1222 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO.
6, NOVEMBER 1997
Neural Networks in Financial Engineering:
A Study in Methodology
Apostolos-Paul N. Refenes, A. Neil Burgess, and Yves Bentz
(Invited Paper)
Abstract—Neural networks have shown considerable successes
in modeling financial data series. However, a major weakness
of neural modeling is the lack of established procedures for
performing tests for misspecified models, and tests of statis-
tical significance for the various parameters that have been
estimated. This is a serious disadvantage in applications where
there is a strong culture for testing not only the predictive
power of a model or the sensitivity of the dependent variable
to changes in the inputs but also the statistical significance of
the finding at a specified level of confidence. Rarely is this more
important than in the case of financial engineering, where the
data generating processes are dominantly stochastic and only
partially deterministic. Partly a tutorial, partly a review, this
paper describes a collection of typical applications in options
pricing, cointegration, the term structure of interest rates and
models of investor behavior which highlight these weaknesses
and propose and evaluate a number of solutions. We describe a
number of alternative ways to deal with the problem of variable
selection, show how to use model misspecification tests, we deploy
a novel way based on cointegration to deal with the problem of
nonstationarity, and generally describe approaches to predictive
neural modeling which are more in tune with the requirements
for modeling financial data series.
Index Terms— Cointegration, computational finance, financial
engineering, model identification, model selection, neural net-
works, variable selection, volatility, yield curve.
I. ACTIVE ASSET MANAGEMENT,
NEURAL NETWORKS, AND RISK
T HE ultimate goal of any investment strategy is to max-
imize returns with the minimum risk. In the framework
of modern portfolio management theory, this is achieved by
constructing a portfolio of investments which is weighted in
a way that seeks to achieve the required balance of maximum
return and minimum risk. The construction of such an optimal
portfolio clearly requires a priori estimates of asset returns
and risk. Traditionally, it used to be accepted that returns are
random and that the best prediction for tomorrow’s return is
today’s return. Over a longer period, expected returns were
calculated by averaging historical returns. Any deviation from
this (“naive”) prediction was considered as unpredictable noise
Manuscript received August 10, 1996; revised August 10, 1997. This work
was supported in part by the ESRC under the ROPA program, Research
Grant R022 250 057, Barclays, Citibank, Hermes Investment Management, the
Mars group and Sabre Fund Management. The methodology and applications
described in this paper were developed over a period of two years at the
Decision Technology Centre, London Business School.
The authors are with the London Business School, Regents Park, London
NW1 4SA, U.K.
Publisher Item Identifier S 1045-9227(97)07972-1.
1045–9227/97$10.00  1997 IEEE
and so asset risks were estimated by the standard deviation of
historical returns.
Subsequently, portfolio theory suggested that the efficient
frontier [51] is obtained by solving for the weights which
maximize a utility of the following form:
(1)
According to (1) the portfolio’s expected return is
determined by the expected returns of the individual securities
in the portfolio and the proportion of each security
represented in the portfolio . The expected risk of the
portfolio is determined by three factors: the proportion of
each security represented in the portfolio , the standard
deviation of each security from its expected return,
and the correlation between these deviations for each pair
of securities in the portfolio . (The term is
commonly referred to as the covariance).
This traditional assumption was founded upon the theory of
market efficiency, which stated simply implies that all public
information on future price movement for a tradable asset
has already been incorporated in its current price, and that
therefore it is not possible to earn economic profits by trading
on this information set. In statistical terms, this implies the
so-called “random walk” model, whereby the expectation for
the next period is the current value. The empirical finance
literature up to the 1970’s universally reinforced this view
for all actively traded capital markets, by testing and failing
to refute the random walk hypothesis on daily, weekly, and
monthly data. Yet this posed a serious dilemma, a gulf between
theory and practice, as traders did continue to make profits in
the short term. If they were just lucky, their luck seemed to
show no signs of running out.
By the end of the 1980’s theory had matured to provide a
more comfortable fit with trading realities. In the first place
it was recognized that the conventional tests of the random
walk hypothesis were very “weak,” in the sense that the
evidence would have to be very strong to reject this null
hypothesis. Typically, period by period changes were tested for
zero mean and white noise. Minor departures from randomness
would not be significant in these tests; yet it only takes
minor departures to offer real trading opportunities. From
the perspective of scientific method, it is remarkable that the
EMH should have gained such empirical support based upon
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
a testing methodology that started by assuming it is true, and
then adopted tests which would rarely have the power to refute
it!
Econometric tests introduced during the 1980’s specified
a more general model for the time series behavior of asset
returns, involving autoregressive and other terms, such that
the random walk would be a special case if the first-order
autoregressive coefficient were equal to one, and all others
were zero. Thus a more general structural model was proposed
for which the random walk is a special case. It turned out that
under this model-based estimation procedure, it was possible
to reject the random walk special case hypothesis for almost
all of the major capital market series. Not only is this turn-
around more satisfactory in providing results which close the
gap between statistical conclusions and practical observation,
it also demonstrated the methodological need to propose a
general model first, before concluding that a time-series has
no structure.
Finance theory has now matured to the position whereby
markets can still be considered efficient in the more sophisti-
cated way of representing the expectations, risk attitudes and
economic actions of many agents, yet still have a deterministic
component to their price movements relating to fundamental
factors. Thus we now have the so-called “multifactor” capital
asset pricing model [70] and arbitrage pricing theory [65]
which attempt to explain asset returns as a weighted com-
bination of the assets’ exposure to different factors as shown
in (2)
(2)
where is the return of asset are the determinant factors,
the exposure of asset to factor is the expected
abnormal return from the asset, and is the nonpredictable
part of the return, i.e., the error of the model.
Hence, the “naive” estimate (or unconditional expectation)
of asset returns is replaced by a more general estimate condi-
tioned on the values of (fundamental or market) factors .
Accepting the random work hypothesis is now the default
case which will be accepted should it turn out that none of
the factors under consideration is statistically significant. In
the more general case there is no reason why the structured
model in (2) should be limited to include only linear structures
with noninteracting independent variables and Gausian distri-
butions. In terms of inviting the question of how general a
model should be proposed in the first place, this focus on
empirical model-building allows us to consider the use of
neural-network technology as being a consistent, if extreme,
example, of this new approach. By proposing the most general
of modeling frameworks, it is also providing a stronger “test”
for market efficiency conclusions, albeit with tests that are not
based upon statistical hypothesis protocols, but on accuracy
and performance metrics.
However, this seemingly minor departure from the efficient
markets hypothesis (EMH) has major implications on the way
in which we manage risk and reward. It also induces strin-
gent requirements on the design and validation of predictive
modeling methodologies, particularly so on neural networks
(NN’s). To appreciate the implications of this apparently minor
1223
departure from EMH let us formulate portfolio management
theory in a more general framework in which the mean-
variance optimization is a special case. The general case is
a simple extension to the utility in (1), whereby
(3)
where represents the expected return for security
conditioned on its exposure to a vector of factors and
defines the exact nature of the model by indexing a class of
structured models or predictors. For example for the random
walk, and for a multifactor CAPM model
takes the form of the structured model in (2).
measures the deviation of each security , from
its expected value i.e., the standard error of model for
each security in the portfolio. For example for the random
walk this is given by the standard deviation i.e.,
but for the more general case the prediction
risk is
According to (3), the expected return of our portfolio is
determined by two factors: 1) the returns of the individual
securities in the portfolio whose expectation for the next period
is no longer the historical average but is given by and
2) the proportion of each security represented in the portfolio.
The expected risk of the portfolio is determined by three
factors: 1) the proportion of each security represented in the
portfolio; 2) the deviation of each security from its predicted
return (i.e., the standard error of model for each security in
the portfolio); and 3) the correlation between the prediction
errors for each pair of securities in the portfolio.
Clearly, the expected value of portfolio [as defined in (3)]
assumes that our expectations for the individual returns are
accurate. However, this is never the case and the actual value
of the portfolio depends on the accuracy of the individual
predictors. To illustrate the effects (benefits and risks) of
prediction accuracy on actual portfolio value let us consider
a simple portfolio composed of two securities. In order to
separate the effects of prediction accuracy from the effects that
are due to covariances between prediction errors we make one
of the securities the risk-free. For the other asset, we simulate
it as hypothetical security the returns of which randomly
generated (100 independent observations, zero mean, standard
deviation one). For each point in the series, we then generate
a set of predictors (with increasing predictive power) and for
each predictor we compute the actual value of the portfolio.
Fig. 1 shows the value of this portfolio as a function of
prediction accuracy. The prediction accuracy, plotted in the
axis is in fact the correlation between actual and predicted
1224 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997

Fig. 1. “It is not actually terribly difficult to make money in the securities markets.”1 Actual return/risk of a simple portfolio of two assets as a function
of prediction accuracy (). The x axis shows the correlation between actual and predicted returns. The actual return/risk of the mean-variance portfolio
(correlation zero) is positioned at the origin.

Fig. 2. “It is actually terribly difficult to make money in the securities markets.”2 Actual return/risk of a simple portfolio of two assets as a function of prediction
accuracy. The x axis shows the correlation between predicted and actual. The return/risk of the mean-variance portfolio ( = 0) is shown by the horizontal line.

for the hypothetical security. The axis plots the actual value
of the portfolio equation.
The return/risk for the mean variance optimization (corre-
lation zero) is positioned at the origin. As we move from
the “naive” predictor (with ) toward the theoretically
perfect predictor (with ) the actual return increases but
not uniformly. It is much steeper in the initial stages but it
tails off for predictors with . Most of the payoff is
obtained by predictors which can explain between 15–25% of
the variability in the securities’ returns. In other words it only
requires minor improvement upon the random walk hypothesis
to gain significant improvement in returns.
In view of this fact, it is seemingly remarkable that the
EMH should have gained such wide acceptance and have
survived for so long. However, to appreciate the forces which
are helping to keep EMH in widespread use, one does not need
to look further than understanding the risks which can arise if
the predictive models are of poor quality. Fig. 2 shows how
portfolio value decreases as a function of prediction accuracy.
The axis shows the correlation between actual and predicted
for each pair of securities in the portfolio. The theoretically
perfect predictor (with ) is depicted on the right-hand
side (RHS) of the axis. The worst-case predictor (with
) is depicted on the extreme left-hand side (LHS)
of the axis. The “naive” predictor (with ) corresponds
to the random walk model.
It is clear from Fig. 2 that in terms of risk/reward the random
walk model is a rather “efficient” predictor, despite its “naive”
nature. But it is also clear from Fig. 1 that it only requires
minor improvements upon the random walk hypothesis to

