model where
the volatility follows a GARCH process (to capture the time varying volatility). The evi-
184
Value at Risk95% (one day) and loss, %
10
VaR S&P 500, daily data 1954:12014:3
max(loss,0)
The VaR is based on GARCH(1,1) & N()
8
Loss > VaR95% in 0.051 of the cases
Negative losses are shown as zero
0
1980 1985 1990 1995 2000 2005 2010 2015
Figure 7.16: Backtesting VaR from a GARCH model, assuming normally distributed
shocks
dence suggests that this model, combined with the assumption that the return is normally
distributed (but with time-varying parameters), works relatively well.
Remark 7.12 (Bernoulli and binomial distributions) In a Bernoulli distribution, the ran-
dom variable X can only take two values: 1 or 0, with probability p and 1 p respectively.
This gives E.X/ D p and Var.X/ D p.1 p/. After n independent trials, the number of
successes (y) has a binomial distribution with E.y/ D np and Var.y/ D np.1 p/.
To perform a statistical back test of a VaR model, define a variable that is one if the
loss is greater than the VaR
(
1 if R t < VaR
dt D (7.31)
0 otherwise
By using the properties of a binomial distribution, we can notice that

PT
t D1 d t =T !d N 1 ; .1 /=T : (7.32)
185
Backtesting VaR from GARCH(1,1) + N(), daily S&P 500 returns
0.1
0.09
lines: null hypothesis
and 90% confidence band
0.08
Empirical Prob(loss > VaR)
circles: empirical fractions

0.07
0.06
0.05
0.04
0.03
0.02
0.01 Daily S&P 500 returns, 1954:12014:3
0
0.9 0.92 0.94 0.96 0.98 1
VaR confidence level ( in VaR )
Figure 7.17: Backtesting VaR from a GARCH model, assuming normally distributed
shocks
(This follows from TtD1 d t !d N .1 /T; T .1 /.) In particular, the second

P
expression can be used for testing the null hypothesis that R t < VaR for the fraction
1 of the observations. Alternatively, we could use GMM with the moment condition
gt D dt .1 / D 0: (7.33)
From the usual properties of GMM, we then have

p
T gN !d N.0; S0 /, so (7.34)
PT
t D1 d t =T !d N.1 ; S0 =T /; (7.35)
PT p
where gN D t D1 g t =T is the average moment condition and S0 D Var. T g/ N is the
variance. The latter can be estimated by, for instance, a Newey-West approach. Clearly,
the only difference between (7.32) and (7.35) is that the former specifies the variance as
.1 /=T , while the latter open up the possibility to use another way of estimating the
variance. Compare Figures 7.17 and 7.18.
186
Backtesting VaR from GARCH(1,1) + N(), daily S&P 500 returns
0.1
0.09
lines: null hypothesis
and 90% confidence band (GMM)
0.08
Empirical Prob(loss > VaR)
circles: empirical fractions

0.07
0.06
0.05
0.04
0.03
0.02
0.01 Daily S&P 500 returns, 1954:12014:3
0
0.9 0.92 0.94 0.96 0.98 1
VaR confidence level ( in VaR )
Figure 7.18: Backtesting VaR from a GARCH model, GMM based
7.5 Non-Linear Extensions
A very large number of extensions of the basic GARCH model have been suggested.
Estimation is straightforward since MLE is done as for any other GARCH modeljust
the specification of the variance equation differs.
An asymmetric GARCH (Glosten, Jagannathan, and Runkle (1993)) can be con-
structed as
t2 D ! C u2t 1 C t2 1 C .u t 1 > 0/u2t 1 , where (7.36)

(
1 if q is true
.q/ D
0 else.
This means that the effect of the shock u2t 1 is if the shock was negative and C if
the shock was positive. With < 0, volatility increases more in response to a negative
u t 1 (bad news) than to a positive u t 1 .
187
GARCH std, annualized eGARCH std, annualized
50 50
40 40
30 30
20 20
10 10
0 0
1980 1990 2000 2010 1980 1990 2000 2010
S&P 500 (daily) 1954:12014:3

with eGARCH(1,1) errors
with GARCH(1,1) errors |ut1 | ut1
t2 = + u2t1 + t1
2 ln t2 = + 2
+ ln t1 +
t1 t1
Coefficients: Coefficients:

0.08 0.91 0.10 0.99 -0.06
Figure 7.19: GARCH and EGARCH estimates
The EGARCH (exponential GARCH, Nelson (1991)) sets
ju t 1j ut 1
ln t2 D ! C C ln t2 1 C : (7.37)
t 1 t 1
Apart from being written in terms of the log (which is a smart trick to make t2 > 0
hold without any restrictions on the parameters), this is an asymmetric model. The ju t 1 j
term is symmetric: both negative and positive values of u t 1 affect the log volatility in
the same way. The linear term in u t 1 modifies this to make the effect asymmetric. In
particular, if < 0, then the log volatility increases more in response to a negative u t 1
(bad news) than to a positive u t 1 . This model is stationary if jj < 1.
To estimate the model, we can still use the likelihood function (7.21) and do a MLE.
We typically create the starting value of u0 D y0 x00 bO and 02 D Var.uO t /, where uO t D
O See Figure 7.19 for an illustration.
y t x t0 b.
Hentschel (1995) estimates several models of this type, as well as a very general
formulation on daily stock index data for 1926 to 1990 (some 17,000 observations). Most
standard models are rejected in favour of a model where t depends on t 1 and ju t 1
bj3=2 .
188
7.6 GARCH Models with Exogenous Variables
We could easily extend the GARCH(1,1) model by adding exogenous variables x t 1 , for
instance, VIX
t2 D ! C u2t 1 C t2 1 C x t 1 ; (7.38)
where care must be taken to guarantee that t2 > 0. One possibility is to make sure that
x t > 0 and then restrict to be non-negative. Alternatively, we could use an EGARCH
formulation like
ju t 1 j
ln t2 D ! C C ln t2 1 C x t 1 : (7.39)
t 1
These models can be estimated with maximum likelihood.
7.7 Stochastic Volatility Models
A stochastic volatility model differs from GARCH models by making the volatility truly
stochastic. Recall that in a GARCH model, the volatility in period t ( t ) is known already
in t 1. This is not the case in a stochastic volatility model where the log volatility follows
an ARMA process. The simplest case is the AR(1) formulation
ln t2 D ! C ln t2 1 C t , (7.40)
with t iid N.0; 1/;
combined with (7.14) and (7.15).

The estimation of a stochastic volatility model is complicatedand the basic reason
is that it is very difficult to construct the likelihood function. So far, the most practical
way to do MLE is by simulations.
Instead, stochastic volatility models are often estimated by quasi-MLE. For the model
(7.15) and (7.40), this could be done as follows: square (7.15) and take logs to get
ln u2t D E ln v t2 C ln t2 C .ln v t2 E ln v t2 /: (7.41)
We could use this as the measurement equation in a Kalman filter (pretending that ln v t2
E ln v t2 is normally distributed), and (7.40) as the state equation. (The Kalman filter is a
convenient way to calculate the likelihood function.) In essence, this is an AR(1) model
with noisy observations.
If ln v t2 is normally distributed , then this will give MLE, otherwise just a quasi-MLE.
189
S&P 500, stochastic volatility
50 S&P 500 (daily) 1954:12014:3
Stochastic volatility model for demeaned returns

40
0.99 0.11
std, annualized
30
20
10
0
1980 1985 1990 1995 2000 2005 2010 2015
Figure 7.20: Conditional standard deviation, stochastic volatility model
For instance, if v t is i idN.0; 1/ (see Ruiz (1994)) then we have approximately E ln v t2

1:27 and Var.ln v t2 / D 2 =2 (with D 3:14:::) so we could write the measurement
equation as
ln u2t D 1:27 C ln t2 C w t ; with (7.42)

w t N.0; 2 =2/:
In this case, only the state equation contains parameters that we need to estimate: !; ; .
7.8 (G)ARCH-M
It can make sense to let the conditional volatility enter the regression (mean) equation
for instance, as a proxy for risk which may influence the expected return.
Example 7.13 (Mean-variance portfolio choice) A mean variance investor solves
max E Rp p2 k=2;

subject to Rp D Rm C .1 /Rf ;
where Rm is the return on the risky asset (the market index) and Rf is the riskfree return.
190
GARCH-M std, annualized
50 S&P 500 (daily) returns 1954:12014:3
40 AR(1) + GARCH-M:
30
e
Rte = a + bRt1 + t + ut
t = + u2t1 + t1
2 2
20
Coefficients:
10
b
0 0.09 0.08 0.08 0.91
1980 1990 2000 2010
Figure 7.21: GARCH-M example
The solution is
1 E.Rm Rf /
D :
k m2
In equilibrium, this weight is one (since the net supply of bonds is zero), so we get
E.Rm Rf / D km2 ;
which says that the expected excess return is increasing in both the market volatility and
risk aversion (k).
We modify the mean equation (7.14) to include the conditional variance t2 or the
standard deviation t (taken from any of the models for heteroskedasticity) as a regressor
y t D x t0 b C ' t2 C u t ; E.u t jx t ; t / D 0: (7.43)
Note that t2 is predetermined, since it is a function of information in t 1. This model

can be estimated by using the likelihood function (7.21) to do MLE.
It can also be noted (see Gourieroux and Jasiak (2001) 11.3) that a slightly modified
GARCH-M model is the discrete time sampling version of a continuous time stochastic
volatility model (where the mean is affected by one Wiener process and the variance by
another).
Remark 7.14 (Coding of (G)ARCH-M) We can use the same approach as in Remark
7.8, except that we use (7.43) instead of (7.14) to calculate the residuals (and that we
obviously also need a guess of ').
191
7.9 Multivariate (G)ARCH
7.9.1 Different Multivariate Models
This section gives a brief summary of some multivariate models of heteroskedasticity. Let
the model (7.14) be a multivariate model where y t and u t are n 1 vectors. We define
the conditional (on the information set in t 1) covariance matrix of u t as
t D Et 1 u t u0t : (7.44)
It may seem as if a multivariate (matrix) version of the GARCH(1,1) model would

be simple, but it is not. The reason is that it would contain far too many parameters.
Although we only need to care about the unique elements of t , that is, vech. t /, this
still gives very many parameters
0
vech. t / D C C Avech.u t 1ut 1/ C Bvech. t 1 /: (7.45)
This typically gives too many parameters to handleand makes it difficult to impose
sufficient restrictions to make t positive definite (compare the restrictions of positive
coefficients in (7.24)).
Example 7.15 (vech formulation, n D 2) For instance, with n D 2 we have

2 3 2 2 3 2 3
11;t u1;t 1 11;t 1
4 21;t 5 D C C A 4 u1;t 1 u2;t 1 5 C B 4 21;t 1 5 ;
6 7 6 7 6 7
22;t u22;t 1 22;t 1
where C is 3 1, A is 3 3, and B is 3 3. This gives 21 parameters, which is already

hard to manage. We have to limit the number of parameters.
The Diagonal Model
The diagonal model assumes that A and B are diagonal. This means that every element
of t follows a univariate process. To make sure that t is positive definite we have
to impose further restrictions. The obvious drawback of this model is that there is no
spillover of volatility from one variable to another.
192
Example 7.16 (Diagonal model, n D 2) With n D 2 we have
2 3 2 3 2 32 2 3 2 32 3
11;t c1 a1 0 0 u1;t 1 b1 0 0 11;t 1
4 21;t 5 D 4c2 5 C 4 0 a2 0 5 4 u1;t 1 u2;t 1 5 C 4 0 b2 0 5 4 21;t 5;

6 7 6 7 6 76 7 6 76 7
1
22;t c3 0 0 a3 u22;t 1 0 0 b3 22;t 1
which gives 3 C 3 C 3 D 9 parameters (in C , A, and B, respectively).
The BEKK Model
The BEKK model makes t positive definite by specifying a quadratic form
t D C C A0 u t 0
1ut 1A C B 0t 1 B; (7.46)
where C is symmetric and A and B are n n matrices. Notice that this equation is
specified in terms of t , not vech. t /. (Recall that a quadratic form is positive definite,
provided the matrices are of full rank.)
Example 7.17 (BEKK model, n D 2) With n D 2 we have

" # " # " #0 " #" #
11;t 12;t c11 c12 a11 a12 u21;t 1 u1;t 1 u2;t 1 a 11 a 12
D C C
12;t 22;t c12 c22 a21 a22 u1;t 1 u2;t 1 u22;t 1 a21 a22
" #0 " #" #
b11 b12 11;t 1 12;t 1 b11 b12
;
b21 b22 12;t 1 22;t 1 b21 b22
which gives 3 C 4 C 4 D 11 parameters (in C , A, and B, respectively).
The Constant Correlation Model
The constant correlation model assumes that every variance follows a univariate GARCH
process and that the conditional correlations are constant. To get a positive definite t ,
each individual GARCH model must generate a positive variance (same restrictions as
before), and that all the estimated (constant) correlations are between 1 and 1. The price
is, of course, the assumption of no movements in the correlations.
Example 7.18 (Constant correlation model, n D 2) With n D 2 the covariance matrix is

" # "p #" # "p #
11;t 12;t 11;t 0 1 12 11;t 0
D p p
12;t 22;t 0 22;t 12 1 0 22;t
193
and each of 11t and 22t follows a GARCH process. Assuming a GARCH(1,1) as in
(7.24) gives 7 parameters (2 3 GARCH parameters and one correlation), which is con-
venient.
Remark 7.19 (Imposing parameter constraints on a correlation) To impose the restric-

tion that 1 < < 1, iterate over Q and let D 1 2=1 C exp./.
Q
Remark 7.20 (Estimating the constant correlation model) A quick (and dirty) method
for estimating is to first estimate the individual GARCH processes and then estimate the
p p
correlation of the standardized residuals u1t = 11;t and u2t = 22;t .
The Dynamic Correlation Model
The dynamic correlation model (see Engle (2002) and Engle and Sheppard (2001)) allows
the correlation to change over time. In short, the model assumes that each conditional
variance follows a univariate GARCH process and the conditional correlation matrix is
(essentially) allowed to follow a univariate GARCH equation.
The conditional covariance matrix is (by definition)
p
t D D t R t D t , with D t D diag. i i;t /; (7.47)
and R t is the conditional correlation matrix (discussed below).
Remark 7.21 (diag(ai ) notation) diag.ai / denotes the nn matrix with elements a1 ; a2 ; : : : an
along the main diagonal and zeros elsewhere. For instance, if n D 2, then
" #
a1 0
diag.ai / D :
0 a2
The conditional correlation matrix R t is allowed to change like in a univariate GARCH

model, but with a transformation that guarantees that it is actually a valid correlation ma-
trix. First, let v t be the vector of standardized residuals and let QN be the unconditional
correlation matrix of v t . For instance, if we assume a GARCH(1,1) structure for the
correlation matrix, then we have
Q t D .1 /QN C v t 0
1vt 1 C Q t 1, with (7.48)
p
vi;t D ui;t = i i;t ;
194
where and are two scalars and QN is the unconditional covariance matrix of the nor-
malized residuals (v t ). To guarantee that the conditional correlation matrix is indeed a
correlation matrix, Q t is treated as if it where a covariance matrix and R t is simply the
implied correlation matrix. That is,
p 1 p 1
R t D diag Q t diag (7.49)

qi i;t qi i;t :
The basic idea of this model is to estimate a conditional correlation matrix as in (7.49)
and then scale up with conditional variances (from univariate GARCH models) to get a
conditional covariance matrix as in (7.47).
See Figures 7.227.23 for illustrationswhich also suggest that the correlation is
close to what an EWMA method delivers. The DCC model is used in a study of asset
pricing in, for instance, Duffee (2005).
Example 7.22 (Dynamic correlation model, n D 2) With n D 2 the covariance matrix

t is
" # "p #" # "p #
11;t 12;t 11;t 0 1 12;t 11;t 0
D p p ;
12;t 22;t 0 22;t 12;t 1 0 22;t
and each of 11t and 22t follows a GARCH process. To estimate the dynamic correla-
tions, we first calculate (where and are two scalars)
" # " # " #" #0 " #
q11;t q12;t 1 qN 12 v1;t 1 v1;t 1 q11;t 1 q12;t 1
D .1 / C C ;
q12;t q22;t qN 12 1 v2;t 1 v2;t 1 q12;t 1 q22;t 1
p
where vi;t 1 D ui;t 1 = i i;t 1 and qN ij is the unconditional correlation of vi;t and vj;t
and we get the conditional correlations by
" # " p #
1 12;t 1 q12;t = q11;t q22;t
D p :
12;t 1 q12;t = q11;t q22;t 1
Assuming a GARCH(1,1) as in (7.24) gives 9 parameters (2 3 GARCH parameters,

.qN 12 ; ; /).
To see what DCC generates, consider the correlation coefficient from a bivariate
195
Std of DAX, GARCH(1,1) Std of FTSE, GARCH(1,1)
60 60
40 40
Std
Std
20 20
0 0
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015
Daily returns 1991:12014:4

The standard deviations are annualized
Correlation of FTSE 100 and DAX 30 DCC model:

1 (a) GARCH(1,1) for each variance

(b) Qt = (1 )Q + vt1 vt1 + Qt1 ,
where Qt is the covariance matrix and
vt are standardized residuals
Corr
0.5 Parameter estimates:

DCC
CC 0.04 0.96
0
1995 2000 2005 2010 2015
Figure 7.22: Results for multivariate GARCH models
model
q12;t
12;t D p p , where (7.50)
q11;t q22;t
q12;t D .1 /qN 12 C v1;t 1 v2;t 1 C q12;t 1
q11;t D .1 / C v1;t 1 v1;t 1 C q11;t 1
q22;t D .1 / C v2;t 1 v2;t 1 C q22;t 1:
This is a complicated expression, but the numerator is the main driver: q11;t and q22;t are
variances of normalized variablesso they should not be too far from unity. Therefore,
q12;t is close to being the correlation itself. The equation for q12;t shows that it has a
GARCH structure: it depends on v1;t 1 v2;t 1 and q12;t 1 . Provided and are large
numbers, we can expect the correlation to be strongly autocorrelated.
196
Correlation of FTSE 100 and DAX 30 Correlation of FTSE 100 and DAX 30
Corr 1 1
Corr
0.5 0.5
EWMA ( = 0.95) EWMA ( = 0.975)

0 0
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015
Correlation of FTSE 100 and DAX 30

1
Corr
0.5
EWMA ( = 0.99)
0
1995 2000 2005 2010 2015
Figure 7.23: Time-varying correlations (different EWMA estimates)
7.9.2 Estimation of a Multivariate Model
In principle, it is straightforward to specify the likelihood function of the model and then
maximize it with respect to the model parameters. For instance, if u t is iid N.0; t /, then
the log likelihood function is
T T
Tn 1X 1X 0
ln L D ln.2/ ln j t j u 1ut : (7.51)
2 2 t D1 2 t D1 t t
In practice, the optimization problem can be difficult since there are typically many pa-
rameters. At least, good starting values are required.
Remark 7.23 (Starting values of a constant correlation GARCH(1,1) model) Estimate

GARCH(1,1) models for each variable separately, then estimate the correlation matrix
on the standardized residuals.
Remark 7.24 (Estimation of the dynamic correlation model) Engle and Sheppard (2001)
suggest estimating the dynamic correlation matrix by two-step procedure. First, estimate
197
the univariate GARCH processes. Second, use the standardized residuals to estimate the
dynamic correlations by maximizing the likelihood function (7.51 if we assume normally
distributed errors) with respect to the parameters and . In this second stage, both the
parameters for the univariate GARCH process and the unconditional covariance matrix
QN are kept constant.
7.10 LAD and Quantile Regressions
Quantile regressions are useful for estimating models where the heteroskedasticity is re-
lated to the regressors.
7.10.1 LAD
Reference: Amemiya (1985) 4.6, Greene (2012) 7.3

The least absolute deviations (LAD) estimator is a special case of quantile regressors
and a good way to introduce the general concept. LAD minimizes the sum of absolute
residuals (rather than the squared residuals)
T
bOLAD D arg min x t0 b
X
(7.52)

y t
b
t D1
The optimization is a non-linear problem, but a simple iteration works nicely (see below).
The estimator is typically less sensitive to outliers than OLS. (There are also other ways
to estimate robust regression coefficients.) This is illustrated in Figure 7.24.
See Figure 7.25 for an empirical example.
If we assume that the median of the true residual, u t , is zero, then (under strict as-
sumptions, discussed below) we have
p
T .bOLAD b0 / !d N 0; f .0/ 2 xx1 =4 , where (7.53)

XT
xx D plim x t x t0 =T;
t D1
where f .0/ is the value of the pdf of the residual at zero. Unless we know this density
function (or else we would probably have used MLE instead of LAD), we need to estimate
itfor instance with a kernel density method. However, to arrive at the result in (7.53)
we must assume that the residual is independent of the regressors. (This is discussed in
some detail below, see quantile regressions).
198
OLS vs LAD of y = 0.75x + u
2
y: -1.125 -0.750 1.750 1.125
x: -1.500 -1.000 1.000 1.500
0
y
1
Data
OLS (0.25 0.90)
LAD (0.00 0.75)
2
3 2 1 0 1 2 3
x
Figure 7.24: Data and regression line from OLS and LAD
p
Example 7.25 (N.0; 2 /) When u t N.0; 2 ), then f .0/ D 1= 2 2 , so the covari-
ance matrix in (7.53) becomes 2 xx1 =2. This is =2 times larger than when using
LS.
Remark 7.26 (Algorithm for LAD) The LAD estimator can be written
T
bOLAD D arg min
X
w t uO t .b/2 , w t D 1= juO t .b/j ; with
b
t D1
O D yt
uO t .b/ x t0 bO

O
so it is a weighted least squares where both y t and x t are multiplied by 1= uO t .b/ . It can

O
be shown that iterating on LS with the weights given by 1= uO t .b/ , where the residuals
are from the previous iteration, converges very quickly to the LAD estimator.
7.10.2 Reinterpreting the LAD
Consider a linear regression

y t D x t0 b C u t : (7.54)
199
US industry portfolios,
1.5
Monthly data 1947:12013:12 OLS
LAD
0.5
A B C D E F G H I J
Figure 7.25: Betas of US industry portfolios
In the OLS context we typically assume E u t D 0 and Cov.x t ; u t / D 0. The latter is the
same as E.u t jx t / D 0 which means that
E.y t jx t / D x t0 b: (7.55)
We can interpret the LAD estimator as an alternative way of getting good estimates of b,
especially when the error distribution has fat tails. In fact, when the errors have a Laplace
distribution, f .u/ D exp. juj =/=2), then LAD is the MLE.
Remark 7.27 (E .ujx/ D 0 or (E u t D 0; Cov.x t ; u t / D 0/ ) For any random variables

u and x,
Cov .x; u/ D Cov x; E .ujx/ :
The condition E .ujx/ D 0 therefore implies Cov .x; u/ D 0. It also implies E u D 0

since E u D Ex E .ujx/ D Ex 0 D 0.
Remark 7.28 (Mean and median as solutions to minimization problems) If u is a random

variable, then the mean, , is the solution to min E.u /2 , while the median, m, is the
solution to minm E ju mj. (There are some restrictions on u for this to be true, but we
disregard that here.)
200
The previous remark shows that the LAD estimator (7.52) amounts to finding the b
coefficients (in a linear model) so that
Median.u t jx t / D 0; which implies (7.56)

Median.y t jx t / D x t0 b: (7.57)
This is the alternative interpretation of the LAD: it tries to set the median of the residuals,
at a given x t vector, equal to zero. In contrast, OLS tries to set the mean of the residuals,
at a given x t vector, to zero.
7.10.3 Quantile Regressions
A quantile regression is a generalization of the LAD. Instead of focusing on the 0.5th

quantile (the median), as is done in (7.56), it rather states that the qth quantile (conditional
on x t ) of the residual in zero
Q.u t jx t I q/ D 0; which implies (7.58)

Q.y t jx t I q/ D x t0 b .q/ : (7.59)
Here Q.u t jx t I q/ denotes the qth quantile of u t at a particular value of x t and we also
index the coefficients b .q/ to remember that this refers to the qth quantile. Clearly, the
LAD is the special case when q D 0:5.
We could estimate (see below for how) such coefficients for various quantile. When
x t just contains a constant and one more regressor, then it is easy to illustrate. See Figure
7.26 for an example where the slopes differ across the quantiles and Figure 7.27 where
they do not. In particular, in Figure 7.26 the data follows a location and scale model
y t D x t0 C u t where u t D x t0 " t ; and " t is iid. (7.60)
This is basically a linear model (y t D x t0 ), but where the residuals (u t ) are heteroskedas-
tic. In particular, the volatility of u t is increasing in jx t0 j. This highlights the key feature
of quantile regressions: they are well suited for showing how both the typical (median)
and tails (for instance, the 0:1th and 0:9th quantiles) are related to the regressors. Notice,
however, that we are always referring to conditional quantiles, that is, to quantiles of y t
at a particular value of x t . We are not referring to unconditional quantiles of y t . This
means that the slopes for a high quantile (0.9, say) do not necessarily describe the rela-
tion between y t and x t at generally (unconditionally) high y t (or x t ) valuessee Figure
201
Scatter and fitted values for various quantiles (0.1,0.3,0.5,0.7,0.9)
8
y = 0.2 + 0.9x + 0.5(x + 3)
where is iid N(0,1)
6
Estimated: y = a + bx + u (for each quantile):
quantile a b
4 0.90 2.15 1.62
0.70 0.98 1.18
0.50 0.18 0.92
2
y
0.30 -0.73 0.65

0.10 -1.75 0.30
4
3 2 1 0 1 2 3
x
Figure 7.26: Example of quantile regression
7.26. Rather, the slopes describes the relation between y t and x t at high " t values. This
is perhaps best seen by using the location and scale model in (7.60) which implies
Q.y t jx t I q/ D x t0 C Q.u t jx t I q/ (7.61)

D x t0 C x t0 Q." t I q/ (7.62)
D x t0 C Q." t I q/: (7.63)
(In the second line, Q." t I q/ need not be conditioned on x t since " t is independent of x t .)
Comparing with (7.59) shows that
b .q/ D C Q." t I q/: (7.64)
For instance, if > 0, then b .q/ is increasing with q since Q." t I q/ is. For instance,
if " t N.0; 1/, then Q." t I 0:05/ D 1:64 and Q." t I 0:95/ D 1:64. This is the case
illustrated in Figure 7.26where the higher slopes at high quantiles basically capture
heteroskedasticity. In contrast, Figure 7.27 shows the case where the coefficient on the
non-constant regressors are all zero: the b .q/ coefficients (except for the constants) are the
same across quantiles.
202
Scatter and fitted values for various quantiles (0.1,0.3,0.5,0.7,0.9)
8
y = 0.2 + 0.9x + 0.5(0 + 3)
where is iid N(0,1)
6
Estimated: y = a + bx + u (for each quantile):
quantile a b
4 0.90 2.08 1.01
0.70 0.96 0.98
0.50 0.28 0.91
2
y
0.30 -0.55 0.84

0.10 -1.72 1.01
4
3 2 1 0 1 2 3
x
Figure 7.27: Example of quantile regression
Figure 7.28 illustrates these points by showing the predicted quantiles of a return as a
function of the lagged return. The empirical evidence suggests that the typical (median)
effect of a lagged return on todays return is almost zero (there is a weak pattern of neg-
ative return to be followed by positive returns and vice versa). More pronounced is the
smaller dispersion of returns after positive returnsand this is where the real payoff of
the quantile regressions is.
The estimated coefficients for the qth quantile, b .q/ , solves the following problem
minb.q/ t Wu t 0 qju t j C q/ju t j, where (7.65)

P P
t Wu t <0 .1
ut D yt x t0 b .q/ :
This is a highly non-linear problem (and the objective function does not have continuous
derivatives), which can be solved by either a linear programming method or a derivative-
free minimization algorithm. As a special case, q D 0:5 gives the LAD where (7.65)
becomes
minb .0:5/ 0:5 TtD1 ju t j, where u t D y t x t0 b .q/ ; (7.66)
P
which is clearly the same as (7.52).
203
Fitted values for various quantiles
5
4
Estimated: Rt = a + bRt1 + ut (for each quantile):
3
2
1
Rt , %
0
1 quantile a b
0.99 4.50 -0.34
2 0.95 1.66 -0.13
0.75 0.56 -0.05
3 0.50 0.05 -0.03
0.25 -0.49 0.02 S&P 500 (daily), 1979:12014:4
4 0.05 -1.65 0.05
0.01 -4.86 0.05
3 2 1 0 1 2 3
Rt 1, %
Figure 7.28: Quantile regression of AR(1) of daily returns
Remark 7.29 (Alternative way of writing (7.65)) Suppose u1 0 and u2 < 0, then the
sum in (7.65) can be written qu1 C .q 1/u2 . This suggests that if we define a dummy d t
to be 1 if u t < 0 and zero otherwise, then we can write the sum as .q d1 /u1 C.q d2 /u2 .
In general, the minimisation problem can then be written
PT
minb .q/ t D1 .q d t /u t :
The term .q d t /u t is sometimes written as a function q .u t /, so the sum becomes

PT
t D1 q .u t /. As a function of u t , the q .u t / function has a (skewed) v-shape around
u t D 0. For u t < 0 the function is .q 1/u t so it is linear with a (negative) slope of
q 1, and for u t it is also linear but with a slope of q.
The asymptotic distribution of the estimates is typically

p
T .bO .q/ b0.q/ / !d N 0; q.1 q/C 1 xx C 1
, where (7.67)

XT
xx D plim x t x t0 =T and
t D1
C D plim TtD1 f .0jx t /x t x t0 =T;

P
204
where f .0jx t / is the value of the pdf of the residual, conditional on the regressor value,
at a zero residual. If x t is independent of the regressor, then f .0jx t / D f .0/ where the
latter is the unconditional density of the residual. In this case, the covariance matrix can
be written ; q.1 q/f .0/ 2 xx1 , which gives the result in (7.53) once we set q D 0:5.
One way of obtaining a consistent estimate of C is via a kernel density estimate
0
PT
C D t D1 w t x t x t =T , with (7.68)
1 h i
w t D p exp .uO t = h/2 =2 ,
h 2
and where uO t is the fitted residual.
7.11 A Closed-Form GARCH Option Valuation Model by Heston

and Nandi
References: Heston and Nandi (2000) (HN); Duan (1995)

This paper derives an option price formula for an asset that follows a GARCH process.
This is applied to S&P 500 index options, and it is found that the model works well
compared to a Black-Scholes formula.
7.11.1 Background: GARCH vs Normality
The ARCH and GARCH models imply that volatility is random, so they are (strictly
speaking) not consistent with the B-S model. However, they are often combined with the
B-S model to provide an approximate option price. See Figure 7.29 for a comparison
of the actual distribution of the log asset price at different horizons when the returns
are generated by a GARCH modeland a normal distribution with the same mean and
variance. It is clear that the normal distribution is a good approximation unless the horizon
is short and the ARCH component (1 u2t 1 ) dominates the GARCH component (1 t2 1 ).
7.11.2 Option Price Formula: Part 1
Over the period from t to t C the change of log asset price minus a riskfree rate (includ-
ing dividends/accumulated interest), that is, the continuously compounded excess return,
205
Pdf from GARCH, T = 1
0.4
Normal (Distribution of cumulated
0.3 Simulated returns over T periods)
0.2
0.1
0
5 0 5
Return over 1 day
Pdf from GARCH, T = 10 Pdf from GARCH, T = 10

0.2 0.2
GARCH parameters: GARCH parameters:
(, ) = (0.8, 0.09) (, ) = (0.09, 0.8)
0.15 0.15
0.1 0.1
0.05 0.05
0 0
10 5 0 5 10 10 5 0 5 10
Cumulated return over 10 days Cumulated return over 10 days
Figure 7.29: Comparison of normal and simulated distribution of m-period returns
follows a kind of GARCH(1,1)-M process

p
ln S t ln S t r D h t C h t z t ; where z t is iid N.0; 1/ (7.69)
p
h t D ! C 1 .z t 1 h t /2 C 1 h t : (7.70)
The conditional variance would be a standard GARCH(1,1) process if 1 D 0. The

p
additional term makes the response of h t to an innovation symmetric around i h t i
instead of around zero. (HN also treat the case when the process is of higher order.)
If 1 > 0 then the return, ln S t ln S t , is negatively correlated with subsequent
volatility h t C as often observed in data. To see this, note that the effect on the return of
z t is linear, but that a negative z t drives up the conditional variance h t C D ! C 1 .z t
p
1 h t /2 C 1 h t more than a positive z t (if 1 > 0). The effect on the correlations is
illustrated in Figure 7.30.
The process (7.69)(7.70) does of course mean that the conditional (as of t )
distribution of the log asset price ln S t is normally distributed. This is not enough to price
206
Correlation of ln St and ht+s in Heston and Nandi (2000, RFS)
Parameter value
0.1 0.205
105 0.502
0 0.132
105
0.589
0.1 421.390
0.2
0.3
0.4
0.5
10 5 0 5 10
s (lead of h)
Figure 7.30: Simulated correlations of lnS t and h t Cs
options on this asset, since we cannot use a dynamic hedging approach to establish a no-
arbitrage price since there are (by the very nature of the discrete model) jumps in the price
of the underlying asset. Recall that the price on a call option with strike price K is
Ct D Et fM t max S t K; 0g : (7.71)
Alternatively, we can write
Ct De r
Et fmax S t K; 0g ; (7.72)
where Et is the expectations operator for the risk neutral distribution. See, for instance,
Huang and Litzenberger (1988).
For parameter estimates on a more recent sample, see Table 7.5. These estimates
suggests that has the wrong sign (high volatility predicts low future returns) and the
persistence of volatility is much higher than in HN ( is much higher).
7.11.3 Option Price Formula: Part 2
HN assume that the risk neutral distribution of ln S t (conditional on the information in

t ) is normal, that is
Assumption: the price in t of a call option expiring in t follows BS.
207
T =5 T = 50
20 8
N N
Sim Sim
15 6
10 4
5 2
0 0
4.5 4.55 4.6 4.65 4.7 4.5 4.55 4.6 4.65 4.7
ln ST ln ST
Heston-Nandi model,
ln(S0 ) = ln(100) 4.605
T = 50 Parameter value
0.205
8 char fun 105 0.502
Sim 105 0.132
6 0.589
421.390
4
2
0
4.5 4.55 4.6 4.65 4.7
ln ST
Figure 7.31: Distribution (physical) of ln ST in the Heston-Nandi model
-2.5
! 1.22e-006
0.00259
0.903
6.06
Table 7.5: Estimate of the Heston-Nandi model on daily S&P500 excess returns, in %.
Sample: 1990:1-2011:5
This is the same as assuming that ln S t and ln M t have a bivariate normal distribution
(conditional on the information in t )since this is what it takes to motivates the BS
model. This type of assumption was first used in a GARCH model by Duan (1995), who
effectively assumed that ln M t was iid normally distributed (this assumption is probably
implicit in HN).
HN show that the risk neutral process must then be as in (7.69)(7.70), but with 1
replaced by 1 D 1 C C 1=2 and replaced by 1=2 (not in 1 , of course). This
208
Heston-Nandi model, T = 50
physical
8 risk-neutral
0
4.5 4.55 4.6 4.65 4.7 4.75
ln ST
Figure 7.32: Physical and riskneutral distribution of lnST in the Heston-Nandi model
means that they use the assumption about the conditional (as of t ) distribution of S t
to build up a conditional (as of t ) risk neutral distribution of ST for any T > t. This
risk neutral distribution can be calculated by clever tricks (as in HN) or by Monte Carlo
simulations.
Once we have a risk neutral process it is (in principle, at least) straightforward to
derive any option price (for any time to expiry). For a European call option with strike
price K and expiry at date T , the result is
C t .S t ; r; K; T / D e r
Et max ST K; 0 (7.73)
r
D S t P1 e KP2 ; (7.74)
where P1 and P2 are two risk neutral probabilities (implied by the risk neutral version of
(7.69)(7.70), see above). It can be shown that P2 is the risk neutral probability that ST >
K, and that P1 is the delta, @C t .S t ; r; K; T /=@S t (just like in the Black-Scholes model).
In practice, HN calculate these probabilities by first finding the risk neutral characteristic
function of ST , f ./ D Et exp.i ln ST /, where i 2 D 1, and then inverting to get the
probabilities.
Remark 7.30 (Characteristic function and the pdf) The characteristic function of a ran-
209
dom variable x is
f ./ D E exp.ix/
D x exp.ix/pdf.x/dx;
R
where pdf.x/ is the pdf. This is a Fourier transform of the pdf (if x is a continuous random
variable). For instance, the cf of a N.; 2 / distribution is exp.i 2 2 =2/. The pdf
can therefore be recovered by the inverse Fourier transform as
1 R1
pdf.x/ D exp. ix/f ./d:
2 1
In practice, we typically use a fast (discrete) Fourier transform to perform this calcula-
tion, since there are very quick computer algorithms for doing that (see the appendix).
Remark 7.31 (Characteristic function of ln ST in the HN model) First, define

1
A t D A tC1 C ir C B t C1 ! ln.1 21 B t C1 /
2
1 2 1 .i 1 /2
B t D i . C 1 / 1 C 1 B t C1 C ;
2 2 1 1 B t C1
which can be calculated recursively backwards ((AT ; BT ), then (AT 1 ; BT 1 ), and so
forth until (A0 ; B0 )) starting from AT D 0 and BT D 0, where T is the investment
horizon (time to expiration of the option contract). Notice that i is the imaginary number
such that i 2 D 1. Second, the characteristics function for the horizon T is
f ./ D S0i exp .A0 C B0 h1 / :
Clearly, A0 and B0 need to be recalculated for each value of .
Remark 7.32 (Characteristic function in the iid case) In the special case when 1 , 1 and
1 are all zero, then process (7.69)(7.70) has constant variance. Then, the recursions
give

1 2
A0 D T ir C .T 1/ ! i
2
1 2
B0 D i :
2
210
We can then write the characteristic function as
f ./ D exp .i ln S0 C A0 C B0 !/

D exp i ln S0 C T .r C !/ 2 T !=2 ;

which is the characteristic function of a normally distributed variable with mean ln S0 C

T .r C !/ and variance T !.
7.11.4 Application to S&P 500 Index Option
Returns on the index are calculated by using official index plus dividends. The riskfree
rate is taken to be a synthetic T-bill rate created by interpolating different bills to match
the maturity of the option. Weekly data for 19921994 are used (created by using lots of
intraday quotes for all Wednesdays).
HN estimate the GARCH(1,1)-M process (7.69)(7.70) with ML on daily data on
the S&P500 index returns. It is found that the i parameter is large, i is small, and that
1 > 0 (as expected). The latter seems to be important for the estimated h t series (see
Figures 1 and 2).
Instead of using the GARCH(1,1)-M process estimated from the S&P500 index
returns, all the model parameters are subsequently estimated from option prices. Recall
that the probabilities P1 and P2 in (7.74) depend (nonlinearly) on the parameters of the
risk neutral version of (7.69)(7.70). The model parameters can therefore be estimated
by minimizing the sum (across option price observation) squared pricing errors.
In one of several different estimations, HN estimate the model on option data for
the first half 1992 and then evaluate the model by comparing implied and actual option
prices for the second half of 1992. These implied option prices use the model parameters
estimated on data for the first half of the year and an estimate of h t calculated using
these parameters and the latest S&P 500 index returns. The performance of this model is
compared with a Black-Scholes model (among other models), where the implied volatility
in week t 1 is used to price options in period t. This exercise is repeated for 1993 and
1994.
It is found that the GARCH model outperforms (in terms of MSE) the B-S model. In
particular, it seems as if the GARCH model gives much smaller errors for deep out-of-
the-money options (see Figures 2 and 3). HN argue that this is due to two aspects of the
model: the time-profile of volatility (somewhat persistent, but mean-reverting) and the
negative correlation of returns and volatility.
211
7.12 Fundamental Values and Asset Returns in Global Equity Mar-
kets, by Bansal and Lundblad
Reference: Bansal and Lundblad (2002) (BL)

This paper studies how stock indices for five major markets are related to news about
future cash flows (dividends and/or earnings). It uses monthly data on France, Germany,
Japan, UK, US, and a world market index for the period 19731998.
BL argue that their present value model (stock price equals the present value of future
cash flows) can account for observed volatility of equity returns and the cross-correlation
across markets. This is an interesting result since most earlier present value models have
generated too small movements in returnsand also too small correlations across mar-
kets. The crucial features of the model are a predictable long-run component in cash flows
and time-varying systematic risk.
7.12.1 Basic Model
It is assumed that the individual stock markets can be described by CAPM
Riet D i Rmt
e
C "i t ; (7.75)
where Rmt e
is the world market index. As in CAPM, the market return is proportional to
its volatilityhere modelled as a GARCH(1,1) process. We therefore have a GARCH-M
(-in-Mean) process
e 2
Rmt D mt C "mt , E t 1 "mt D 0 and Var t 1 ."mt /
2
D mt ; (7.76)
2
mt D C "2m;t 1
2
C m;t 1: (7.77)
(Warning: BL uses a different timing/subscript convention for the GARCH model.)
7.12.2 The Price-Dividend Ratio
A gross return
Di;t C1 C Pi;t C1
Ri;t C1 D ; (7.78)
Pi t
can be approximated in terms of logs (lower case letters)
ri;tC1 i .pi;t C1 di;t C1 / .pi t di t / C .di;t C1 di t /; (7.79)

zi;tC1 zit gi;tC1
212
where i is the average dividend-price ratio for asset i.
Take expectations as of t and solve recursively forward to get the log price/dividend
ratio as a function of expected future dividend growth rates (gi ) and returns (ri )
1
X
pi t di t D zi t is E t .gi;t CsC1 ri;t CsC1 / : (7.80)
sD0
To calculate the right hand side of (7.80), notice the following things. First, the div-
idend growth (cash flow dynamics) is modelled as an ARMA(1,1)see below for de-
tails. Second, the riskfree rate (rf t ) is assumed to follow an AR(1). Third, the expected
return equals the riskfree rate plus the expected excess returnwhich follows (7.75)
(7.77).
Since all these three processes are modelled as univariate first-order time-series pro-
cesses, the solution is
2
pi t di t D zi t D Ai;0 C Ai;1 gi t C Ai;2 m;t C1 C Ai;3 rf t : (7.81)
(BL use an expected dividend growth instead of the actual but that is just a matter of
convenience, and has another timing convention for the volatility.) This solution can be
thought of as the fundamental (log) price-dividend ratio. The main theme of the paper is
to study how well this fundamental log price-dividend ratio can explain the actual values.
The model is estimated by GMM (as a system), but most of the moment conditions
are conventional. In practice, this means that (i) the betas and the AR(1) for the riskfree
rate are estimated by OLS; (ii) the GARCH-M by MLE; (iii) the ARMA(1,1) process
by moment conditions that require the innovations to be orthogonal to the current levels;
and (iv) moment conditions for changes in pi t di t D zi t defined in (7.81). This is the
overidentified part of the model.
7.12.3 A Benchmark Case with No Predictability
As a benchmark for comparison, consider the case when the right hand side in (7.80)
equals a constant. This would happen when the growth rate of cash flows is unpredictable,
the riskfree rate is constant, and the market risk premium is too (which here requires that
the conditional variance of the market return is constant). In this case, the price-dividend
ratio is constant, so the log return equals the cash flow growth plus a constant.
This benchmark case would not be very successful in matching the observed volatility
and correlation (across markets) of returns: cash flow growth seems to be a lot less volatile
213
than returns and also a lot less correlated across markets.
What if we allowed for predictability of cash flow growth, but still kept the assump-
tions of constant real interest rate and market risk premium? Large movements in pre-
dictable cash flow growth could then generate large movements in returns, but hardly the
correlation across markets.
However, large movements in the market risk premium would contribute to both. It is
clear that both mechanisms are needed to get a correlation between zero and one. It can
also be noted that the returns will be more correlated during volatile periodssince this
drives up the market risk premium which is a common component in all returns.
7.12.4 Cash Flow Dynamics
The growth rate of cash flow, gi t , is modelled as an ARMA(1,1). The estimation results
show that the AR parameter is around 0:95 and that the MA parameter is around 0:85.
This means that the growth rate is almost an iid process with very low autocorrelation
but only almost. Since the MA parameter is not negative enough to make the sum of the
AR and MA parameters zero, a positive shock to the growth rate will have a long-lived
effect (even if small). See Figure 7.33.
Remark 7.33 (ARMA(1,1)) An ARMA(1,1) model is
y t D ay t 1 C " t C " t 1, where " t is white noise.
The model can be written on MA form as

1
X
yt D "t C as 1 .a C /" t s :
sD1
The autocorrelations are

.1 C a/.a C /
1 D , and s D as 1 for s D 2; 3; : : :
1 C 2 C 2a
and the conditional expectations are
E t y t Cs D as 1 .ay t C " t /; s D 1; 2; : : :
214
Impulse response, a = 0.9 Autocorrelation function, a = 0.9
2 1
0 0.5
= 0.8
1 =0
= 0.8
2 0
0 5 10 0 5 10
period period
ARMA(1,1): yt = ayt1 + t + t1
Figure 7.33: Impulse response and autcorrelation functions of ARMA(1,1)
7.12.5 Results
1. The hypothesis that the CAPM regressions have zero intercepts (for all five country
indices) cannot be rejected.
2. Most of the parameters are precisely estimated, except (the risk aversion).
3. Market volatility is very persistent.
4. Cash flow has a small, but very persistent effect of news.
5. The overidentifying restrictions are rejected , but the model still seems able to ac-
count for quite a bit of the data: the volatility and correlation (across countries) of
the fundamental price-dividend ratios are quite similar to those in the data. Note
that the cross correlations are driven by the common movements in the riskfree rate
and the world market risk premia (driven by mt 2
).
215
A Using an FFT to Calculate the PDF from the Charac-
teristic Function
A.1 Characteristic Function
The characteristic function h.x/ of a random variable x is
h./ D E exp.ix/
R1
D 1 exp.ix/f .x/dx; (A.1)
where f .x/ is the pdf. This is a Fourier transform of the pdf (if x is a continuous random
variable). For instance, the cf of a N.; 2 / distribution is exp.i 2 2 =2/. The pdf
can therefore be recovered by the inverse Fourier transform as
1 R1
f .x/ D exp. ix/h./d: (A.2)
2 1
In practice, we typically use a fast (discrete) Fourier transform to perform this calculation,
since there are very quick computer algorithms for doing that.
A.2 Invert the Characteristic Function
Approximate the characteristic function (A.1) as the integral over xmin ; xmax (assuming
the pdf is zero outside)
R xmax i x
h./ D xmin e f .x/dx: (A.3)
Approximate this by a Riemann sum

PN i xk
h./ kD1 e f .xk /x: (A.4)
Split up xmin ; xmax into N intervals of equal size, so the step (and interval width) is
xmax xmin
x D : (A.5)
N
The mid point of the kth interval is
xk D xmin C .k 1=2/x; (A.6)
which means that x1 D xmin C x=2, x2 D xmin C 1:5x and that xN D xmax x=2.
216
Example A.1 With .xmin ; xmax / D .1; 7/ and N D 3, then x D .7 1/=3 D 2. The xj
values are 2 3
k xk D xmin C .k 1=2/x
C D
6 7
61 1 1=2 2 2 7
6 7
62
4 1 C 3=2 2 D 4 7
5
3 1 C 5=2 2 D 6:
This gives the Riemann sum
i xmin C.k 1=2/x

PN
hj kD1 e fk x; (A.7)
where hj D h.j / and fk D f .xk /.

We want
2 j 1
j D b C ; (A.8)
N x
so we can control the central location of . Use that in the Riemann sum
j 1
i xmin C.k 1=2/x 2
e i xmin C.k
PN 1=2/xb
hj kD1 e
N x fk x; (A.9)
j 1
and multiply both sides by exp i.xmin C 1=2x/ 2 =N to get

N x
i.xmin C1=2x/ 2 j 1 1 1 PN 2 i .j 1/.k 1/ i xmin C.k 1=2/xb

e N x hj eN e fk x ; (A.10)
N N kD1
Qk

qj
which has the same form as the ifft. We should therefore be able to calculate Qk by
applying the fft on qj . We can then recover the density function as
i xmin C.k 1=2/xb

fk D e Qk =x: (A.11)
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8 Factor Models
8.1 CAPM Tests: Overview
Reference: Cochrane (2005) 12.1; Campbell, Lo, and MacKinlay (1997) 5

Let Riet D Ri t Rf t be the excess return on asset i in excess over the riskfree asset,
and let f t D Rmt Rf t be the excess return on the market portfolio. CAPM with a
riskfree return says that i D 0 in
Riet D C f t C "i t , where (8.1)

E "i t D 0 and Cov.f t ; "i t / D 0:
The economic importance of a non-zero intercept () is that the tangency portfolio

changes if the test asset is added to the investment opportunity set. See Figure 8.1 for an
illustration.
The basic test of CAPM is to estimate (8.1) on a single asset and then test if the
intercept is zero. This can easily be extended to several assets, where we test if all the
intercepts are zero.
Notice that the test of CAPM can be given two interpretations. If we assume that Rmt
is the correct benchmark, then it is a test of whether asset Ri t is correctly priced (this is
the approach in mutual fund evaluations). Alternatively, if we assume that Ri t is correctly
priced, then it is a test of the mean-variance efficiency of Rmt (compare the Roll critique).
8.2 Testing CAPM: Traditional LS Approach
8.2.1 CAPM with One Asset: Traditional LS Approach
If the residuals in the CAPM regression are iid, then the traditional LS approach is just
fine: estimate (8.1) and form a t-test of the null hypothesis that the intercept is zero. If the
disturbance is iid normally distributed, then this approach is the ML approach.
220
MV frontiers before and after ( = 0) MV frontiers before and after ( = 0.05)
Solid curves: 2 assets,
0.1 0.1
Dashed curves: 3 assets
Mean
Mean
0.05 0.05
0 0
0 0.05 0.1 0.15 0 0.05 0.1 0.15
Std Std
The new asset has the abnormal return
compared to the market (of 2 assets)
MV frontiers before and after ( = 0.04) Mean 0.0800 0.0500 + (Rm Rf )

beta 1.2459 0.7787 0.5970
0.1 Cov 0.0256 0.0000 0.0016
matrix 0.0000 0.0144 0.0096
0.0016 0.0096 0.0100
Mean
0.05 Tang N =2 =0 = 0.05 = 0.04

portf 0.47 0.47 0.21 1.10
0.53 0.53 -0.58 3.17
0 NaN 0.00 1.36 -3.26
0 0.05 0.1 0.15
Std
Figure 8.1: MV frontiers with 2 and 3 assets
The variance of the estimated intercept in the CAPM regression (8.1) is
.E f t /2

Var.O 0 / D 1 C 2 =T (8.2)
Var .f t /
D .1 C SRf2 / 2 =T; (8.3)
where 2 is the variance of the residual in (8.1) and SRf2 is the squared Sharpe ratio of
the market portfolio (recall: f t is the excess return on market portfolio). We see that
the uncertainty about the intercept is high when the disturbance is volatile and when the
sample is short, but also when the Sharpe ratio of the market is high. Note that a large
market Sharpe ratio means that the market asks for a high compensation for taking on
risk. A bit uncertainty about how risky asset i is then gives a large uncertainty about what
the risk-adjusted return should be.
Proof. (of (8.2)) Consider the regression equation y t D x t0 b0 C u t . With iid errors
that are independent of all regressors (also across observations), the LS estimator, bOLs , is
221
asymptotically distributed as
p d
T .bOLs b0 / ! N.0; 2 xx1 /, where 2 D E u2t and xx D E tTD1 x t x t0 =T:
When the regressors are just a constant (equal to one) and one variable regressor, f t , so
x t D 1; f t 0 , then we have
" # " #
1 1 f t 1 E f t
xx D E t D1 x t x t0 =T D E
PT T
D , so
P
T t D1 f t f t2 E f t E f t2
" # " #
2
E f t
2
E f t 2
Var.f t / C .E f t /2
E f t
2 xx1 D D :
E f t2 .E f t /2 E ft 1 Var.f t / E ft 1
(In the last line we use Var.f t / D E f t2 .E f t /2 :) The upper left cell is (8.2).
The t-test of the hypothesis that 0 D 0 is then
O O d
Dq ! N.0; 1/ under H0 : 0 D 0: (8.4)
Std./
O .1 C SRf2 / Var."i t /=T
Note that this is the distribution under the null hypothesis that the true value of the inter-
cept is zero, that is, that CAPM is correct (in this respect, at least).
Remark 8.1 (Quadratic forms of normally distributed random variables) If the n 1
vector X N.0; /, then Y D X 0 1 X 2n . Therefore, if the n scalar random
variables Xi , i D 1; :::; n, are uncorrelated and have the distributions N.0; i2 /, i D
1; :::; n, then Y D inD1 Xi2 =i2 2n .
Instead of a t-test, we can use the equivalent chi-square test
O 2 O 2 d
D ! 21 under H0 : 0 D 0: (8.5)
Var./ O .1 C SRf / Var."i t /=T
2
The chi-square test is equivalent to the t-test when we are testing only one restriction, but
it has the advantage that it also allows us to test several restrictions at the same time. Both
the t-test and the chisquare tests are Wald tests (estimate unrestricted model and then test
the restrictions).
It is quite straightforward to use the properties of minimum-variance frontiers (see
Gibbons, Ross, and Shanken (1989), and MacKinlay (1995)) to show that the test statistic
in (8.5) can be written
O i2 c c /2 .SR
.SR c f /2
D ; (8.6)
Var.O i / 1 C .SR
cf /2 =T
222
where SRf is the Sharpe ratio of the market portfolio and SRc is the Sharpe ratio of
the tangency portfolio when investment in both the market return and asset i is possible.
(Recall that the tangency portfolio is the portfolio with the highest possible Sharpe ratio.)
If the market portfolio has the same (squared) Sharpe ratio as the tangency portfolio of the
mean-variance frontier of Ri t and Rmt (so the market portfolio is mean-variance efficient
also when we take Ri t into account) then the test statistic, O i2 = Var.O i /, is zeroand
CAPM is not rejected.
Proof. (of (8.6)) From the CAPM regression (8.1) we have
" # " # " # " #
Riet i2 m2 C Var."i t / i m2 ei i C i em
Cov e
D , and D :
Rmt i m2 m2 em em
Suppose we use this information to construct a mean-variance frontier for both Ri t and
Rmt , and we find the tangency portfolio, with excess return Rct
e
. It is straightforward to
show that the square of the Sharpe ratio of the tangency portfolio is e0 1 e , where
e is the vector of expected excess returns and is the covariance matrix. By using the
covariance matrix and mean vector above, we get that the squared Sharpe ratio for the
tangency portfolio, e0 1 e , (using both Ri t and Rmt ) is
2 e 2
ec i2

m
D C ;
c Var."i t / m
which we can write as
i2
.SRc /2 D C .SRm /2 :
Var."i t /
Use the notation f t D Rmt Rf t and combine this with (8.3) and to get (8.6).
It is also possible to construct small sample test (that do not rely on any asymp-
totic results), which may be a better approximation of the correct distribution in real-life
samplesprovided the strong assumptions are (almost) satisfied. The most straightfor-
ward modification is to transform (8.5) into an F1;T 1 -test. This is the same as using a
t -test in (8.4) since it is only one restriction that is tested (recall that if Z tn , then
Z 2 F .1; n/).
An alternative testing approach is to use an LR or LM approach: restrict the intercept
in the CAPM regression to be zero and estimate the model with ML (assuming that the
errors are normally distributed). For instance, for an LR test, the likelihood value (when
D 0) is then compared to the likelihood value without restrictions.
A common finding is that these tests tend to reject a true null hypothesis too often
223
when the critical values from the asymptotic distribution are used: the actual small sam-
ple size of the test is thus larger than the asymptotic (or nominal) size (see Campbell,
Lo, and MacKinlay (1997) Table 5.1). To study the power of the test (the frequency of
rejections of a false null hypothesis) we have to specify an alternative data generating
process (for instance, how much extra return in excess of that motivated by CAPM) and
the size of the test (the critical value to use). Once that is done, it is typically found that
these tests require a substantial deviation from CAPM and/or a long sample to get good
power.
8.2.2 CAPM with Several Assets: Traditional LS Approach
Suppose we have n test assets. Stack the expressions (8.1) for i D 1; : : : ; n as

2 3 2 3 2 3 2 3
e
R1t 1 1 "1t
6 : 7 6 : 7 6 : 7
6 :: 7 D 6 :: 7 C 6 :: 7 f t C 6 ::: 7 , where (8.7)
6 7
4 5 4 5 4 5 4 5
e
Rnt n n "nt
E "i t D 0 and Cov.f t ; "i t / D 0:
This is a system of seemingly unrelated regressions (SUR)with the same regressor (see,
for instance, Greene (2003) 14). In this case, the efficient estimator (GLS) is LS on each
equation separately. Moreover, the covariance matrix of the coefficients is particularly
simple.
Under the null hypothesis of zero intercepts and iid residuals (although possibly cor-
related across regressions), the LS estimate of the intercept has the following asymptotic
distribution
p
T O !d N 0n1 ; .1 C SR2 / , where (8.8)

2 3
11 : : : 1n
6 : :: 7
5 with ij D Cov."i t ; "jt /:
D6 :: : 7
4
n1 : : : O nn
PT
In practice, we use the sample moments for the covariance matrix, ij D Oi t "Ojt =T .
t D1 "
This result is well known, but a simple proof is found in Appendix A.
224
To test the null hypothesis that all intercepts are zero, we then use the test statistic
T O 0 .1 C SR2 / 1 1
O 2n , where (8.9)
SR2 D .E f /2 = Var.f /:
8.3 Testing CAPM: GMM
8.3.1 CAPM with Several Assets: GMM and a Wald Test
To test n assets at the same time when the errors are non-iid we make use of the GMM
framework. A special case is when the residuals are iid. The results in this section will
then coincide with those in Section 8.2.
Write the n regressions in (8.7) on vector form as
Ret D C f t C " t , where (8.10)

E " t D 0n1 and Cov.f t ; "0t / D 01n ;
where and are n 1 vectors. Clearly, setting n D 1 gives the case of a single test
asset.
The 2n GMM moment conditions are that, at the true values of and ,
E g t .; / D 02n1 , where (8.11)

" # " #
"t Ret f t
g t .; / D D : (8.12)
ft "t f t Ret f t
There are as many parameters as moment conditions, so the GMM estimator picks values
of and such that the sample analogues of (8.11) are satisfied exactly
T T O t
" #
e
O D 1 X
O D 1 X R t O f
N ;
g. O / O /
g t .; D 02n1 ; (8.13)
T t D1 T tD1 f t .Ret O f O t/
which gives the LS estimator. For the inference, we allow for the possibility of non-iid
errors, but if the errors are actually iid, then we (asymptotically) get the same results as in
Section 8.2.
With point estimates and their sampling distribution it is straightforward to set up a
Wald test for the hypothesis that all elements in are zero
d
O 0 Var./
O 1 O ! 2n : (8.14)
225
Remark 8.2 (Easy coding of the GMM Problem (8.13)) Estimate by LS, equation by
equation. Then, plug in the fitted residuals in (8.12) to generate time series of the moments
(will be important for the tests).
Remark 8.3 (Distribution of GMM) Let the parameter vector in the moment condition
have the true value b0 . Define
hp i N 0/
@g.b
S0 D Cov T gN .b0 / and D0 D plim :
@b 0
When the estimator solves min gN .b/0 S0 1 gN .b/ or when the model is exactly identified, the
distribution of the GMM estimator is
p d
T .bO b0 / ! N .0k1 ; V / , where V D .D0 S0 1 .D00 / 1 :
When D0 is invertible (as it would be in an exactly identified model), then we can also
write V D D0 1 S0 .D0 1 /0 .
Details on the Wald Test
Note that, with a linear model, the Jacobian of the moment conditions does not involve
the parameters that we want to estimate. This means that we do not have to worry about
evaluating the Jacobian at the true parameter values. The probability limit of the Jacobian
is simply the expected value, which can be written as
" #
@gN t .; / 1 ft
plim D D0 D E In
@; f t f t2
" #" #0 !
1 1
D E In ; (8.15)
ft ft
where is the Kronecker product. (The last expression applies also to the case of several
factors.) Notice that we order the parameters as a column vector with the alphas first and
the betas second. It might be useful to notice that in this case
" #" #0 ! 1
1 1
D0 1 D E In ; (8.16)
ft ft
since .A B/ 1
DA 1
B 1
(if conformable).
226
Remark 8.4 (Kronecker product) If A and B are matrices, then
2 3
a11 B a1n B
6 : :: 7
AB D6 :
4 : : 75:
am1 B amn B
Example 8.5 (Two test assets) With assets 1 and 2, the parameter vector is b D 1 ; 2 ; 1 ; 2 0 .
Write out (8.11) as
2 3 2 3
e
gN 1 .; / R1t 1 1 f t " # " #
6 gN 2 .; / 7 XT 6 Re e
6 7 6 7
1 2t 2 2 f t 7 1 XT 1 R 1t 1 1 f t
6 gN .; / 7 D T
6 7 6 7D ;
t D1 6 f .R e T tD1 e
4 t 1t 1 1 f t / 5 ft R2t 2 2 f t
7
4 3 5
e
gN 4 .; / f t .R2t 2 2 f t /
where gN 1 .; / denotes the sample average of the first moment condition. The Jacobian
is
2 3
@gN 1 =@1 @gN 1 =@2 @gN 1 =@1 @gN 1 =@2
N 6 @gN 2 =@1 @gN 2 =@2 @gN 2 =@1 @gN 2 =@2 7
6 7
@g.; /
D66 7
@1 ; 2 ; 1 ; 2 0 4 @gN 3 =@1 @gN 3 =@2 @gN 3 =@1 @gN 3 =@2 5
7
@gN 4 =@1 @gN 4 =@2 @gN 4 =@1 @gN 4 =@2
2 3
1 0 ft 0 " #" #0 !
6 7
1 XT 6 0 1 0 f t 7 1 XT 1 1
D 6
2
7D I2 :
T t D1 6 f T t D1
4 t 0 ft 0 7 5 ft ft
0 f t 0 f t2
p
The asymptotic covariance matrix of T times the sample moment conditions, eval-
uated at the true parameter values, that is at the true disturbances, is defined as
p T ! 1
T X X
S0 D Cov g t .; / D R.s/, where (8.17)
T tD1 sD 1
R.s/ D E g t .; /g t s .; /0 : (8.18)
227
With n assets, we can write (8.18) in terms of the n 1 vector " t as
R.s/ D E g t .; /g t s .; /0
" #" #0
"t "t s
DE
ft "t ft s "t s
" " # ! " # !0 #
1 1
DE "t "t s : (8.19)
ft ft s
(The last expression applies also to the case of several factors.)