1 Allegedly attributable to Peter Baring, two months prior to the collapse of 2 Nick Leeson, “Rogue Trader,” (1996) immediately after the collapse of
Barings Bank. Barings.
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
gain significant improvement in returns. It is also clear that if
any predictive modeling methodology is to become as widely
accepted as the random walk model it must be accompanied
by robust procedures for testing the validity of the estimated
models. In terms of extending the EMH to provide a more
comfortable fit with trading realities in the more sophisticated
way of representing the nonlinearities in the expectations, risk
attitudes, and economic actions of many agents participating
in the market, NN’s can be seen as a consistent example of
multifactor CAPM and APT models whereby asset returns
can be explained as a nonlinear combination of the assets’
exposure to different factors
(4)
where is an unknown function, the inputs are drawn
independently with an unknown stationary probability density
function, is a vector of free parameters which determine
the structure of the model and is an independent random
variable with a known (or assumed) distribution. The learning
or regression problem is to find an of given
the dataset D from a class of predictors or models indexed by
. exchange rate volatility, interest rate volatility, etc.
The novelty about NN’s lies in the ability to model nonlinear
processes with few (if any) a priori assumptions about the
specific functional form of . This is particularly useful
in financial engineering applications where much is assumed
and little is actually known about the nature of the processes
determining asset prices. Neural networks are a relatively
recent development in the field of nonparametric estimation.
Well-studied and frequently used members of the family
include nearest neighbors regression and kernel smoothers
(e.g., [39]), projection pursuit [31], alternating condional ex-
pectations (ACE’s), or average derivative estimation (ADE)
[78], classification and regression trees (CART’s) [11], etc.
Because of their universal approximation properties, NN’s
provide an elegant formalism for unifying all these paradigms.
However, much of the application development with neural
networks has been done in an ad hoc basis without due
consideration for dealing with the requirements which are
specific in financial data. These requirements include: 1)
testing the statistical significance of the input variables; 2)
testing for misspecified models; 3) dealing with nonstationary
data; 4) handling leverages in the datasets; and 5) generally
formulating the problem in a way which is more amenable to
predictive modeling.
In this paper we describe a collection of applications in
options pricing, cointegration, the term structure of interest
rates, and models of investor behavior which highlight these
weaknesses and propose and evaluate a number of solutions.
We describe a number of ways for principled variable selection
including a stepwise procedure building upon the Box–Jenkins
methodology [9], analysis of variance and regularization. We
show how model misspecification tests can be used to ensure
against models which make systematic error. We describe
how the principle of cointegration can be used to deal with
nonstationary data and generally describe ways of formulating
the problem in a manner that makes predictive modeling more
likely to succeed.
1225
In Section II, we use the problem of high-frequency volatil-
ity forecasting to demonstrate a stepwise modeling strategy
which builds upon classical linear techniques for model iden-
tification and variable selection. The analysis identifies some
important linear and nonlinear characteristics of the data with
strong implications for the market maker. A strong linear
mean reversion component of intraday implied volatility is
reported. A second component induced by the bid/ask bounce
of volatility quotes is also present. Changes in the underlying
asset have a significant non linear effect on implied volatility
quotes over the following trading hour. The evolution of the
strike price also has a strong influence on volatility changes
over the next trading hour. Finally, a volatility smile is reported
indicating how implied volatility innovations, are related to
maturity effects.
In Section III, we use the principle of cointegration to deal
with nonstationary data and to demonstrate how partial -tests
can be used to perform significance tests on parts of an NN
and particularly variable selection. The approach is applied to
the nontrivial problem of explaining the cointegration residuals
among European equity derivative indexes in the context of
In Section IV, we analyze the problem of modeling the
yield curve to demonstrate how the careful application of
financial economics theory and regularization methods can
be used to deal with both the problems of nonstationary and
with variable selection. A factor analysis indicates that the
bulk of changes in Eurodollar futures are accounted for by
unpredictable parallel shifts in the yield curve which closely
follow a random walk. However, the second and third factors
correspond roughly to a tilt and a flex in the yield curve and
these show evidence of a degree of predictability in the form of
mean-reversion. We construct portfolios of Eurodollar futures
which are immunized against the first two factors but exposed
to the third and compare linear and nonlinear techniques to
model the expected return on these portfolios. The approach
is best described as attempting to identify combinations of
assets which offer opportunities for statistical arbitrage.
In Section V, we take a metamodeling approach and argue
that even if security price fluctuations are largely unpre-
dictable, it is possible that investor behavior may not be.
Within this framework, we construct a metamodel of investor
behavior using a dataset composed of financial data on 90
French Stocks drawn from the SBF250 index. Based on the
predictions of the metamodel, we show how it is possible to
manage actively investment strategies rather than the underly-
ing assets in order to produce excess returns.
II. VOLATILITY FORECASTING AND VARIABLE SELECTION
A. Overview
Of all the inputs required in option valuation, volatility is
the most difficult for traders to understand. At the same time,
as any experienced trader will attest, volatility often plays
the most important role. Changes in our assumptions about
volatility can have a dramatic effect on our evaluation of an
option, and the manner in which the market assesses volatility
1226 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
can have an equally dramatic effect on an option’s price. The
two basic approaches to measuring volatility [15] are either
to compute the realized volatility over the recent past from
historical price data or to calculate the “implied volatility”
from current option prices by solving the pricing model for
the volatility that equates the model and market prices. It has
become widely recognized in the academic finance literature
that the implied volatility is the “market’s” volatility forecast,
and that it is a better estimate than historical volatility [47],
[17], [75], [4], [73], [55]. Other approaches to forecasting
volatility have been available in the past years using formal
time-varying volatility models, fitting models of the ARCH
family to past data and computing the expected value of future
variance [79]. Again, it has been found that volatility forecasts
estimated from call and put options prices with exogenous
variables contain incremental information relative to standard
ARCH specifications for conditional volatility which only
use information in past returns. The two approaches are not
mutually exclusive. Subsequently, it would be desirable to
develop nonlinear models of implied volatility which take
advantage not only of the time structure in a (univariate)
series (of volatility) but also make use of exogenous variables
i.e., information contained in other potentially informative
variables that have been reported to have an influence on
volatility such as trading effects, maturity effects, spreads, etc.
The literature suggests several potential advantages that
NN’s have over statistical methods for this type of modeling
but one of the important weaknesses of NN’s is that they are as
yet not supported by the rich collection of model diagnostics
which are an integral part of statistical procedures. We utilize
a stepwise modeling procedure which builds upon classical
linear techniques for model identification and variable selec-
tion. Within this framework, we investigate the relationship
between changes in implied volatility and various exogenous
variables suggested in the literature. Using European index
Ibex35 option data we investigate the construction of reliable
estimators of implied volatility by a simple stepwise procedure
consisting of two phases.
In the first phase the objective is to construct a well-specified
model of implied volatility which captures both the time de-
pendency of implied volatility and the most significant linear
dependencies on the exogenous variables. In the second phase,
the objective is to provide incremental value by extending the
model to capture any residual nonlinear dependencies which
may still be significant.
We show that with conservative use of complexity penalty
terms and model cross validation, this simple step-wise for-
ward modeling strategy has been successful in capturing
both the main linear influences and some important nonlinear
dependencies in high-frequency models of implied volatility.
Changes in intraday implied volatility are dominated by a
mean reverting time dependency component which is primarily
a linear effect. The NN model is able to capture this effect
and also some significant nonlinear characteristics of the data
with important implications to the market maker. Of particular
significance is the relationship between implied volatility and
the effects on the strike, maturity, and changes in spot prices of
the underlying market. For example, large movements (either
positive or negative) in the price of the underlying index
induce a U-shaped response on the quoted volatility while a
volatility smile is reported near expiration dates.
B. Experimental Setup—Empirical Properties of Volatility
We examine intraday movements of the Ibex35 Implied
Volatility series obtained from short maturity close to the
money call options during a six-month sample period: Novem-
ber 92 through to April 93. Intraday historical data are avail-
able on the Spanish Financial Futures Exchange option con-
tract on Ibex35. The Ibex35 index contains the 35 most liquid
stocks that trade in the Spanish Stock Exchange through
its CATS system. This dataset has been made available by
the research department of MEFF providing high-quality and
precise real time information from electronically recorded
trades. Options on Ibex35 are European style options, have
a monthly expiration date and at every point in time the three
closer correlative contracts are quoted (i.e., in March 1993,
there will be quotes for the end of March, April, and May
contracts). The measure of the implied volatility is obtained by
solving the pricing model [8] for the volatility that equates the
model and market prices using the Newton–Raphson method.
Our sampling interval is 60 min and the prediction interval
one (60-min) period ahead. The calculated volatility is the
implied volatility of the option price which is nearest to the
next time border. We define the change in implied volatility as
(5)
where denotes the hourly changes of implied volatility at
time . So is the difference between the implied
volatility immediately past the time border 12:00:00 and the
implied volatility immediately past the time boarder 11:00:00.
Our empirical analysis of the implied volatility uses volatil-
ity changes as defined in (5) rather than the levels as quoted (in
basis points) at MEFF. Two considerations motivate this. First
the academic and practitioner interest lies in understanding the
changes or innovations to expected volatility: how changes
in expected volatility influence changes in security valuation.
Second, the series of Ibex35 implied volatility levels appear to
be a near random walk. Implied Volatility levels have a first-
order autocorrelation of 90%, indicating that although a unit
root can be rejected for the series such high autocorrelation
may affect inference in finite samples.
We select our universe of exogenous variables (see summary
on Table I) on the basis of their availability to the market
maker at a specific point of time and the variable’s relevance
to explaining implied volatility as reported in the literature. For
example, [27] and [29] found that volatility is larger when the
exchange is open than when it is closed while [30] suggested
that volatility is to some extent caused by trading itself. It
would therefore seem desirable to make use of an exogenous
variable to account for trading effects on volatility. The high-
frequency data available in this study facilitates the use of two
such variables: volume and velocity. Volume is the number of
contracts traded in an hour and velocity is the number of
trades per hour.
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
TABLE I
SUMMARY OF ALL VARIABLES
Day and Lewis [20] found that option prices reflect increases
in the volatility of the underlying stock indexes at both
quarterly and nonquarterly expiration dates. The behavior of
the implied volatility for options spanning the expiration date
is consistent with an unexpected component to the increase
in volatility nearby expiration dates. It would be desirable to
account for this maturity effect by making use of an exogenous
dummy variable which is encoded as one when there are four