The Newey-West estimator is often a good estimator of S0 , but the performance of the
test improved, by imposing (correct, of course) restrictions on the R.s/ matrices.
From Remark 8.3, we can write the covariance matrix of the 2n 1 vector of param-
eters (n parameters in and another n in ) as
p
" #!
O
Cov T D D0 1 S0 .D0 1 /0 : (8.20)
O
Example 8.6 (Special case 1: f t is independent of"" t s , errors are# iid, and n D 1) With
1 E ft
these assumptions R.s/ D 022 if s 0, and S0 D Var."i t /. Combining
E f t E f t2
with (8.15) gives
1
p
" #! " #
O 1 E ft
Cov T D Var."i t /;
O E f t E f t2
which is the same expression as 2 xx1 in (8.2), which assumed iid errors.
Example 8.7 (Special case 2: as in Special

" case 1, #but n 1) With these assumptions
1 E ft
R.s/ D 02n2n if s 0, and S0 D E " t "0t . Combining with (8.15)
E ft E ft 2
gives
# 1
p
" #! "
O 1 E ft
Cov D E " t "0t :

T
O E ft E f 2
t
This follows from the facts that .A B/ 1 D A 1 B 1 and .A B/.C D/ D

AC BD (if conformable). This is the same as in the SURE case.
228
8.3.2 CAPM and Several Assets: GMM and an LM Test
We could also construct an LM test instead by imposing D 0 in the moment condi-

tions (8.11) and (8.13). The moment conditions are then
" #
Ret f t
E g./ D E D 02n1 : (8.21)
f t .Ret f t /
Since there are q D 2n moment conditions, but only n parameters (the vector), this
model is overidentified.
We could either use a weighting matrix in the GMM loss function or combine the
moment conditions so the model becomes exactly identified.
With a weighting matrix, the estimator solves
N 0 W g.b/;
minb g.b/ N (8.22)
where g.b/
N is the sample average of the moments (evaluated at some parameter vector b),
and W is a positive definite (and symmetric) weighting matrix. Once we have estimated
the model, we can test the n overidentifying restrictions that all q D 2n moment condi-
O If not, the restriction (null hypothesis)
tions are satisfied at the estimated n parameters .
that D 0n1 is rejected. The test is based on a quadratic form of the moment conditions,
N 0 1 g.b/
T g.b/ N which has a chi-square distribution if the correct matrix is used.
Alternatively, to combine the moment conditions so the model becomes exactly iden-
tified, premultiply by a matrix A to get
An2n E g./ D 0n1 : (8.23)
The model is then tested by testing if all 2n moment conditions in (8.21) are satis-
fied at this vector of estimates of the betas. This is the GMM analogue to a classical
LM test. Once again, the test is based on a quadratic form of the moment conditions,
N 0 1 g.b/
T g.b/ N which has a chi-square distribution if the correct matrix is used.
Details on how to compute the estimates effectively are given in Appendix B.1.
For instance, to effectively use only the last n moment conditions in the estimation,
we specify " #
h i Ret f t
A E g./ D 0nn In E D 0n1 : (8.24)
f t .Ret f t /
229
This clearly gives the classical LS estimator without an intercept
PT
O f t Ret =T
D Pt D1
T
: (8.25)
2
f
t D1 t =T
Example 8.8 (Combining moment conditions, CAPM on two assets) With two assets we
can combine the four moment conditions into only two by
2 3
e
" # 6 R 1t 1 f t
e
7
0 0 1 0 R 2t 2 f t
A E g t .1 ; 2 / D E6
6 7
7 D 021 :
0 0 0 1 6 f .Re f / 7
4 t 1t 1 t 5
e
f t .R2t 2 f t /
Remark 8.9 (Test of overidentifying assumption in GMM) When the GMM estimator
N 0 S0 1 g./
solves the quadratic loss function g./ N (or is exactly identified), then the J test
statistic is
O 0 S 1 g.
N / O d 2
T g. 0 N / ! q k ;
where q is the number of moment conditions and k is the number of parameters.
Remark 8.10 (Distribution of GMM, more general results) When GMM solves minb g.b/ N 0 W g.b/
N
O D 0k1 , the distribution of the GMM estimator and the test of overidentifying
N /
or Ag.
assumptions are different from those in Remarks 8.3 and 8.9.
8.3.3 Size and Power of the CAPM Tests
The size (using asymptotic critical values) and power in small samples is often found
to be disappointing. Typically, these tests tend to reject a true null hypothesis too often
(see Campbell, Lo, and MacKinlay (1997) Table 5.1) and the power to reject a false null
hypothesis is often fairly low. These features are especially pronounced when the sample
is small and the number of assets, n, is high. One useful rule of thumb is that a saturation
ratio (the number of observations per parameter) below 10 (or so) is likely to give poor
performance of the test. In the test here we have nT observations, 2n parameters in and
, and n.n C 1/=2 unique parameters in S0 , so the saturation ratio is T =.2 C .n C 1/=2/.
For instance, with T D 60 and n D 10 or at T D 100 and n D 20, we have a saturation
ratio of 8, which is very low (compare Table 5.1 in CLM).
One possible way of dealing with the wrong size of the test is to use critical values
from simulations of the small sample distributions (Monte Carlo simulations or bootstrap
simulations).
230
US industry portfolios, 1970:12013:12 US industry portfolios, 1970:12013:12
Mean excess return 10 10
Mean excess return

D
A D
A
H GC H GC
F F
I JB E I JB E
5 5
Average excess market return: 6.2%

0 0
0 0.5 1 1.5 0 5 10
e
(against the market) Predicted excess return (i ERm )
pval CAPM: Rie = i + i Rm

e
+ ei
all NaN 0.04 NaN
A (NoDur) 3.56 0.01 8.66 Factor: US market
B (Durbl) -1.09 0.59 13.58 and (Std(ei ))
C (Manuf ) 0.71 0.47 6.30 are in annualized %
D (Enrgy) 3.92 0.08 14.62
E (HiTec) -2.00 0.26 11.84
F (Telcm) 1.93 0.26 11.03
G (Shops) 1.35 0.37 9.44
H (Hlth ) 2.31 0.17 11.30
I (Utils) 2.80 0.12 11.65
J (Other) -0.61 0.57 6.93
Figure 8.2: CAPM, US industry portfolios
8.3.4 Choice of Portfolios
This type of test is typically done on portfolios of assets, rather than on the individual
assets themselves. There are several econometric and economic reasons for this. The
econometric techniques we apply need the returns to be (reasonably) stationary in the
sense that they have approximately the same means and covariance (with other returns)
throughout the sample (individual assets, especially stocks, can change character as the
company moves into another business). It might be more plausible that size or industry
portfolios are stationary in this sense. Individual portfolios are typically very volatile,
which makes it hard to obtain precise estimate and to be able to reject anything.
It sometimes makes economic sense to sort the assets according to a characteristic
(size or perhaps book/market)and then test if the model is true for these portfolios.
Rejection of the CAPM for such portfolios may have an interest in itself.
231
alpha t LS t NW t boot
US industry portfolios, 1970:12013:12 all NaN NaN NaN NaN
15 A (NoDur) 3.56 2.71 2.52 2.24
Mean excess return
B (Durbl) -1.09 -0.53 -0.54 -0.52

C (Manuf ) 0.71 0.75 0.71 0.64
10 D (Enrgy) 3.92 1.77 1.76 1.85
D
A
GC E (HiTec) -2.00 -1.11 -1.12 -1.00
I FH JB E 1.93 1.15 1.12 0.97
F (Telcm)
5 G (Shops) 1.35 0.94 0.90 0.89
H (Hlth ) 2.31 1.35 1.38 1.37
0 I (Utils) 2.80 1.58 1.53 1.58
0 0.5 1 1.5 J (Other) -0.61 -0.58 -0.56 -0.47
(against the market)
NW uses 1 lag
The bootstrap samples (yt , xt ) in blocks of 10
3000 simulations
Figure 8.3: CAPM, US industry portfolios, different t-stats
Fit of CAPM
18
16
14
12
10
6 US data 1957:12013:12
25 FF portfolios (B/M and size)
4 p-value for test of model: 0.00
4 6 8 10 12 14 16 18
Predicted mean excess return (CAPM), %
Figure 8.4: CAPM, FF portfolios
8.3.5 Empirical Evidence
See Campbell, Lo, and MacKinlay (1997) 6.5 (Table 6.1 in particular) and Cochrane
(2005) 20.2.
232
Fit of CAPM
18
16
14
12
lines connect same size

10
6 1 (small)
2
3
4
4 5 (large)
4 6 8 10 12 14 16 18
One of the more interesting studies is Fama and French (1993) (see also Fama and
French (1996)). They construct 25 stock portfolios according to two characteristics of the
firm: the size and the book value to market value ratio (BE/ME). In June each year, they
sort the stocks according to size and BE/ME. They then form a 5 5 matrix of portfolios,
where portfolio ij belongs to the ith size quantile and the j th BE/ME quantile (so this is
a double-sort). This is illustrated in Table 8.1.
Book value/Market value

1 2 3 4 5
Size 1 1 2 3 4 5
2 6 7 8 9 10
3 11 12 13 14 15
4 16 17 18 19 20
5 21 22 23 24 25
Table 8.1: Numbering of the FF portfolios.
Fama and French run a traditional CAPM regression on each of the 25 portfolios
233
Fit of CAPM
18
16
14
12
lines connect same B/M

10
6 1 (low)
2
3
4
4 5 (high)
4 6 8 10 12 14 16 18
(monthly data 19631991)and then study if the expected excess returns are related
to the betas as they should according to CAPM (recall that CAPM implies E Riet D
i E Rmte
). However, there is little relation between E Riet and i (see Figure 8.4). This
lack of relation (a cloud in the i E Riet space) is due to the combination of two features
of the data. First, within a size quantile there is a negative relation (across BE/ME quan-
tiles) between E Riet and i in stark contrast to CAPM (see Figure 8.5). Second, within
a BE/ME quantile, there is a positive relation (across size quantiles) between E Riet and
i as predicted by CAPM (see Figure 8.6).
In Figure 8.2, the results are presented in two different ways:
horizontal axis vertical axis

PT
1 W i e
t D1 Ri =T (8.26)
PT e T e
2 W i t D1 Rm
P
=T t D1 Ri =T
In the first approach, CAPM says that all data points (different assets, i ) should cluster
around a straight line with a slope equal to the average market excess return, TtD1 Rm
e
=T .
P
In the second approach, CAPM says that all data points should cluster around a 45-degree
234
line. In either case, the vertical distance to the line is i (which should be zero according
to CAPM).
8.4 Testing Multi-Factor Models (Factors are Excess Returns)
Reference: Cochrane (2005) 12.1; Campbell, Lo, and MacKinlay (1997) 6.2.1
8.4.1 A Multi-Factor Model
When the K factors, f t , are excess returns, the null hypothesis typically says that i D 0
in
Riet D i C i0 f t C "i t , where (8.27)

E "i t D 0 and Cov.f t ; "i t / D 0K1 ;
and i is now an K 1 vector. The CAPM regression is a special case when the market
excess return is the only factor. In other models like ICAPM (see Cochrane (2005) 9.2),
we typically have several factors. We stack the returns for n assets to get
2 3 2 3 2 32 3 2 3
e
R1t 1 11 : : : 1K f1t "1t
6 : 7 6 : 7 6 : : : :: 76 : 7 6 : 7
6 :: 7 D 6 :: 7 C 6 :: : : 7 6 :: 7 C 6 :: 7
4 5 4 5 4 54 5 4 5
e
Rnt n n1 : : : nK fKt "nt
or in vector form
Ret D C f t C " t ; where (8.28)

E " t D 0n1 and Cov.f t ; "0t / D 0Kn ;
where is n 1 and is n K. Notice that ij shows how the i th asset depends on the
j th factor.
This is, of course, very similar to the CAPM (one-factor) modeland both the LS and
GMM approaches are straightforward to extend.
8.4.2 Multi-Factor Model: Traditional LS (SURE)
The results from the LS approach of testing CAPM generalizes directly. In particular,
(8.9) still holdsbut where the residuals are from the multi-factor regressions (8.27) and
235
where the Sharpe ratio of the tangency portfolio (based on the factors) depends on the
means and covariance matrix of all factors
T O 0 .1 C SR2 / 1 1
O 2n , where (8.29)
SR2 D E f 0 Cov.f / 1
E f:
This result is well known, but some properties of SURE models are found in Appendix
A.
8.4.3 Multi-Factor Model: GMM
The moment conditions are

" # ! " # !
1 1
E g t .; / D E "t D E .Ret f t / D 0n.1CK/1 :
ft ft
(8.30)
Note that this expression looks similar to (8.11)the only difference is that f t may now
be a vector (and we therefore need to use the Kronecker product). It is then intuitively
clear that the expressions for the asymptotic covariance matrix of O and O will look very
similar too.
When the system is exactly identified, the GMM estimator solves
N
g.; / D 0n.1CK/1 ; (8.31)
which is the same as LS equation by equation. The model can be tested by testing if all
alphas are zeroas in (8.14).
Instead, when we restrict D 0n1 (overidentified system), then we either specify a
weighting matrix W and solve
N 0 W g./;
min g./ N (8.32)
or we specify a matrix A to combine the moment conditions and solve
N
AnKn.1CK/ g./ D 0nK1 : (8.33)
For instance, to get the classical LS estimator without intercepts we specify

" # !
h i 1
A D 0nKn InK E .Ret f t / : (8.34)
ft
236
More generally, details on how to compute the estimates effectively are given in Appendix
B.1.
Example 8.11 (Moment condition with two assets and two factors) The moment condi-
tions for n D 2 and K D 2 are
2 3
e
R1t 1 11 f1t 12 f2t
e
6 7
6 R2t 2 21 f1t 22 f2t 7
6 7
6 f .Re
6 1t 1t 1 11 f1t 12 f2t / 7
7
E g t .; / D E 6 e
7 D 061 :
6 f1t .R2t 2 21 f1t 22 f2t / 7
6 7
6 f .Re f f / 7
4 2t 1t 1 11 1t 12 2t 5
e
f2t .R2t 2 21 f1t 22 f2t /
Restricting 1 D 2 D 0 gives the moment conditions for the overidentified case.
Details on the Wald Test
For the exactly identified case, we have the following results. The expressions for the
Jacobian D0 and its inverse are the same as in (8.15)(8.16). Notice that in this Jacobian
we differentiate the moment conditions (8.30) with respect to vec.; /, that is, where the
parameters are stacked in a column vector with the alphas first, then the betas for the first
factor, followed by the betas for the second factor etc. The test is based on a quadratic
N 0 1 g.b/
form of the moment conditions, T g.b/ N which has a chi-square distribution if
the correct matrix is used. The covariance matrix of the average moment conditions
are as in (8.17)(8.19).
Fama and French (1993) also try a multi-factor model. They find that a three-factor model
fits the 25 stock portfolios fairly well (two more factors are needed to also fit the seven
bond portfolios that they use). The three factors are: the market return, the return on a
portfolio of small stocks minus the return on a portfolio of big stocks (SMB), and the
return on a portfolio with high BE/ME minus the return on portfolio with low BE/ME
(HML).
Remark 8.12 (The Fama-French factors) The SMB and HML are created by a double
sort. First classify firms according to size: small or big, using the median as a cutoff.
Second, classify firms according the book/market value: low (growth stocks, using 30th
237
pval
US industry portfolios, 1970:12013:12 all NaN 0.00 NaN
A (NoDur) 2.66 0.04 8.44
Mean excess return
B (Durbl) -4.81 0.01 12.31

10 -0.43 0.64 6.02
C (Manuf )
AD 2.73 0.21 14.16
H GC D (Enrgy)
F E (HiTec) 1.27 0.40 9.88
E I J B
5 F (Telcm) 1.56 0.36 10.79
G (Shops) 0.76 0.60 9.33
H (Hlth ) 4.48 0.01 10.59
0 I (Utils) 0.29 0.86 10.47
0 5 10 J (Other) -2.95 0.00 5.82
Predicted excess return (with = 0)
Fama-French model
Factors: US market, SMB (size), and HML (book-to-market)
and (StdErr of residual) are in annualized %
Figure 8.7: Three-factor model, US industry portfolios
percentile as cutoff), neutral or high (value stocks, using 70th percentile as cutoff). Create
six value weighted portfolios from the intersection of those groups
Low book/market Medium book/market High book/market

Small: Small Growth (SG) Small Neutral (SN) Small Value (SV)
Big: Big Growth (BG) Big Neutral (BN) Big Value (BV)
The SMB is the average of the small portfolios minus the average of the big portfolios:
SMB D 1=3.SG C SN C SV / 1=3.BG C BN C BV /. Rearranging gives SMB D
1=3.S G BG/C1=3.SN BN /CSV /C1=3.SV BV /, which shows that it represents
the return on small stocks (for a given book/market) minus the return on big stocks (for
same book/market). The HML is the average of the value stocks minus the growth stocks,
HML D 1=2.SV C BV / 1=2.SG C BG/, which can be rearranged as HML D
1=2.S V SG/ C 1=2.BV BG/, which shows that it represents the return on value
stocks (for a given size) minus the return on growth stocks (for the same size).
The Fama-French three-factor model is rejected at traditional significance levels (see

Campbell, Lo, and MacKinlay (1997) Table 6.1 or Fama and French (1993) Table 9c),
but it can still capture a fair amount of the variation of expected returnssee Figures
8.78.10.
238
Fit of FF model
18
16
14
12
10
6 US data 1957:12013:12
4 p-value for test of model: 0.00
4 6 8 10 12 14 16 18
Predicted mean excess return (FF), %
Figure 8.8: FF, FF portfolios
8.4.5 Calendar Time and Cross Sectional Regression
To investigate how the performance (alpha) or exposure (betas) of different investors/funds

are related to investor/fund characteristics, we often use the calendar time (CalTime) ap-
proach. First define M discrete investor groups (for instance, age 1830, 3140, etc) and
calculate their respective average excess returns (RNjt
e
for group j )
1 P
RNjt
e
D Re ; (8.35)
Nj i 2Groupj i t
where Nj is the number of individuals in group j .

Then, we run a factor model
RNjt
e
D j C j0 f t C vjt ; for j D 1; 2; : : : ; M (8.36)
where f t typically includes various return factors (for instance, excess returns on equity
and bonds). By estimating these M equations as a SURE system with Whites (or Newey-
Wests) covariance estimator, it is straightforward to test various hypotheses, for instance,
that the intercept (the alpha) is higher for the M th group than for the for first group.
239
Fit of FF model
18
16
14
12
lines connect same size

10
6 1 (small)
2
3
4
4 5 (large)
4 6 8 10 12 14 16 18
Example 8.13 (CalTime with two investor groups) With two investor groups, estimate the
following SURE system
RN 1t
e
D 1 C 10 f t C v1t ;
RN 2t
e
D 2 C 20 f t C v2t :
The CalTime approach is straightforward and the cross-sectional correlations are fairly
easy to handle (in the SURE approach). However, it forces us to define discrete investor
groupswhich makes it hard to handle several different types of investor characteristics
(for instance, age, trading activity and income) at the same time.
The cross sectional regression (CrossReg) approach is to first estimate the factor
model for each investor
Riet D i C i0 f t C "i t ; for i D 1; 2; : : : ; N (8.37)
and to then regress the (estimated) betas for the pth factor (for instance, the intercept) on
the investor characteristics
Opi D zi0 cp C wpi : (8.38)
240
Fit of FF model
18
16
14
12
lines connect same B/M

10
6 1 (low)
2
3
4
4 5 (high)
4 6 8 10 12 14 16 18
In this second-stage regression, the investor characteristics zi could be a dummy variable

(for an age group, say) or a continuous variable (age, say). Notice that using a continuous
investor characteristics assumes that the relation between the characteristics and the beta
is linearsomething that is not assumed in the CalTime approach. (This saves degrees of
freedom, but may sometimes be a very strong assumption.) However, a potential problem
with the CrossReg approach is that it is often important to account for the cross-sectional
correlation of the residuals.
8.5 Testing Multi-Factor Models (General Factors)
Reference: Cochrane (2005) 12.2; Campbell, Lo, and MacKinlay (1997) 6.2.3 and 6.3
241
8.5.1 GMM Estimation with General Factors
Linear factor models imply that all expected excess returns are linear functions of the
same vector of factor risk premia ()
E Riet D i0 , where is K 1, for i D 1; : : : n: (8.39)
Stacking the test assets gives

2 3 2 32 3
e
R1t 11 : : : 1K 1
6 : 7 6 : ::
E6 :: 7 6 ::: 7 , or
7 6 7
: 7 D 6 :: :
4 : 5 4 : 54 5
e
Rnt n1 : : : nK K
E Ret D ; (8.40)
where is n K.
When the factors are excess returns, then the factor risk premia must equal the ex-
pected excess returns of those factors. (To see this, let the factor also be one of the test
assets. It will then get a beta equal to unity on itself (for instance, regressing Rmt e
on
itself must give a coefficient equal to unity). This shows that for factor k, k D E Rk t .e
More generally, the factor risk premia can be interpreted as follows. Consider an asset
that has a beta of unity against factor k and zero betas against all other factors. This asset
will have an expected excess return equal to k . For instance, if a factor risk premium is
negative, then assets that are positively exposed to it (positive betas) will have a negative
risk premiumand vice versa.
Remark 8.14 (Factor mimicking portfolios) It is more difficult to estimate and test a
model with general factors than a model with excess return factors. A common approach
to get around the difficulties is to replace any general factor with the linear combination
of excess returns that best mimics the general factor. This linear combination can be
constructed be either forming a regression of the general factor on a vector of excess
returns, or by creating an arbitrage portfolio that is long assets that are highly correlated
with the general factor and short assets that are less or even negatively correlated with
the factor.
The old way of testing this is to do a two-step estimation: first, estimate the i vectors
in a time series model like (8.27) (equation by equation); second, use Oi as regressors in
242
18 18
16 16

14 14
12 12
= 0.67 = 0.63 -11.27
10 b = -13.1 10 b = -299 15520
8 pval: 0.00 8 pval: 0.00
6 6
4 4
5 10 15 5 10 15
US data 1957:12013:12 CAPM:

25 FF portfolios (B/M and size) Ri = i + i Rm and ERi = i

ERi = i1 1 + i2 2
a regression equation of the type (8.39) with a residual added
T
tD1 Riet =T D Oi0 C ui : (8.41)
It is then tested if ui D 0 for all assets i D 1; : : : ; n. This approach is often called a

cross-sectional regression while the previous tests are time series regressions. The main
problem of the cross-sectional approach is that we have to account for the fact that the
regressors in the second step, Oi , are just estimates and therefore contain estimation errors.
This errors-in-variables problem is likely to have two effects (i) it gives a downwards bias
of the estimates of and an upward bias of the mean of the fitted residuals; and (ii)
invalidates the standard expression of the test of .
A way to handle these problems is to combine the moment conditions for the regres-
sion function (8.30) (to estimate ) with (8.40) (to estimate ) to get a joint system
2 " # 3
1
.Ret f t / 7
E g t .; ; / D E 4 f t 5 D 0n.1CKC1/1 : (8.42)
6
Ret
See Figures 8.118.13 for an empirical example of a co-skewness model.
243
18 18
16 16

14 14
12 12
= 0.52 = 0.52 -25.26
10 b = -10.1 10 b = -654 34774
8 pval: 0.00 8 pval: 0.00
6 6
4 4
5 10 15 5 10 15
US data 1957:12013:12 CAPM:

25 FF portfolios (B/M and size) Ri = i + i Rm and ERi = i , = ERm

ERi = i1 1 + i2 2 , 1 = ERm
Notice: Rm is exactly priced
Figure 8.12: CAPM and quadratic model, market excess is exactly priced
against market x 10
3 against market 2
1.4 5
0
1.2
5
1
10
0 10 20 0 10 20
Portfolio Portfolio
US data 1957:12013:12
We can then test the overidentifying restrictions of the model. There are n.1 C K C
1/ moment condition (for each asset we have one moment condition for the constant,
K moment conditions for the K factors, and one moment condition corresponding to
244
the restriction on the linear factor model). There are only n.1 C K/ C K parameters
(n in , nK in and K in ). We therefore have n K overidentifying restrictions
which can be tested with a chi-square test. Notice that this is, in general, a non-linear
estimation problem, since the parameters in multiply the parameters in . From the
GMM estimation using (8.42) we get estimates of the factor risk premia and also the
variance-covariance of them. This allows us to not only test the moment conditions, but
also to characterize the risk factors and to test if they are priced (each of them, or perhaps
all jointly) by using a Wald test.
One approach to estimate the model is to specify a weighting matrix W and then solve
a minimization problem like (8.32). The test is based on a quadratic form of the moment
N 0 1 g.b/
conditions, T g.b/ N which has a chi-square distribution if the correct matrix
is used. In the special case of W D S0 1 , the distribution is given by Remark 8.3. For
other choices of the weighting matrix, the expression for the covariance matrix is more
complicated.
It is straightforward to show that the Jacobian of these moment conditions (with re-
spect to vec.; ; /) is
2 " #" #0 ! 3
1 1
6 T1 TtD1 In 0n.1CK/K 7
P
D0 D 6 4 h f t
i f t
7
5 (8.43)
0 I nK
0 n
where the upper left block is similar to the expression for the case with excess return
factors (8.15), while the other blocks are new.
Example 8.15 (Two assets and one factor) we have the moment conditions
2 3
e
R1t 1 1 f t
e
6 7
6 R2t 2 2 f t 7
6 7
6 f .Re
6 t 1t 1 1 f t / 7
7
E g t .1 ; 2 ; 1 ; 2 ; / D E 6 e
7 D 061 :
6 f t .R2t 2 2 f t / 7
6 7
e
6
4 R 1t 1 7
5
e
R2t 2
There are then 6 moment conditions and 5 parameters, so there is one overidentifying
restriction to test. Note that with one factor, then we need at least two assets for this
testing approach to work (n K D 2 1). In general, we need at least one more asset
245
than factors. In this case, the Jacobian is
2 3
1 0 ft 0 0
6 7
6
6 0 1 0 ft 0 7 7
@gN 1 XT 6 f t 0 f t2 0 0 7
D
6 7
@1 ; 2 ; 1 ; 2 ; 0 T 2
6 7
tD1 6 0 ft 0 ft 0 7
6 7
6
4 0 0 0 1 7 5
0 0 0 2
2 " #" #0 ! 3
1
PT 1 1
t D1 I2 041 7
D T
ft ft 5:
6
4
0; I2
8.5.2 Traditional Cross-Sectional Regressions as Special Cases
Instead of estimating the overidentified model (8.42) (by specifying a weighting matrix),
we could combine the moment equations so they become equal to the number of param-
eters. This can be done, by specifying a matrix A and combine as A E g t D 0. This does
not generate any overidentifying restrictions, but it still allows us to test hypotheses about
some moment conditions and about . One possibility is to let the upper left block of A
be an identity matrix and just combine the last n moment conditions, Ret , to just K
moment conditions
A E g t D 0n.1CK/CK1 (8.44)
2 " # 3
" # 1
In.1CK/ 0n.1CK/n .Ret f t / 7
E4 ft 5D0 (8.45)
6
0Kn.1CK/ Kn
Ret
2 " # 3
1
.Ret f t / 7
E4 ft 5D0 (8.46)
6
.Ret /
Here A has n.1 C K/ C K rows (which equals the number of parameters (; ; /) and
n.1 C K C 1/ columns (which equals the number of moment conditions). (Notice also
that is K n, is n K and is K 1.)
Remark 8.16 (Calculation of the estimates based on (8.45)) In this case, we can estimate
and with LS equation by equationas a standard time-series regression of a factor
246
model. To estimate the K 1 vector , notice that we can solve the second set of K
moment conditions as
1
E.Ret / D 0K1 or D ./ E Ret ;
which is just like a cross-sectional instrumental variables regression of E Ret D (with

being the regressors, the instruments, and E Ret the dependent variable).
With D 0 , we get the traditional cross-sectional approach (8.39). The only differ-
ence is we here take the uncertainty about the generated betas into account (in the testing).
Alternatively, let be the covariance matrix of the residuals from the time-series estima-
tion of the factor model. Then, using D 0 gives a traditional GLS cross-sectional
approach.
To test the asset pricing implications, we test if the moment conditions E g t D 0 in
(8.44) are satisfied at the estimated parameters. The test is based on a quadratic form of
the moment conditions, T g.b/N 0 1 g.b/
N which has a chi-square distribution if the correct
matrix is used (typically more complicated than in Remark 8.3).
Example 8.17 (LS cross-sectional regression, two assets and one factor) With the mo-
ment conditions in Example (8.15) and the weighting vector D 1 ; 2 (8.46) is
2 e
3
R1t 1 1 f t
e
R2t 2 2 f t
6 7
6 7
A E g t .1 ; 2 ; 1 ; 2 ; / D E 6
6 7
f t .R e
1 1 f t / 7 D 051 ;
6 1t 7
e
f .R f /
6 7
4 t 2t 2 2 t 5
e e
1 .R1t 1 / C 2 .R2t 2 /
which has as many parameters as moment conditions. The test of the asset pricing model
is then to test if
2 3
e
R1t 1 1 f t
e
6 7
6 R2t 2 2 f t 7
6 7
6 f .Re
6 t 1t 1 1 f t / 7
7
E g t .1 ; 2 ; 1 ; 2 ; / D E 6 e
7 D 061 ;
6 f t .R2t 2 2 f t / 7
6 7
e
6
4 R 1t 1 7
5
e
R2t 2
are satisfied at the estimated parameters.
247
Example 8.18 (Structure of E.Ret /) If there are 2 factors and three test assets,
then 021 D E.Ret / is
E R1t
02 e
3 2 3 1
" # " # 11 12 " #
0 11 12 13 B6 7 1 C
D @4E R2t
e 7
421 22 5 A:
6
5
0 21 22 23 2
E R3t
e
31 32
8.5.3 Alternative Formulation of Moment Conditions
The test of the general multi-factor models is sometimes written on a slightly different
form (see, for instance, Campbell, Lo, and MacKinlay (1997) 6.2.3, but adjust for the
fact that they look at returns rather than excess returns). To illustrate this, note that the
regression equations (8.27) imply that
E Ret D C E f t : (8.47)
Equate the expected returns of (8.47) and (8.39) to get
D . E f t /; (8.48)
which is another way of summarizing the restrictions that the linear factor model gives.
We can then rewrite the moment conditions (8.42) as (substitute for and skip the last set
of moments)
"" # #
1
E g t .; / D E .Ret . E f t / f t / D 0n.1CK/1 : (8.49)
ft
Note that there are n.1 C K/ moment conditions and nK C K parameters (nK in and
K in ), so there are n K overidentifying restrictions (as before).
Example 8.19 (Two assets and one factor) The moment conditions (8.49) are
2 3
e
R1t 1 . E f t / 1 f t
e
E
6 7
6 R2t 2 . f t / 2 f t
E g t .1 ; 2 ; / D E 6
7
7 D 041 :
6 f Re
4 t 1t 1 . E f t / f
1 t 5
7
e
f t R2t 2 . E f t / 2 f t
This gives 4 moment conditions, but only three parameters, so there is one overidentifying
restriction to testjust as with (8.45).
248
8.5.4 What If the Factors Are Excess Returns?
It would (perhaps) be natural if the tests discussed in this section coincided with those in
Section 8.4 when the factors are in fact excess returns. That is almost so. The difference is
that we here estimate the K 1 vector (factor risk premia) as a vector of free parameters,
while the tests in Section 8.4 impose D E f t . This can be done in (8.45)(8.46) by doing
two things. First, define a new set of test assets by stacking the original test assets and the
excess return factors " #
Ret
RQ et D ; (8.50)
ft
which is an .n C K/ 1 vector. Second, define the K .n C K/ matrix as
h i
Q D 0Kn IK : (8.51)
Together, this gives

D E ft : (8.52)
It is also straightforward to show that this gives precisely the same test statistics as the
Wald test on the multifactor model (8.27).
Proof. (of (8.52)) The betas of the RQ et vector are
" #

Q D
nK
:
IK
The expression corresponding to E.Ret / D 0 is then

" # " #
h i Ret h i
nK
0Kn IK E D 0Kn IK , or
ft IK
E f t D :
Remark 8.20 (Two assets, one excess return factor) By including the factors among the
249
test assets and using the weighting vector D 0; 0; 1 gives
2 e
3
R1t 1 1 f t
e
R2t 2 2 f t
6 7
6 7
6 7
6
6 f t 3 3 f t 7
7
A E g t .1 ; 2 ; 3 ; 1 ; 2 ; 3 ; / D E 6 f t .R1te
1 1 f t / 7 D 071 :
6 7
6 7
e
6
6 f t .R2t 2 2 f t / 7
7
f t .f t 3 3 f t /
6 7
4 5
e e
0.R1t 1 / C 0.R2t 2 / C 1.f t 3 /
Since 3 D 0 and 3 D 1, this gives the estimate D E f t . There are 7 moment

conditions and as many parameters. To test the asset pricing model, test if the following
moment conditions are satisfied at the estimated parameters
2 e
3
R1t 1 1 f t
e
6 R2t 2 2 f t 7
6 7
6 7
6
6 f t 3 3 f t
7
7
e
6 f t .R1t 1 1 f t / 7
6 7
E g t .1 ; 2 ; 3 ; 1 ; 2 ; 3 ; / D E 6
6 7
f t .R e
2 2 f t / 7 D 091 :
6 2t 7
6 f t .f t 3 3 f t / 7
6 7
6 7
e
6
6 R 1t 1 7
7
e
R2t 2
6 7
4 5
f t 3
In fact, this gives the same test statistic as when testing if 1 and 2 are zero in (8.14).
Remark 8.21 (What is an excess return? ) Short answer: the return of a zero cost port-
folio. More detailed answer: consider a portfolio with the (net) return
Rp D v1 R1 C v2 R2 C v3 R3 C .1 v1 v2 v3 /R4 ;
where vi is the portfolio weight on asset i which has the net return Ri . The balance
(1 v1 v2 v3 ) is made up of asset 4 with the net return R4 (which may be a riskfree
asset). Rearrange as
Rp R4 D v1 .R1 R4 / C v2 .R2 R4 / C v3 .R3 R4 / :
Clearly, Rp R4 is an excess returnand it is a linear combination of other excess

returns (even if v1 , v2 and/or v3 happen to be negative and they do not sum to unity). If
250
v3 D v2 , then we can rearrange further to get
Rp R4 D v1 .R1 R4 / C v2 .R2 R3 / :
This is still an excess return, although the excess on the right hand side is over different
returns. When we use excess returns as factors, then we typically require the portfolio
weights (see above) to be constant over time.
8.5.5 When Some (but Not All) of the Factors Are Excess Returns
Partition the vector of factors as " #

Zt
ft D ; (8.53)
Ft
where Z t is an v 1 vector of excess return factors and F t is a w 1 vector of general
factors (K D v C w).
It makes sense (and is econometrically efficient) to use the fact that the factor risk
premia of the excess return factors are just their average excess returns (as in CAPM).
This can be done in (8.45)(8.46) by doing two things. First, define a new set of test
assets by stacking the original test assets and the excess return factors
" #
Ret
RQ et D ; (8.54)
Zt
which is an .n C v/ 1 vector. Second, define the K .n C K/ matrix

" #
0 I
Q D
vn v
; (8.55)
#wn 0wv
where # is some w n matrix. Together, this ensures that

" # " #
E Z
Q D
Z t
D ; (8.56)
F .# F / 1 #.E Ret Z Z /
where the Z and F are just betas of the original test assets on Z t and F t respectively
according to the partitioning
h i
nK D nv Z F
nw : (8.57)
One possible choice of # is # D F 0 , since then F are the same as when running a
251
cross-sectional regression of the expected abnormal return (E Ret Z Z ) on the betas
( F ).
Proof. (of (8.56)) The betas of the RQ et vector are
" #
Z F

Q D nv nw
:
Iv 0vw
The expression corresponding to E.Ret / D 0 is then
Q E RQ et D Q Q Q
" #" # " #" #" #
0vn Iv E Ret 0vn Iv Z
nv F
nw Z
D
#wn 0wv E Zt #wn 0wv Iv 0vw F
" # " #" #
E Zt Iv 0vw Z
D :
#wn E R t
e Z F
#wn nv #wn nw F
The first v equations give

Z D E Z t :
The remaining w equations give
# E Ret D # Z Z C # F F ; so
F D .# F / 1 #.E Ret Z Z /:
Example 8.22 (Structure of to identify for excess return factors) Continue Example
e
8.18 (where there are 2 factors and three test assets) and assume that Z t D R3t so the
first factor is really an excess returnwhich we have appended last to set of test assets.
Then 31 D 1 and 32 D 0 (regressing Z t on Z t and F t gives the slope coefficients 1
P If we set .11 ; 12 ; 13 / D .0; 0; 1/, then the moment conditions in Example 8.18
and 0.)
can be written
E R1t
02 e
3 2 3 1
" # " # 11 12 " #
0 0 0 1 B6 7 Z C
D @4E R2t e 7
5 421 22 5 A:
6
0 21 22 23 F
E Zt 1 0
252
The first line reads
" #
h i
Z
0 D E Zt 1 0 , so Z D E Z t :
F
Chen, Roll, and Ross (1986) use a number of macro variables as factorsalong with
traditional market indices. They find that industrial production and inflation surprises are
priced factors, while the market index might not be. Breeden, Gibbons, and Litzenberger
(1989) and Lettau and Ludvigson (2001) estimate models where consumption growth is
the factorwith mixed results.
8.6 Linear SDF Models
This section discusses how we can estimate and test the asset pricing equation
E m t Ret D 0: (8.58)
Assume that the SDF is linear in the factors
N C b 0 .f t
mt D m E f t /; (8.59)
where the K 1 vector f t contains the factors. Combining with (8.58) gives the sample
moment conditions
T
X
N
g.b/ D g t .b/=T D 0n1 , where (8.60)
t D1
N et C b 0 .f t
g t .b/ D m t Ret D mR fNt /Ret ; (8.61)
since m t is a scalar. There are K parameters (in b) and n moment conditions (the number
of assets). The mean of the SDF cannot be estimated from excess returns (it could if we
used returns), but it is straightforward to show that the choice of m
N does not matter for the
test based on excess returns.
Remark 8.23 (The SDF model and the mean SDF) Take expectations of the moment con-
ditions (8.61) and set equal to zero to get
b 0 Cov.f t ; Ret / D N E Ret :

m
253
N b/ D .0; 0/, which makes no sense. Instead, for any m
This would be satisfied by .m; N 0,
we could have
1 0
E Ret D b Cov.f t ; Ret /;
mN
which allows us to test if there is a K 1 vector b that prices all n assets, given how the
covariance matrix of the returns and factors looks like.
Remark 8.24 (Theoretical relation between a linear factor model and an SDF) Rewrite
the last equation in the previous remark as
1 0
E Ret D b Var.f /Var.f / 1 Cov.f t ; Ret /
mN

0
D 0
This shows the relation between a linear SDF model and the beta pricing relation from a
linear factor model.
To estimate this model with a weighting matrix W , we minimize the loss function
N 0 W g.b/:
J D g.b/ N (8.62)
Alternatively, the moment conditions are combined into K effective conditions as
N
AKn g.b/ D 0K1 : (8.63)
See Appendix B.2 for details on how to calculate the estimates.

To test the asset pricing implications, we test if the moment conditions E g t D 0 are
satisfied at the estimated parameters. The test is based on a quadratic form of the moment
N 0 1 g.b/
conditions, T g.b/ N which has a chi-square distribution if the correct matrix is
used.
8.6.1 SDF Models versus Linear Factor Models: The Tests
Reference: Ferson (1995); Jagannathan and Wang (2002) (theoretical results); Cochrane
(2005) 15 (empirical comparison); Bekaert and Urias (1996); and Sderlind (1999)
The test of the linear factor model and the test of the linear SDF model are (generally)
not the same: they test the same implications of the models, but in slightly different ways.
The moment conditions look a bit differentand combined with non-parametric methods
254
for estimating the covariance matrix of the sample moment conditions, the two methods
can give different results (in small samples, at least). Asymptotically, they are always the
same, as showed by Jagannathan and Wang (2002).
There is one case where we know that the tests of the linear factor model and the
SDF model are identical: when the factors are excess returns and the SDF is constructed
to price these factors as well. To demonstrate this, let R1t e
be a vector of excess returns
on some benchmarks assets. Construct a stochastic discount factor as in Hansen and
Jagannathan (1991):
mt D m N C .R1te
RN 1t
e 0
/ b; (8.64)
where m
N is a constant and b is chosen to make m t price R1t
e
in the sample, that is, so
tTD1 E R1t
e
m t =T D 0: (8.65)
Consider the test assets with excess returns R2t

e
, and SDF performance
1 PT
gN 2t D Re m t : (8.66)
T t D1 2t
Let the factor portfolio model be the linear regression
e e
R2t D C R1t C "t ; (8.67)
where E " t D 0 and Cov.R1t e

; " t / D 0. Then, the SDF-performance (pricing error) is
proportional to a traditional alpha
gN 2t =m
N D :
O (8.68)
In both cases we are thus testing if is zero or not.

Notice that (8.68) allows for the possibility that R1t
e
is the excess return on dynamic
portfolios, R1t D s t 1 R0t , where s t 1 are some information variables (not payoffs as
e e
before), for instance, lagged returns or market volatility, and R0t e

are some basic bench-
marks (S&P500 and bond, perhaps). The reason is that if R0t are excess returns, so are
e
e
R1t D s t 1 R0te
. Therefore, the typical cross-sectional test (of E Re D 0 ) coincides
with the test of the alphaand also of zero SDF pricing errors.
Notice also that R2te
could be the excess return on dynamic strategies in terms of the
test assets, R2t D z t 1 Rpt
e e
, where z t 1 are information variables and Rpt
e
are basic test
assets (mutual funds say). In this case, we are testing the performance of these dynamic
strategies (in terms of mutual funds, say). For instance, suppose R1t is a scalar and the
255
for z t 1 R1t is positive. This would mean that a strategy that goes long in R1t when z t 1
is high (and vice versa) has a positive performance.
Proof. (of (8.68)) (Here written in terms of population moments, to simplify the nota-
tion.) It follows directly that b D Var.R1t e
/ 1 E R1te
N . Using this and the expression

m
for m t in (8.66) gives
E g2t D E R2t
e
N Cov R2t
e e
Var.R1t
e 1
E R1t
e
N

m ; R1t / m:
We now rewrite this equation in terms of the parameters in the factor portfolio model
(8.67). The latter implies E R2t
e
D C E R1te
, and the least squares estimator of the slope
1
coefficients is D Cov R2t ; R1t Var R1t . Using these two facts in the equation
e e e

aboveand replacing population moments with sample moments, gives (8.68).
8.7 Conditional Factor Models
Reference: Cochrane (2005) 8; Ferson and Schadt (1996)

The simplest way of introducing conditional information is to simply state that the
factors are not just the usual market indices or macro economic series: the factors are
non-linear functions of them (this is sometimes called scaled factors to indicate that
we scale the original factors with instruments). For instance, if Rmt
e
is the return on the
market portfolio and z t 1 is something else which is thought to be important for asset
pricing (use theory), then the factors could be
e
f1t D Rmt and f2t D z t e
1 Rmt : (8.69)
Since the second factor is not an excess return, the test is done as in (8.42).
An alternative interpretation of this is that we have only one factor, but that the coef-
ficient of the factor is time varying. This is easiest seen by plugging in the factors in the
time-series regression part of the moment conditions (8.42), Riet D C f t C "i t ,
e
Riet D C 1 Rmt C 2 z t e
1 Rmt C "i t
e
D C .1 C 2 z t 1 /Rmt C "i t : (8.70)
The first line looks like a two factor model with constant coefficients, while the second
line looks like a one-factor model with a time-varying coefficient (1 C 2 z t 1 ). This
is clearly just a matter of interpretation, since it is the same model (and is tested in the
same way). This model can be estimated and tested as in the case of general factorsas
256
against Rm against zRm
0.05
1.4
1.2 0
1
0.05
0.8
0 10 20 0 10 20
FF portfolio no. FF portfolio no.
Monthly US data 1957:12013:12 Rie = + 1 Rem + 2 zRm

e
+
25 FF portfolios (B/M and size) z: lagged momentum return
Figure 8.14: Conditional betas of the 25 FF portfolios
zt e
1 Rmtis not a traditional excess return.
See Figure 8.148.15 for an empirical illustration.
Remark 8.25 (Figures 8.148.15, equally weighted 25 FF portfolios) Figure 8.14 shows
the betas of the conditional model. It seems as if the small firms (portfolios with low num-
bers) have a somewhat higher exposure to the market in bull markets and vice versa,
while large firms have pretty constant exposures. However, the time-variation is not
marked. Therefore, the conditional (two-factor model) fits the cross-section of average
returns only slightly better than CAPMsee Figure 8.15.
Conditional models typically have more parameters than unconditional models, which
is likely to give small samples issues (in particular with respect to the inference). It is
important to remember some of the new factors (original factors times instruments) are
probably not an excess returns, so the test is done with an LM test as in (8.42).
8.8 Conditional Models with Regimes
Reference: Christiansen, Ranaldo, and Sderlind (2010)

It is also possible to estimate non-linear factor models. The model could be piecewise
linear or include higher order times. For instance, Treynor and Mazuy (1966) extend the
CAPM regression by including a squared term (of the market excess return) to capture
market timing.
257
Mean excess return, % 14 14

12 12
10 10
8 8
6 6
4 4
5 10 15 5 10 15
Rie = + 1 Rem + 2 zRm

e
+
Rie = + Rm
e
+

Figure 8.15: Unconditional and conditional CAPM tests of the 25 FF portfolios
Different logistic functions Coefficient on x, different 2

1
0.4 2 = 0.5
0.3 2 = 0.25
0.5
0.2 2 = 0
=1 0.1
=5
0 0
2 0 2 2 0 2
z z
y = [1 G(z)]1 x + G(z)2 x +
G(z) = 1/[1 + exp ( (z c))], c = 0
1 = 0.25
G(z) is a logistic function with
= 2 and c = 0
Figure 8.16: Logistic function and the effective slope coefficient in a Logistic smooth
transition regression
Alternatively, the conditional model (8.70) could be changed so that the time-varying
coefficients are non-linear in the information variable. In the simplest case, this could be
dummy variable regression where the definition of the regimes is exogenous.
More ambitiously, we could use a smooth transition regression, which estimates both
the abruptness of the transition between regimes as well as the cutoff point. Let G.z/
258
be a logistic (increasing but S -shaped) function
1
G.z/ D ; (8.71)
1 C exp .z c/
where the parameter c is the central location (where G.z/ D 1=2) and > 0 determines
the steepness of the function (a high implies that the function goes quickly from 0 to 1
around z D c.) See Figure 8.16 for an illustration. A logistic smooth transition regression
is
y t D .z t 1 /0 x t C " t
D 1 G.z t 1 / 10 C G.z t 0
xt C "t

1 /2
0 0
D 1 G.z t 1 / 1 x t C G.z t 1 /2 x t C "t : (8.72)
At low z t values, the regression coefficients are (almost) 1 and at high z t values they are
(almost) 2 . See Figure 8.16 for an illustration.
Remark 8.26 (NLS estimation) The parameter vector ( ; c; 1 ; 2 ) is easily estimated by

Non-Linear least squares (NLS) by concentrating the loss function: optimize (numeri-
cally) over . ; c/ and let (for each value of . ; c/) the parameters (1 ; 2 ) be the OLS
coefficients on the vector of regressors .1 G.z t 1 / x t ; G.z t 1 /x t /.
The most common application of this model is by letting x t D y t s . This is the

LSTAR modellogistic smooth transition auto regression model, see Franses and van
Dijk (2000).
For an empirical application to a factor model, see Figures 8.178.18.
8.9 Fama-MacBeth
Reference: Cochrane (2005) 12.3; Campbell, Lo, and MacKinlay (1997) 5.8; Fama and
MacBeth (1973)
The Fama and MacBeth (1973) approach is a bit different from the regression ap-
proaches discussed so faralthough it seems most related to what we discussed in Section
8.5. The method has three steps, described below.
First, estimate the betas i (i D 1; : : : ; n) from (8.1) (this is a time-series regres-

sion). This is often done on the whole sampleassuming the betas are constant.
259
Slope on factor
2
factor: Rm, state: RMom low state
high state
1.5
0.5
0 5 10 15 20 25
FF portfolio no.
Figure 8.17: Betas on the market in the low and high regimes, 25 FF portfolios
Fit of CAPM Fit of CAPM-LSTAR

14 14
12 12
10 10
8 8
6 6
4 4
5 10 15 5 10 15
Rie = + [1 G(z)]1 Rm
e
+
Rie = + Rm
e
+ G(z)2 Rme
+
G(z) is a logistic function
Figure 8.18: Test of 1 and 2-factor models, 25 FF portfolios
Sometimes, the betas are estimated separately for different sub samples (so we
could let Oi carry a time subscript in the equations below).
Second, run a cross sectional regression for every t. That is, for period t , estimate
260
t from the cross section (across the assets i D 1; : : : ; n) regression
Riet D 0t Oi C "i t ; (8.73)
where Oi are the regressors. (Note the difference to the traditional cross-sectional
approach discussed in (8.10), where the second stage regression regressed E Riet on
Oi , while the Fama-French approach runs one regression for every time period.)
Third, estimate the time averages

T
1X
"Oi D "Oi t for i D 1; : : : ; n, (for every asset) (8.74)
T t D1
T
O D 1 O t :
X
(8.75)
T t D1
The second step, using Oi as regressors, creates an errors-in-variables problem since

Oi are estimated, that is, measured with an error. The effect of this is typically to bias
the estimator of t towards zero (and any intercept, or mean of the residual, is biased
upward). One way to minimize this problem, used by Fama and MacBeth (1973), is to
let the assets be portfolios of assets, for which we can expect that some of the individual
noise in the first-step regressions to average outand thereby make the measurement
error in O smaller. If CAPM is true, then the return of an asset is a linear function of the
market return and an error which should be uncorrelated with the errors of other assets
otherwise some factor is missing. If the portfolio consists of 20 assets with equal error
variance in a CAPM regression, then we should expect the portfolio to have an error
variance which is 1/20th as large.
We clearly want portfolios which have different betas, or else the second step regres-
sion (8.73) does not work. Fama and MacBeth (1973) choose to construct portfolios
according to some initial estimate of asset specific betas. Another way to deal with the
errors-in-variables problem is adjust the tests. Jagannathan and Wang (1996) and Jagan-
nathan and Wang (1998) discuss the asymptotic distribution of this estimator.
We can test the model by studying if "i D 0 (recall from (8.74) that "i is the time
average of the residual for asset i , "it ), by forming a t-test "Oi = Std.O"i /. Fama and MacBeth
(1973) suggest that the standard deviation should be found by studying the time-variation
in "Oi t . In particular, they suggest that the variance of "Oi t (not "Oi ) can be estimated by the
261
(average) squared variation around its mean
T
1X
Var.O"i t / D .O"i t "Oi /2 : (8.76)
T t D1
Since "Oi is the sample average of "Oi t , the variance of the former is the variance of the latter
divided by T (the sample size)provided "Oi t is iid. That is,
T
1 1 X
Var.O"i / D Var.O"i t / D 2 .O"i t "Oi /2 : (8.77)
T T t D1
A similar argument leads to the variance of O

T
O D 1 X O O 2:
Var./ . t / (8.78)
T 2 t D1
Fama and MacBeth (1973) found, among other things, that the squared beta is not
significant in the second step regression, nor is a measure of non-systematic risk.
A Details of SURE Systems

Proof. (of (8.8)) Write each of the regression equations in (8.7) on a traditional form
" #
1
Riet D x t0 i C "i t , where x t D :
ft
Define
XT XT
xx D plim x t x t0 =T , and ij D plim "i t "jt =T;
t D1 t D1
then the asymptotic covariance matrix of the vectors Oi and Oj (assets i and j ) is ij xx1 =T
(see below for a separate proof). In matrix form,
2 3
11 : : : 1n
p
Cov. T / O D 6 ::: :: 7 1
6
4 5 xx ;
: 7
n1 : : : O nn
where O stacks O1 ; : : : ; On . As in (8.3), the upper left element of xx1 equals 1 C SR2 ,
where SR is the Sharpe ratio of the market.
Proof. (of distribution of SURE coefficients, used in proof of (8.8) ) To simplify,
262
consider the SUR system
y t D x t C u t
z t D x t C v t ;
where y t ; z t and x t are zero mean variables. We then know (from basic properties of LS)
that
1
O D C PT .x1 u1 C x2 u2 C : : : xT uT /
t D1 x t x t
1
O D C PT .x1 v1 C x2 v2 C : : : xT vT / :
t D1 x t x t
In the traditional LS approach, we treat x t as fixed numbers (constants) and also assume
that the residuals are uncorrelated across and have the same variances and covariances
across time. The covariance of O and O is therefore
!2
O / 1
Cov.;
2
O D x1 Cov .u1 ; v1 / C x22 Cov .u2 ; v2 / C : : : xT2 Cov .uT ; vT /

PT
t D1 x t x t
!2
1 P
T

D PT t D1 x t x t uv , where uv D Cov .u t ; v t / ;
t D1 x t x t
1
D PT uv :
t D1 x t x t
Divide and multiply by T to get the result in the proof of (8.8). (We get the same results
if we relax the assumption that x t are fixed numbers, and instead derive the asymptotic
distribution.)
Remark A.1 (General results on SURE distribution, same regressors) Let the regression
equations be
yi t D x t0 i C "i t , i D 1; : : : ; n;
where x t is a K 1 vector (the same in all n regressions). When the moment conditions
are arranged so that the first n are x1t " t , then next are x2t " t
E g t D E.x t " t /;
then Jacobian (with respect to the coefs of x1t , then the coefs of x2t , etc) and its inverse
263
are
D0 D xx In and D0 1 D xx1 In :
The covariance matrix of the moment conditions is as usual S0 D 1 0

sD 1 E g t g t s . As
P
an example, let n D 2, K D 2 with x t0 D .1; f t / and let i D .i ; i /, then we have

2 3 2 3
gN 1 y1t 1 1 f t
6 gN 2 7
6 7 XT 6 7
7D 1
6 y2t 2 2 f t 7
6 6 7;
6 gN 7 T t D1 6 f .y
4 t 1t 1 1 f t / 5
7
4 3 5
gN 4 f t .y2t 2 2 f t /
and
2 3
@gN 1 =@1@gN 1 =@2 @gN 1 =@1 @gN 1 =@2
@gN @gN 2 =@1@gN 2 =@2 @gN 2 =@1 @gN 2 =@2
6 7
6 7
0
D 6 7
@1 ; 2 ; 1 ; 2 6
4@gN 3 =@1@gN 3 =@2 @gN 3 =@1 @gN 3 =@2 7
5
@gN 4 =@1@gN 4 =@2 @gN 4 =@1 @gN 4 =@2
2 3
1 0 ft 0
6 7
1 XT 6 6 0 1 0 ft 7 1 XT
D 7D x t x t0 I2 :
T t D1 6 f
4 t 0 f t2 0 7 5 T t D1
2
0 ft 0 ft
Remark A.2 (General results on SURE distribution, same regressors, alternative order-
ing of moment conditions and parameters ) If instead, the moment conditions are ar-
ranged so that the first K are x t "1t , the next are x t "2t as in
E g t D E." t x t /;
then the Jacobian (wrt the coefficients in regression 1, then the coefficients in regression
2 etc.) and its inverse are
D0 D In . xx / and D0 1 D In . xx1 /:
Reordering the moment conditions and parameters in Example A.1 gives

2 3 2 3
gN 1 y1t 1 1 f t
6 gN 2 7
6 7
XT 6 f t .y1t 1 1 f t / 7
6
7D 1
7
6 6 7;
6 gN 7 T t D1
4 y2t 2 2 f t 5
6 7
4 3 5
gN 4 f t .y2t 2 2 f t /
264
and
2 3
@gN 1 =@1 @gN 1 =@1 @gN 1 =@2 @gN 1 =@2
@gN @gN 2 =@1 @gN 2 =@1 @gN 2 =@2 @gN 2 =@2 7
6 7
6
D 6 7
@1 ; 1 ; 2 ; 2 0 6
4@gN 3 =@1 @gN 3 =@1 @gN 3 =@2 @gN 3 =@2 7
5
@gN 4 =@1 @gN 4 =@1 @gN 4 =@2 @gN 4 =@2
2 3
1 ft 0 0
6 f t f t2
6 7
1 X T 0 0 7 1 XT 0
D 6 7 D I2 xt xt :
T t D1 6 0 0 1 ft 7 T t D1
4 5
0 0 f t f t2
B Calculating GMM Estimator
B.1 Coding of the GMM Estimation of a Linear Factor Model
This section describes how the GMM problem can be programmed. We treat the case
with n assets and K Factors (which are all excess returns). The moments are of the form
" # !
1
gt D .Ret f t /
ft
" # !
1
gt D .Ret f t /
ft
for the exactly identified and overidentified case respectively

Suppose we could write the moments on the form
gt D zt yt x t0 b ;

to make it easy to use matrix algebra in the calculation of the estimate (see below for how
to do that). These moment conditions are similar to those for the instrumental variable
method. In that case we could let
T T T
1X 1X 0 1X
zy D z t y t and zx D z t x t , so g t D zy zx b:
T t D1 T t D1 T t D1
In the exactly identified case, we then have
gN t D zy zx b D 0, so bO D zx1 zy :
265
(It is straightforward to show that this can also be calculated equation by equation.) In the
overidentified case with a weighting matrix, the loss function can be written
gN 0 W gN D .zy zx b/0 W .zy zx b/; so

0
zx W zy 0
zx W zx bO D 0 and bO D .zx
0 0
W zx / 1 zx W zy :
In the overidentified case when we premultiply the moment conditions by A, we get
AgN D Azy Azx b D 0, so b D .Azx / 1 Azy :
In practice, we never perform an explicit inversionit is typically much better (in terms of
both speed and precision) to let the software solve the system of linear equations instead.
To rewrite the moment conditions as g t D z t y t x t0 b , notice that

0 1
" # !B " #0 ! C
1 B e 1 C , with b D vec.; /
C
gt D In B R
B t I n b
ft @ f t
C
A

zt x t0
0 1
" # !
1
gt D In @Ret f t0 In b A , with b D vec./
B C
ft
x t0
zt
for the exactly identified and overidentified case respectively. Clearly, z t and x t are ma-
trices, not vectors. (z t is n.1 C K/ n and x t0 is either of the same dimension or has n
rows less, corresponding to the intercept.)
Example B.1 (Rewriting the moment conditions) For the moment conditions in Example
8.11 we have
0 1
2 3B 2 30 2 3C
1 0 B 1 0 1 C
6 7B 6 7 6 7C
6 0 1 7B 0 1 7C
7 6 2 7C
6 7 6
6 7B " # 6
e
6f B 7 6 7C
6 1t 0 7 B R
7 6f 0
1t 1t 7 6 11 7C
g t .; / D 6 :
6
7B e
6 7 6 7C
6 0 f1t 7 B R 0 f 1t 7 621 7C
7 B 2t
B 6
6 6 7 6 7C
6f 7 6 7C
4 2t 0 5 B
7 6f 0
B 4 2t 5 4 12 5C C
0 f2t B @ 0 f 2t 22
C
A

zt x t0
266
Proof. (of rewriting the moment conditions) From the properties of Kronecker prod-
ucts, we know that (i) vec.ABC / D .C 0 A/vec.B/; and (ii) if a is m 1 and c is n 1,
then a c D .a In /c. The first rule allows to write
" # " #0 !
h i 1 1 h i
C f t D In as In vec. /:
ft ft
b

x t0
The second rule allows us two write

" # " # !
1 1
.Ret f t / as In .Ret f t /:
ft ft

zt
(For the exactly identified case, we could also use the fact .A B/0 D A0 B 0 to notice
that z t D x t .)
Remark B.2 (Quick matrix calculations of zx and zy ) Although a loop wouldnt take
too long time to calculate zx and zy , there is a quicker way. Put 1 f t0 in row t
of the matrix ZT .1CK/ and Re0t in row t of the matrix RT n . For the exactly identified
case, let X D Z. For the overidentified case, put f t0 in row t of the matrix XT K . Then,
calculate
zx D .Z 0 X=T / In and vec.R0 Z=T / D zy :
B.2 Coding of the GMM Estimation of a Linear SDF Model
The asset pricing equation is

E pt 1 D E xt mt ;
where x t are the payoffs and p t 1 the prices of the assets. We can either interpret
p t 1 as actual asset prices and x t as the payoffs, or we can set p t 1 D 1 and let x t be
gross returns, or set p t 1 D 0 and x t be excess returns. Assume that the SDF is linear in
the factors
mt D 0ft ;
267
where the .1 C K/ 1 vector f t contains a constant and the other factors. Combining
gives the sample moment conditions
T
X
N
g. / D g t . /=T D 0n1 , where
t D1
gt D xt mt pt 1 D x t f t0 pt 1:
There are 1 C K parameters and n moment conditions (the number of assets). To estimate
this model with a weighting matrix W , we minimize the loss function
N 0 W g. /:
J D g. / N
Alternatively, the moment conditions are combined into 1 C K effective conditions as
N
A.1CK/n g. / D 0.1CK/1 :
B.2.1 No Restrictions on the Mean SDF
To simplify the notation, define

T T
x t f t0 =T and p D
X X
xf D pt 1 =T:
t D1 t D1
The moment conditions can then be written
N
g. / D xf p ;
and the loss function as

0
J D xf

p W xf p :
The first order conditions are

0
N /
O

@J @g.
0.1CK/1 D D N /
W g. O
@ @ 0
0
D xf W xf O p , so

0
1 0
O D xf W xf xf W p :
268
In can also be noticed that the Jacobian is
N
@g. /
D xf :
@ 0
Instead, with Ag. /

N D 0, we have
Axf Ap D 0, so
D .Axf / 1 Ap :
B.2.2 Restrictions on the Mean SDF
To simplify the notation, let

T T T
E f t /0 =T and p D
X X X
x D x t =T; xf D x t .f t pt 1 =T:
t D1 tD1 t D1
The moment conditions are
N
g.b/ D x m
N C xf b p
With a weighting matrix W , we minimize

0
J D x m
N C xf b N C xf b

p W x m p :
The first order conditions (with respect to b only, since m

N is given) are

0K1 D xf 0
W x m N C xf bO p , so
bO D xf 0
1 0
N :

W xf xf W p x m
Instead, with Ag. /

N D 0, we have
N C Axf b
Ax m Ap D 0, so
b D .Axf / 1 A p N :

x m
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271
9 Consumption-Based Asset Pricing
Reference: Bossaert (2002); Campbell (2003); Cochrane (2005); Smith and Wickens
(2002)
9.1 Consumption-Based Asset Pricing
9.1.1 The Basic Asset Pricing Equation
The basic asset pricing equation says
Et 1 R t M t D 1: (9.1)
where R t is the gross return of holding an asset from period t 1 to t , M t is a stochastic

discount factor (SDF). E t 1 denotes the expectations conditional on the information in
period t 1, that is, when the investment decision is made. This equation holds for
any assets that are freely traded without transaction costs (or taxes), even if markets are
incomplete.
In a consumption-based model, (9.1) is the Euler equation for optimal saving in t 1
where M t is the ratio of marginal utilities in t and t 1, M t D u0 .C t /=u0 .C t 1 /. I will
focus on the case where the marginal utility of consumption is a function of consumption
only, which is by far the most common formulation. This allows for other terms in the
utility function, for instance, leisure and real money balances, but they have to be addi-
tively separable from the consumption term. With constant relative risk aversion (CRRA)
, the stochastic discount factor is

M t D .C t =C t 1/ , so (9.2)
ln M t D ln c t ; where c t D ln C t =C t 1: (9.3)
The second line is only there to introduce the convenient notation c t for the consumption
growth rate.
The next few sections study if the pricing model consisting of (9.1) and (9.2) can fit
historical data. To be clear about what this entails, note the following. First, general
equilibrium considerations will not play any role in the analysis: the production side will
272
not be even mentioned. Instead, the focus is on one of the building blocks of an otherwise
unspecified model. Second, complete markets are not assumed. The key assumption is
rather that the basic asset pricing equation (9.1) holds for the assets I analyse. This means
that the representative investor can trade in these assets without transaction costs and taxes
(clearly an approximation). Third, the properties of historical (ex post) data are assumed
to be good approximations of what investors expected. In practice, this assumes both
rational expectations and that the sample is large enough for the estimators (of various
moments) to be precise.
To highlight the basic problem with the consumption-based model and to simplify the
exposition, I assume that the excess return, Ret , and consumption growth, c t , have a
bivariate normal distribution. By using Steins lemma, we can write the the risk premium
as
E t 1 Ret D Cov t 1 .Ret ; c t / : (9.4)
The intuition for this expressions is that an asset that has a high payoff when consumption
is high, that is, when marginal utility is low, is considered risky and will require a risk
premium. This expression also holds in terms of unconditional moments. (To derive that,
start by taking unconditional expectations of (9.1).)
We can relax the assumption that the excess return is normally distributed: (9.4) holds
also if Ret and c t have a bivariate mixture normal distributionprovided c t has the
same mean and variance in all the mixture components (see Section 9.1.1 below). This
restricts consumption growth to have a normal distribution, but allows the excess return
to have a distribution with fat tails and skewness.
Remark 9.1 (Steins lemma) If x and y have a bivariate normal distribution and h.y/ is
a differentiable function such that Ejh0 .y/j < 1, then Covx; h.y/ D Cov.x; y/ Eh0 .y/.
Proof. (of (9.4)) For an excess return Re , (9.1) says E Re M D 0, so
E Re D Cov.Re ; M /= E M:
Steins lemma gives CovRe ; exp.ln M / D Cov.Re ; ln M / E M . (In terms of Steins

lemma, x D Re , y D ln M and h./ D exp./.) Finally, notice that Cov.Re ; ln M / D
Cov.Re ; c/.
273
The Gains and Losses from Using Steins Lemma
The gain from using (the extended) Steins lemma is that the unknown relative risk aver-
sion, , does not enter the covariances. This facilitates the empirical analysis consider-
ably. Otherwise, the relevant covariance would be between Ret and .C t =C t 1 / .
The price of using (the extended) Steins lemma is that we have to assume that con-
sumption growth is normally distributed and that the excess return have a mixture normal
distribution. The latter is not much of a price, since a mixture normal can take many
shapes and have both skewness and excess kurtosis.
In any case, Figure 9.1 suggests that these assumptions might be reasonable. The
upper panel shows unconditional distributions of the growth of US real consumption per
capita of nondurable goods and services and of the real excess return on a broad US equity
index. The non-parametric kernel density estimate of consumption growth is quite similar
to a normal distribution, but this is not the case for the US market excess return which has
a lot more skewness.
e
Pdf of c Pdf of Rm
1 0.06
Kernel
Normal
0.04
0.5
0.02
0 0
1 0 1 2 20 10 0 10 20
Consumption growth, % Market excess return, %
US quaterly data 1957Q12013Q3
Figure 9.1: Density functions of consumption growth and equity market excess returns.
The kernel density function of a variable x is estimated by using a N.0; / kernel with
D 1:06 Std.x/T 1=5 . The normal distribution is calculated from the estimated mean
and variance of the same variable.
An Extended Steins Lemma for Asset Pricing
To allow for a non-normal distribution of the asset return, an extension of Steins lemma
is necessary. The following proposition shows that this is possibleif we restrict the
distribution of the log SDF to be gaussian.
274
Figure 9.2 gives an illustration.
Joint distribution: y N, x mixN
0.2
0.1
2
0
3 0
2
1
0
1 2
2 x
y 3
Figure 9.2: Example of a bivariate mixed-normal distribution The marginal distributions

are drawn at the back.
Proposition 9.2 Assume (a) the joint distribution of x and y is a mixture of n bivari-
ate normal distributions; (b) the mean and variance of y is the same in each of the
n components; (c) h.y/ is a differentiable function such that E jh0 .y/j < 1. Then
Covx; h.y/ D E h0 .y/ Cov.x; y/. (See Sderlind (2009) for a proof.)
9.2 Asset Pricing Puzzles
9.2.1 The Equity Premium Puzzle
This section studies if the consumption-based asset pricing model can explain the histor-
ical risk premium on the US stock market.
To discuss the historical average excess returns, it is convenient to work with the
unconditional version of the pricing expression (9.4)
E Ret D Cov.Ret ; c t / : (9.5)
Table 9.1 shows the key statistics for quarterly US real returns and consumption growth.
275
Mean Std Autocorr Corr with c
c 1:88 0:95 0:44 1:00
e
Rm 6:50 17:09 0:07 0:17
Riskfree 0:96 2:52 0:68 0:25
Table 9.1: US quarterly data, 1957Q12013Q3 , (annualized, in %, in real terms)
We see, among other things, that consumption has a standard deviation of only 1%
(annualized), the stock market has had an average excess return (over a T-bill) of 68%
(annualized), and that returns are only weakly correlated with consumption growth. These
figures will be important in the following sections. Two correlations with consumption
growth are shown, since it is unclear if returns should be related to what is recorded as
consumption this quarter or the next. The reason is that consumption is measured as a
flow during the quarter, while returns are measured at the end of the quarter.
Table 9.1 shows that we can write (9.5) as
E Ret D Corr.Ret ; c t / Std.Ret / Std.c t / (9.6)

0:065 0:17 0:17 0:01 : (9.7)
which requires a value of 225 for the equation to fit.