or less days to expiration and zero otherwise. A separate
variable, time to maturity, is introduced for the following
reason: volatility is calculated for call options close to the
money with short time to maturity (less than three months)
and the quotation system provides the three closer correlative
contracts. This means that the obtained implied volatility series
has been derived from different maturity contracts. Although
we expect that the implied volatilities obtained from different
maturity contracts will be significantly similar (due to the fact
that we are dealing with short maturity contracts), we shall
nevertheless introduce a time to maturity variable.
One possible explanatory factor for future changes in im-
plied volatility that is often described in literature, is the
relative bid-ask spread or any shifts in it. In a market with zero
transaction costs, changes in the price of an option are caused
by the arrival of new information regarding the distributions
of returns on the option or by innovations in the process
governing the option value. In other words, if the dealers incur
costs in executing a transaction, they require compensation.
One part of the compensation includes the bid-ask spread.
On the other hand, the market maker will widen the bid-ask
spread if the probability increases that he is dealing with better
informed traders [18]. The variable average-spread is used to
encode this information as the sum of the spreads in all trades
taking place within an hour divided by the number of trades
in the hour.
Some recent studies of S&P index options show that options
with low strikes have significantly higher implied volatil-
ities than those with high strikes [34]. Derman and Kani
[21] showed that the average of at-the-money call and put
implied volatilities fall as the strike level increases. Out-of-
the-money puts trade at higher implied volatilities than out-
of-the-money calls. This asymmetry is commonly called the
volatility “skew.” They attempt to extend the Black–Scholes
1227
model to account for the volatility smile replacing the constant
local volatility term with a local volatility function deduced
from observed market prices. Pozo [58] has observed U-
shaped patterns occurring in the Ibex35 options during various
subperiods between 1991 and 1993. It is not the task of this
study to look for volatility smile patterns in the Ibex35 data
but in order to account for a possible volatility smile it would
be desirable to make use of a measure of the degree to which
short maturity call options are in-, at-, or out-of-the money.
We use the variable moneyness as a measure of the degree
to which short maturity call options are in-, at-, or out-of-the
money. This is calculated as the average ratio of the spot/strike
price for every option traded within the hour.
It has also been argued that volatility is expected to be
higher on certain days than others as well as on certain times
within the day. While this problem cannot be totally eliminated
it is helpful to include a weekend or day effect in our models
and confirm of refute the presence of negative correlation
in the time series. Three variables are used to capture these
effects: day, week-end, and time effect: day effect is a variable
set to (1, 2, , 5) for each week day. The weekend effect
is set to one for Fridays and Mondays and zero elsewhere.
Likewise a dummy time of trade variable is incorporated as
an input into the models: trades registered in the first hour of
the day are coded one, the rest are coded zero (i.e., overnight
new information can affect the behavior of the market at the
opening hour).
The remaining variables in Table I are easy to encode:
Change in spot is a measure of changes in the spot price of
the underlying asset (Futures on Ibex35) at the end of every
hour. So, at 12:00:00 the value of the variable change of spot
will be the difference of the closing price at (or just before)
12:00:00 minus the closing price at (or just before) 11:00:00.
Historic volatility is the standard deviation of past index
Ibex35 returns. The horizon over which historic volatility
is computed is related to time-to-maturity of traded options.
When the majority of options traded have a time to maturity
longer than 15 days, a historical volatility measure is computed
with a sample horizon of 25 days of index returns. Otherwise
the sample horizon is 15 days. The combination of these two
measures appears to have the highest correlation coefficient
with the implied volatility series. Finally, the interest rate is
1228
the current yield of the T-bill whose maturity most closely
matches the option expiration.
The objective here is to identify the subset of variables
which are most significant in explaining implied volatility
variations from the universe of the 11 variables outline above
also augmented by any significant time-dependency terms.
This requires a procedure for searching a relatively large space
of candidate variables and selecting those which: 1) give the
best explanation in terms of ; 2) have the strongest effect;
and 3) are statistically the most significant. The modeling
strategy is described in the next section.
C. Modeling Strategy
Given the hypothesis that the data generating process for
implied volatility is inherently a non linear process (as the
option pricing model would suggest) it would seem desirable
to attempt to estimate the unknown “true” model with a
nonparametric method which can capture nonlinear effects
such as an NN. However, a major weakness of NN’s is the lack
of an established procedure for performing tests of significance
for input variables. Many techniques and algorithms have
been proposed to “measure” the “effect” of different parts of
an NN model, usually for use in one of three cases: either
input variables (in the case of methods devoted to “sensitivity
analysis”), weights (in the case of “pruning” algorithms) or,
and more rarely, hidden units. Typically these methods are not
supported by a coherent statistical argument but are instead
justified on the practical grounds of being better than nothing.
In the cases where statistical arguments are presented the
algorithms are often very computationally and conceptually
complex (for instance requiring the calculation of the Hessian
matrix for the network, and/or assuming nonnegative eigen-
values) and always prone to producing misleading results due
to overfitting.
This section describes a step-wise procedure for neural
model identification which builds upon classical linear tech-
niques for model identification and variable selection. We
adopt a conservative approach whereby complexity is intro-
duced only if the resultant model provides significant incre-
mental value, and the additional parameters are statistically
significant. The procedure consists of two phases. In the first
phase the objective is to construct a well-specified model of
the dependent variable (i.e., implied volatility) which captures
both the time dependency of implied volatility and the most
significant linear dependencies on the exogenous variables.
In the second phase, the objective is to provide incremental
value by extending the model to capture any residual nonlinear
dependencies which may still be significant.
Phase 1:
1) Identifying time structure: Using univariate time series
analysis and the Box–Jenkins identification procedure
investigate the time structure of the output variable and
build a reliable estimator of implied volatility of the form
(6)
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
Arguably, if the ARMA(p, q) orders are “well specified,”
by definition we accept the hypothesis that the residuals
are white noise disturbances. In practise however, due
to weaknesses in randomness tests it is often observed that
the addition of exogenous variables may also produce “well
specified” models with better performance.
2) Identifying exogenous influences: Using stepwise mul-
tiple linear regression analysis identify the predictive
power of each exogenous variable and build a par-
simonious model, incorporating any error correcting
and/or autoregressive terms as suggested in Step 1), e.g.,
(7)
where are the most significant
exogenous variables.
3) Identifying nonlinear dependencies: Using multivari-
ate NN analysis with the variables and/or error correct-
ing/autoregressive terms identified in Step 2), construct
a well-specified neural model of implied volatility
(8)
with
and the vectors denoting the significant
autoregressive terms, moving average terms, and exoge-
nous variables, respectively, as identified in (7). In this
paper the number of hidden units are chosen by simple
cross validation but more sophisticated methods can be
used.
Clearly, this simple procedure is rather limiting to the
neural-network approach for two reasons. Firstly, the predic-
tive variables have already been selected in Step 2) in a way
that best suits the linear regression. It is therefore probable
that the selected variables only explain the linear part of the
relationship. Nevertheless, even in these restrictive conditions
it is possible that a nonlinear estimator can provide incremental
value to the model, perhaps arising from the interaction
between the exogenous variables and/or the time dependencies.
Furthermore, to the extend that one of the main criticisms
of NN methods is their lack of statistical explainability,
working from a platform of statistical insight and looking
for incremental value over a conventionally understood set of
input variables, we can view this restriction as being the price
for potentially improved credibility. Second, it is possible that
variables which could have higher explanatory power in the
nonlinear sense may have been rejected by the linear criterion
in the first phase. This hypothesis needs to be verified in a
second pass.
The second phase of the model identification procedure
verifies if incremental value can be achieved by including
additional variables in the model which although rejected
by the linearity criterion in the first phase, may still have
significant explanatory power in the nonlinear sense. The
second phase is an iterative procedure analogous to forward
variable selection with regression analysis.
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
Phase 2:
1) Forward model estimation: For each variable not
already included in the input vector of the model at
the current iteration construct a new well-specified
model incorporating all the old variables plus each
as follows:
(9)
this will produce as many new models as there are
“unused” variables. The starting input variable vector
comprises only those significant variables that were
identified in (7) and used in (9).
2) Variable significance estimation: Compute a
complexity-adjusted payoff measure to evaluate
the change in model performance that would result if
variable were added to the model. The payoff is
computed by
(10)
The first term in (10), measures the correlation between
the observed values of the dependent variable (implied
volatility) and the predictions of the model which uses
an additional variable The second term in (10)
penalises the model for the complexity introduced by the
additional degrees of freedom, . There are several ways
in which we can measure payoff against complexity in
an NN model. These will be explored in Section II-G.
3) Model extension: If during this current iteration there
exists no model whose performance is greater than
the previous iteration the procedure is termi-
nated. Our baseline metric, , is defined as the correla-
tion between observed and predicted by the multivariate
neural model which uses only the variables selected
by the linear analysis [see (8)]. If there is at least
one model which outperforms the baseline metric we
proceed to construct a well-specified model in which
is extended to include all
the old variables plus one (or more) new variables
selected on the basis of the highest payoff . The
procedure is repeated from Step 1).
The procedure described here is only one of several alterna-
tive ways in which forward selection can be controlled. Ideally,
it would be desirable to consider not only a single candidate
variable in each step but (at least) pairwise combinations
of variables. This is particularly important if the candidate
variables are believed to be interacting in some way, cf. the
eXclusive OR problem where none of the individual inputs
has any explanatory power but it is only when both of them
are put together that the solution is achievable. We select the
simple version of the forward search in order to reduce the
computational requirements. Nevertheless, in order to account
for potential interaction effects we shall use a “short-cut”
whereby we construct a single model with the entire universe
of variables at the end of the procedure. If the performance
of this model (in the validation set) is better than the baseline
model (in unadjusted terms) we shall take this as an indication
of significant interaction.
1229
Clearly, it is possible to perform the search entirely in the
opposite (backward) direction. Our main reason for preferring
forward selection is that it is difficult to obtain an accurate
estimate of the effective degrees of freedom in a neural model
for the complexity penalty term. Although several methods
are described in the literature (e.g., [53] among others) they
require the Hessian to be positive definite which in practice is
difficult to achieve and very expensive to compute. As we are
taking a cautious approach to avoid overfitting our estimate of
will always be upper bounded by the number of additional
parameters that a variable introduces to the model.
Another optimization to the procedure described in phase 2
above would be to control the selection of candidate variables
on the basis of the (linear) correlation of each candidate