The basic problem with the consumption-based asset pricing model is that investors
enjoy a fairly stable consumption series (either because income is smooth or because it is
easy/inexpensive to smooth consumption by changing savings), so only an extreme risk
aversion can motivate why investors require such a high equity premium. This is the
equity premium puzzle stressed by Mehra and Prescott (1985) (although they approach
the issue from another angle). Indeed, even if the correlation was one, (9.7) would require
38.
9.2.2 The Equity Premium Puzzle over Time
In contrast to the traditional interpretation of efficient markets, it has been found that
excess returns might be somewhat predictableat least in the long run (a couple of years).
In particular, Fama and French (1988a) and Fama and French (1988b) have argued that
future long-run returns can be predicted by the current dividend-price ratio and/or current
returns.
Some evidence suggests that excess returns may perhaps have a predictable compo-
276
nent, that is, that (ex ante) risk premia are changing over time. To see how that fits with
the consumption-based model, notice that (9.4) says that the conditional expected excess
return should equal the conditional covariance times the risk aversion.
Figure 9.3.a shows recursive estimates of the mean return of the aggregate US stock
market and the covariance with consumption growth (dated t C 1). The recursive esti-
mation means that the results for (say) 1965Q2 use data for 1955Q21965Q2, the results
for 1965Q3 add one data point, etc. The second subfigure shows the same statistics, but
estimated on a moving data window of 10 years. For instance, the results for 1980Q2 are
for the sample 1971Q31980Q2. Finally, the third subfigure uses a moving data window
of 5 years.
Together these figures give the impression that there are fairly long swings in the
data. This fundamental uncertainty should serve as a warning against focusing on the fine
details of the data. It could also be used as an argument for using longer data series
provided we are willing to assume that the economy has not undergone important regime
changes.
It is clear from the earlier Figure 9.3 that the consumption-based model probably can-
not generate plausible movements in risk premia. In that figure, the conditional moments
are approximated by estimates on different data windows (that is, different subsamples).
Although this is a crude approximation, the results are revealing: the actual average excess
return and the covariance move in different directions on all frequencies.
9.2.3 The Riskfree Rate Puzzle
The CRRA utility function has the special feature that the intertemporal elasticity of sub-
stitution is the inverse of the risk aversion, that is, 1= . Choosing the risk aversion pa-
rameter, for instance, to fit the equity premium, will therefore have direct effects on the
riskfree rate.
A key feature of any consumption-based asset pricing model, or any consumption/saving
model for that matter, is that the riskfree rate governs the time slope of the consumption
profile. From the asset pricing equation for a riskfree asset (9.1) we have E t 1 .Rf t /
E t 1 .M t / D 1. Note that we must use the conditional asset pricing equationat least as
long as we believe that the riskfree asset is a random variable. A riskfree asset is defined
by having a zero conditional covariance with the SDF, which means that it is regarded
as riskfree at the time of investment (t 1). In practice, this means a real interest rate
(perhaps approximated by the real return on a T-bill since the innovations in inflation are
277
Recursive estimation 10-year data window
e
4 ERm 4
e
Cov(Rm , c)
2 2
0 0
2 2
1960 1980 2000 1960 1980 2000
5-year data window Quarterly US data 1952Q12013Q3

mean excess return on equity, in percent
4 Covariance with cons growth, in basis points
Initialization: data for first 10 years
2
e e
To test: Et1 Rm = Covt1 (Rm , c)
0
2
1960 1980 2000
Figure 9.3: The equity premium puzzle for different samples
small), which may well have a nonzero unconditional covariance with the SDF.1 Indeed,
in Table 9.1 the real return on a T-bill is as correlated with consumption growth as the
aggregate US stockmarket.
When the log SDF is normally distributed (the same assumption as before), then the
log expected riskfree rate is
ln E t 1 Rf t D ln C E t 1 c t 2 Var t 1 .c t /=2: (9.8)
To relate this equation to historical data, we take unconditional expectations to get
E ln E t 1 Rf t D ln C E c t 2 E Var t 1 .c t /=2: (9.9)
Before we try to compare (9.9) with data, several things should be noted. First, the log
gross rate is very close to a traditional net rate (ln.1 C z/ z for small z), so it makes
sense to compare with the data in Table 9.1. Second, we can safely disregard the variance
1
As a very simple example, let x t D z t 1 C" t and y t D z t 1 Cu t where " t are u t uncorrelated with each
other and with z t 1 . If z t 1 is observable in t 1, then Cov t D 0, but Cov.x t ; y t / D 2 .z t 1 /.
1 .x t ; y t /
278
term since it is very small, at least as long as we are considering reasonable values of .
Although the average conditional variance is not directly observable, we know that it must
be smaller than the unconditional variance2 , which is very small in Table 9.1. In fact, the
variance is around 0.0001 whereas the mean is around 0.02.
Proof. (of (9.8)) For a riskfree gross return Rf , (9.1) with the SDF (9.2) says
E t 1 .Rf t / E t 1 .C t =C t 1 / D 1. Recall that if x N.; 2 / and y D exp.x/
then E y D exp. C 2 =2/. When c t is conditionally normally distributed, the log of
E t 1 .C t =C t 1 / equals ln E t 1 c t C 2 Var t 1 .c t /=2/.
According to (9.9) there are two ways to reconcile a positive consumption growth rate
with a low real interest rate (around 1% in Table 9.1): investors may prefer to consume
later rather than sooner ( > 1) or they are willing to substitute intertemporally without
too much compensation (1= is high, that is, is low). However, fitting the equity pre-
mium requires a high value of , so investors must be implausibly patient if (9.9) is to
hold. For instance, with D 25 (which is a very conservative guess of what we need to
fit the equity premium) equation (9.9) says
0:01 D ln C 25 0:02 (9.10)
(ignoring the variance terms), which requires 1:6. This is the riskfree rate puzzle
stressed by Weil (1989). The basic intuition for this result is that it is hard to reconcile a
steep slope of the consumption profile and a low compensation for postponing consump-
tion if people are insensitive to intertemporal pricesunless they are extremely patient
(actually, unless they prefer to consume later rather than sooner).
Another implication of a high risk aversion is that the real interest rate should be
very volatile, which it is not. According to Table 9.1 the standard deviation of the real
interest rate is perhaps twice the standard deviation of consumption growth. From (9.8)
the volatility of the (expected) riskfree rate should be
Stdln E t 1 Rf t D StdE t 1 c t ; (9.11)
if the conditional variance of consumption growth is constant. This expression says that
the standard deviation of expected real interest rate is times the standard deviation of ex-
pected consumption growth. We cannot observe the conditional expectations directly, and
therefore not estimate their volatility. However, a simple example is enough to demon-
2
Let E.yjx/ and Var.yjx/ be the expectation and variance of y conditional on x. The unconditional
variance is then Var.y/ D VarE.yjx/ C EVar.yjx/.
279
strate that high values of are likely to imply counterfactually high volatility of the real
interest rate.
As an approximation, suppose both the riskfree rate and consumption growth are
AR(1) processes. Then (9.11) can be written
Corrln E t 1 .Rf t /; ln E t 1 .Rf t / Stdln E t 1 .Rf t / D Corr.c t ; c t C1 / Std.c t /

(9.12)
0:75 0:02 0:3 0:01 (9.13)
where the second line uses the results in Table 9.1. With D 25, (9.13) implies that the
RHS is much too volatile This shows that an intertemporal elasticity of substitution of
1/25 is not compatible with the relatively stable real return on T-bills.
Proof. (of (9.12)) If x t D x t 1 C " t , where " t is iid, then E t 1 .x t / D x t 1 , so
.E t 1 x t / D .x t 1 /.
9.3 The Cross-Section of Returns: Unconditional Models
The previous section demonstrated that the consumption-based model has a hard time ex-
plaining the risk premium on a broad equity portfolioessentially because consumption
growth is too smooth to make stocks look particularly risky. However, the model does
predict a positive equity premium, even if it is not large enough. This suggests that the
model may be able to explain the relative risk premia across assets, even if the scale is
wrong. In that case, the model would still be useful for some issues. This section takes a
closer look at that possibility by focusing on the relation between the average return and
the covariance with consumption growth in a cross-section of asset returns.
The key equation is (9.5), which I repeat here for ease of reading
E Ret D Cov.Ret ; c t / :
This can be tested with a GMM framework or a traditional cross-sectional regressions of

returns on factors with unknown factor risk premia (see, for instance, Cochrane (2005)
chap 12 or Campbell, Lo, and MacKinlay (1997) chap 6).
Remark 9.3 (GMM estimation of (9.5)) Let there be N assets. The original moment
280
conditions are
2 3
.c t c / D 0
T 6
.Riet i / D 0 for i D 1; 2; :::; N
7
1 X6 7
gT ./ D 6 7
T t D1 6
4 .c t c /.Riet i / ci D 0 for i D 1; 2; :::; N 7
5
.Riet ci / D 0 for i D 1; 2; :::; N;
where c is the mean of c t , i the mean of Riet , ci the covariance of c t and Riet .
This gives 1 C 3N moment conditions and 2N C 3 parameters, so there are N 2
overidentifying restrictions.
To estimate, we define the combined moment conditions as
AgT ./ D 0.2N C3/1 ; where

2 3
1 01N 01N 01N
60N 1 IN 0N N 0N N 7
6 7
6 7
A.2N C3/.1C3N / D 60 0
6 N 1 N N I N 0N N 7 ;
7
4 0 01N 01N i0c 5
6 7
0 01N 01N 11N
where i0c is an 1 N vector of covariances of the returns with consumption growth.

These moment conditions mean that means and covariances are estimated in the tradi-
tional way, and that is estimated by a LS regression of E Riet on a constant and ci . The
test that the pricing errors are all zero is a Wald test that gT ./ are all zero, where the
covariance matrix of the moments are estimated by a Newey-West method (using one lag).
This covariance matrix is singular, but that does not matter (as we never have to invert
it).
It can be shown (see Sderlind (2006)) that (i) the recursive utility function in Epstein
and Zin (1991); (ii) the habit persistence model of Campbell and Cochrane (1999) in the
case of no return predictability, as well as the (iii) models of idiosyncratic risk by Mankiw
(1986) and Constantinides and Duffie (1996) also in the case of no return predictability,
all imply that (9.5) hold. The only difference is that the effective risk aversion ( ) differs.
Still, the basic asset pricing implication is the same: expected returns are linearly related
to the covariance.
Figure 9.4 shows the results of both C-CAPM and the standard CAPMfor the 25
Fama and French (1993) portfolios. It is clear that both models work badly, but CAPM
actually worse.
281
C-CAPM CAPM
20 20
: 216 : -0.3
15 t-stat of : 1.7 15 t-stat of : -0.2
ERe , %
ERe , %
R2: 0.40 R2: 0.00
10 10
5 5
0 0
0 2 4 6 0 1 2 3 4 5
Cov(c, Re ), bps e
Cov(Rm , Re ), %
US quarterly data 1957Q12013Q3
Figure 9.4: Test of C-CAPM and CAPM on 25 FF portfolios
C-CAPM C-CAPM
20 20
1 (small) 1 (low)
15 2 15 2
3 3
ERe , %
ERe , %
4 4
10 5 (large) 10 5 (high)
5 5
lines connect same size lines connect same B/M
0 0
0 2 4 6 0 2 4 6
Cov(c, Re ), bps Cov(c, Re ), bps
CAPM CAPM
20 20
15 15
ERe , %
ERe , %
10 10
5 5
lines connect same size lines connect same B/M
0 0
0 1 2 3 4 5 0 1 2 3 4 5
e
Cov(Rm , Re ), % e
Cov(Rm , Re ), %
Figure 9.5: Diagnosing C-CAPM and CAPM, 25 FF portfolios
Figure 9.5 takes a careful look at how the C-CAPM and CAPM work in different
smaller cross-sections. A common feature of both models is that growth firms (low book-
282
to-market ratios) have large pricing errors (in the figures with lines connecting the same
B/M categories, they are the lowest lines for both models).
In contrast, a major difference between the models is that CAPM shows a very strange
pattern when we compare across B/M categories (lines connecting the same size cate-
gory): mean excess returns are decreasing in the covariance with the marketthe wrong
sign compared to the CAPM prediction. This is not the case for C-CAPM.
The conclusion is that the consumption-based model is not good at explaining the
cross-section of returns, but it is no worse than CAPMif it is any comfort.
9.4 The Cross-Section of Returns: Conditional Models
The basic asset pricing model is about conditional moment and it can be summarizes as
in (9.4) which is given here again
Et 1 Ret D Cov t e
1 .R t ; c t / : (EPP3c again)
Expression this in terms of unconditional moments as in (9.5) shows only part of the
story. It is, however, fair to say that if the model does not hold unconditionally, then that
is enough to reject the model.
However, it can be shown (see Sderlind (2006)) that several refinements of the con-
sumption based model (the habit persistence model of Campbell and Cochrane (1999)
and also the model with idiosyncratic risk by Mankiw (1986) and Constantinides and
Duffie (1996)) also imply that (9.4) holds, but with a time varying effective risk aversion
coefficient (so should carry a time subscript).
9.4.1 Approach 1 of Testing the Conditional CCAPM: A Scaled Factor Model
Reference: Lettau and Ludvigson (2001b), Lettau and Ludvigson (2001a)

Lettau and Ludvigson (2001b) use a scaled factor model, where they impose the re-
striction that the time variation (using a beta representation) is a linear function of some
conditioning variables (specifically, the cay variable) only.
The cay variable is defined as the log consumption/wealth ratio. Wealth consists of
both financial assets and human wealth. The latter is not observable, but is assumed to
be proportional to current income (this would, for instance, be true if income follows and
283
AR(1) process). Therefore, cay is modelled as
cay t D c t !a t .1 !/y t ; (9.14)
where c t is log consumption, a t log financial wealth and y t is log income. The coeffi-
cient ! is estimated with LS to be around 0.3. Although (9.14) contains non-stationary
variables, it is interpreted as a cointegrating relation so LS is an appropriate estimation
method. Lettau and Ludvigson (2001a) shows that cay is able to forecast stock returns (at
least, in-sample). Intuitively, cay should be a signal of investor expectations about future
returns (or wage earnings...): a high value is probably driven by high expectations.
The SDF is modelled as time-varying function of consumption growth
M t D a t C b t c t , where (9.15)
a t D 0 C 1 cay t 1 and b t D 0 C 1 cay t 1: (9.16)
This is a conditional C-CAPM. It is clearly the same as specifying a linear factor model
Riet D C i1 cay t 1 C i 2 c t C i 3 .c t cay t 1/ C "i t ; (9.17)
where the coefficients are estimated in time series regression (this is also called a scaled
factor model since the true factor, c, is scaled by the instrument, cay). Then, the
cross-sectional pricing implications are tested by
E Ret D ; (9.18)
where (i 2 ; i 2 ; i 3 ) is row i of the matrix and is a 3 1 vector of factor risk premia.

Lettau and Ludvigson (2001b) use the 25 Fama-French portfolios as test assets and
compare the results from (9.17)(9.18) with several other models, for instance, a tradi-
tional CAPM (the SDF is linear in the market return), a conditional CAPM (the SDF is
linear in the market return, cay and their product), a traditional C-CAPM (the SDF is
linear in consumption growth) and a Fama-French model (the SDF is linear in the market
return, SMB and HML). It is found that the conditional CAPM and C-CAPM provides a
much better fit of the cross-sectional returns that the unconditional models (including the
Fama-French model)and that the C-CAPM is actually a pretty good model.
9.4.2 Approach 2 of Testing the Conditional CCAPM: An Explicit Volatility Model
Reference: Duffee (2005)
284
Duffee (2005) estimates the conditional model (9.4) by projecting both ex post returns
and covariances on a set of instrumentsand then studies if there is a relation between
these projections.
A conditional covariance (here of the asset return and consumption growth) is the
covariance of the innovations. To create innovations (denoted eR;t and ec;t below), the
paper uses the following prediction equations
0
Ret D R YR;t 1 C eR;t (9.19)
c t D c0 Yc;t 1 C ec;t : (9.20)
In practice, only three lags of lagged consumption growth is used to predict consumption
growth and only the cay variable is used to predict the asset return.
Then, the return is related to the covariance as
Ret D b0 C .b1 C b2 p t 1 / eR;t ec;t C wt ; (9.21)
where .b1 C b2 p t 1 / is a model of the effective risk aversion. In the CRRA model, b2 D
0, so b1 measures the relative risk aversion as in (9.4). In contrast, in Campbell and
Cochrane (1999) p t 1 is an observable proxy of the surplus ratio which measure how
close consumption is to the habit level.
The model (9.19)(9.21) is estimated with GMM, using a number of instruments
(Z t 1 ): lagged values of stock market value/consumption, stock market returns, cay and
the product of demeaned consumption and returns. This can be thought of as first finding
proxies for
bR
Et e 0
D R YR;t and (9.22)
2 .e
1 t 1
Cov t 1 R;t ; ec;t / D v0 Z t 1
and then relating this proxies as
bR
Et 1
e
t D b0 C .b1 C b2 p t 2
1 / Cov t 1 .eR;t ; ec;t / C ut : (9.23)
The point of using a (GMM) system is that this allows handling the estimation uncer-
tainty of the prediction equations in the testing of the relation between the predictions.
The empirical results (using monthly returns on the broad U.S. stock market and per
capita expenditures in nondurables and services, 19592001) suggest that there is a strong
negative relation between the conditional covariance and the conditional expected market
285
returnwhich is clearly at odds with a CRRA utility function (compare (9.4)). In addi-
tion, typical proxies of the p t 1 variable do not seem to any important (economic) effects.
In an extension, the paper also studies other return horizons and tries other ways to
model volatility (including a DCC model).
(See also Sderlind (2006) for a related approach applied to a cross-section of returns.)
9.5 Ultimate Consumption
Reference: Parker and Julliard (2005)

Parker and Julliard (2005) suggest using a measure of long-run changes in consump-
tion instead of just a one-period change. This turns out to give a much better empirical fit
of the cross-section of risk premia.
To see the motivation for this approach, consider the asset pricing equation based on
a CRRA utility function. It says that an excess return satisfies
Et 1 Ret .C t =C t 1/

D0 (9.24)
Similarly, an n-period bond price (Pn;t ) satisfies
E t n .C t Cn =C t /
D Pnt , so (9.25)

Ct D E t n C t Cn =Pn;t : (9.26)
Use in (9.24) to get
Et 1 Ret Mn;t D 0; where (9.27)

Mn;t D .1=Pn;t /.C t Cn =C t 1/ :
This expression relates the one-period excess return to an n-period SDFwhich involves
the interest rate (1=Pn;t ) and ratio of marginal utilities n periods apart.
If we can apply Steins lemma (possibly extended) and use yn;t D ln 1=Pnt to denote
the n-period log riskfree rate, then we get
Et 1 Ret D Cov t 1 .R t ; ln Mn;t /

e
D Cov t e
1 R t ; ln.C t Cn =C t 1 / Cov t e
1 R t ; yn;t : (9.28)
This first term is very similar to the traditional expression (9.2), except that we here have
the (nC1)-period (instead of the 1-period) consumption growth. The second term captures
286
the covariance between the excess return and the n-period interest rate in period t (both
are random as seen from t 1). If we set n D 0, then this equation simplifies to the
traditional expression (9.2). Clearly, the moments in (9.28) could be unconditional instead
of conditional.
The empirical approach in Parker and Julliard (2005) is to estimate (using GMM) and
test the cross-sectional implications of this model. (They do not use Steins lemma.) They
find that the model fits data much better with a high value of n (ultimate consumption)
than with n D 0 (the traditional model). Possible reasons could be: (i) long-run changes
in consumption are better measured in national accounts data; (ii) the CRRA model is a
better approximation for long-run movements.
C-CAPM, 1 quarter Ultimate C-CAPM, 4 quarters

20 20
: 216 : 236
15 t-stat of : 1.7 15 t-stat of : 1.9
ERe , %
ERe , %
R2: 0.40 R2: 0.32
10 10
5 5
0 0
0 2 4 6 0 2 4 6
Cov(c, Re ), bps Cov(c, Re ), bps
Unconditional C-CAPM
Ultimate C-CAPM, 8 quarters US quarterly data 1957Q12013Q3
20
15
ERe , %
10
: 402
5 t-stat of : 2.1
R2: 0.55
0
0 2 4 6
Cov(c, Re ), bps
Figure 9.6: C-CAPM and ultimate consumption, 25 FF portfolio.
Proof. (of (9.25)(9.27)) To prove (9.25), let M tC1 D .C t C1 =C t / denote the

SDF and Pnt the price of an n-period bond. Clearly, P2t D E t M tC1 P1;t C1 , so P2t D
E t M tC1 E t C1 .M t C2 P0;tC2 /. Use the law of iterated expectations (LIE) and P0;t C2 D 1
to get P2t D E t M t C2 M t C1 . The extension from 2 to n is straightforward, which gives
287
(9.25). To prove (9.27), use (9.26) in (9.24), apply LIE and simplify.
Bibliography
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Campbell, J. Y., 2003, Consumption-based asset pricing, in George Constantinides,

Milton Harris, and Rene Stultz (ed.), Handbook of the Economics of Finance . chap. 13,
pp. 803887, North-Holland, Amsterdam.

205251.

revised edn.
Constantinides, G. M., and D. Duffie, 1996, Asset pricing with heterogeneous con-
sumers, The Journal of Political Economy, 104, 219240.
Duffee, G. R., 2005, Time variation in the covariance between stock returns and con-
sumption growth, Journal of Finance, 60, 16731712.
Epstein, L. G., and S. E. Zin, 1991, Substitution, risk aversion, and the temporal behavior
of asset returns: an empirical analysis, Journal of Political Economy, 99, 263286.
Fama, E. F., and K. R. French, 1988a, Dividend yields and expected stock returns,
Fama, E. F., and K. R. French, 1988b, Permanent and temporary components of stock
prices, Journal of Political Economy, 96, 246273.
Lettau, M., and S. Ludvigson, 2001a, Consumption, wealth, and expected stock returns,
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288
Lettau, M., and S. Ludvigson, 2001b, Resurrecting the (C)CAPM: a cross-sectional test
when risk premia are time-varying, Journal of Political Economy, 109, 12381287.
Mankiw, G. N., 1986, The equity premium and the concentration of aggregate shocks,
Mehra, R., and E. Prescott, 1985, The equity premium: a puzzle, Journal of Monetary
Economics, 15, 145161.
Parker, J., and C. Julliard, 2005, Consumption risk and the cross section of expected
returns, Journal of Political Economy, 113, 185222.
Smith, P. N., and M. R. Wickens, 2002, Asset pricing with observable stochastic discount
factors, Discussion Paper No. 2002/03, University of York.
Sderlind, P., 2006, C-CAPM Refinements and the cross-section of returns, Financial
Markets and Portfolio Management, 20, 4973.
Sderlind, P., 2009, An extended Steins lemma for asset pricing, Applied Economics
Letters, 16, 10051008.
Weil, P., 1989, The equity premium puzzle and the risk-free rate puzzle, Journal of
Monetary Economics, 24, 401421.
289
10 Alphas /Betas and Investor Characteristics
10.1 Basic Setup
The task is to evaluate if alphas or betas of individual investors (or funds) are related
to investor (fund) characteristics, for instance, age or trading activity. The data set is
panel with observations for T periods and N investors. (In many settings, the panel is
unbalanced, but, to keep things reasonably simple, that is disregarded in the discussion
below.)
10.2 Calendar Time and Cross Sectional Regression
The calendar time (CalTime) approach is to first define M discrete investor groups (for
instance, age 1830, 3140, etc) and calculate their respective average excess returns (yNjt
for group j )
1 P
yNjt D yi t ; (10.1)
Nj i 2Groupj
where Nj is the number of individuals in group j .
Then, we run a factor model
yNjt D x t0 j C vjt ; for j D 1; 2; : : : ; M (10.2)
where x t typically includes a constant and various return factors (for instance, excess re-
turns on equity and bonds). By estimating these M equations as a SURE system with
Whites (or Newey-Wests) covariance estimator, it is straightforward to test various hy-
potheses, for instance, that the intercept (the alpha) is higher for the M th group than
for the for first group.
Example 10.1 (CalTime with two investor groups) With two investor groups, estimate the
following SURE system
yN1t D x t0 1 C v1t ;
yN2t D x t0 2 C v2t :
290
The CalTime approach is straightforward and the cross-sectional correlations are fairly
easy to handle (in the SURE approach). However, it forces us to define discrete investor
groupswhich makes it hard to handle several different types of investor characteristics
(for instance, age, trading activity and income) at the same time.
The cross sectional regression (CrossReg) approach is to first estimate the factor
model for each investor
yi t D x t0 i C "i t ; for i D 1; 2; : : : ; N (10.3)
and to then regress the (estimated) betas for the pth factor (for instance, the intercept) on
the investor characteristics
Opi D zi0 cp C wpi : (10.4)
In this second-stage regression, the investor characteristics zi could be a dummy variable

(for age group, say) or a continuous variable (age, say). Notice that using a continuous
investor characteristics assumes that the relation between the characteristics and the beta
is linearsomething that is not assumed in the CalTime approach. (This saves degrees of
freedom, but may sometimes be a very strong assumption.) However, a potential problem
with the CrossReg approach is that it is often important to account for the cross-sectional
correlation of the residuals.
10.3 Panel Regressions, Driscoll-Kraay and Cluster Methods
References: Hoechle (2007) and Driscoll and Kraay (1998)
10.3.1 OLS
Consider the regression model

yi t D xi0 t C "i t ; (10.5)
where xi t is an K 1 vector. Notice that the coefficients are the same across individuals
(and time). Define the matrices
T N
1 XX
xx D xi t xi0 t (an K K matrix) (10.6)
T N t D1 i D1
T N
1 XX
xy D xi t yi t (a K 1 vector). (10.7)
T N t D1 i D1
291
The LS estimator (stacking all T N observations) is then
O D xx1 xy : (10.8)
Remark 10.2 (Panel regression vs average coefficient ) Consider the regression for in-
vestor i
yi t D x t0 i C "i t , i D 1:::N;
where the regressors are the same in all regressionsbut where the coefficients might
differences across investors. Clearly, we have for each i
Oi D Sxx1 Sxyi ;
T T
x t x t0 =T and Sxyi D
X X
where Sxx D x t yi t =T:
t D1 t D1
The cross-sectional average of the regression coefficients are therefore

N N
1 X O 1 X
i D Sxx Sxyi :
N i D1 N i D1
Compare that to (10.6) and notice that since x t is repeated N times, we have xx D Sxx .
Similarly, comparing with (10.7) gives
N
1 X
Sxyi D xy :
N i D1
1
PN O D ,
O where the latter is from the panel regression (10.8).
This shows that N i D1 i
10.3.2 GMM
The sample moment conditions for the LS estimator are

T N
1X 1 X
hi t D 0K1 , where hi t D xi t "i t D xi t .yi t xi0 t /: (10.9)
T t D1 N i D1
Remark 10.3 (Distribution of GMM estimates) Under fairly weak assumption, the ex-
p d
actly identified GMM estimator T N .O 0 / ! N.0; D0 1 S0 D0 1 /, where D0 is the
p
Jacobian of the average moment conditions and S0 is the covariance matrix of T N
times the average moment conditions.
292
Remark 10.4 (Distribution of O 0 ) As long as T N is finite, we can (with some abuse
p
of notation) consider the distribution of O instead of T N .O 0 / to write
O 0 N.0; D0 1 SD0 1 /;
where S D S0 =.T N / which is the same as the covariance matrix of the average moment
conditions (10.9).
To apply these remarks, first notice that the Jacobian D0 corresponds to (the probabil-
ity limit of) the xx matrix in (10.6)
D0 D xx : (10.10)
To see that, differentiate the moment conditions (10.9) with respect to 0 .

Second, notice that
T N
!
1X 1 X
Cov.average moment conditions/ D Cov hi t (10.11)
T t D1 N i D1
looks differently depending on the assumptions of cross correlations.

In particular, if hi t has no correlation across time (effectively, N1 N i D1 hi t is not auto-
P
correlated), then we can simplify as

T N
!
1 X 1 X
Cov.average moment conditions/ D 2 Cov hi t : (10.12)
T t D1 N i D1
We would then design an estimator that would consistently estimate this covariance matrix
by using the time dimension.
Example 10.5 (DK on T D 2 and N D 4) As an example, suppose K D 1, T D 2 and

N D 4. Then, (10.11) can be written

1 1
Cov .h1t C h2t C h3t C h4t / C .h1;tC1 C h2;tC1 C h3;tC1 C h4;tC1 / :
24 24
If there is no correlation across time periods, then this becomes

1 1 1 1
Cov .h1t C h2t C h3t C h4t / C 2 Cov .h1;t C1 C h2;t C1 C h3;t C1 C h4;t C1 / ;
22 4 2 4
which has the same form as (10.12).
293
10.3.3 Driscoll-Kraay
The Driscoll and Kraay (1998) (DK) covariance matrix is
O D 1 S 1 ;
Cov./ (10.13)
xx xx
where
T N
1 X 0 1 X
SD 2 h t h t ; with h t D hi t , hi t D xi t "i t ; (10.14)
T t D1 N i D1
where hi t is the LS moment condition for individual i . Clearly, hi t and h t are K 1, so S
is KK. Since we use the covariance matrix of the moment conditions, heteroskedasticity
is accounted for.
Notice that h t is the cross-sectional average moment condition (in t ) and that S is an
estimator of the covariance matrix of those average moment conditions
b

1 PT PN
S D Cov hi t :
T N tD1 i D1
To calculate this estimator, (10.14) uses the time dimension (and hence requires a reason-
ably long time series).
Remark 10.6 (Relation to the notation in Hoechle (2007)) Hoechle writes Cov./ O D
.X 0 X/ 1 SOT .X 0 X/ 1 , where SOT D TtD1 hO t hO 0t ; with hO t D N
i D1 hi t . Clearly, my xx D
P P
X 0 X=.T N / and my S D SOT =.T 2 N 2 /. Combining gives Cov./ O D .xx T N / 1 ST 2 N 2 .xx T N / 1 ,

which simplifies to (10.13).
Example 10.7 (DK on N D 4) As an example, suppose K D 1 and N D 4. Then,

(10.14) gives the cross-sectional average in period t
1
ht D .h1t C h2t C h3t C h4t / ;
4
294
and the covariance matrix
T
1 X
SD 2 h t h0t
T t D1
T 2
1 X 1
D 2 .h1t C h2t C h3t C h4t /
T t D1 4
T
1 X 1 2
D 2 .h C h22t C h23t C h24t ;
T t D1 16 1t
C 2h1t h2t C 2h1t h3t C 2h1t h4t C 2h2t h3t C 2h2t h4t C 2h3t h4t /
so we can write
" 4
1 X
SD Var.h
c it /
T 16 i D1
b b b
C 2Cov.h1t ; h2t / C 2Cov.h1t ; h3t / C 2Cov.h1t ; h4t /
bov.h ; h / C 2Cbov.h
C 2C 2t 3t 2t ; h4t /
C2Cbov.h ; h /i :
3t 4t
Notice that S is the (estimate of) the variance of the cross-sectional average, Var.h t / D
Var.h1t C h2t C h3t C h4t /=4.
A cluster method puts restrictions on the covariance terms (of hi t ) that are allowed
to enter the estimate S. In practice, all terms across clusters are left out. This can be
implemented by changing the S matrix. In particular, instead of interacting all i with
each other, we only allow for interaction within each of the G clusters (g D 1; :::; G/
G T
X 1 X g g 0 1
h t h t , where hgt D
X
SD 2
hi t : (10.15)
gD1
T t D1 N i 2 cluster g
(Remark: the cluster sums should be divided by N , not the number of individuals in the
cluster.)
Example 10.8 (Cluster method on N D 4, changing Example 10.7 directly) Reconsider

Example 10.7, but assume that individuals 1 and 2 form cluster 1 and that individuals 3
and 4 form cluster 2and disregard correlations across clusters. This means setting the
295
covariances across clusters to zero,
T
1 X 1 2
SD 2
.h1t C h22t C h23t C h24t ;
T t D1 16
2h1t h2t C 2h1t h3t C 2h1t h4t C 2h2t h3t C 2h2t h4t C 2h3t h4t /

0 0 0 0
so we can write
b b
" 4 #
1 X
SD Var.h
c i t / C 2Cov.h1t ; h2t / C 2Cov.h3t ; h4t / :
T 16 i D1
Example 10.9 (Cluster method on N D 4) From (10.15) we have the cluster (group)
averages
1 1
h1t D .h1t C h2t / and h2t D .h3t C h4t / :
4 4
T 0
Assuming only one regressor (to keep it simple), the time averages, T1 hgt hgt , are
P
t D1
then (for cluster 1 and then 2)
T T 2 T
1 X 1 1 0 1X 1 1X 1 2
ht ht D .h1t C h2t / D h1t C h22t C 2h1t h2t , and

T t D1 T t D1 4 T t D1 16
T T
1 X 2 2 0 1X 1 2
ht ht D h3t C h24t C 2h3t h4t :

T t D1 T t D1 16
Finally, summing across these time averages gives the same expression as in Example
10.8. The following 4 4 matrix illustrates which cells that are included (assumption: no
dependence across time)
i 1 2 3 4
1 h21t h1t h2t 0 0
2
2 h1t h2t h2t 0 0
3 0 0 h23t h3t h4t
4 0 0 h3t h4t h24t
In comparison, the iid and Whites cases only sum up the principal diagonal, while the
DK method fills the entire matrix.
Instead, we get Whites covariance matrix by excluding all cross terms. This can be
296
accomplished by defining
T N
1 X 1 X
SD 2 hi t h0i t : (10.16)
T t D1 N 2 i D1
Example 10.10 (Whites method on N D 4) With only one regressor (10.16) gives
T
1 X 1 2
SD 2 h1t C h22t C h23t C h24t

T tD1 16
4
1 X
D Var.h
c it /
T 16 i D1
Finally, the traditional LS covariance matrix assumes that E hi t h0i t D xx E "2it , so

we get
T N
O 1 XX 2
CovLS ./ D xx s =T N , where s D
1 2 2
" : (10.17)
T N t D1 i D1 i t
It is a special case of Whites approach, but does not allow for x t2 and "2it to interact.
Remark 10.11 (Why the cluster method fails when there is a missing time fixed effect
and one of the regressors indicates the cluster membership) To keep this remark short,
assume yi t D 0qi t C "i t , where qi t indicates the cluster membership of individual i (con-
stant over time). In addition, assume that all individual residuals are entirely due to an
(excluded) time fixed effect, "i t D w t . Let N D 4 where i D .1; 2/ belong to the first
cluster (qi D 1) and i D .3; 4/ belong to the second cluster (qi D 1). (Using the values
qi D 1 gives qi a zero mean, which is convenient.) It is straightforward to demon-
strate that the estimated (OLS) coefficient in any sample must be zero: there is in fact no
uncertainty about it. The individual moments in period t are then hi t D qi t w t
2 3 2 3
h1t wt
6 7 6 7
6 h2t 7 6 w t 7
7D6
6 h 7 6 w 7:
6 7
4 3t 5 4 t 5
h4t wt
297
The matrix in Example 10.9 is then
i 1 2 3 4
1 w t2 w t2 0 0
2 2
2 wt wt 0 0
3 0 0 w t2 w t2
4 0 0 w t2 w t2
These elements sum up to a positive numberwhich is wrong since N i D1 hi t D 0 by

P
definition, so its variance should also be zero. In contrast, the DK method adds the off-
diagonal elements which are all equal to w t2 , so summing the whole matrix indeed gives
zero. If we replace the qi t regressor with something else (eg a constant), then we do not
get this result.
To see what happens if the qi variable does not coincide with the definitions of the clus-
ters change the regressor to qi D . 1; 1; 1; 1/ for the four individuals. We then get
.h1t ; h2t ; h3t ; h4t / D . w t ; w t ; w t ; w t /. If the definition of the clusters (for the covari-
ance matrix) are unchanged, then the matrix in Example 10.9 becomes
i 1 2 3 4
1 w t2 w t2 0 0
2 w t2 w t2 0 0
3 0 0 w t2 w t2
4 0 0 w t2 w t2
which sum to zero: the cluster covariance estimator works fine. The DK method also
works since it adds the off-diagonal elements which are
i 1 2 3 4
1 w t2 w t2
2 w t2 w t2
3 w t2 w t2
4 w t2 w t2
which also sum to zero. This suggests that the cluster covariance matrix goes wrong
only when the cluster definition (for the covariance matrix) is strongly related to the qi
regressor.
298
10.4 From CalTime To a Panel Regression
The CalTime estimates can be replicated by using the individual data in the panel. For
instance, with two investor groups we could estimate the following two regressions
yi t D x t0 1 C u.1/
i t for i 2 group 1 (10.18)
yi t D x t0 2 C u.2/
i t for i 2 group 2. (10.19)
More interestingly, these regression equations can be combined into one panel regres-
sion (and still give the same estimates) by the help of dummy variables. Let zj i D 1 if
individual i is a member of group j and zero otherwise. Stacking all the data, we have
(still with two investor groups)
yi t D .z1i x t /0 1 C .z2i x t /0 2 C ui t
" #!0 " #
z1i x t 1
D C ui t
z2i x t 2
# "
z 1i
D .zi x t /0 C ui t , where zi D : (10.20)
z2i
This is estimated with LS by stacking all N T observations.

Since the CalTime approach (10.2) and the panel approach (10.20) give the same
coefficients, it is clear that the errors in the former are just group averages of the errors in
the latter
1 P
vjt D u.j / : (10.21)
Nj i 2Group j i t
We know that
1
Var.vjt / D . i i ih / C ih ; (10.22)
Nj
where i i is the average Var.u.j / .j / .j /
i t / and ih is the average Cov.ui t ; uht /. With a large
cross-section, only the covariance matters. A good covariance estimator for the panel
approach will therefore have to handle the covariance with a groupand perhaps also
the covariance across groups. This suggests that the panel regression needs to handle the
cross-correlations (for instance, by using the cluster or DK covariance estimators).
10.5 The Results in Hoechle, Schmid and Zimmermann
Hoechle, Schmid, and Zimmermann (2009) (HSZ) suggest the following regression on all
299
data (t D 1; : : : ; T and also i D 1; : : : ; N )
yi t D .zi t x t /0 d C vi t (10.23)
D .1; z1i t ; : : : ; zmi t 1; x1t ; : : : ; xk t /0 d C vi t ; (10.24)
where yi t is the return of investor i in period t , zqi t measures characteristics q of investor

i in period t and where xpt is the pth pricing factor. In many cases zj i t is time-invariant
and could even be just a dummy: zj i t D 1 if investor i belongs to investor group j
(for instance being 1830 years old). In other cases, zj i t is still time invariant and con-
tains information about the number of fund switches as well as other possible drivers of
performance like gender. The x t vector contains the pricing factors. In case the charac-
teristics z1i t ; : : : ; zmi t sum to unity (for a given individual i and time t ), the constant in
1; z1i t ; : : : ; zmi t is dropped.
This model is estimated with LS (stacking all N T observations), but the standard
errors are calculated according to Driscoll and Kraay (1998) (DK)which accounts for
cross-sectional correlations, for instance, correlations between the residuals of different
investors (say, v1t and v7t ).
HSZ prove the following two propositions.
Proposition 10.12 If the zi t vector in (10.23) consists of dummy variables indicating

exclusive and constant group membership (z1i t D 1 means that investor i belongs to
group 1, so zj i t D 0 for j D 2; :::; m), then the LS estimates and DK standard errors
of (10.23) are the same as LS estimates and Newey-West standard errors of the CalTime
approach (10.2). (See HSZ for a proof.)
This proposition basically says that panel regression is as good as the CT approach.
So why use a panel regression, then? A. Because if allows for (a) many characteristics
(poor, old, men) without having to define a very large set of dummies (poor&old&men,
poor&old&female, poor&young&men,...); (b) a finer (continuous) characteristics grid
(age in years, months, days and...).
Proposition 10.13 (When zi t is a measure of investor characteristics, eg number of fund

switches) The LS estimates and DK standard errors of (10.23) are the same as the LS
estimates of CrossReg approach (10.4), but where the standard errors account for the
cross-sectional correlations, while those in the CrossReg approach do not. (See HSZ for
a proof.)
300
Example 10.14 (One investor characteristic and one pricing factor). In this case (10.23)
is
2 30
1
6 7
6 x1t 7
yi t D 6
6 7 d C vi t ;
4 zi t 5
7
zi t x1t
D d0 C d1 x1t C d2 zi t C d3 zi t x1t C vi t :
In case we are interested in how the investor characteristics (zi t ) affect the alpha (inter-
cept), then d2 is the key coefficient.
10.6 Monte Carlo Experiment
10.6.1 Basic Setup
This section reports results from a simple Monte Carlo experiment. We use the model
yi t D C f t C gi C "i t ; (10.25)
where yi t is the return of individual i in period t, f t a benchmark return and gi is the

(demeaned) number of the cluster ( 2; 1; 0; 1; 2) that the individual belongs to. This is
a simplified version of the regressions we run in the paper. In particular, measures how
the performance depends on the number of fund switches.
The experiment uses 3000 artificial samples with t D 1; : : : ; 2000 and i D 1; : : : ; 1665.
Each individual is a member of one of five equally sized groups (333 individuals in each
group). The benchmark return f t is iid normally distributed with a zero mean and a stan-
p
dard deviation equal to 15= 250, while "i t is also normally distributed with a zero mean
and a standard deviation of one (different cross-sectional correlations are shown in the
table). In generating the data, the true values of and are zero, while is oneand
these are also the hypotheses tested below. To keep the simulations easy to interpret, there
is no autocorrelation or heteroskedasticity.
Results for three different GMM-based methods are reported: Driscoll and Kraay
(1998), a cluster method and Whites method. To keep the notation short, let the re-
gression model be yi t D xi0 t b C "i t , where xi t is a K 1 vector of regressors. The (least
301
squares) moment conditions are
1 PT PN
hi t D 0K1 , where hi t D xi t "i t : (10.26)
T N t D1 i D1
Standard GMM results show that the variance-covariance matrix of the coefficients is
O D 1 S 1 , where xx D 1 PT PN
Cov.b/ xi t xi0 t ; (10.27)
xx xx
T N t D1 i D1
and S is covariance matrix of the moment conditions.
The three methods differ with respect to how the S matrix is estimated
1 PT 0
PN
SDK D t D1 h t h t , where h t D i D1 hi t ;
T 2N 2
1 PT PM j j 0 j
X
SC l D t D1 j D1 h t .h t / , where h t D hi t ;
T 2N 2 i 2 cluster j
1 PT PN 0
SW h D t D1 i D1 hi t hi t : (10.28)
T 2N 2
To see the difference, consider a simple example with N D 4 and where i D .1; 2/ belong
to the first cluster and i D .3; 4/ belong to the second cluster. The following matrix shows
the outer product of the moment conditions of all individuals. Whites estimator sums up
the cells on the principal diagonal, the cluster method adds the underlined cells, and the
DK method adds also the remaining cells
2 3
i 1 2 3 4
6 1 h1t h01t h1t h02t h1t h03t h1t h04t 7
6 7
6 7
0 0 0 0 7
6 2 h2t h1t h2t h2t h2t h3t h2t h4t 7 (10.29)
6
6 3 h3t h0 h3t h0 h3t h0 h3t h0 7
6 7
4 1t 2t 3t 4t 5
4 h4t h1t h4t h2t h4t h3t h4t h04t
0 0 0
10.6.2 MC Covariance Structure
To generate data with correlated (in the cross-section) residuals, let the residual of indi-
vidual i (belonging to group j ) in period t be
"i t D ui t C vjt C w t ; (10.30)
302
where uit N.0; u2 ), vjt N.0; v2 ) and w t N.0; w2 )and the three components
are uncorrelated. This implies that
Var."i t / D u2 C v2 C w2 ;

" #
v2 C w2 if individuals i and k belong to the same group
Cov."i t ; "k t / D
w2 otherwise.
(10.31)
Clearly, when w2 D 0 then the correlation across groups is zero, but there may be corre-
lation within a group. If both v2 D 0 and w2 D 0, then there is no correlation at all across
individuals. For CalTime portfolios (one per activity group), we expect the ui t to average
out, so a group portfolio has the variance v2 C w2 and the covariance of two different
group portfolios is w2 .
The Monte Carlo simulations consider different values of the variancesto illustrate
the effect of the correlation structure.
10.6.3 Results from the Monte Carlo Simulations
Table 10.1 reports the fraction of times the absolute value of a t-statistics for a true null
hypothesis is higher than 1.96. The table has three panels for different correlation patterns
the residuals ("i t ): no correlation between individuals, correlations only within the pre-
specified clusters and correlation across all individuals.
In the upper panel, where the residuals are iid, all three methods have rejection rates
around 5% (the nominal size).
In the middle panel, the residuals are correlated within each of the five clusters, but
there is no correlation between individuals that belong to the different clusters. In this
case, but the DK and the cluster method have the right rejection rates, while Whites
method gives much too high rejection rates (around 85%). The reason is that Whites
method disregards correlation between individualsand in this way underestimates the
uncertainty about the point estimates. It is also worth noticing that the good performance
of the cluster method depends on pre-specifying the correct clustering. Further simula-
tions (not tabulated) show that with a completely random cluster specification (unknown
to the econometrician), gives almost the same results as Whites method.
The lower panel has no cluster correlations, but all individuals are now equally cor-
related (similar to a fixed time effect). For the intercept () and the slope coefficient on
the common factor (), the DK method still performs well, while the cluster and Whites
303
Driscoll-
White Cluster Kraay
A. No cross-sectional correlation
0:049 0:049 0:050

0:044 0:045 0:045
0:050 0:051 0:050
B. Within-cluster correlations
0:853 0:053 0:054

0:850 0:047 0:048
0:859 0:049 0:050
C. Within- and between-cluster correlations
0:935 0:377 0:052

0:934 0:364 0:046
0:015 0:000 0:050
Table 10.1: Simulated size of different covariance estimators This table presents the
fraction of rejections of true null hypotheses for three different estimators of the co-
variance matrix: Whites (1980) method, a cluster method, and Driscoll and Kraays
(1998) method. The model of individual i in period t and who belongs to cluster j is
ri t D C f t C gi C "i t , where f t is a common regressor (iid normally distributed)
and gi is the demeaned number of the cluster that the individual belongs to. The sim-
ulations use 3000 repetitions of samples with t D 1; : : : ; 2000 and i D 1; : : : ; 1665.
Each individual belongs to one of five different clusters. The error term is constructed as
"i t D ui t C vjt C w t , where ui t is an individual (iid) shock, vjt is a shock common to
all individuals who belong to cluster j , and w t is a shock common to all individuals. All
shocks are normally distributed. In Panel A the variances of .ui t ; vjt ; w t / are (1,0,0), so
the shocks are iid; in Panel B the variances are (0.67,0.33,0), so there is a 33% correlation
within a cluster but no correlation between different clusters; in Panel C the variances are
(0.67,0,0.33), so there is no cluster-specific shock and all shocks are equally correlated,
effectively having a 33% correlation within a cluster and between clusters.
methods give too many rejects: the latter two methods underestimate the uncertainty since
some correlations across individuals are disregarded. Things are more complicated for the
slope coefficient of the cluster number (). Once again, DK performs well, but both the
304
cluster and Whites methods lead to too few rejections. The reason is the interaction of
the common component in the residual with the cross-sectional dispersion of the group
number (gi ).
To understand this last result, consider a stylised case where yi t D gi C "i t where
D 0 and "i t D w t so all residuals are due to an (excluded) time fixed effect. In this
case, the matrix above becomes
2 3
i 1 2 3 4
6 1 w t2 w t2 w t2 w t2 7
6 7
6 7
6 2 wt 2
wt 2
wt 2 2 7
wt 7 (10.32)
6
6 7
6 3 2 2 2 2
4 wt wt wt wt 7 5
2 2 2 2
4 wt wt wt wt
(This follows from gi D . 1; 1; 1; 1/ and since hi t D gi w t we get .h1t ; h2t ; h3t ; h4t / D
. w t ; w t ; w t ; w t /.) Both Whites and the cluster method sum up only positive cells, so
S is a strictly positive number. (For this the cluster method, this result relies on the as-
sumption that the clusters used in estimating S correspond to the values of the regressor,
gi .) However, that is wrong since it is straightforward to demonstrate that the estimated
coefficient in any sample must be zero. This is seen by noticing that N i D1 hi t D 0 at
P
a zero slope coefficient holds for all t, so there is in fact no uncertainty about the slope
coefficient. In contrast, the DK method adds the off-diagonal elements which are all equal
to w t2 , giving the correct result S D 0.
10.7 An Empirical Illustration
See 10.2 for results on a ten-year panel of some 60,000 Swedish pension savers (Dahlquist,
Martinez and Sderlind, 2011).
Bibliography
Driscoll, J., and A. Kraay, 1998, Consistent Covariance Matrix Estimation with Spatially
Dependent Panel Data, Review of Economics and Statistics, 80, 549560.
Hoechle, D., 2007, Robust Standard Errors for Panel Regressions with Cross-Sectional
Dependence, The Stata Journal, 7, 281312.
305
Alpha (% per year) AlphaIndividual 201206 All0 Model5
10
Default 0 1 25 620 2150 51
2.2
1
25
2
620
2150
1.8 51
1.6
1.4
1.2
0.8
2002 2004 2006 2008 2010
Hoechle, D., M. M. Schmid, and H. Zimmermann, 2009, A Generalization of the Cal-

endar Time Portfolio Approach and the Performance of Private Investors, Working
paper, University of Basel.
306
Table 10.2: Investor activity, performance, and characteristics
I II III IV
Constant 0.828 1.384 0.651 1.274

(2.841) (3.284) (2.819) (3.253)
Default fund 0.406 0.387 0.230 0.217
(1.347) (1.348) (1.316) (1.320)
1 change 0.117 0.125
(0.463) (0.468)
2 5 changes 0.962 0.965
(0.934) (0.934)
620 changes 2.678 2.665
(1.621) (1.623)
2150 changes 4.265 4.215
(2.074) (2.078)
51 changes 7.114 7.124
(2.529) (2.535)
Number of changes 0.113 0.112
(0.048) (0.048)
Age 0.008 0.008
(0.011) (0.011)
Gender 0.306 0.308
(0.101) (0.101)
Income 0.007 0.009
(0.033) (0.036)
R-squared (in %) 55.0 55.1 55.0 55.1
The table presents the results of pooled regressions of an individuals daily excess return on
return factors, and measures of individuals fund changes and other characteristics. The return
factors are the excess returns of the Swedish stock market, the Swedish bond market, and
the world stock market, and they are allowed to across the individuals characteristics. For
brevity, the coefficients on these return factors are not presented in the table. The measure of
fund changes is either a dummy variable for an activity category or a variable counting the
number of fund changes. Other characteristics are the individuals age in 2000, gender, or
pension rights in 2000, which is a proxy for income. The constant term and coefficients on the
dummy variables are expressed in % per year. The income variable is scaled down by 1,000.
Standard errors, robust to conditional heteroscedasticity and spatial cross-sectional correlations
as in Driscoll and Kraay (1998), are reported in parentheses. The sample consists of 62,640
individuals followed daily over the 2000 to 2010 period.
307
11 Expectations Hypothesis of Interest Rates
11.1 Term (Risk) Premia
Remark 11.1 (Prices and yields on zero-coupon bonds ) Consider an m-period zero
coupon bond. Its price B.m/ and continuously compounded interest rate y.m/ are re-
lated according to
B .m/ D exp my .m/ :
Similarly, the continuously compounded forward rate for an m-period investment that
starts in k periods ahead is
1 B.k/ .k C m/y.k C m/ ky.k/

f .k; k C m/ D ln D :
m B.k C m/ m
Term risk premia can be defined in several ways. All these premia are zero (or at least
constant) under the expectations hypothesis (EH).
The (realized) yield term premium is defined as the difference between a long (n-
period) interest rate and the average future short (m-period) rates over the same period
and EH says that is should be constant
1 Xk 1
' tyCn D ynt ym;tCsm , with k D n=m, and (11.1)
k sD0
E t ' tyCn D (a constant) under EH. (11.2)
Figure 11.1 illustrates the timing.
Example 11.2 (Yield term premium, rolling over 3-month rates for a year). Let y1y;t be
the current 1-year rate and y3M;t CsM the 3-month rate s months ahead
1
' tyC1y D y1y;t E t .y3M;t C y3M;t C3M C y3M;t C6M C y3M;t C9M / :
4
Let f t .k; kCm/ be the forward rate that applies for the future period t Ck to t CkCm.
The (realized) forward term premium is the difference between a forward rate for an m-
period investment (starting in k periods ahead) and the short interest rate for the same
308
hold m bond new m bond new m bond new m bond
now m 2m 3m 4m
hold n D 4m bond
Figure 11.1: Timing for yield term premium
period
' tfCkCm D f t .k; k C m/ E t ym;t Ck , and (11.3)

E t ' tfCkCm D under EH. (11.4)
Figure 11.2 illustrates the timing.
Example 11.3 (Forward term premium, 1-month investment starting 2 months from now)
Let f t .2M; 3M / be the 1-month forward rate starting 2 months ahead and let y1M;t C2M
be the one-month interest rate over the same period. Then,
' tfC3M D f t .2M; 3M / E t y1M;t C2M :
hold m bond
now m 2m 3m 4m
forward contract, f .2m; 2m C m/
Figure 11.2: Timing for forward term premium
Finally, the (realized) holding-period premium is the excess return of holding an n-

period bond between t and t Cm (buy it in t for Pnt and sell it in t Cm for Pn m;t Cm )in
excess of holding an m-period bond over the same period
1
' thCm D ln.Pn m;t Cm =Pnt / ymt , and (11.5)
m
E t ' thCm D under EH. (11.6)
309
his version is perhaps the most similar to the definition of risk premia of other assets (for
instance, equity). Figure 11.3 illustrates the timing.
Example 11.4 (Holding-period premium, holding a 10-year bond for one year).
' th .10y; 1y/ D E t ln.P9y;tC1 =P10y;t / y1y;t :

D 10y10y;t 9 E t y9y;tC1

y1y;t :
The second line just rewrites the bond prices in terms of the interest rates.
hold m bond
now m 2m 3m
hold n D 3m bond from now to m
Figure 11.3: Timing for holding-period premium
Notice that these risk premia are all expressed relative to a short(er) ratethey are
term premia. Nothing rules out the possibility that the short rate(-er) also includes risk
premia. For instance, a short nominal interest rate is likely to include an inflation risk
premium since inflation over the next period is risky. However, this is not the focus here.
11.2 Testing the Expectations Hypothesis of Interest Rates
11.2.1 Basic Tests
The expectations hypothesis (see (11.2), (11.4) and (11.6)) says that the expected term
premia should be constant. This implies that the realized term premia should be un-
predictable by any information today (denoted x t below). That is, the slopes (b) in the
following regression should be zero
' t Cs D a C b 0 x t C u tCs ; (11.7)
where ' t Cs denotes any of the realized term premia in (11.1), (11.3) or (11.5). The
intercepts in this regression picks out a constant term premia. A non-zero slope would
310
indicate that the changes of the term premia are predictablewhich is at odds with the
expectations hypothesis.
11.2.2 The Role of Rational Expectations in the Basic Test
Notice that we use realized (instead of expected) values on the left hand side of the re-
gression (11.7). This is validunder the assumption that expectations can be well ap-
proximated by the properties of the sample data, that is, rational expectations.
To see that, notice that we really would like to estimate a regression model where the
expected term premium is the dependent variable
E t ' t Cs D a0 C b00 x t C t Cs ; (11.8)
since this would tell us if market participants price risk when valuing bonds. Such a test
could be performed if we have (good) data for surveys (see Froot (1989) for an example).
However, most tests are done using realized (also called ex post) premia as in (11.7).
Let " t Cs be the prediction error, that is, let it be defined by
' t Cs D E t ' t Cs C " t Cs : (11.9)
We can then rewrite the regression model (11.7) as
E t ' t Cs C " t Cs D a C b 0 x t C u t Cs : (11.10)
If the prediction errors come from a rational prediction model, then they cannot be corre-
lated to x t , assuming x t was known in t. (The prediction errors from a rational model can-
not be predictablesince that would mean that the predictions are systematically wrong.)
In this case, the estimated b captures only how x t is correlated with E t ' tCs (which is
what we want).
In contrast, if E t ' t Cs is a non-rational prediction model, then it is possible that the
estimated b has nothing to do with E t ' t Cs , but that it captures how the prediction errors
can be explained by x t . By assuming rational expectations, we rule out this possibility.
11.2.3 A Single Factor for All Maturities?
Reference: Cochrane and Piazzesi (2005)

Cochrane and Piazzesi (2005) regress excess holding period return on forward rates,
that is, x t in (11.7) contains only forward rates. They observe that the slope coefficients
311
are very similar across different maturities of the bonds held. It seems as if the coefficients
(b) for one maturity are the same as the coefficients for another maturityapart from a
common scaling factor. This means that if we construct a forecasting factor
ff t D b 0 x t (11.11)
for one maturity (2-year bond, say), then the regressions

1
ln.Pn m;t Cm =Pnt / ymt D an C bn ff t (11.12)
m
should work almost as well as using the full vector x t .
Figure 11.4 and Tables 11.111.2 illustrate some results.
Slope coeffients
10
Each line shows the regression of one excess
holding period return on several forward rates
5 US monthly data 1964:12014:3
2
3
10 4
5
1 1.5 2 2.5 3 3.5 4 4.5 5
Regressors: forward rates (years)
Figure 11.4: A single forecasting factor for bond excess hold period returns
11.2.4 Spread-Based Tests
Many classical tests of the expectations hypothesis have only used interest rate spreads as
predictors (x t include only interest rates). Using spreads is a way to overcome issues with
the long swings (being close to non-stationary) in interest rates. This is best illustrated by
the yield term premium.
312
2y 3y 4y 5y
factor 1:00 1:87 2:69 3:47
.6:59/ .6:77/ .6:97/ .7:17/
constant 0:00 0:00 0:00 0:00
.0:00/ . 0:44/ . 0:83/ . 1:21/
R2 0:14 0:15 0:16 0:17
obs 591:00 591:00 591:00 591:00
Numbers in parentheses are t-stats. U.S. data for 1964:12014:3.
2y 3y 4y 5y
factor 1:00 1:87 2:69 3:47
.3:83/ .4:00/ .4:16/ .4:32/
constant 0:00 0:00 0:00 0:00
.0:00/ . 0:21/ . 0:39/ . 0:56/
R2 0:14 0:15 0:16 0:17
obs 591:00 591:00 591:00 591:00
U.S. data for 1964:12014:3. Numbers in parentheses are t-stats. Bootstrapped standard
errors, with blocks of 10 observations.
First, add and subtract ymt (the current short m-period rate) from the yield term pre-
mium (11.1)
1 Xk 1
' tyCn D ynt ym;t Csm C ymt ymt
k sD0
1 Xk 1
D .ynt ymt / .ym;t Csm ymt /: (11.13)
k sD0
If ' tyCn is constant across time, then the first and second term in (11.13) must move equally
muchwhich means that D 1 in a regression like
1 Xk 1
.ym;t Csm ymt / D C .ynt ymt / C " t Cn : (11.14)
k sD0
(A constant risk premium could be captured by 0.) This regression tests if the
current long-short spread is an unbiased predictor of the future changes in the short rate.
313
See Figure 11.5 for an empirical example.
Example 11.5 (Yield term premium, rolling over 3-month rates for a year)
1
.y3M;t y3M;t / C .y3M;t C3m y3M;t / C .y3M;t C6M y3M;t / C .y3M;t C9M y3M;t /
4
regressed on y1y;t y3M;t .
Intercept with 90% conf band Slope with 90% conf band
1.4
0.005 1.2
0.01 1
0.8
0.015
0.6
0.02 0.4
0.025 0.2
0 5 10 0 5 10
maturity (years) maturity (years)
Regression of average future changes in 3m rate
on constant and current term spread (long - 3m)
US monthly data 1970:12014:3
Figure 11.5: Testing the expectations hypothesis on US interest rates
Similarly, adding and subtracting ymt to (11.3) and rearranging gives that EH requires
D 1 in
ym;t Ck ymt D C f t .k; k C m/ ymt C " t CkCm : (11.15)
This regression tests if the forward-spot spread is an unbiased predictor of the change of
the spot rate.
Finally, rearrange (11.5), add and subtract mynt and rewrite it in terms of interest rates
show the EH requires D 1 in
m
yn m;t Cm ynt D C .ynt ymt / C " t Cn : (11.16)
n m
If the holding period (m) is short compared to the maturity (n), then this regression (al-
most) tests if the current spread, scaled by m=.n m/, is an unbiased predictor of the
change in the long rate.
314
11.3 The Properties of Spread-Based EH Tests
Reference: Froot (1989)

The spread-based EH tests ((11.14), (11.15) and (11.16)), can be written
i t C1 D C s t C " t C1 , where (11.17)

s t D Em
t i t C1 C ' t ; (11.18)
where Em t i t C1 is the markets expectations of the interest rate change and ' t is the
risk premium. In this expression, i t C1 is short hand notation for the dependent variable
(which in all three cases is a change of an interest rate) and s t denotes the regressor (which
in all three cases is a term spread).
The regression coefficient in (11.17) is
. C /
D1 C ; where (11.19)
1 C 2 C 2
Std .'/
D , D Corr E m
, and

t i t C1 ; '
Std Em

t i t C1
Cov E t Em t i t C1 ; E t i t C1 C '
m

D ;
Var Em t i t C1 C '

The second term in (11.19) captures the effect of the (time varying) risk premium and
the third term ( ) captures any systematic expectations errors ( E t Em t i tC1 ).