variable with the residuals of the current model or more
effectively in the nonlinear case to use analysis of variance.
Such optimizations are analyzed with synthetic data under
controlled simulation elsewhere (see, for example, [14]) and
also in Section III of this paper.
Having described the basic steps in our stepwise modeling
strategy, we return our attention to its application on the
problem of modeling implied volatility changes.
D. Identifying Time Dependencies—Time Series Analysis
Let us begin by considering the univariate properties of the
hourly changes in volatility. Summary statistics are calculated
for the output variable over the entire sample and for three
different subperiods (to highlight any nonstationarity or drift
effects). Each subsample is a correlative window and contains
200 observations. Table II shows the subsample periods and
summarizes the properties of hourly changes in implied volatil-
ity. The mean hourly changes ranges from 0.011% in the
third subsample to 0.0134% in the second period. The mean
volatility change over the entire sample is 0.28%. Apparently,
over the six-month period, market volatility did not drift in
one direction or another. The standard deviation of the hourly
volatility changes is also fairly stable, ranging from 0.1985 in
the second subsample to 0.2422 in the third.
Table II also provides the autocorrelation structure of the
hourly volatility changes for one through six lags. Like the
mean and standard deviation, the autocorrelation structure is
quite stable for the three subsamples. The first-order autocor-
relations, for example, range from 0.507 to 0.435 and the
second-order range from 0.102 to 0.017, revealing a negative
correlation. This degree of correlation, is higher than the
autocorrelation reported in [40] for S&P100 options. Clearly
we encounter a strong mean reverting phenomena in our
Ibex35 data. Big movements are followed by smaller changes
but with opposite sign. This behavior could be induced by
different causes. Some primary causes for Ibex35 are described
in [61] also in [58]. A similar behavior is encountered by
Jacquillat et al. [44] on the Paris Stock Exchange, and [64]
attributes the behavior to the bid-ask bounce.
Our task is to identify a parsimonious representation of the
generating process for this data set. If the autocorrelations have
a cutoff point, that is, if they are zero for all greater than
some small number and the partial autocorrelations taper off
1230
STATISTICAL PROPERTIES OF HOURLY Ibex35 MARKET CHANGES
UNIVARIATE ESTIMATION OF
for growing an MA representation is suggested. In our case,
see Table II, the autocorrelations have a cutoff point after
the first lag, and the partial autocorrelations are reduced in
magnitude slowly. We identify an MA of order 1 for every
subsample period. The MA(1) estimation results are shown in
Table III.
In every subsample period, the coefficient of the MA(1) is
large and negative, ranging form 0.7213 in subsample 1 to
0.6865 in subsample 3. These coefficients are all significant,
with -statistics above 10.00. They are also consistent with the
moving average identification reported in Table II, confirming
the strong mean reversion effect of the data.
This simple linear model is able to explain a large proportion
of the variability in changes of implied volatility. Adjusted
-squared values range from 34.97% for the entire sample
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
TABLE II
OF IMPLIED VOLATILITY
TABLE III
HOURLY CHANGES OF IMPLIED VOLATILITY
to 36.54% for the first subsample. To check the overall
acceptability of the residual autocorrelations (white noise),
the portmanteau statistic, Q statistic is often used. If the
ARMA orders are well specified, for an ARMA(p, q) process
the statistic Q is approximately distributed with - -
degrees of freedom. In Table III, the hypothesis of white noise
disturbance can be accepted for the residuals. Nevertheless, a
number of researchers have detected intertemporal relations
between expected volatility and market information. Let us
now turn our attention more explicitly to these relations.
E. Identifying Exogenous Influences
We are interested in assessing the degree to which the
exogenous variables in Table I have a significant influence in
explaining changes in implied volatility, and whether by using
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
TABLE IV
ESTIMATION RESULTS FOR MLR EQUATIONS ON HOURLY CHANGES
these variables we obtain incremental value over and above the
time series model. We use the regression model proposed in
the second step of our modeling strategy [see (7)]. To account
for the strong MA(1) component in the regression equation
we incorporate an autoregressive element in the multivariate
model. If we reverse the MA(1) model
we obtain
that is when
(11)
The acf and pacf in Table II suggest that the first three lags
are the only ones that make a significant contribution to the
explanation of changes in implied volatility. After lag3 for
each subsample there is a significant cutoff in the pacf. We
shall therefore use three autoregressive variables in our input
set: and to take into account
the infinite autoregressive order of (11).
Our regression analysis is based on backward stepwise
variable selection. With backward selection, we begin with a
model that contains all of the candidate variables and eliminate
them one at a time. We check at each stage to verify that pre-
viously removed variables are still not significant. We reenter
variables into the model if they become significant when other
variables are removed. We run regression estimations for all
three subsamples.
Table IV gives a summary of the results. Overall, the
addition of exogenous variables gives a small but significant
1231
IN IMPLIED VOLATILITY
improvement in model fit. (i.e., 40.4% Vs 34.9% in terms of
adjusted R-squared).
The results are largely consistent with those obtained in
Table III, and confirm the strong negative linear relation
between changes in implied volatility and its lagged values.
The coefficients for lag one, two, and three are negative and
significant, decreasing in magnitude. This pattern is present
in every subsample period, dominating the explanation of
the output variable. While the autoregressive terms represent
this negative relationship, new variables (moneyness, change
in spot, and maturity effect) appear in the equation adding
extra value. Note the stability of estimation results among the
subsample periods. The coefficient for moneyness is always
positive and significant while the change in spot variable has
a negative linear relation with the output variable. The slope
of the dummy variable, maturity effect, is also significant.
(Volume, which is not shown on the table, also appears as
significant but only in the second subsample with a weak
contribution to the model -statistic of 1.831).
All the estimations present a high -squared value. Evi-
dence in Table IV indicates that there is an improvement in
explaining the variability of the output variable, that ranges
from 12.8% for the third subsample to 2% in the first sub-
sample. To test normality for the residuals we examine the
skewness and kurtosis values. A skewness of zero indicates
that the data are symmetrically distributed. Positive values of
skewness suggest that the upper tail of the curve is longer than
the lower tail, while negative values suggest that the lower
tail is longer. To assess the significance of the skewness value
we use its standardized value . We can reject the hypothesis
about normality of the residuals at the 0.05 significance level
for every subsample. For a normal distribution, the kurtosis
coefficient is zero. When the coefficient is less than zero, the
curve is flat and when is greater than zero, the curve is either
very steep at the center or has relatively long tails. Table IV
1232
TABLE V
LEARNING RESULTS FOR DIFFERENT TOPOLOGIES
shows that the residuals are far from being Gaussian. They
represent curves with relatively long tails for each subsample.
In summary, the normality assumption does not hold but
residuals do not present serial correlation (Durbin–Watson
statistics range from 1.950 in subsample three to 2.060 in
subsample one).
Having analyzed the time structure of the implied volatility
series, and shown that a small but significant incremental value
can be obtained with the use of additional variables and partic-
ularly moneyness, changes in spot, volume, and maturity, the
next step in the modeling procedure is to investigate whether
nonlinear analysis using NN’s can add further incremental
value.
F. Nonlinear Dependencies and Variable Interactions
We start our nonlinear analysis with the third step of phase
one of our modeling strategy whereby we use a multivariate
neural model with the variables and autoregressive terms
identified in Step 2) to construct a well-specified neural model
of implied volatility changes. We then verify if incremental
value can be obtained by including additional variables in
the model through a stepwise forward procedure (phase 2 in
our modeling strategy). To control model selection we make
use of a simple statistical technique based on cross validation.
cross validation requires that the available dataset is divided
into two parts: a training set, used for determining the values
of the weights and biases, and a validation set, used for
deciding when to stop training. In the experiments reported
here we allocate the earlier available timespan data consisting
of 400 observations to the training set and the following 100
observations to the validation set. The final 50 observations
will be used as an (one-off) ex-ante test set to compare all
methods. We use the common backpropagation algorithm for
estimating the network weights with one layer of (up to five)
hidden units, a logistic energy transfer function, linear outputs,
a weight decay term (set to 0.001) and a momentum term
(set to 0.1).
Clearly, since the predictive variables have already been
selected according to a linear criterion (see Table III) any
incremental value obtained in this step will be primarily
attributable to possible interactions between the exogenous
variables and/or time dependencies. A summary of the results
is shown in Table V for four different neural models with
two, three, four, and five hidden units, respectively. Three
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
AND TRAINING TIME
sets of performance measures are shown for the validation
sample ( observations), and the training sample
( observations). For each sample the table shows
the root mean square error (RMSE), the number of iterations at
which minimal was obtained (Converg. It.), the correlation
between estimated and observed ( ), and the percentage of
correctly predicted directional changes (Poccid).
The performance results are stable and similar for different
topologies (except for Net3). The correlations between esti-
mated and observed in the cross validation set range from
0.6465 for Net2 to 0.6941 for Net1 all of which are better
than the in-sample correlation for multiple linear regression
(i.e., 0.635, see Table IV). Rmse values range from 0.075 15
in Net1 to 0.091 84 in Net3. Correlation measures of the vector
are around 0.65 except for Net3 where the correlation
is 0.47.
The first and simplest neural model (Net1) with two hid-
den units does not appear to be able to fit the data well.
Its in-sample RMSE remains constant at 0.1063 throughout
training, with a correlation between actual and predicted of
0.6578 which is only marginally better than the multiple linear
regression (i.e., 0.635 see Table IV). Also its performance (in
terms of correlation ) in the validation set is suspiciously
higher than that in the training set.
The third neural model (Net3) with four hidden units appears
to have been trapped in a local minimum with a mean square
error similar to the first network and an in-sample correlation
between actual and predicted of 0.41 which is worse than the
multiple linear regression.
In principle, models with the characteristics of Net1 and
Net3 exhibit all the signs of a misspecified model. Indeed,
a test for serial correlation on the residuals of both these
models shows that their residuals are autocorrelated to nearly
the same level as the original implied volatility series with one
significant lag . This can also be seen in their
D.W. statistics. Although we cannot formally test the D.W.
for these two nonlinear models, we shall reject both models as
misspecified. Misspecified models can occur with NN’s for the
classical reasons i.e., omitting important variables or fitting a
low-order polynomial to a dataset which has been generated by
a high-order nonlinear process. Being unable to escape from
a local minimum (as for example with Net3) or not having a
sufficiently high number of free parameters (or a combination
of the two) can also lead to a badly specified model.
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
TABLE VI
IN-SAMPLE PERFORMANCE ALL DATA
For both the remaining models Net2 and Net4 with three
and five hidden units, respectively, we can accept the null
hypothesis of the residuals being white noise disturbances.
Net4 appears to give a better fit for the in-sample data
( as opposed to ) but not overly so.
This can be seen in the validation figures (i.e.,
versus ). Thus, we select the model provided by
Net4 for further experiments.
Table VI gives a summary of the overall results so far.
Clearly, the multivariate neural model has provided significant
incremental value in terms of explaining changes in implied
volatility over the MLR and Box–Jenkins models. As we
shall see in Section II-H, this incremental value is persistent
in the ex-ante test set and also in the economic evaluation
of the models. But before evaluating the models on the
ex-ante test set let us examine whether further incremental
value can be achieved by including additional variables which
although rejected by the linear criterion in the first phase of
our modeling methodology, may nevertheless have significant
explanatory power in the nonlinear sense.
G. Nonlinear Variable Selection
In this, the second, phase of our model identification proce-
dure we attempt to identify any residual nonlinear dependen-
cies that may be present through a process of forward variable
selection.
The first step in this procedure is to compute a complexity-
adjusted payoff measure which evaluates the change in model
error that would result if an additional variable, were
added to the model. The payoff (is analogous to the Akaike
information criterion and) penalizes the gain in performance
by a complexity term which depends upon the sample size and
the additional degrees of freedom. Recall, that it is computed
by (10) where is the correlation between
observed and estimated (in the cross validation set) given by
a model which includes all previous variables plus an
additional variable . The second term in the equation
is the complexity penalty term where is the sample size
and is the additional number of free parameters. So, for
example if we have a network with four hidden units, the
addition of a new variable will use a maximum of new
parameters.
With our validation sample size fixed to 100 and a
maximum number of potential degrees of freedom
(i.e., the new connections from the additional variable to all
five hidden units), the complexity penalty term grows almost
linearly with . In other words we shall only include a new
variable if it contributes to a performance gain of 5% or
more. This is a relatively strong criterion for variable entry
particularly when compared to forward regression analysis
1233
TABLE VII
FORWARD VARIABLE SELECTION—FIRST FORWARD PASS
where we are generally prepared to allow variables to enter the
model with a relatively low -statistic. However, by using the
-statistic we are effectively testing the hypothesis of variable
significance at a specified level of confidence. With neural
models it is not straightforward to test the same hypothesis as
it involves making strong and potentially invalid assumptions
(see for example the seminal work of [76] or [62] for variable
significance testing; and also [3] for omitted nonlinearity). An
alternative criterion is goodness of fit but given the fact that
NN’s can fit the data arbitrarily close and the validation sample
is relatively small it is desirable to use a stricter criterion for
(variable) entry (into the model).
The results of the first pass are summarized in Table VII.
From the remaining eight variables, it appears that the addition
of volume, day-effect, velocity, average spread, and maturity
can produce models with better correlation between observed
and estimated in the cross validation period. However, when
adjusted for additional complexity none of these variables ap-
pears to add significant incremental value, over and above the
benchmark multivariate neural model (with
.
The results shown in Table VII essentially preclude any
further analysis for the step wise forward procedure. With
perhaps less restrictive penalties for the additional complexity
it might have been desirable to include volume, and day effect
but our conservative use of extra complexity precludes that.
Instead of running the risk of overfitting the data we choose
to verify this result by a variable significance estimation
procedure which operates in the opposite, i.e., backward
fashion.
Backward variable selection operates in the opposite direc-
tion. It is similar to the sensitivity based pruning introduced
by Moody and Utans [53] whereby we fit a model with all
available variables (using cross validation) and attempt to
determine the most significant variables by computing the
change in error that would result if variable were removed
from the network. By setting each of the input variables to
its mean value (one at a time), we compute the measure
, which assesses the overall contribution to prediction
accuracy due to that particular variable. We use two criteria
for prediction accuracy: 1) the RMSE between observed and
estimated in the validation set and 2) the correlation between
1234
TABLE VIII
LEARNING RESULTS FOR DIFFERENT TOPOLOGIES
observed and estimated (also in the validation)
(26)
and
(27)
where lies between zero and one. Note that in computing
no retraining of the network is required. By ranking the
importance of all variables using a nonlinear criterion, the
objective of this test is simply to verify or refute the hypothesis
that no significant variable have been left out without having
to incur the cost of iteratively reestimating models with all
possible combinations of variables. This test differs from
Moody and Utans [53] in that the sensitivity (contribution)
of each variable is computed only for the validation set and
in that it uses the ratio rather than the difference in the two
error measures.
The results are shown in Tables VIII and IX for different
neural models and different variables, respectively. Table VIII
shows the performance measures obtained for each network’s
crossvalidation, and training sets ( and Insam, respectively).
The performance results are similar for different topologies
(except for NET1—note its D.W. statistic).
Overall including all 14 variables in the model gives worse
results than both the multiple linear regression with the six
most significant variables and the multivariate neural model
with the same six variables. RMSE measures in the validation
set ranges from 0.0833 in NET3 to 0.0966 in NET1. Corre-
lation analysis of the pair of vectors (observed, estimated) is
around 0.59 except for NET1 where correlation is below 0.40
(again note also its D.W. statistic). Again, Poccid shows a
very stable behavior around 75% for all the networks trained,
except for NET1 where Poccid is a low 55%.
The objective of this test, however, is to verify that no
significant variable have been omitted from the nonlinear
analysis. Table IX gives a ranking of all 14 variables according
to both versions of the metric. The results broadly confirm
the information that we had extracted from the univariate
and multivariate linear analysis. The contribution of the au-
toregressive variables, Vol.lag(1), Vol.lag(2), and Vol.lag(3) is
evident, confirming the strong mean reversion effect in the
data. These variables appear always in the top part of the
table for both versions of the metric. The maturity effect,
moneyness, and changes in spot also appear in the top half of
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
AND TRAINING TIME. ALL DATA
TABLE IX
STATISTIC < BASED ON RMSE CORRELATION
the table. However, there are two new variables that appear at
the top of the table: Historical volatility, day effect and volume,
but this is not consistent. Historical volatility is at the bottom
of the table with the RMSE measure of while volume and
day effect are inconsistent in that their importance varies with
the subsampling period.
It also appears from Table IX that the contribution of these
two variables becomes important when they are both included
in the model rather than through their individual contribution
(as the forward analysis has shown) indicating an interaction
effect between volume and day of the week. With hindsight
it might have been desirable to continue the forward selection
process beyond the first pass. Ultimately there is a price to be
paid for being (perhaps too) conservative with the complexity
penalty term in the payoff criterion which we are prepared to
accept.
So far we have studied the in-sample and/or validation set
performance of the models, and have concluded that a simple
step-wise modeling strategy can capture both the main linear
and nonlinear features of the data. In addition, we have shown
that there is significant incremental value to be obtained from
nonlinear dependencies and interaction between the variables
(see Table V). The ultimate goal, however, is to predict future
values of the time series. In the next section we compare
the ex-ante forecasting performance of Box–Jenkins univariate
predictors, forecasts from standard MLR and nonlinear neural
models.
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
TABLE X
OUTSAMPLE PERFORMANCE. ALL DATA (a)
H. Ex Ante Evaluation of The Models
The ex-ante test set consists of 50 observations held out of
the sample to test the validity of our findings. The three models
are evaluated both in terms of their prediction accuracy on this
test set and in terms of their the economic performance.
The prediction accuracy of each model is evaluated by a
single-step ahead prediction. At the closing of each trading
hour, when the values of all independent variables are known
we make a forecast for the change in implied volatility over
the next trading hour. The forecasts of each model are then
compared with the actual changes. Two measures are used to
evaluate forecasting accuracy. The correlation between actual
and predicted over the unseen 50 observations, and Poccid:
the percentage of correctly predicted directional changes. The
results for each model are shown in Table X. Recall that the
Box–Jenkins and MLR models have been estimated over the
entire sample of 500 observations, whereas the neural model
has used only the first 400 of these observations directly for
training.
The results both in terms of correlation and in directional
changes are consistent with the expectations from the in-
sample period (and in the case of neural models with the
validation period). The neural model yields correlation val-
ues around 0.63 against 0.55 of the MLR model and 0.50
of the univariate model. The improvement obtained by the
neural model is significant in terms of . Starting from
the Box–Jenkins model which uses the least information
available (i.e., the implied volatility series alone) it is pos-
sible to add extra value by introducing exogenous influences
via new inputs: first in a straightforward linear model and
then considering possible nonlinear interactions among the
variables.
Financial data series are very often nonstationary. One test
that is often used to safeguard against spurious models is
to divide the training data into a number of subsamples.
A separate model is then reestimated for each subsample
and a test for stationarity is performed on the parameters of
each model. If the separate models are radically different or
their performance on the ex-ante test set is radically different
then there is risk that the estimated models have captured
some temporary and perhaps unrepeatable relationship rather
than a relationship which is invariant through time. The
results, shown in Table X, are consistent with those obtained
with applying the modeling strategy to each of the three
subsampling periods as shown in Table II. The analysis is
described in [61] and safely concludes that all models give
acceptably stable performance.
1235
The economic evaluation of the models involves the use
of a simple “trading strategy” for a market participant using
the predictions of the neural, MLR, and time-series models to
purchase or sell delta-hedged short maturity call options in the
Ibex35 option market (between ten and 45 days). This requires
the purchase/sale of at-the-money call options on Ibex35 in
every time border. The option positions are held until the
end of the hour at which point another position is established
based on the forecasted direction by the models. In a general
sense, the strategy will profit when the forecasted direction
is the same as the true direction taken by the market and
when the true implied volatility quotes remain rather volatile
or in other words the magnitude of the movement of true
volatility is large. We conduct the evaluation in two stages. In
the first stage we ignore transaction costs and assume that
trades are available at the end of every time border. The
number of trades is set to 50. The profit/loss figures are based
on hourly investments of 100 option contracts and do not
incorporate reinvested profits. Clearly, this is a simplification
of real market conditions.
The cumulative profit curves associated with each model
forecasts (NN, MLR, and Box–Jenkins) show a steady prof-
itability for each model (see Fig. 3).
Though cumulative profits have a slight drawdown near the
end of the forecasted period for the three models, the trends for
the remainder of the period are strong and consistent. The cu-
mulative profit curve for the MA(1) model predictions presents
a considerable number of peaks and troughs. Nonetheless, the
strategy using the forecasts from the MA(1) model otherwise
earns consistent and positive profits. The NN predictions are
more profitable than MLR or univariate predictions. Univariate
forecasts present the worst performance overall. The ability to
consistently profit from the trading strategy based on any of
the model predictions may be due to the strong mean reversion
effect reported in earlier sections. In that sense, these profits
are not riskless. Their riskiness must also be considered in
evaluating their significance.
Table XII provides a measure of the risk-adjusted returns of
the strategy. The mean hourly profit is reported, along with
the -statistic with the null hypothesis that the sample mean
is zero. Since the divisor of the computation is the sample
standard divided by the squared root of the sample size, the
-statistic (other than a scaling factor) bear a correspondence
to the reward/risk tradeoff of each model.
Table XII indicates that the profits based on the forecasts
of all models are impressively large. The reward/risk ratios
ranges from 1.99 for MA(1) model to 4.00 for the NN
1236 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997

TABLE XII
HOURLY PROFITS FOR Ibex35 OPTION TRADING STRATEGY (a)

Fig. 3. Profit and loss of different models under a simplistic trading strategy.

Fig. 4. Profit and loss of different models, adjusted for transaction costs.

system. This evidence supports the notion that model forecasts
are able to give economic value to the market participant.
However, to demonstrate that the strategy can benefit from
the forecasting models, it is also required that we include
the effect of transaction costs. This is shown in Fig. 4 Also
the last two columns of Table XII indicate the influence of
bid/ask transactions costs on trading strategy profits. As the
results indicate, the introduction of transaction costs (at 0.5%)
virtually eliminates the profitability of the linear models but
not so for the neural forecasts. The -statistic or reward/risk
ratio ranges from 0.233 for the univariate model to 2.06 for
the NN model. Clearly, trading the forecasts of the neural
model appears to have economic significance in contrast with
the MLR and univariate models.
So far we have described a step-wise model selection
procedure for NN’s and evaluated its use in forecasting implied
volatility changes. We have shown that this simple procedure is
successful in capturing the main linear and nonlinear depen-
dencies of implied volatility to various exogenous variables
described in the literature, and that in the case of Ibex-35
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
options neural models give significant incremental value both
in terms of forecasting accuracy and also in economic in
terms. However, it has been argued that NN’s are “black
boxes” which are difficult to analyze and understand and hence
competitive rather than synergetic with theory formulation. In
the next section, we use sensitivity analysis to obtain some
insight into the nature of the relationship that has been captured
by the neural model between innovations in implied volatility
and its determinant factors.
I. Sensitivity Analysis
Fig. 5 shows graphs of the response functions of the output
with respect to the inputs. The graphs obtained refer to the
training of NET4. Recall that the variables Vol.lag1, Vol.lag2,
and Vol.lag3 are those with the greatest influence on the change
in implied volatility and they should represent a mean reverting
effect. Fig. 5 clearly confirms this effect.
Fig. 6 indicates how the independent variable, volatility
changes, moves with the maturity effect variable while holding
the remaining inputs constant to their most typical value
(median). The neural model activates only two different points
in the maturity effect domain, i.e., zero and one. This result is
not surprising since this is a dummy variable (0,1). What the
model does is to sensitise the output variable near these two
points. Note that the influence on volatility changes is minimal
in the intermediate values of the interval (0,1).
The model succeeds in recognizing and differentiating the
effect of the dummy in the data, separating the changes in
volatility occurred in days where the maturity of the contract is
equal or less than three days (dummy ) from those realized
when the option has a maturity longer than three trading days
(dummy ). The eventual relationship between these two
variables is not entirely clear since the extreme values zero
and one, appear to compensate each other.
Fig. 7 depicts how the independent variable varies as we
change the other input variable in our model, (changes in spot).
Large changes in spot would typically induce similarly large
changes in implied volatility. Alternatively, when changes in
spot are relatively small, the derivatives with respect to this
variable are almost flat. This behavior of volatility changes
with respect to changes in spot is what we would expect but
which is undetectable with linear methods..
Fig. 8 shows how changes in volatility moves with the
moneyness variable. Hull and White [43] and Stein and Stein
[72] have shown that it is rational for implied volatility to
vary with the strike price , when the asset volatility is
believed to be stochastic. When special assumptions are made,
their equations and calculations show that a plot of theoretical
implieds against displays a smile: the function has a U-
shape and the minimum implied occurs at a value of near
the forward price of the underlying asset.
Some authors have reported smile effects in different data
sets [69], [71], [32]. Pozo [58] has argued that U-shaped
pattern occurred for Ibex35 options during various subperiods
between 1991 and 1993. It is not the task of this study to
look for volatility smile patterns in the Ibex35 data. However,
Fig. 8 gives a measure of the way in which volatility changes
1237
are influenced by the situation of the strike. In other words,
it indicates how the volatility smile changes through time
with changes in the strike. When moneyness is close to zero,
i.e., strike is close to spot price, the influence of this input
variable is minimal. Conversely, when moneyness moves away
from zero the influence on the output becomes larger although
this relation appears to be asymmetric. For in-the-money
options moneyness seems to influence the changes
in volatility to a higher degree than for out-of-the-money
options . Again, this result has important economic
implications for market participants. The neural model has
succeed in capturing the importance of this variable and in
doing so providing valuable information.
We described a step-wise model selection procedure for
NN’s and evaluated its use in forecasting implied volatility
changes. We have shown that this simple procedure is success-
ful in capturing the main linear and nonlinear dependencies of
implied volatility to various exogenous variables described in
the literature, and that in the case of Ibex-35 options neural
models give significant incremental value both in terms of
forecasting accuracy and also in economic in terms.
The modeling strategy is based on a integrative approach,
combining information in a hierarchical building process. We
departed from the least available information set given by
the univariate series itself using the well-known Box–Jenkins
time series analysis. From this bottom line, we incorporated
exogenous influences, first making use of a linear econometric
tool (MLR) and then implementing a more complex nonlinear
model using NN’s. This strategy intends to overcome the lack
of a systematic model-building process for neural models, and
aims to make neurotechnology a more understandable and
useful tool for financial economists.
Besides the problem of variable selection, the construction
of reliable neural estimators for financial data entails two
further problems: dealing with nonstationary data and handling
influential observations or leveraged data. In this section we
addressed the problem of nonstationarity by differencing the
implied volatility series. In the next section we use the concept
of conditional cointegration as a framework for handling
nonstationary data which has the added benefit of enhancing
statistical inference. Within this framework, we describe an
alternative way for principled variable selection and address
the issue of robustness to influential observations.
III. MODELING COINTEGRATION IN
INTERNATIONAL EQUITY INDEX FUTURES
A. Overview
Recent years have witnessed a growing dissatisfaction with
the stationarity and ergodicity assumptions upon which the
bulk of time-series theory has been founded. Although these
assumptions may be reasonable for many time series in the
natural sciences they are rather too restrictive for economic
and financial data series most of which appear to have first
and second unconditional moments that are far from being
time invariant. A time series can be nonstationary in an
unlimited number of ways but one particular class of non-
1238
Fig. 5. Mean reversion effects in volatility.
stationary process has monopolized the interest of econome-
tricians, namely that of integrated (i.e., stochastically trending)
processes primarily due to Granger and Newbold [35]. They
advocated the use of differencing as a way of dealing with
nonstationarity. As a result, a vast literature on testing for
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
(a)
(b)
(c)
integrated behavior, as well as on statistical inference in
the presence of integrated variables, has appeared and keeps
growing steadily. However, when modeling only in terms of
differenced variables considerable long-run information (which
might be present on the levels of the variables), is lost and
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING 1239

Fig. 6. Volatility changes as a function of the maturity effect.

Fig. 7. Volatility changes as a function of changes in the underlying spot.

Fig. 8. Volatility changes as a function of moneyness.

statistical inference may be impeded. This is particularly likely, due for example to random shocks or indeed due to
important in finance where theory suggests the existence of deterministic but unknown factors, these deviations tend to
long-run equilibrium relationships among variables. Although be bounded through the actions of a variety of agents which
short-run deviations from the equilibrium point are most act as stabilizing mechanisms bringing the system back to
1240 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
equilibrium. Granger [36]–[38] and Engle [25] developed what
can be regarded as the statistical counterpart of these ideas:
the concept of cointegration.
Cointegration allows individual time series to be stationary
in first differences (but not in levels), while some linear
combinations of the series are stationary in levels. By inter-
preting such a linear combination as a long-run relationship
or an “attractor” of the system, cointegration implies that
deviations from this attractor are stationary, even though
the series themselves have infinite variance. Cointegration
provides a way of alleviating the inefficiencies caused by
the disuse of long-run information (available on the levels
of the variables) while considerably facilitating statistical
inference. The need to make use of information about long-
run relationships among the levels of variables has long been
recognized by the advocates of error correction mechanisms
(ECM’s) [66], [19], [42], which attempt to incorporate both
short-run dynamics and long-run information through the
use of error-correction terms in linear regression. There is
however an impressive relationship between error correction
mechanisms and cointegration. Granger [37] showed that
if a set of variables is cointegrated, then it has an ECM
representation and conversely, an ECM always produces a set
of variables that are cointegrated. This means that for variables
that move stochastically together over time the ECM model
provides a linear representation which is capable of adequately
representing the time series properties of the data set.
Such models of cointegration have been very useful in
expanding our understanding of financial time series; never-
theless many empirical “anomalies” have remained unexplain-
able. This may be due to the linear nature of the models and
the fact that short-run deviations from the equilibrium point are
attributed to random shocks. It is entirely plausible that short-
run deviations may be (at least partially) attributable to other
economic factors. For example, if the short term influence
of other factors can disturb the longer term cointegration,
we would hope to be able to model the strength of the
cointegration as a function of other events occurring in the
financial markets. For instance, it is entirely plausible to
suggest that a rapid increase in oil prices would tend to
decouple two cointegrated markets, especially if one belonged
to an oil-producing nation and the other to an oil consumer.
Unfortunately, traditional linear models fail to capture this type
of behavior because the sensitivity of the model to a given
factor is constant and reflected by a single coefficient. In a
traditional regression model this coefficient comes to represent
the average strength of the relationship between asset returns
and a given factor. Subsequently it would be desirable to
develop nonlinear models of cointegration in which short-run
deviation from the equilibrium point are conditioned on other
factors which may effect the strength of the cointegration in
nonlinear ways.
In this section we introduce the concept of “conditional
cointegration” and show how this provides both a framework
for dealing with nonstationarity and enhancing statistical infer-
ence. The methodology consists of four stages. In the first stage
we verify the presence of cointegration in the linear sense.
In the second stage we examine if incremental value can be
provided by extending the model to capture any dependencies
of the cointegration on other factors both in the linear and
nonlinear sense. In the third stage we apply a nonlinear
variable selection methodology to identify the most significant
of the (unknown) factors which influence the strength of the
cointegration. Finally in the fourth stage we address the issue
of robustness to outliers and influential observations and show
that combining a median estimator with the less robust mean-
squared-error estimator, using a simple trading rule, further
enhances the out-of-sample risk/return performance of the
system.
B. Experimental Setup—Identifying Cointegration
We examine cointegration among international equity fu-
tures indexes mostly drawn from the European markets. The
idea behind cointegration is quite simple: there are markets
and/or economic variables which in the long run share a
common stochastic trend but from which there may be tem-
porary divergences. Such markets are called cointegrated if
the residuals of the regression of one variable on another
are stationary (mean-reverting). The hypothesis is that these
residuals, which represent temporary discrepancies in the
relative values of the variables, are due to factors outside the
cointegration and, in the short run, current events may take
priority over the longer term cointegration.
To demonstrate how cointegration works let us consider the
index of FTSE futures and its relationship with a basket of
other indexes, comprising the U.S. S&P, German Dax, French
Cac, Dutch Eoe and Swiss SMI. The data are daily closing
prices for all the indexes from 6 June 1988 to 17 November
1993.
The procedure for identifying cointegration is as follows:
firstly we regress the level of the FTSE on the levels of the
other indexes. The coefficients of the regression represent the
amounts of each of the other indexes which should be held in a
portfolio in order to obtain, on average, the same performance
as the FTSE. Saying that the indexes are cointegrated is
equivalent to saying that the markets have an idea of a “fair”
level of the FTSE compared to the other indexes and that if
the FTSE rises above or falls below this level then it will tend
to move back toward it; this mean reversion usually takes
place over a longish time period (weeks or months). In a
statistical sense we can test for a stable relationship over time
by testing the residuals of this regression for stationarity. This
is a straightforward procedure using the well-known “unit root
test” [22].
Fig. 9 shows the levels of FTSE plotted together with the
levels of a basket of DAX, CAC, EoE, S&P, and SMI. The
proportions of each of the other indexes is determined by their
beta in the regression
FTSE DAX EoE S P
SMI (28)
where is random noise.
It easy to see that the FTSE is periodically under/over
valued. This becomes clearer when we plot the residuals
of the regression which show a clear mean-reversion (see
Fig. 10).
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
Fig. 9. Cointegration between the FTSE and a portfolio of international indexes—in level terms, the six indexes are individually stochastically trending
together over time but in the long run the system is brought back to equilibrium.
Fig. 10. Residuals from the cointegrating regression.
We test the residuals for stationarity using the unit-root test.
We find that the critical value for the 99% confidence level
of the stationarity test is 3.5 and that the actual value which
we obtain is 5.2. This value is higher than the critical value
and hence shows that the cointegration effect is statistically
significant.
If cointegration were the only factor at work then any
small discrepancies in prices would rapidly be eliminated
by the mean-reversion effect. In fact this would then be
indistinguishable from a conventional “no arbitrage” situation
in which price discrepancies can be exploited to generate
a riskless profit. However, this is clearly not the case in
this instance where significant mispricings can occur and can
persist for long periods of time. This reflects the fact that
economic, financial, political, and industry specific factors
will influence the relative prices of the different markets.
The cointegration hypothesis suggests that in spite of these
factors the markets will move together in the long term
and that a “mispricing” will cause upward price pressure
on the undervalued asset and downward pressure on the
overvalued asset, tending to push the prices of the two assets
together.
1241
The key difference between cointegration and no-arbitrage
relationships is that cointegration is a statistical rather than
a guaranteed relationship; the fact that prices have moved
together in the past can suggest that they will continue to do
so in future but can not guarantee that this will in fact happen.
Because of this cointegration does not offer a riskless profit
and is perhaps best considered as statistical arbitrage to reflect
the similarity to “normal” arbitrage while acknowledging the
presence of uncertainty or risk.
If the short-term influence of other factors can disturb the
longer term cointegration, we would hope to be able to model
the strength of the cointegration as a function of other events
occurring in the financial markets. Table XIII describes a set of
candidate variables which might explain short-run deviations
from the equilibrium point (i.e., the way in which the residuals
fluctuate).
For instance, it is entirely plausible to suggest that a rapid
change in oil prices would tend to decouple two cointegrated
markets, especially if one belonged to an oil-producing nation
and the other to an oil consumer. Unfortunately, traditional
linear models fail to capture this type of behavior because
the sensitivity of the model to a given factor is constant
1242
TABLE XIII
SUMMARY OFCANDIDATE VARIABLES
and reflected by a single coefficient. In a traditional regres-
sion model this coefficient comes to represent the average
strength of the relationship between asset returns and a given
factor.
However, this situation changes when we consider NN
models. The powerful universal approximation abilities of
NN’s allow them to represent arbitrary nonlinear functions.
An important corollary of this is that the sensitivity (or partial
derivative) of the model to a given factor can arbitrarily vary
as a function of the other inputs to the model. In the case
of cointegration, this would allow us to model a relationship
which is strongly cointegrated under certain circumstances,
weakly cointegrated under others and perhaps even negatively
cointegrated under yet others.
This notion of conditional cointegration becomes particu-
larly relevant when we consider the increasing efficiency of
the financial markets. Cointegration effects strong enough to
prevail under all market conditions would be relatively easy
to detect using linear techniques, and hence would be unlikely
to generate excess profits for very long. On the other hand,
more subtle conditional cointegration effects are less amenable
to linear techniques and hence are less likely to have been
eliminated by market activity. For instance, two assets might
exhibit an average cointegration which generates insufficient
profits, but this might be a composite of a strong (profitable)
cointegration under certain circumstances and a weak (or even
negative) cointegration under other circumstances. NN’s and
other nonlinear methodologies provide a tool for identifying
and exploiting this type of relationship. From a technical per-
spective, the concept of conditional cointegration provides an
economically and financially feasible framework for applying
NN’s to financial modeling and forecasting applications.
C. Modeling Strategy
The modeling strategy described here is applicable to mar-
kets and instruments where finance theory and/or market
dynamics may recognize long-run equilibrium relationships.
The objective of the procedure is to 1) verify the presence
of cointegration; 2) identify exogenous factors influencing the
short-run dynamics of the cointegration; 3) identify the most
significant of those factors; and 4) construct a reliable esti-
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
mator which is robust to influential observations and leverage
data.
There are many ways of dealing with these issues. It is,
for example, entirely acceptable to use the modeling strategy
described in the previous section of this paper to identify time
structure in the cointegrating residuals, exogenous influences,
and nonlinear dependencies. However, with this method the
criteria for variable selection and hypothesis testing are to a
large extent model-dependent. It is often desirable for such
criteria to be independent of the actual model. Although not
always possible, this is particularly true for models which are
susceptible to overfitting. In this section we shall deploy a
slightly different procedure for the purposes of illustrating
an alternative way of variable selection (which is model
independent) and hypothesis testing. The procedure consists
of the following steps.
1) Identifying cointegration: Using multiple linear regres-
sion regress the level of the dependent variable against
the levels of the independent variables and test the
residuals for stationarity
(29)
(30)
The test for stationarity involves constructing the auxil-
iary regression in (30) and rejecting the hypothesis that
This simple method of identifying cointegration
may not be appropriate in all cases (for example when
there is no obvious causal relationship it can produce
biased coefficients); nevertheless since it is one of the
simplest available we retain its use. For more sophisti-
cated tests of identifying cointegration, see, for example,
[56] and [46].
2) Identifying exogenous influences: The objective of this
test is to verify if short-run deviations for the equilibrium
point can be attributed to a vector of exogenous variables
such as for example those described in Table XIII.
Although this can be achieved by using the approach
described in Section II of this paper, in this step we
shall deploy a slightly different procedure. We start by
constructing the following well-specified models of the
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
cointegrating residuals
(31)
(32)
To test if incremental value can be obtained by the
multivariate linear and neural model we evaluate their
performance on an unseen dataset. For each estimator we
test the hypothesis that its performance is significantly
better than the auxiliary regression in (30). We also
repeat the test between the two estimators in (31) and
(32). For any two estimators, this is done using the
statistic
(33)
where and denote the respective mean performance
and and the standard errors of the relevant estima-
tors. The mean performance can be formulated in terms
of correlation between observed and estimated in the test
sample. It can also be formulated in terms of economic
performance should the two estimators be used in the
context of the same trading strategy. The hypothesis is
formulated in terms of H0: , in which
case the statistic should follow a standard normal
distribution, against the alternative H1: . prediction of whether the return of the FTSE will be higher
3) Identifying nonlinear dependencies and interactions:
The use of an ANOVA-derived F-test of conditional
expectations is suggested as an alternative means of
preliminary variable selection for NN’s. Unlike other
model-independent methods such as correlation analysis,
it is capable of identifying nonlinearities, either directly,
in the relationship between individual explanatory vari-
ables and the dependent variable, or indirectly, in the
form of interaction effects. Using this approach we
refine the models down to a small number of variables.
These models both perform better than the original,
overspecified, models and also make sense from an eco-
nomic viewpoint. Again, the nonlinear model performs
substantially better out-of-sample than the equivalent
linear model.
Median learning and robustness: The use of a mean-
absolute-deviation cost function leads to an estimator of
the conditional median of the dependent variable and as
such is more robust than the conventional estimators of
the mean which arise from the use of MSE/OLS. In par-
ticular, estimators of mean and median will diverge most
noticeably under the influence of extreme observations and
such divergence can be taken as an indicator of unreliable
predictions. Using a simple rule for combining forecasts
whereby we take a position if the estimators of mean and
median agree on the sign of the predicted return we show
that the hybrid system produces very similar out-of-sample
returns (approx. 46% over two years) but with substantially
reduced risk; the Sharpe ratio of the combined system
1243
(representing risk/return profile) is 2.42 compared to the
1.78 and 1.72 of the individual neural models.
The modeling strategy described above is not necessarily
the only procedure or indeed the most appropriate modeling
strategy. It is, for example, entirely acceptable to use the
strategy described in the previous section of this paper in
Steps 2) and 3) of the procedure. The two methods are not
mutually exclusive but they differ primarily in the way in
which variables are selected for entry into the model. The -
test selects variables in a model independent way and in many
respects it is preferable. However, when testing for interaction
effects, in a large number of dimensions it requires relatively
large samples which are not always available.
Having applied the first step of our modeling procedure (see
Section III-B) and satisfied the cointegration criterion let us
turn our attention to verifying that the cointegration residuals
reflect the existence of other factors which effect the markets
in the short-run.
D. Identifying Exogenous Influences
The cointegration residuals reflect the existence of other
factors which affect the markets in the short run. Changes
in the cointegration residual reflect changes in the relative
return of the FTSE compared to the basket of international
indexes [the RHS of (28)]. The evaluation of nonlinear and
linear models will be based on a simple trading strategy which
takes long/short positions on both sides of (28) based on a
or lower than that of the basket portfolio over the subsequent
ten-day forecast period.
There is a slight complication to the modeling procedure
because the nature of the cointegration regression in itself
induces a slight element of mean-reversion into the residuals
(the insample residuals of a regression are, by construction,
unbiased). Also, for implementation purposes, the cointegrat-
ing relationship should only be estimated using past data.
The solution to both of these problems is to use a moving
window regression for the cointegrating relationship and then
to generate the (out-of-sample) residuals by applying this
model to future data. In our case we use a window of 200
points to estimate the coefficients of the regression [the ’s in
(28)] and reestimate the relationship every 100 points.
The initial step is to verify the existence of the underlying
cointegrating relationship itself. Rather than performing a
traditional “in-sample” test such as those discussed above,
our focus is to test the predictive information contained in
the cointegrating residual, as indicated by the generalization
ability of the models in the out-of-sample period. We test both
a linear model of the form:
(34)
Note that modeling the relative price changes on the LHS
of (34) is equivalent to modeling changes in the residuals
except during periods where the cointegrating regression is
reestimated. We then go on to test for direct nonlinearities by
building the model which is the nonlinear generalization of
1244
Fig. 11. Cumulative profit/loss for the initial linear and nonlinear models.
TABLE XIV
OUT OF SAMPLE PERFORMANCE OF UNI-VARIATE MODELS
(34) given by
(35)
The parameters in (34) and the function in (35) were
estimated by gradient descent in the parameter space using
a feedforward NN. A moving window modeling approach
was deployed using the first 300 observations for training,
the next 100 for cross validation/early-stopping and a further
100 for out-of-sample testing. The “window” is then shifted
forward 100 observations and the process repeated until a
total of 500 out-of-sample predictions were available. As the
model was built using overlapping daily observations this is
approximately equivalent to a two-year out-of-sample period.
Fig. 11. shows the cumulative returns of the two models in
the out of sample period of 500 observations (transaction costs
of eight basis points are included, which is consistent with the
model being executed through the futures markets).
Selected performance metrics for the two models are shown
in Table XIV. “Correlation” refers to standard correlation
coefficient of predicted and actual returns, “Correct” represents
the proportion of predictions with the same sign as the actual
return, “Return” is the profit generated by a simple long–short
trading strategy over the two-year period and “Sharpe Ratio”
is the (annualized) Sharpe ratio of the equity curve which
indicates risk/return profile.
The first thing to notice is that both models show a highly
significant predictive correlation between actual and forecasted
relative returns. This is also reflected in the positive equity
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
produced by each of the two models. Secondly, the overall
similarity of the two models combined with the slightly better
performance of the linear model, suggests that there are no
significant nonlinearities in this direct relationship and that
the slight degradation in the performance of the nonlinear
model is due to overfitting. For this reason we will use only
the performance of the linear model as a benchmark for the
subsequent stages.
The next step was to examine multivariate models. Starting
with the set of candidate variables listed in Table XIII, we
consider the following two models that might explain the
relative returns on the two assets. First the linear model
(36)
Second, to account for the possibility of 1) unknown non-
linear effects between these factors and the residuals and 2)
possible nonlinearities accruing from the interaction between
these factors, we also consider a nonparametric nonlinear
model with the same independent variables but of the form
(37)
As before, the function in and the parameter vector
in (37) were estimated by gradient descent in the parameter
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING 1245

Fig. 12. Cumulative profit/loss for the multivariate linear and nonlinear models.

TABLE XV
OUT-OF-SAMPLE PERFORMANCE OF MULTIVARIATE MODELS

TABLE XVI
STATISTICAL AND ECONOMIC SIGNIFICANCE OF RESULTS

space using a feedforward NN, and the same moving-window
modeling approach is retained.
Fig. 12 shows the cumulative returns of the two multivariate
models.
The performance statistics of these two models are summa-
rized in Table XV.
The results in Table XV indicate that both multivariate mod-
els return a profit during the out-of-sample period. Let us now
test the hypothesis that the results are significantly different
for the different models. We do this by performing -tests to
compare both the correlation and the economic performance of
each pair of models. For instance, in comparing the predictive
correlation of the multivariate models we us
(38)
The results are summarized in Table XVI.
On the whole, the performance of the models is broadly
similar, as indicated by the reltively high -values. The multi-
variate linear model is not significantly different from the basic
model in terms of correlation and actually under-performs
in terms of trading performance. Thus any small predic-
tive information which might be contained in the additional
variables, in a linear sense, is offset by overfitting. This is
consistent with the view that the markets should be efficient
to commonly available data applied within a conventional
modeling framework. On the other hand, the NN model, while
only significantly better in the correlation sense at around
an 80% level of confidence, does improve on the other two
models from a trading perspective with a confidence level of
90% against the basic model and 99% against the multivariate
linear model.
The much improved performance of the NN model over the
linear model suggests the presence of significant nonlinearities
either in the cointegration itself or in the relationships between
the FTSE and the other explanatory variables. Nevertheless, it
was our belief that many of the variables were either redundant
and/or insignificant and that the presence of these was more
likely to cause problems due to overfitting. The next phase of
the study was to perform a variable selection process in order
to obtain a parsimonious model of the cointegration.
E. A Methodology for Nonlinear Variable Selection
Within a linear framework there are a variety of statistical
procedures which assist in the stages of model identification,
1246 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
construction and verification. The model identification stage of
these techniques is typically based on correlation analysis. For
time-series modeling for instance there is the well-known and
established Box–Jenkins framework, [9], which examination
of the autocorrelation function (ACF) allows the modeller
to identify both the order and type (autoregressive, moving
average, or mixed) of the model. Similarly, for multivariate
modeling the most commonly used methodology is that of
stepwise regression, [74], which is likewise based upon the
concepts of correlation and covariance.
Currently there is a lack of an established nonlinear model
identification procedure. When performing time-series model-
ing using NN’s it is still the norm to use correlation analysis as
a preliminary variable selection technique. However, correla-
tion analysis will in many cases fail to identify the existence of
significant nonlinear relationships. This might cause variables
to be erroneously left out of later stages of modeling and result
in poorer models than would be the case had a more powerful
identification procedure been used.
Both linear regression models and NN’s are commonly fitted
by minimizing mean squared error. They provide an estimate
of the mean value of the output variable given the current
values of the input variable, i.e., a conditional expectation.
This insight allows us to realize why measures of dependence
which have been developed for linear models are not always
suitable for nonlinear models.
In a broad sense, a linear relationship exists if and only
if the conditional expectation either consistently increases
or consistently decreases as we increase the value of the
independent variable. A nonlinear relationship, however, only
requires that the conditional expectation varies as we increase
the independent variable. The class of functions which would
thus be missed by a linear measure but identified by a suitable
nonlinear one includes symmetric functions, periodic functions
(e.g., sinewave), and many others besides.
We propose a measure of the degree to which the conditional
expectation of the dependent variable varies with a given set
of independent variables but which imposes no condition that
this variation should be of a particular form.
1) Analysis of Variance or ANOVA: The ANOVA tech-
nique is a standard statistical technique, usually used for
analysis of categorical independent variables, which divides a
sample into groups and then tests to see if the differences
between the groups are statistically significant. It does this
by comparing the variability within the individual groups to
the variability between the different groups. First, the total
variability within the groups is calculated by
SSW (39)
Where is the group to which the th observation
belongs. With groups we lose degrees of freedom in
estimating the group means, so we can estimate the variance
of the data by SSW . Second, the variability between
the groups is calculated by
SSB (40)
Where is the number of observations in group . Here
we lose one degree of freedom for using the sample mean.
Thus we can also use SSB to estimate the true variance of the
data by dividing by .
If the different groups represent samples from the same
underlying distribution then SSW and SSB are simply depen-
dent on the underlying true variance. Adjusting for degrees
of freedom, each can be used as an estimate of the variance
and the ratio given in (41) follows an distribution with
degrees of freedom
SSB
(41)
SSW
Under the null hypothesis that all groups are drawn from
the same distribution then the ratio will be below the 10%
critical value nine times out of ten and below the 1% critical
value 99 times out of 100, etc. However if a pattern exists
then the between group variation will be increased. This will
cause a higher -ratio and, if the pattern is sufficiently strong,
lead to the rejection of the null hypothesis.
2) Testing a Single Variable: Thus we can perform an
ANOVA test to establish whether the variance in the
conditional expectation of given different values of is
statistically significant.
The first step is to choose the number of groups;
typically this would be in the range three–ten. Following
this, each observation is allocated to the appropriate group
by dividing the continuous range of the original variable into
nonoverlapping regions. For a normally distributed variable,
using boundary values which correspond to of
the cumulative normal distribution will cause the number in
each group to be approximately the same.
For example, let be normally distributed with mean ten
and standard deviation five, let , the values for 1/4, 2/4
and 3/4 are 0.675, zero, and 0.675. These correspond to
values of 6.625, ten, and 13.375. Group 1 consists of all those
observations for which ; group 2 is those for which
; group 3 those where and
group 4 those where .
The mean value of the dependent variable within each group
can then be computed. Under the null hypothesis that the
independent variable contains no useful information about the
dependent variable the -ratio SSB SSW
follows an distribution with degrees of
freedom.
3) Testing Sets of Two or More Independent Variables: We
can also test sets of variables simultaneously. For instance,
with two variables the variation between the groups can be
broken down into one component due to the first variable, one
component due to the second variable, and a third component
due to the interaction between the two, i.e.,
SSB SSB SSB
degrees of freedom (42)
Thus we can use this approach to test directly for both
positive interactions, where the two variables together contain
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
Fig. 13. Cumulative profit/loss for parsimonious models.
more information than separately, and also negative interac-
tions, where some of the information is redundant.
F. Ex-Ante Evaluation of the Models
From the original set of 12 variables in Table XIII we
chose to retain those variables which are consistently the most
significant (i.e., those with the largest -statistic but also those
that retain their significance when we divide the training set
into two consecutive parts). According to these criteria the
selected variables, at the 99% level of confidence, are the
following:
1) the cointegration residual (F-ratio 5.94);
2) the change in oil price (F-ratio 3.87);
3) the change in the sterling index (F-ratio 4.62);
4) the volatility in interest rates (F-ratio 2.76 used alone,
but 8.47 allowing for two-way combination with coin-
tegration residual).
We then repeated the modeling process using only these four
selected variables. Fig. 13 shows the cumulative returns of the
resulting linear and NN models for the out-of-sample period.
As can be seen in Fig. 13, there is a marked improvement on
the net returns for both models (see also Table XVII). This is
reflected in the improved correlations and correctness but also,
and most importantly, in the Sharpe ratios of the two models.
This suggests that the original models were overspecified and
suffered from the problem of overfitting which is particularly
dangerous in high-dimensional highly noisy data. Intuitively,
the reduced models make economic sense because they sug-
gest that uncertainties about short-term interest rates tend to
influence the cointegration effect (most likely by distracting
the attention of participants from longer term issues such as
cointegration). The presence of recent changes in oil price
in the model is perhaps linked to the fact that the U.K.
is a net oil producer, whereas the indexes comprising the
cointegrating portfolio primarily represent countries which are
net consumers of oil. Similarly the changes in the Sterling
index reflect changes in the average strength of the U.K.
currency against foreign currencies and it is not surprising
that under certain conditions, this might influence the relative
performance of the FTSE against international equity markets.
1247
TABLE XVII
PERFORMANCE OF PARSIMONIOUS MODELS
Comparing the performance of the network against the
linear model we find that the appropriate -statistics are
correlation: 1.02 -value 0.15), and economic: 1.39 ( -value
0.082). While these improvements are not proof of nonlinear-
ities in the statistical sense (i.e., the -values are too high to
reject the null hypothesis of equal performance) they represent
confidence levels of over 80 and 90%, respectively, that the
nonlinear model has captured interaction effects which are
ignored by the linear model.
G. Combining Standard and Robust Estimators
An important issue when using NN’s to model noisy data
such as asset returns is that of robustness to influential obser-
vations. Influential observations are those (groups of) training
vectors which although relatively a small proportion of the
sample size they have the potential to dominate the character-
istics of the fitted function. A main reason for this is the use
of the mean-squared-error cost function in training NN’s. The
effect of using the MSE cost function is to cause the network
to learn the conditional expectation of the dependent variable.
It may be possible to improve the robustness properties of our
trading system by using an NN trained using a mean absolute
deviation (MAD) cost function. As opposed to the mean, this
causes the NN to learn the conditional median of a function.
In contrast to the mean, any given point can only exert a
limited influence on an estimate of the median. Thus, moving
any single observation to infinity will not drag the median
with it, and even changing the sign of an extreme observation
would only be expected to affect the median very slightly.
More detailed intuitive and theoretical treatments of this and
related issues are included in [74] and [12].
In practice, it is unlikely that we would want to largely
ignore magnitude information and rely solely on a prediction
1248
Fig. 14. Equity curve for combined strategy.
of the median. In general we might choose to use the two
estimates in conjunction; assuming that under normal circum-
stances our estimate of the mean provides useful information
concerning both direction and magnitude but that we can use
our estimate of the median to indicate abnormal circumstances.
For instance if the estimates of the mean and median are
substantially different from each other this suggests that a
small number of influential observations are dominating the
model at the particular query point. This suggests that we
should attach less reliance to the network predictions and
consequently either downweight our position or stay out of
the market completely. This is the approach which we shall
adopt here.
In the first step we train a network using the MAD cost
function and the four previously selected variables. Notably,
the out-of-sample performance of this model is roughly com-
parable to that of the NN model trained using MSE cost
function. This is not surprising because except under the
presence of extreme observations the mean and median are
likely to be similar and hence we would expect the two models
to be broadly the same.
The next step is to combine the two models using a simple
trading strategy—namely that a position in the market is only
taken when the two models are in agreement. If the two models
produce predictions which are opposite in sign then the system
takes a neutral position (i.e., stays out of the market). The
equity curve for the combined system is shown in Fig. 14.
The performance statistics for both the median network and
the combined system are shown in Table XVIII
In practice, the model combination strategy causes us to
take 379 positions (i.e., we are active in the market almost
exactly three quarters of the time). Of these trades 66% are
correct which is an improvement over either of the individual
networks. Although the overall profit made is very similar
to that of the individual networks, it is achieved with fewer
trades and a much improved risk/return profile (as shown in the
Sharpe ratio). If we adjust the trading strategy for the combined
system in such a way as to make the average market exposure
match that of the previous models (i.e., allowing for being
out of the market roughly one-quarter of the time) the Sharpe
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
ratio improves from 2.07 to 2.42, representing almost a 50%
improvement on the best individual models and over a 150%
improvement on the benchmark cointegration model given by
(34). The -statistic for the trading performance of the final
system, versus that of the basic cointegration model is 2.85,
which is significant at a confidence level of over 99.5%. On
this evidence at least, it seems that combining the predictions
of mean and median does provide useful information about
the reliability of the predictions, which can be translated into
improved trading performance.
We have described the concept of conditional cointegration
and showed how it can be used to deal with nonstationary
data and to enhance statistical inference. We have shown that
nonlinear methods can explain short-run deviations from the
equilibrium point better than their linear counterparts. The key
factor contributing to this success is attributable to careful
problem formulation. This involves the “intelligent use” of
financial economics theory on market dynamics so that the
problem can be formulated in a way which makes the task of
predictive modeling more likely to succeed. In other words it is
much easier to model the dynamics of a (stationary) mispricing
than it is to model the dynamics of price fluctuations. In the
next section we take this approach one step further and show
how such mispricings can be detected in the term structure of
interest rates and how they can be exploited, particularly when
we have no a priori knowledge of the exogenous variables
involved. This approach is complementary to variable selection
approaches described in the previous two sections and it is
particularly useful in cases that there is a high degree of
colinearity between the independent variables.
IV. YIELD CURVE ARBITRAGE IN EURODOLLAR FUTURES
A. Overview
To maximize the return on a portfolio of bonds with different
maturities, it is critical to understand how the price differ-
ences between bond of different maturities (i.e., the so-called
yield curve) change over time and what factors drive those
changes. Recent research using principal components analysis
demonstrates that 90–95% of the yield curve movements are
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
TABLE XVIII
PERFORMANCE OF MEDIAN AND COMBINED MODELS
(a)
(b)
explained by two uncorellated factors. The first factor accounts
for approximately 90% of the variability, the second factor
approximately 5%. [49]. Furthermore, these two factors, have
approximately been identified as (unpredictable) parallel shifts
and changes in the slope of the yield curve which closely
follow a random walk. Parallel shifts are largely a function
of the long rate, while changes in slope are a function of
the spread between the long and short rates. By showing that
the correlation between the long rate and spread is very close
to zero, [67] indicated that they are nearly equivalent to the
two “unknown” factors postulated by the principal components
analysis.
These findings are now applied by major financial institu-
tions in every day trading. It is therefore reasonable to assume
that any arbitrage opportunities arising from discrepancies in
how accurately securities prices reflect yield curve changes
resulting from these two factors are quickly and efficiently
“traded away.” Thus, the yield curve is essentially arbitrage-
free with respect to parallel shifts and changes in slope.
However, the residual yield curve movements arising from
“unexplained” factors may not be equally well understood
by market participants, and there may still exist arbitrage
opportunities here. It has been suggested that a third factor
is identifiable, and that this “unexplained” factor responsible
for some 2–5% of yield curve movements is in large part
attributable to volatility. Furthermore, several authors suggest
1249
that volatility may be mean reverting. If, therefore, one could
construct a portfolio which immunises against the first two
factors, the behavior over time of the third (unknown) factor
would be isolated and analyzed. Moreover, if this factor is
indeed mean-reverting one would expect the value of this
“immune” portfolio to revert through time. If this reversion
is consistent or predictable it would in theory be possible to
earn excess returns through arbitrage.3
It is therefore desirable to identify the variables which drive
changes in this unknown factor and to construct predictive
models of its behavior. Should these changes be attributable
to a vector of exogenous variables, this would suggest the use
of a methodology similar to that employed in the previous
two sections of this paper. But, there is a slight complication
in the modeling procedure. In our case it is not clear which,
if any, exogenous factors might influence an asset as abstract
as the “third factor of the Eurodollar yield curve.” We are
therefore confined to using a purely time series approach.
However, past experience in a variety of financial time-
series applications has shown that simply using lagged values
of the price as informative variables may lead to models
with unstable performance. Another option is to explore the
predictive ability of “technical indicators” such as “moving
3 Moreover, if this factor is indeed a proxy for volatility as it has been
argued we should be able to extract information about volatility from the
yield curve which can be used in a variety of ways (e.g., pricing options)
beyond the scope of this paper.
1250 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
averages” and “oscillators,” but since most technical indicators
are themselves parameterized, this creates the possibility of
“overfitting” the technical indicators themselves by choosing
parameter values which are predictive during the training
period but which fail to generalize to subsequent data. Instead,
we propose an approach whereby we generate a limited
set of “technical indicators” (which are unavoidably highly
correlated) and then applying a variable selection methodology
which explicitly removes the correlations within this dataset.
The approach is in many respects complementary to those
described in the previous sections and is particularly useful
in cases that there is a high degree of colinearity between
candidate variables and/or limited sample sizes prohibit the
use of analysis of variance.
In this section we describe a study of statistical yield curve
arbitrage among Eurodollar futures. A factor analysis confirms
that the bulk of changes in Eurodollar futures are accounted
for by unpredictable parallel shifts and tilts in the yield curve
which closely follow a random walk. However, the third factor
corresponds roughly to a flex in