Figure 11.6 shows how the expectations corrected regression coefficient ( ) de-
pends on the relative volatility of the term premium and expected interest change ( ) and
their correlation (). A regression coefficient of unity could be due to either a constant
term premium ( D 0), or to a particular combination of relative volatility and correlation
( D ), which makes the forward spread an unbiased predictor.
When the correlation is zero, the regression coefficient decreases monotonically with
, since an increasing fraction of the movements in the forward rate are then due to the
risk premium. A coefficient below a half is only possible when the term premium is more
volatile than the expected interest rate change ( > 1), and a coefficient below zero also
requires a negative correlation ( < 0).
U.S. data often show values between zero and one for very short maturities, around
zero for maturities between 3 to 9 months, and often relatively close to one for longer
maturities. Also, tends to increase with the forecasting horizon (keeping the maturity
constant), at least for horizons over a year.
315
Expectations corrected regression coefficient,
1.5
= 0.75
=0
= 0.75
1
0.5
0.5
0 0.5 1 1.5 2 2.5 3

Figure 11.6: Regression coefficient in EH test
The specification of the regression equation also matters, especially for long matu-
rities: is typically negative if the left hand side is the change in long rates, but much
closer to one if it is an average of future short rates. The estimates are typically much
closer to one if the regression is expressed in levels rather than differences. Even if this is
disregarded, the point estimates for long maturities differ a lot between studies. Clearly,
if is strongly negative, then even small changes in around one can lead large changes
in the estimated .
Froot (1989) uses a long sample of survey data on interest rate expectations. The re-
sults indicate that risk premia are important for the 3-month and 12-month maturities, but
not for really long maturities. On the other hand, there seems to be significant systematic
expectations errors ( < 0) for the long maturities which explain the negative estimates
in ex post data. We cannot, of course, tell whether these expectation errors are due to a
small sample (for instance, a peso problem) or to truly irrational expectations.
Proof. (of (11.19)) Define
i t C1 D E t i t C1 C u tC1
E t i t C1 D Em
t i t C1 C t C1 :
316
The regression coefficient is
Cov.s t ; i t C1 /
D
Var.s t /
Cov.Em t i t C1 C ' t ; E t i tC1 C t C1 C u t C1 /
m
D
Var.Em
t i tC1 C ' t /
Var.E t i t C1 /
m
Cov.' t ; Em
t i t C1 / Cov.Em
t i t C1 C ' t ; t C1 /
D C C
Var.E t i tC1 C ' t / Var.E t i t C1 C ' t /
m m
Var.Em
t i t C1 C ' t /
The third term is . Write the first two terms as
mm C m' mm C ' ' C 2m'

mm C m'
D1C
mm C ' ' C 2m' mm C ' ' C 2m'
m ' C '2
D1
m2 C '2 C 2m '
m ' C '2 =m2

D1
m2 C '2 C 2m ' =m2

. C /
D1
1 C 2 C 2
where the second line multiplies by m2 =m2 and the third line uses the definition D
' =m .
Bibliography
Cochrane, J. H., and M. Piazzesi, 2005, Bond risk premia, American Economic Review,
95, 138160.
Froot, K. A., 1989, New Hope for the Expectations Hypothesis of the Term Structure of
Interest Rates, The Journal of Finance, 44, 283304.
317
11 Yield Curve Models: MLE and GMM
Reference: Cochrane (2005) 19; Campbell, Lo, and MacKinlay (1997) 11, Backus, Foresi,
and Telmer (1998); Singleton (2006) 1213
11.1 Overview
On average, yield curves tend to be upward sloping (see Figure 11.2), but there is also
considerable time variation on both the level and shape of the yield curves.
US interest rates, 3m to 10 years
20
15
10
10
5 8
6
0
4
1970 1975 maturity
1980 1985 2
1990 1995 2000 2005 0
2010
Figure 11.1: US yield curves
It is common to describe the movements in terms of three factors: level, slope, and
318
Average yields
7.2
Sample: 1970:12014:3
7
6.8
6.6
yield
6.4
6.2
5.8
5.6
0 1 2 3 4 5 6 7 8 9 10
Maturity (years)
Figure 11.2: Average US yield curve
curvature. One way of measuring these factors is by defining
Level t D y10y
Slope t D y10y y3m
Curvature t D .y2y y3m / .y10y y2y /: (11.1)
This means that we measure the level by a long rate, the slope by the difference be-
tween a long and a short rateand the curvature (or rather, concavity) by how much the
medium/short spread exceeds the long/medium spread. For instance, if the yield curve
is hump shaped (so y2y is higher than both y3m and y10y ), then the curvature measure is
positive. In contrast, when the yield curve is U-shaped (so y2y is lower than both y3m and
y10y ), then the curvature measure is negative. See Figure 11.3 for an example.
An alternative is to use principal component analysis. See Figure 11.4 for an example.
Remark 11.1 (Principal component analysis) The first (sample) principal component of
the zero (possibly demeaned) mean N 1 vector z t is w10 z t where w1 is the eigenvec-
tor associated with the largest eigenvalue of D Cov.z t /. This value of w1 solves the
319
problem maxw w 0 w subject to the normalization w 0 w D 1. This eigenvalue equals
1 D Var.w10 z t / D w10 w1 . The j th principal component solves the same problem, but
under the additional restriction that wi0 wj D 0 for all i < j . The solution is the eigenvec-
tor associated with the j th largest eigenvalue (which equals j D Var.wj0 z t / D wj0 wj ).
If the rank of is K, then only K eigenvalues are non-zero. From the properties of eigen-
vectors, it can be shown that D N i wi wi0 . Taking the trace (summing the diagonal
P
PN PNi D1
elements) gives i D1 Var.zi t / D i D1 i . (This follows from that the sum of the diago-
0
nal elements of N
P PN PN 2
i D1 i wi wi equals i D1 i . j D1 wj i / and that the inner sum is 1.) To-
gether this means: (a): principal components are uncorrelated; (b) an eigenvalue equals
the variance of the corresponding principal component (the first being most volatile etc);
(c) the sum of the eigenvalues equals the total variance of the data ( N i D1 Var.zi t /). Divid-
P
ing an eigenvalue with the sum of eigenvalues gives a measure of the relative importance
of that principal component (in terms of variance).
Remark 11.2 (Principal component analysis 3) Let W be N xN matrix with wi as col-

umn i. We can then calculate the N x1 vector of principal components as pc t D W 0 z t .
Since W 1 D W 0 (the eigenvectors are orthogonal), we can invert as z t D Wpc t . The
wi vector (column i of W ) therefore shows how the different elements in z t change as the
i th principal component changes.
Example 11.3 (PCA with 2 series) Let wi.j / be the t th element in the ith eigenvector.
With two series we have
" #0 " # " #0 " #
w1.1/ z1t w2.1/ z1t
pc1t D .2/ and pc2t D .2/ or
w1 z2t w2 z2t
" # " #0 " #
pc1t w1.1/ w2.1/ z1t
D .2/ .2/ and
pc2t w1 w2 z2t
" # " #" #
z1t w1.1/ w2.1/ pc1t
D
z2t w1.2/ w2.2/ pc2t
For instance, for the two elements in the second eigenvector, w2.1/ shows how pc2t affects
z1t , while w2.2/ shows how the same pc2t affects z2t .
Interest rates are strongly related to business cycle conditions, so it often makes sense
to include macro economic data in the modelling. See Figure 11.5 for how the term
spreads are related to recessions: term spreads typically increase towards the end of re-
cessions. The main reason is that long rates increase before short rates.
320
US interest rates, 3m to 10 years Level factor
20 15
long rate
15
10
10
5
5
0 0
1970 1980 1990 2000 2010 1970 1980 1990 2000 2010
Slope factor Curvature factor

long/short spread medium/short spread minus
5 5 long/medium spread
0 0
-5 -5
1970 1980 1990 2000 2010 1970 1980 1990 2000 2010
Figure 11.3: US yield curves: level, slope and curvature
11.1.1 The Diebold-Li Approach
Diebold and Li (2006) use the Nelson-Siegel model for an m-period interest rate as
1 exp . m=1 / 1 exp . m=1 /

m
y.m/ D 0 1 C 1 C 2 exp ; (11.2)
m=1 m=1 1
and set 1 D 1=.12 0:0609/. Their approach is as follows. For a given trading date,
construct the factors (the terms multiplying the beta coefficients) for each bond. Then,
run a regression of the cross-section of yields on these factorsto estimate the beta
coefficients. Repeat this for every trading dayand plot the three time series of the
coefficients (0 is the level factor, 1 the slope factor and 2 the curvature factor).
Remark 11.4 (Diebold and Li (2006) vs (11.1)) Use .T0 ; T1 ; T2 ) to label the terms in
321
US interest rates, 3m to 10 years US interest spreads
20 4
15 2
10 0
5 -2
0 -4
1970 1980 1990 2000 2010 1970 1980 1990 2000 2010
US interest rates, principal components US interest rates, eigenvectors

20 An eigenvector shows the effect of
0.5 its pc on different yields
10
0 1st (97.6) 0
-10 2nd (2.2)
3rd (0.1)
-20 -0.5
1970 1980 1990 2000 2010 3m 6m 1y 3y 5y 7y 10y
Maturity
Figure 11.4: US yield curves and principal components
(11.2). Observe that we have (approximately)

2 3
m T0 T1 T2
6 7
60 1 1 0 7
6 7
6 2 1 0:5 0:257
4 5
1 1 0 0
Therefore, y.0/ D 0 C 1 , y.2/ D 0 C 0:51 C 0:252 and y.1/ D 0 . Comparing

with (11.1) shows that the long rate corresponds to 0 , that the spred between a very
long and a very short rate corresponds to 1 and that y.2/ y.0/ y.1/ y.2/
corresponds to 0:52 .
See Figure 11.6 for an example. The results are very similar to the factors calculated
directly from yields (cf. Figure 11.3).
322
US interest spreads (and recessions)
4
-1 Spreads: long minus short interest rate (3m)
-2
1y - 3m
-3 3y - 3m
10y - 3m
-4
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Figure 11.5: US term spreads (over a 3m T-bill)
11.2 Risk Premia on Fixed Income Markets
There are many different types of risk premia on fixed income markets.
Nominal bonds are risky in real terms, and are therefore likely to carry inflation risk
premia. Long bonds are risky because their market values fluctuate over time, so they
probably have term premia. Corporate bonds and some government bonds (in particular,
from developing countries) have default risk premia, depending on the risk for default.
Interbank rates may be higher than T-bill of the same maturity for the same reason (see
the TED spread, the spread between 3-month Libor and T-bill rates) and illiquid bonds
may carry liquidity premia (see the spread between off-the run and on-the-run bonds).
Figures 11.711.10 provide some examples.
323
US interest rates, Diebold-Li factors Level coefficient
1 15
level
slope 10
curvature
0.5
5
0 0
0 2 4 6 8 10 1970 1980 1990 2000 2010
Maturity (in years)
(negative of) Slope coefficient (0.5) Curvature coefficient
5 5
0 0
-5 -5
1970 1980 1990 2000 2010 1970 1980 1990 2000 2010
Figure 11.6: US yield curves: level, slope and curvature, Diebold-Li approach
Long-term interest rates

15 Baa (corporate)
Aaa (corporate)
10-y Treasury
10
%
0
1970 1975 1980 1985 1990 1995 2000 2005 2010
Figure 11.7: US interest rates
324
TED spread
4 3-month LIBOR minus T-bill
3
%
0
1990 1995 2000 2005 2010
Figure 11.8: TED spread
TED spread (shorter sample)
4 3-month LIBOR minus T-bill
3
%
0
2007 2008 2009 2010 2011 2012 2013 2014
Figure 11.9: TED spread recently
11.3 Summary of the Solutions of Some Affine Yield Curve Models
An affine yield curve model implies that the yield on an n-period discount bond can be
written
ynt D an C bn0 x t , where (11.3)

an D An =n and bn D Bn =n;
325
off/on-the-run spread
0.8 Spread between off-the-run and

on-the-run 10y Treasury bonds
0.6
%
0.4
0.2
1998 2000 2002 2004 2006 2008 2010 2012 2014
Figure 11.10: Off-the-run liquidity premium
where x t is an K 1 vector of state variables. The An (a scalar) and the Bn (a K 1

vector) are functions of the model parametersdiscussed below.
The price of an n-period bond equals the cross-moment between the pricing kernel
(M t C1 ) and the value of the same bond next period (then an n 1-period bond)
Pnt D E t M tC1 Pn 1;tC1 : (11.4)
The Vasicek model assumes that the log SDF (m t C1 ) is an affine function of a single
AR(1) state variable
m tC1 D x t C " t C1 , where " t C1 is iid N.0; 1/ and (11.5)

x t C1 D .1 / C x t C " t C1 : (11.6)
To extend to a multifactor model, specify
m t C1 D 10 x t C 0 S" t C1 , where " t C1 is iid N.0; I / and (11.7)

x t C1 D .I / C x t C S" t C1 ; (11.8)
where S and are matrices while and are (column) vectors; and 1 is a vector of ones.
Example 11.5 (Two-factor Vasicek model, independent factors) A multivariate Vasicek
326
Intercept (scaled by 1200), Vasicek Slope coefficient, Vasicek
1
6
4
0.5
2
0
0
60 120 60 120
Months to maturity Months to maturity
Coefficients of yn = an + bn x
1200 1200
0.9 -100 6 0.5 (monthly)
Figure 11.11: an and bn in the Vasicek model
model with two independent factors is

" # " #" #
h i x h i S 0 "1;t C1
1t 1
m t C1 D 1 1 C 1 2 , and
x2t 0 S2 "2;t C1
" # " #" # " #" # " #" #
x1;t C1 1 1 0 1 1 0 x1t S1 0 "1;t C1
D C C :
x2;t C1 0 1 2 2 0 2 x2t 0 S2 "2;t C1
For the single-factor Vasicek model the coefficients in (11.3) can be shown to be
Bn D 1 C Bn 1 and (11.9)
An D An 1 C Bn 1 .1 / . C Bn 1 /2 2 =2; (11.10)
where the recursion starts at B0 D 0 and A0 D 0. See Figure 11.11 for an illustration.
Example 11.6 (An and Bn in the Vasicek model) (11.9(11.10) give
B0 D 0 and A0 D 0
B1 D 1 and A1 D 2 2 =2
C .1 C /2 2 =2:
2
B2 D 1 C and A2 D .1

/
If < 1, then long rates are less sensitive to x t than short rates are.
327
Yields, Vasicek Yields, CIR
8 1200 1200
8
is replaced by /

0.9 -100 6 0.5 (monthly)
annualized, %
annualized, %
6 6
4 4
1200xt = (4, 6, 8)%

2 2
60 120 60 120
Forward term premia, Vasicek Forward term premia, CIR

0.2 0.2
annualized, %
0.15 annualized, % 0.15
0.1 0.1
0.05 0.05
0 0
60 120 60 120
Figure 11.12: Yield curves and risk premia in the Vasicek and CIR models
The Vasicek model has constant risk premia. In contrast, the Cox-Ingersoll-Ross
model, which modifies the Vasicek model by letting the variance of the shock (") be
proportional to the state variable (x), has higher risk premia when the general interest rate
level is high (and this the volatility). See Figure 11.12 for an illustration.
The interest rates on long bonds are mostly driven by the expectation of future short
rates. In addition, the uncertainty/persistence/price of risk all affect the risk premia. See
Figures 11.1311.14 for an illustration.
For the multivariate Vasicek model we have the solution
Bn D 1 C 0 Bn 1 , and (11.11)
An D An C Bn0 0 C Bn0 SS 0 . C Bn 1 / =2; (11.12)

1 1 .I / 1
where the recursion starts at B0 D 0 and A0 D 0. Clearly, An is a scalar and Bn is a K 1

vector.
328
Expected future short rate, Vasicek
8
1200 1200
annualized, % 7 0.9 -100 6 0.5 (monthly)
3
1200xt = (4, 6, 8)%
2
60 120
Forecasting horizon
Figure 11.13: Expected future short rate in the Vasicek model
Forward term premia, Vasicek
0.2
(monthly)
0.15
annualized, %
Baseline: 1200 1200

0.9 -100 6 0.5
0.1
Baseline
0.05 0.75
0.95
0.85
0
60 120
Months to maturity
Figure 11.14: Risk premia in the Vasicek model
Figure 11.15 illustrates the an and bn coefficients in a 2-factor Vasicek model. Figure
11.16 shows that the 2-factor model is capable of generating many more shapes of the
yield curve than a 1-factor model is.
A model with affine market price of risk defines the log SDF in terms of the short rate
329
Intercept (scaled by 1200), two-factor Vasicek Slope coefficients, two-factor Vasicek
1
6
4 Factor 1
0.5 Factor 2
2
0
0
60 120 60 120
Coefficients of yn = an + bn1 x1 + bn2 x2

1 2 i
0.99 0.50 -100 (monthly)
12001 12002 1200i
0 6 0.35
Figure 11.15: an and bn in a two-factor Vasicek model
(y1t ) and an innovation to the SDF ( t C1 ) as
y1t D a1 C b10 x t ;
m t C1 D y1t t C1 ;
t C1 D t0 t =2 t0 " t C1 , with " tC1 N.0; I /: (11.13)
The K 1 vector of market prices of risk ( t ) is affine in the state vector
t D 0 C 1xt ; (11.14)
where 0 is a K 1 vector of parameters and 1 is K K matrix of parameters. Finally,

the state vector dynamics is the same as in the multivariate Vasicek model (11.8).
330
Yields, two-factor Vasicek, low x2 Yields, two-factor Vasicek, medium x2
8 8
annualized, %
annualized, %
6 6
4 4
2 2
x1 1200 = (2, 0, 2)%
0 0
60 120 60 120
Spot rates, %
Two independent AR(1) factors
Yields, two-factor Vasicek, high x2
8 1 2 i
0.99 0.50 -100 (monthly)
annualized, %
6 12001 12002 1200i

0 6 0.35
4
0
60 120
Months to maturity
Figure 11.16: Yield curves in a two-factor model, the SDF is a sum of two AR(1)
Example 11.7 (Two factor model) With K D 2, (11.13)(11.14) are

" #0 " #
b1;1 x1t
y1t D a1 C ;
b1;2 x2t
" #0 " # " #0 " #
1t 1t 1t "1tC1
t C1 D =2
2t 2t 2t "2tC1
" # " # " #" #
1t 0 1 12 1
x1t
D 10 C 11 1 1
2t 2 21 22 x2t
For this model, the coefficients are
Bn0 D Bn0 S 1 C b10 (11.15)

1
An D An 1 C Bn0 1 .I / 0
Bn0 1 SS 0 Bn 1 =2 C a1 ; (11.16)

S
where the recursion starts at B0 D 0 and A0 D 0 (or B1 D b1 and A1 D a1 ).
331
Forward term premia, Vasicek Forward term premia, CIR
0.2 0.2
annualized, %
annualized, %
0.15 0.15
0.1 0.1
0.05 0.05
0 0
60 120 60 120
Parameters for the model with

Forward term premia, affine price of risk affine price of risk:
0.2 12000 1
annualized, %
-0.5 -7.3
0.15
(the other parameters are as
in the Vasicek model)
0.1
0.05
0
60 120
Months to maturity
Figure 11.17: Yield curves and risk premia in different models. Same parameters as in
Figure 11.12.
Example 11.8 (An and Bn in the model with affine market price of risk) In the univariate
case we have
B0 D 0 and A0 D 0;
B1 D b1 and A1 D a1
B2 D b1 1 C 1 and A2 D b1 .1 0 b12 2 =2 C 2a1 :

/
If 1 D 0 (so the price of risk is constant), then we have b1 .1 C / which is similar to the
Vasicek model. Indeed, with the (free) choices 0 D , b1 D 1 and a1 D 2 2 =2 we
get exactly the same expressions as in the Vasicek model (see Example 11.6).
Figure 11.17 illustrates the risk premia in three different 1-factor models.
332
Proof. (of (11.9)(11.10)) First, use the dynamics to write
m t C1 C pn 1;t C1 D xt " A B x
t C1
n 1
n 1 t C1

m t C1 pn 1tC1
D .1 C Bn 1 / x t . C Bn 1 / " t C1 An 1 Bn 1 .1 / ;
where the second line follows from using the time series process of x t (see (11.6)). (We
clearly dont need to transpose Bn 1 since it is a scalar.) The conditional moments are
E t .m t C1 C pn 1;t C1 / D .1 C Bn 1 / x t An 1 Bn 1 .1 /
Var t .m t C1 C pn 1;t C1 / D . C Bn 1 /2 2 :
Second, use in
pnt D E t .m tC1 C pn 1;t C1 / C Var t .m t C1 C pn 1;t C1 / =2;
to get
An Bn x t D .1 C Bn 1 / x t An 1 Bn 1 .1 / C . C Bn 1 /2 2 =2
This equation must always hold (for any x t ), so matching coefficients gives (11.9)
(11.10).
Proof. (of (11.15)(11.16)) First,
m t C1 C pn 1;tC1 D y1t t0 t =2 t0 " t C1 An 1 Bn0 1 x t C1
The conditional moments are
E t m t C1 C pn 1;tC1 D t0 t =2 An 1 Bn0 1 .I
y1t / Bn0 1 x t
0
Var t m t C1 C pn 1;tC1 D t0 C Bn0 1 S t0 C Bn0 1 S

D t0 C Bn0 1 S t C S 0 Bn 1

D t0 t C t0 S 0 Bn 1 C Bn0 1 S t C Bn0 1 SS 0 Bn 1
333
Second,
Bn0 x t D y1t t0 t =2 An 1 Bn0 1 .I / Bn0 1 x t C

An
0
t t C t0 S 0 Bn 1 C Bn0 1 S t C Bn0 1 SS 0 Bn 1 =2

D a1 b10 x t An 1 Bn0 1 .I / Bn0 1 x t C

Bn0 1 S 0 C 1 x t C Bn0 1 SS 0 Bn 1 =2

D a1 An 1 C Bn0 1 S 0 .I / C Bn0 1 SS 0 Bn 1 =2

b10 x t Bn0 1 x t C Bn0 1 S 1 x t
This equation must always hold (for any x t ), so matching coefficients gives (11.15)
(11.16).
11.4 MLE of Affine Yield Curve Models
The maximum likelihood approach typically backs out the unobservable factors from
the yieldsby either assuming that some of the yields are observed without any errors or
by applying a filtering approach.
11.4.1 Backing out Factors from Yields without Errors
We assume that K yields (as many as there are factors) are observed without any errors
these can be used in place of the state vector. Put the perfectly observed yields in the
vector yot and stack the factor model for these yieldsand do the same for the J yields
(times maturity) with errors (unobserved), yut ,
yot D ao C bo0 x t so x t D bo0 1 .yot ao / ; and (11.17)

yut D au C bu0 x t C t (11.18)
where t are the measurement errors. The vector ao and matrix bo stack the an and bn for
the perfectly observed yields; au and bu for the yields that are observed with measurement
errors (u of unobserved, although that is something of a misnomer). Clearly, the a
vectors and b matrices depend on the parameters of the model, and need to be calculated
(recursively) for the maturities included in the estimation.
The measurement errors are not easy to interpret: they may include a bit of pure
measurement errors, but they are also likely to pick up model specification errors. It is
therefore difficult to know which distribution they have, and whether they are correlated
334
across maturities and time. The perhaps most common (ad hoc) approach is to assume that
the errors are iid normally distributed with a diagonal covariance matrix. To the extent
that is a false assumption, the MLE approach should perhaps be better thought of as a
quasi-MLE.
The estimation clearly relies on assuming rational expectations: the perceived dynam-
ics (which govern who the market values different bonds) is estimated from the actual
dynamics of the data. In a sense, the models themselves do not assume rational expec-
tations: we could equally well think of the state dynamics as reflecting what the market
participants believed in. However, in the econometrics we estimate this by using the actual
dynamics in the historical sample.
Remark 11.9 (Log likelihood based on normal distribution) The log pdf of an q1 vector
z t N. t ; t / is
q 1 1
ln pdf.z t / D ln.2/ ln j t j .z t t /0 t 1 .z t t /:
2 2 2
Example 11.10 (Backing out factors) Suppose there are two factor and that y1t and
y12t are assumed to be observed without errors and y6t with a measurement error, then
(11.17)(11.18) are
" # " # " #" #
y1t a1 b10 x1t
D C 0
y12t a12 b12 x2t

ao bo0
" # " #" #
a1 b1;1 b1;2 x1t
D C , and
a12 b12;1 b12;2 x2t
" #
x1t
y6t D a6 C b60 C 6t
x2t
au 0
bu
" #
h i x
1t
D a6 C b6;1 b6;2 C 6t :
x2t
Remark 11.11 (Discrete time models and how to quote interest rates) In a discrete time
model, it is often convenient to define the period length according to which maturities
we want to analyse. For instance, with data on 1-month, 3-month, and 4 year rates, it is
convenient to let the period length be one month. The (continuously compounded) interest
rate data are then scaled by 1/12.
335
Remark 11.12 (Data on coupon bonds) The estimation of yield curve models is typically
done on data for spot interest rates (yields on zero coupon bonds). The reason is that
coupon bond prices (and yield to maturities) are not exponentially affine in the state
vector. To see that, notice that a bond that pays coupons in period 1 and 2 has the price
P2c D cP1 C .1 C c/P2 D c exp. A1 B10 x t / C .1 C c/ exp. A2 B20 x t /. However, this
is not difficult to handle. For instance, the likelihood function could be expressed in terms
of the log bond prices divided by the maturity (a quick approximate yield), or perhaps
in terms of the yield to maturity.
Remark 11.13 (Filtering out the state vector) If we are unwilling to assume that we
have enough yields without observation errors, then the backing out approach does
not work. Instead, the estimation problem is embedded into a Kalman filter that treats the
states are unobservable. In this case, the state dynamics are combined with measurement
equations (expressing the yields as affine functions of the states plus errors). The Kalman
filter is a convenient way to construct the likelihood function (when errors are normally
distributed). See de Jong (2000) for an example.
Remark 11.14 (GMM estimation) Instead of using MLE, the model can also be estimated
by GMM. The moment conditions could be the unconditional volatilities, autocorrelations
and covariances of the yields. Alternatively, they could be conditional moments (condi-
tional on the current state vector), which are transformed into moment conditions by
multiplying by some instruments (for instance, the current state vector). See, for instance,
Chan, Karolyi, Longstaff, and Sanders (1992) for an early examplewhich is discussed
in Section 11.5.3.
11.4.2 Adding Explicit Factors
Assume that we have data on KF factors, F t . We then only have to assume that Ky D
K KF yields are observed without errors. Instead of (11.17) we then have
0
" # " # " #
yot ao b o i x so x D bQ 0 1 .yQ
D C h t t o ot aQ o / : (11.19)
Ft 0KF 1 0KF Ky IKF

yQot aQ 0 bQ0
Clearly, the last KF elements of x t are identical to F t .
Example 11.15 (Some explicit and some implicit factors) Suppose there are three factors
and that y1t and y12t are assumed to be observed without errors and F t is a (scalar)
336
explicit factor. Then (11.19) is
b10
2 3 2 3 2 32 3
y1t a1 x1t
7 6 7 6 0 76 7
4y12t 5 D 4a12 5 C 4 b12 5 4x2t 5
6
Ft 0 0; 0; 1 x3t
2 3 2 32 3
a1 b1;1 b1;2 b1;3 x1t
D 4a12 5 C 4b12;1 b12;2 b12;3 5 4x2t 5
6 7 6 76 7
0 0 0 1 x3t
Clearly, x3t D F t .
11.4.3 A Pure Time Series Approach
Reference: Chan, Karolyi, Longstaff, and Sanders (1992), Dahlquist (1996)

In a single-factor model, we could invert the relation between (say) a short interest
rate and the factor (assuming no measurement errors)and then estimate the model pa-
rameters from the time series of this yield. The data on the other maturities are then not
used. This can, in principle, also be used to estimate a multi-factor model, although it
may then be difficult to identify the parameters.
The approach is to maximize the likelihood function
XT
ln Lo D ln Lot , with ln Lot D ln pdf.yot jyo;t 1 /: (11.20)
t D1
Notice that the relation between x t and yot in (11.17) is continuous and invertible, so a
density function of x t immediately gives the density function of yot . In particular, with a
multivariate normal distribution x t jx t 1 N E t 1 x t ; Cov t 1 .x t / we have
2 3
yot jyo;t N 4ao C bo0 E t x t ; bo0 Cov t 1 .x t / bo 5 , with (11.21)

6 7
1 1

Et 1 yot Var t 1 .yot /
x t D bo0 1 .yot ao / :
To calculate this expression, we must use the relevant expressions for the conditional
mean and covariance.
337
Pricing errors, Vasicek (TS) Avg yield curve, Vasicek (TS)
0.04
1 year 0.07 at average xt
0.02 7 years data
0.065
0
0.06
-0.02 0.055
-0.04 0.05
1970 1980 1990 2000 2010 0 2 4 6 8 10
Maturity (years)
No errors (months): 3
With errors: none
Restricted parameters: and
1200 1200
-225 10 1.00 0.49
Figure 11.18: Estimation of Vasicek model, time-series approach
Example 11.16 (Time series estimation of the Vasicek model) In the Vasicek model,
m t C1 D x t C " t C1 , where " t C1 is iid N.0; 1/ and

x t C1 D .1 / C x t C " t C1
we have the 1-period interest rate
y1t D 2 2 =2 C x t :
The distribution of x t conditional on x t 1 is
x t jx t N .1 / C x t ; 2 :

1
Similarly, the distribution of y1t conditional on y1;t 1 is
y1t jy1;t N a1 C b1 .1 / C x t ; b1 2 b1 with

1
a1 D 2 2 =2; b1 D 1, E t 1 x t D .1 / C x t 1:
Inverting the short rate equation (compare with (11.17)) gives
x t D y1t C 2 2 =2:
338
Combining gives
y1t jy1;t N .1 2 2 =2/ C y1;t 2

1 /. 1; :
This can also be written as an AR(1)
y1t D .1 /. 2 2 =2/ C y1;t 1 C " t :
Clearly, we can estimate an intercept, , and 2 from this relation (with LS or ML), so it is
not possible to identify and separately. We can therefore set to an arbitrary value.
For instance, we can use to fit the average of a long interest rate. The other parameters
are estimated to fit the time series behaviour of the short rate only.
Remark 11.17 (Slope of yield curve when D 1) When D 1, then the slope of the
yield curve is
y1t D 3n C 2n2 =6 C .n 1/ 2 =2:

ynt 1
(To show this, notice that bn D 1 for all n when D 1.) As a starting point for calibrating
, we could therefore use
1 yNnt yN1t 1 3n C 2n2

guess D C ;
n 1 2 =2 6
where yNnt and yN1t are the sample means of a long and short rate.
Example 11.18 (Time series estimation of the CIR model) In the CIR model,
p
m t C1 D x t C x t " t C1 , where " t C1 is iid N.0; 1/ and
p
x tC1 D .1 / C x t C x t " t C1
we have the short rate

y1t D .1 2 2 =2/x t :
The conditional distribution is then
y1t jy1;t N .1 2 2 =2/.1 / C y1;t 2 2 =2/ 2 , that is,

1 1 ; y1;t 1 .1
p p
y1t D .1 2 2 =2/.1 / C y1;t 1 C y1;t 1 .1 2 2 =2/" tC1 ;
which is a heteroskedastic AR(1)where the variance of the residual is proportional to

p
y1;t 1 . Once again, not all parameters are identified, so a normalization is necessary,
339
for instance, pick to fit a long rate. In practice, it may be important to either restrict
the parameters so the implied x t is positive (so the variance is), or to replace x t by
max.x t ; 1e 7/ or so in the definition of the variance.
Example 11.19 (Empirical results from the Vasicek model, time series estimation) Figure
11.18 reports results from a time series estimation of the Vasicek model: only a (relatively)
short interest rate is used. The estimation uses monthly observations of monthly interest
rates (that is the usual interest rates/1200). The restriction D 200 is imposed (as is
not separately identified by the data), since this allows us to also fit the average 10-year
interest rate. The upward sloping (average) yield curve illustrates the kind of risk premia
that this model can generate.
Remark 11.20 (Likelihood function with explicit factors) In case we have some explicit
factors like in (11.19), then (11.17) must be modified as
h i
yQot jyQo;t 1 N aQ o C bQo0 E t 1 x t ; bQo0 Cov t 1 .x t / bQo , with x t D bQo0 1 .yQot aQ o / :
11.4.4 A Pure Cross-Sectional Approach
Reference: Brown and Schaefer (1994)

In this approach, we estimate the parameters by using the cross-sectional information
(yields for different maturities).
The approach is to maximize the likelihood function
XT
ln Lu D ln Lut , with ln Lut D ln pdf .yut jyot / (11.22)
t D1
It is common to assume that the measurement errors are iid normal with a zero mean and
a diagonal covariance with variances !i2 (often pre-assigned, not estimated)
2 3
yut jyot N 4au C bu0 x t ; diag.!i2 / 5 , with (11.23)

6 7

E.yut jyot / Var.yut jyot /
x t D bo0 1 .yot ao / :
Under this assumption (normal distribution with a diagonal covariance matrix), maximiz-
ing the likelihood function amounts to minimizing the weighted squared errors of the
yields
XT X ynt yOnt 2
arg max ln Lu D arg min ; (11.24)
tD1
n2u
!i
340
where yOnt are the fitted yields, and the sum is over all unobserved yields. In some ap-
plied work, the model is reestimated on every date. This is clearly not model consistent
since the model (and the expectations embedded in the long rates) is based on constant
parameters.
Example 11.21 (Cross-sectional likelihood for the Vasicek model) In the Vasicek model
in Example 11.16, the two-period rate is
y2t D .1 / =2 C .1 C /x t =2 2 C .1 C /2 2 =4:

The pdf of y2t , conditional on y1t , is therefore
y2t jy1t N.a2 C b2 x t ; ! 2 /, with x t D y1t C 2 2 =2; where

C .1 C /2 2 =4:
2
b2 D .1 C /=2 and a2 D .1 / =2

Clearly, with only one interest rate (y2t ) we can only estimate one parameter, so we
need a larger cross section. However, even with a larger cross-section there are serious
identification problems. The parameter is well identified from how the entire yield curve
typically move in tandem with yot . However, , 2 , and can all be tweaked to generate
a sloping yield curve. For instance, a very high mean will make it look as if we are (even
on average) below the mean, so the yield curve will be upward sloping. Similarly, both a
very negative value of (essentially the negative of the price of risk) and a high volatility
(risk), will give large risk premiaespecially for longer maturities. In practice, it seems
as if only one of the parameters , 2 , and is well identified in the cross-sectional
approach.
Example 11.22 (Empirical results from the Vasicek model, cross-sectional estimation)
Figure 11.19 reports results from a cross-sectional estimation of the Vasicek model, where
it is assumed that the variances of the observation errors (!i2 ) are the same across yields.
The estimation uses monthly observations of monthly interest rates (that is the usual in-
terest rates/1200). The values of and 2 are restricted to the values obtained in the time
series estimations, so only and are estimated. Choosing other values for and 2
gives different estimates of , but still the same yield curve (at least on average).
341
Pricing errors, Vasicek (CS) Avg yield curve, Vasicek (CS)
0.04
0.02 7 years data
0.065
0
0.06
-0.02 0.055
-0.04 0.05
1970 1980 1990 2000 2010 0 2 4 6 8 10
Maturity (years)
With errors (months): 6 12 36 60 84 120
Restricted parameters: and
1200 1200 1200

-225 0.03 1.00 0.49 1.02
Figure 11.19: Estimation of Vasicek model, cross-sectional approach
11.4.5 Combined Time Series and Cross-Sectional Approach

The approach here combines the time series and cross-sectional methodsin order to
fit the whole model on the whole sample (all maturities, all observations). This is the full
maximum likelihood, since it uses all available information.
The log likelihood function is
XT
ln L D ln L t , with ln L t D ln pdf .yut ; yot jyo;t 1/ : (11.25)
t D1
Notice that the joint density of .yut ; yot /, conditional on yo;t 1 can be split up as
pdf .yut ; yot jyot 1/ D pdf .yut jyot / pdf.yot jyo;t 1 /; (11.26)
since yo;t 1 does not affect the distribution of yut conditional on yot . Taking logs gives
ln L t D ln pdf .yut jyot / C ln pdf.yot jyo;t 1 /: (11.27)
The first term is the same as in the cross-sectional estimation and the second is the same
as in the time series estimation. The log likelihood (11.25) is therefore just the sum of the
342
log likelihoods from the pure cross-sectional and the pure time series estimations
XT
ln L D ln Lut C ln Lot : (11.28)
t D1
See Figures 11.2011.25 for illustrations. Notice that the variances of the observation
errors (!i2 ) are important for the relative weight of the contribution from the time series
and cross-sectional parts. Also, see Figure 11.20 for an estimation of an affine one-factor
model.
Example 11.23 (MLE of the Vasicek Model) Consider the Vasicek model, where we ob-
serve y1t without errors and y2t with measurement errors. The likelihood function is then
the sum of the log pdfs in Examples 11.16 and 11.21, except that the cross-sectional part
must be include the variance of the observation errors (! 2 ) which is assumed to be equal
across maturities.
Pricing errors, Vasicek (TS&CS) Avg yield curve, Vasicek (TS&CS)

0.04
0.02 7 years data
0.065
0
0.06
-0.02 0.055
-0.04 0.05
1970 1980 1990 2000 2010 0 2 4 6 8 10
Maturity (years)
1200 1200 1200

-249 9.67 0.99 0.52 0.79
Figure 11.20: Estimation of Vasicek model, combined time series and cross-sectional
approach
Example 11.24 (Empirical results from the Vasicek and affine models, combined time se-
ries and cross-sectional estimation) Figure 11.20 reports results from a combined time
series and cross-sectional estimation of the Vasicek model. The estimation uses monthly
observations of monthly interest rates (that is the usual interest rates/1200). All model
343
Intercept1200, Vasicek and OLS Slope on short rate, Vasicek and OLS
3 1
Vasicek
OLS
2 0.9
1 0.8
0
0 2 4 6 8 10 0 2 4 6 8 10
maturity (years) maturity (years)
The figures show the relation yn = n + n y1
The Vasicek model is estimated with ML (TS&CS),

while OLS is a time-series regression for each maturity
Figure 11.21: Loadings in a one-factor model: LS and Vasicek
parameters (; ; ; 2 ) are estimated, along with the variance of the measurement er-
rors. (All measurement errors are assumed to have the same variances, !.) Figure 11.21
reports the loadings on the constant and the short rate according to the Vasicek model
and (unrestricted) OLS. The patterns are fairly similar, suggesting that the cross-equation
(-maturity) restrictions imposed by the Vasicek model are not at great odds with data.
The estimated affine model in Figure 11.22 suggests that the risk premia are higher when
short rates are higher, but otherwise the results look similar to the Vasicek model.
Remark 11.25 (Imposing a unit root) If a factor appears to have a unit root, it may be
easier to impose this on the estimation. This factor then causes parallel shifts of the
yield curveand makes the yields being cointegrated. Imposing the unit root leads the
estimation being effectively based on the changes of the factor, so standard econometric
techniques can be applied. See Figure 11.24 for an example.
Example 11.26 (Empirical results from a two-factor Vasicek model) Figure 11.23 reports
results from a two-factor Vasicek model. The estimation uses monthly observations of
monthly interest rates (that is the usual interest rates/1200). We can only identify the
mean of the SDF, not whether if it is due to factor one or two. Hence, I restrict 2 D 0.
The results indicate that there is one very persistent factor (affecting the yield curve level),
and another slightly less persistent factor (affecting the yield curve slope). The price of
344
Pricing errors, affine (TS&CS) Avg yield curve, affine (TS&CS)
0.04
0.02 7 years data
0.065
0
0.06
-0.02 0.055
-0.04 0.05
1970 1980 1990 2000 2010 0 2 4 6 8 10
Maturity (years)
Restrictions: a1 = 0, b1 = 1
0 1 1200 1200 1200

-0.08 -7.38 3.54 0.99 0.52 0.79
Figure 11.22: Estimation of an affine one-factor model, combined time series and cross-
sectional approach
Pricing errors, 2-factor Vasicek Avg yield curve, 2-factor Vasicek

0.04 0.08
1 year at avgerage xt
0.02 7 years data
0.07
0
0.06
-0.02
-0.04 0.05
1970 1980 1990 2000 2010 0 2 4 6 8 10
Maturity (years)
No errors (months): 3 120
With errors (months): 6 12 36 60 84
Restricted parameters: 1 , 2 and 1
1 2 1 2 12001 12002
1 1 -191 -98 0.00 4.87
1 2 1200S1 1200S2 1200

1.00 0.95 0.54 0.56 0.24
Figure 11.23: Estimation of 2-factor Vasicek model, time-series&cross-section approach
345
Pricing errors, 2-factor Vasicek Avg yield curve, 2-factor Vasicek
0.04 0.08
1 year at avgerage xt
0.02 7 years data
0.07
0
0.06
-0.02
-0.04 0.05
1970 1980 1990 2000 2010 0 2 4 6 8 10
Maturity (years)
No errors (months): 3 120
With errors (months): 6 12 36 60 84
Restricted parameters: 1 , 2 , 1 and 1
1 2 1 2 12001 12002
1 1 -100 -309 0.00 -6.76
Notice: 1 is restricted to unity
1 2 1200S1 1200S2 1200
1.00 0.96 0.30 0.53 0.29
Figure 11.24: Estimation of 2-factor Vasicek model, time-series&cross-section approach,

1 D 1 is imposed
Forecasting, 2-factor Vasicek

15
y(36m), 2 years ahead
10
0
0 2 4 6 8 10 12 14 16
Forecast of y(36m), 2 years ahead
Figure 11.25: Forecasting properties of estimated of 2-factor Vasicek model
346
risk is larger (i more negative) for the more persistent factor. This means that the risk
premia will scale almost linearly with the maturity. As a practical matter, it turned out
that a derivative-free method worked much better than standard optimization routines.
The pricing errors are clearly smaller than in a one-factor Vasicek model. Figure 11.25
illustrates the forecasting performance of the model by showing scatter plots of predicted
yields and future realized yields. An unbiased forecasting model should have the points
scattered (randomly) around a 45 degree line. There are indications that the really high
forecasts (above 10%, say) are biased: they are almost always followed be realized rates
below 10%. A standard interpretation would be that the model underestimates risk premia
(overestimates expected future rates) when the current rates are high. I prefer to think of
this as a shift in monetary policy regime: all the really high forecasts are done during the
Volcker deflationwhich was surprisingly successful in bringing down inflation. Hence,
yields never became that high again. The experience from the optimization suggests that
the objective function has some flat parts.
11.5 Summary of Some Empirical Findings
11.5.1 Term Premia and Interest Rate Forecasts in Affine Models by Duffee (2002)

This paper estimates several affine and essentially affine models on monthly data
19521994 on US zero-coupon interest rates, using a combined time series and cross-
sectional approach. The data for 19951998 are used for evaluating the out-of-sample
forecasts of the model. The likelihood function is constructed by assuming normally
distributed errors, but this is interpreted as a quasi maximum likelihood approach. All the
estimated models have three factors. A fairly involved optimization routine is needed in
order to keep the parameters such that variances are always positive.
The models are used to forecast yields (3, 6, and 12 months) ahead, and then evaluated
against the actual yields. It is found that a simple random walk beats the affine models in
forecasting the yields. The forecast errors tend to be negatively correlated with the slope
of the term structure: with a steep slope of the yield curve, the affine models produce too
high forecasts. (The models are closer to the expectations hypothesis than data is.) The
essentially affine model produce much better forecasts. (The essentially affine models
extend the affine models by allowing the market price of risk to be linear functions of the
state vector.)
347
11.5.2 A Joint Econometric Model of Macroeconomic and Term Structure Dy-
namics by Hrdahl et al (2005)
Reference: Hrdahl, Tristiani, and Vestin (2006), Ang and Piazzesi (2003)
This paper estimates both an affine yield curve model and a macroeconomic model on
monthly German data 19751998.
To identify the model, the authors put a number of restrictions on the 1 matrix. In
particular, the lagged variables in x t are assumed to have no effect on t .
The key distinguishing feature of this paper is that a macro model (for inflation, output,
and the policy for the short interest rate) is estimated jointly with the yield curve model.
(In contrast, Ang and Piazzesi (2003) estimate the macro model separately.) In this case,
the unobservable factors include variables that affect both yields and the macro variables
(for instance, the time-varying inflation target). Conversely, the observable data includes
not only yields, but also macro variables (output, inflation). It is found, among other
things, that the time-varying inflation target has a crucial effect on yields and that bond
risk premia are affected both by policy shocks (both to the short-run policy rule and to the
inflation target), as well as the business cycle shocks.
11.5.3 An Empirical Comparison of Alternative Models of the Short-Term Inter-

est Rate by Chan et al (1992)
Reference: Chan, Karolyi, Longstaff, and Sanders (1992) (CKLS), Dahlquist (1996)
This paper focuses on the dynamics of the short rate process. The models that CKLS
study have the following dynamics (under the natural/physical distribution) of the one-
period interest rate, y1t
y1;t C1 y1t D C y1t C " t C1 , where (11.29)

2
E t " tC1 D 0 and E t "2tC1 D Var t ." t C1 / D 2 y1t :
This formulation nests several well-known models: D 0 gives a Vasicek model and
D 1=2 a CIR model (which are the only cases which will deliver a single-factor affine
model). It is an approximation of the diffusion process
dr t D .0 C 1 r t /dt C r t d W t ; (11.30)
where W t is a Wiener process. (For an introduction to the issue of being more careful with
estimating a continuous time model on discrete data, see Campbell, Lo, and MacKinlay
348
(1997) 9.3 and Harvey (1989) 9.) In some cases, like the homoskedastic AR(1), there is
no approximation error because of the discrete sampling. In other cases, there is an error.)
CKLS estimate the model (11.29) with GMM using the following moment conditions
2 3
" # " "
# 6 t C1 7
2 " t C1 1 6 " t C1 y1t
7 ; (11.31)
7
g t .; ; ; / D 2 D 6
2 2
"2tC1 2 y1t y1t 6 "2
4 t C1 y1t
7
5
2 2 2
." tC1 y1t /y1t
so there are four moment conditions and four parameters (; ; 2 , and ). The choice of
the instruments (1 and y1t ) is somewhat arbitrary since any variables in the information
set in t would do.
CKLS estimate this model in various forms (imposing different restrictions on the pa-
rameters) on monthly data on one-month T-bill rates for 19641989. They find that both O
and O are close to zero (in the unrestricted model O < 0 and almost significantly different
from zeroindicating mean-reversion). They also find that O > 1 and significantly so.
This is problematic for the affine one-factor models, since they require D 0 or D 1=2.
A word of caution: the estimated parameter values suggest that the interest rate is non-
stationary, so the properties of GMM are not really known. In particular, the estimator is
probably not asymptotically normally distributedand the model could easily generate
extreme interest rates.
Example 11.27 (Re-estimating the Chan et al model) Some results obtained from re-
estimating the model on a longer data set are found in Figure 11.26. In this figure, D
D 0 is imposed, but the results are very similar if this is relaxed. One of the first thing
to note is that the loss function is very flat in the spacethe parameters are not
pinned down very precisely by the model/data. Another way to see this is to note that
the moments in (11.31) are very strongly correlated: moment 1 and 2 have a very strong
correlation, and this is even worse for moments 3 and 4. The latter two moment conditions
are what identifies 2 from , so it is a serious problem for the estimation. The reason
for these strong correlations is probably that the interest rate series is very persistent so,
for instance, " t C1 and " tC1 y1t look very similar (as y1t tends to be fairly constant due to
the persistence). Figure 11.27, which shows cross plots of the interest rate level and the
change and volatility in the interest rate, suggests that some of the results might be driven
by outliers. There is, for instance, a big volatility outlier in May 1980 and most of the data
349
Federal funds rate GMM loss function
0.2
0.15 300
200
0.1
100
0.05
2
0.5
0 1
1960 1980 2000 0 0
Year
7
x 10 GMM loss function, local Federal funds rate, (monthly) 1954:72014:3
Point estimates of and : 1.67 and 0.38

6
Correlations of moments:
4
1.00 0.93 -0.30 -0.34
2 0.93 1.00 -0.42 -0.47
-0.30 -0.42 1.00 0.99
1.8
0.45 -0.34 -0.47 0.99 1.00
1.7 0.4
0.35
1.6 0.3
Figure 11.26: Federal funds rate, monthly data, D D 0 imposed
points with high interest rate and high volatility are probably from the Volcker deflation
in the early 1980s. It is unclear if that particular episode can be modelled as belonging
to the same regime as the rest of the sample (in particular since the Fed let the interest
rate fluctuate a lot more than before). Maybe this episode needs a special treatment.
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Drift vs level Volatility vs level
0.1
100(yt+1 yt )2
0.05 0.4
yt+1 yt
0.3
0
0.2
0.05 0.1
0.1 0
0 0.05 0.1 0.15 0.2 0 0.05 0.1 0.15 0.2
yt yt
Federal funds rate, sample: 1954:72014:3
Figure 11.27: Federal funds rate, monthly data
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12 Yield Curve Models: Nonparametric Estimation
12.1 Nonparametric Regression
12.1.1 Testing Continuous-Time Models of the Spot Interest Rate, by Ait-Sahalia

(1996)
Reference: Ait-Sahalia (1996)

Interest rate models are typically designed to describe the movements of the entire
yield curve in terms of a small number of factors. For instance, the model
r t C1 D C r t C " t C1 , where (12.1)

E t " t C1 D 0 and Var t ."2tC1 / D 2 r t2 :
nests several well-known models. Subtract r t 1 from both sides to get
r t C1 rt D C r C " t C1 : (12.2)
t
10
This is an approximation of the diffusion process
dr t D .0 C 1 r t /dt C r t d W t ; (12.3)
Drift vs level, kernel regression Vol vs level, kernel regression

0.1 1.5
interest rate
Volatility
0 1
0.1 0.5
Optimal h
Larger h(4)
0.2 0
0 5 10 15 20 0 5 10 15 20
Interest rate Interest rate
Daily federal funds rates 1954:72014:3 Volatility = (actual fitted interest rate)2
Figure 12.1: Kernel regression
353
Cross validation simulations, kernel regression
Avg prediction error, relative to min

1.0007
interest rate is regressed
1.0006 on interest rate level
1.0005 Daily federal funds rates
1954:72014:3
1.0004
1.0003
1.0002
1.0001
1
0.4 0.5 0.6 0.7 0.8 0.9 1
bandwidth (h)
Figure 12.2: Cross-validation
Drift vs level, kernel regression Vol vs level, kernel regression

0.1 1.5
interest rate
Volatility
0 1
0.1 0.5
Point estimate and
90% confidence band
0.2 0
0 5 10 15 20 0 5 10 15 20
Interest rate Interest rate
Volatility = (actual fitted interest rate)2
Daily federal funds rates 1954:72014:3

The bandwidth is from cross-validation
Figure 12.3: Kernel regression, confidence band
where W t is a Wiener process. Recall that affine one-factor models require D 0 (the
Vasicek model) or D 0:5 (Cox-Ingersoll-Ross). Notice that this linear model implies
that E t .r t C1 r t / D C r t is a downward sloping line as a function of r t (flat if no
mean reversion, D 1 so D 0). It also implies that the conditional variance, 2 r t2 , is
flat if Vasicek and linear (upward sloping) if CIR.
This paper tests several models of the short interest rate by using a nonparametric
technique.
354
1. The first step of the analysis is to estimate the unconditional distribution of the
short interest rate by a kernel density estimator. The estimated pdf at the value r is
denoted O 0 .r/.
2. The second step is to estimate the parameters in a short rate model (for instance,
Vasiceks model) by making the unconditional distribution implied by the model
parameters (denoted .; r/ where is a vector of the model parameters and r a
value of the short rate) as close as possible to the nonparametric estimate obtained
in step 1. This is done by choosing the model parameters as
T
1X
O D arg min .; r t / O 0 .r/2 : (12.4)
T
t D1
3. The model is tested by using a scaled version of the minimized value of the right
hand side of (12.4) as a test statistic (it has an asymptotic normal distribution).
4. It is found that most standard models are rejected (daily data on 7-day Eurodollar
deposit rate, June 1973 to February 1995, 5,500 observations), mostly because ac-
tual mean reversion is much more non-linear in the interest rate level than suggested
by most models (the mean reversion seems to kick in only for extreme interest rates
and to be virtually non-existent for moderate rates).
5. For a critique of this approach (biased estimator...), see Chapman and Pearson
(2000)
Remark 12.1 The very non-linear mean reversion in Figure 12.1 seems to be the key
reason for why Ait-Sahalia (1996) rejects most short rate models.
12.2 Approximating Non-Linear Regression Functions
12.2.1 Partial Linear Model
A possible way out of the curse of dimensionality of the multivariate kernel regression is
to specify a partially linear model
y t D z t0 C b.x t / C " t ; (12.5)
where " t is uncorrelated over time and where E " t D 0 and E." t jx t ; z t / D 0. This model
is linear in z t , but possibly non-linear in x t since the function b.x t / is unknown.
355
To construct an estimator, start by taking expectations of (12.5) conditional on x t
E.y t jx t / D E.z t jx t /0 C b.x t /: (12.6)
Subtract from (12.5) to get
yt E.y t jx t / D z t E.z t jx t /0 C " t : (12.7)
The double residual method (see Pagan and Ullah (1999) 5.2) has several steps. First,
estimate E.y t jx t / by a kernel regression of y t on x t (bOy .x//, and E.z t jx t / by a similar
kernel regression of z t on x t (bOz .x/). Second, use these estimates in (12.7)
yt bOy .x t / D z t bOz .x t /0 C " t (12.8)
and estimate by least squares. Third, use these estimates in (12.6) to estimate b.x t / as
O t / D bOy .x t /
b.x bOz .x t /0 :
O (12.9)
It can be shown that (under the assumption that y t , z t and x t are iid)
p
T .O / !d N 0; Var." t / Cov.z t jx t / 1 : (12.10)

We can consistently estimate Var." t / by the sample variance of the fitted residuals in
(12.5)plugging in the estimated and b.x t /: and we can also consistently estimate
Cov.z t jx t / by the sample variance of z t bOz .x t /. Clearly, this result is based on the idea
that we asymptotically know the non-parametric parts of the problem (which relies on the
consistency of their estimators).
12.2.2 Basis Expansion
Reference: Hastie, Tibshirani, and Friedman (2001); Ranaldo and Sderlind (2010) (for
an application of the method to exchange rates)
The label non-parametrics is something of a misnomer since these models typically
have very many parameters. For instance, the kernel regression is an attempt to estimate
a specific slope coefficient at almost each value of the regressor. Not surprisingly, this
becomes virtually impossible if the data set is small and/or there are several regressors.
An alternative approach is to estimate an approximation of the function b.x t / in
y t D b.x t / C " t : (12.11)
356
Basis expansion Piecewise linear function
Coeffs of basis functions: 2 -3 5
2 4
Slopes are indicated below
4
2
0
-1
x
max(x 1, 0) 0 2
2 max(x 2, 0)
2
1 0 1 2 3 1 0 1 2 3
x x
Figure 12.4: Example of piecewise linear function, created by basis expansion
This can be done by using piecewise polynomials or splines. In the simplest case, this
amounts to just a piecewise linear (but continuous) function. For instance, if x t is a scalar
and we want three segments (pieces), then we could use the following building blocks
2 3
xt
4max.x t 1 ; 0/5 (12.12)
6 7
max.x t 2 ; 0/
and approximate as
b.x t / D 1 x t C 2 max.x t 1 ; 0/ C 3 max.x t 2 ; 0/: (12.13)
This can also be written
if x t < 1
2 3
1 x t
b.x t / D 4 1 x t C 2 .x t 1 / if 1 x t < 2 5 : (12.14)
6 7
1 x t C 2 .x t 1 / C 3 .x t 2 / if 2 x t
This function has the slope 1 for x t < 1 , the slope 1 C 2 between 1 and 2 , and
1 C 2 C 3 above 2 . It is no more sophisticated than using dummy variables (for the
different segments), except that the current approach is a convenient way to guarantee
that the function is continuous (this can be achieved also with dummies provided there
are dummies for the intercept and we impose restrictions on the slopes and intercepts).
Figure 12.4 gives an illustration. It is straightforward to extend this to more segments.
However, the main difference to the typical use of dummy variables is that the knots
(here 1 and 2 ) are typically estimated along with the slopes (here 1 , 2 and 3 ). This
can, for instance, be done by non-linear least squares.
357
Remark 12.2 (NLS estimation) The parameter vector (; ) is easily estimated by Non-
Linear least squares (NLS) by concentrating the loss function: optimize (numerically)
over and let (for each value of ) the parameters in be the OLS coefficients on the
vector of regressors z t (as in (12.12)).
Let V be the covariance of the parameters collected in the vector (here 1 ; 2 ; 1 ; 2 ; 3 ).

For instance, we can use the t-stat for 2 to test if the slope of the second segment (1 C2 )
is different from the slope of the first segment (1 ).
To get the variance of b.x t / at a given point x t , we can apply the delta method. To do
that, we need the Jacobian of the b.x t / function with respect to . In applying the delta
method we are assuming that b.x t / has continuous first derivativeswhich is clearly
not the case for the max function. However, we could replace the max function with an
approximation like max.z; 0/ z=1 C exp. 2kz/ and then let k become very small
and we get virtually the same result. In any case, apart from at the knot points (where
x t D 1 or x t D 2 ) we have the following derivatives
2 3 2 3
@b .x t / =@1 2 I.x t 1 0/
6 @b .x t / =@2 7 6 3 I.x t 2 0/7
6 7 6 7
@b.x t / 6
(12.15)
7 6 7
D6 @b .x t / =@1 7 D6 xt 7;
@ 6 7 6 7
4@b .x t / =@2 5 4 max.x t 1 ; 0/ 5
6 7 6 7
@b .x t / =@3 max.x t 2 ; 0/
O t / is then
where I.q/ D 1 if q is true and 0 otherwise. The variance of b.x
O t / D @b.x t / @b.x t /
Varb.x V : (12.16)
@ 0 @
Remark 12.3 (The derivatives of b.x t /) From (12.14) we have the following derivatives
2 3 2 3 2 3 2 3
@b .x t / =@1 0 2 2
6 @b .x t / =@2 7 6 0 7 6 0 7 6 3 7
6 7 6 7 6 7 6 7
6 7 6 7 6 7 6 7
6@b .x t / =@1 7 D 6x t 7 if x t < 1 ; 6 x t 7 if 1 x t < 2 , 6 x t 7 if 2 x t :
6 7 6 7 6 7 6 7
4@b .x t / =@2 5 4 0 5 4 x t 1 5 4x t 1 5
6 7 6 7 6 7 6 7
@b .x t / =@3 0 0 x t 2
It is also straightforward to extend this several regressorsat least as long as we

assume additivity of the regressors. For instance, with two variables (x t and z t )
b.x t ; z t / D bx .x t / C bz .z t /; (12.17)
358
Daily federal funds rates 1954:72014:3
piecewise linear regession
Drift vs level, fitted values coeff Std
0.1
knot 1 2.75 4.11
interest rate
knot 2 19.49 0.01

0 slope seg 1 -0.01 0.01
extra slope seg 2 0.00 0.01
Point estimate and extra slope seg 3 -0.43 0.12
0.1 90% confidence band
const 0.03 0.01
0.2
0 5 10 15 20
Interest rate
Figure 12.5: Federal funds rate, piecewise linear model
where both bx .x t / and bz .z t / are piecewise functions of the sort discussed in (12.14).
Estimation is just as before, except that we have different knots for different variables.
Estimating VarbOx .x t / and VarbOz .z t / follows the same approach as in (12.16).
Bibliography
Ait-Sahalia, Y., 1996, Testing continuous-time models of the spot interest rate, Review
of Financial Studies, 9, 385426.
Chapman, D., and N. D. Pearson, 2000, Is the short rate drift actually nonlinear?, Jour-
nal of Finance, 55, 355388.
Pagan, A., and A. Ullah, 1999, Nonparametric econometrics, Cambridge University

Press.
Ranaldo, A., and P. Sderlind, 2010, Safe haven currencies, Review of Finance, 14,
385407.
359

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Lecture Notes in Empirical Finance (MSc, PhD

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Lecture Notes in Empirical Finance (MSc, PhD)

1 Econometrics Cheat Sheet 5

2 Basic Asset Pricing Theory 26

3 Simulating the Finite Sample Properties 50

5 Predicting Asset Returns 112

6 Predicting Asset Returns: Nonparametric Estimation 150

7 Predicting and Modelling Volatility 163

8 Factor Models 220

A Details of SURE Systems 262

B Calculating GMM Estimator 265

9 Consumption-Based Asset Pricing 272

10 Alphas /Betas and Investor Characteristics 290

11 Yield Curve Models: MLE and GMM 318

12 Yield Curve Models: Nonparametric Estimation 353

1.1 The Variance of a Sample Mean

Instead, if x t is autocorrelated, then

Proof. (of (1.3)) Notice that for T D 3, we have

Var .x1 C x2 C x3 / D 3 Var.x t / C 2 Cov.x t ; x t C1 / C 2 Cov.x t ; x t 1 /C

The general pattern is

Divide both sides by T to get (1.3).

10 Data process: xt = xt1 + ut

Example 1.1 (Variance of sample mean of AR(1).) Let x t D x t 1 Cu t , where Var .u t / D

asymptotic (as T ! 1 so jsj =T ! 0 in (1.3)) variance can be written

1.2.1 The Basic GMM

In general, the q 1 sample moment conditions in GMM are written

Ok1 D arg min g./

There is one parameter and one moment condition: exactly identified.

There are as many parameters as moment conditions: exactly identified.

This case is overidentified (q D 4 and k D 2), so a weighting matrix is needed.

GMM estimators are typically asymptotically normally distributed, with a covariance

where Cov./ is a matrix of covariances. When there is no autocorrelation of the moments,

S0 D Cov g t .0 / , if g t is not autocorrelated. (1.8)

It can be shown that under the Gauss-Markov assumptions S0 D  2 xx . In practice,

Example 1.9 (Estimating/testing a normal distribution, covariance) For the moments in

Example 1.12 (OLS, Jacobian) For the moments in Example 1.5

Example 1.13 (Estimating/testing a normal distribution, covariance) For the moments in

Combining the previous results, we have that

Under the Gauss-Markov assumptions S0 D  2 xx , so

Example 1.16 (Estimating/testing a normal distribution, distribution) For the moment

Example 1.17 (Estimating/testing a normal distribution, testing) After having estimated

1.2.2 GMM with a Suboptimal Weighting Matrix

Example 1.18 (Estimating/testing a normal distribution) Example 1.6 is overidentified

V2 D VA2 D00 W S0 W 0 D0 VA2

Similarly, the test of overidentifying restrictions becomes

where 2C is a generalized inverse of

Example 1.20 (Pseudo inverse of a square matrix) For the matrix

1.2.3 GMM without a Loss Function

where the matrix A is chosen by the researcher.

Example 1.21 (Overidentified example: estimating/testing a normal distribution) Exam-

It is straightforward to show that the variance-covariance matrix in (1.10) should be

V3 D VA3 A0 S0 A00 VA3

where A0 is the probability limit of A (if it is random).

Example 1.23 (Estimating/testing a normal distribution) Continuing the previous exam-

Example 1.24 (Estimating/testing a normal distribution) Continuing the previous exam-

1.2.4 GMM Example: The Means and Second Moments of Returns

E vech.R t R0t / vech. / D 0N.N C1/=21 : (1.20)

1.3.1 Basic MLE

MLE is typically asymptotically normally distributed

1.3.3 MLE Example: Estimate the Variance

Suppose x t is iid N.0;  2 /. The pdf of x t is

Since x t and x t C1 are independent,

L D pdf .x1 / pdf .x2 / ::: pdf .xT /

1.4 Testing (Linear) Joint Hypotheses

Example 1.1 (Variance of sample mean of AR(1).) Let x t D x t 1 Cu t , where Var .u t / D

It can be shown that under the Gauss-Markov assumptions S0 D 2 xx . In practice,

Under the Gauss-Markov assumptions S0 D 2 xx , so

Suppose x t is iid N.0; 2 /. The pdf of x t is

Example 1.30 (Testing a correlation of x t and y t , .x t ; y t /) For expositional simplicity,

xy @f ./ h 1 xy 1 xy 1

maxfC0 ;i g u .C0 / C E u .C1 / subject to (2.11)

max u .C0 / C E u.y1 C niD1 i xi / C0 C niD1 i Pi (2.14)

wrt C0 : u0 .C0 / D (2.15)

E u0 .C1 / xi D Pi for i D 1:::n (2.17)

Recall that if x N.; 2 /, then E exp.x/ D exp. C 2 =2/. Assume c C ri is

exp. E c C E ri C 2 c2 =2 C r2 =2 cr / D 1:

E c C E ri C 2 c2 =2 C r2 =2 cr D 0, or

E ri rf D cr r2 =2: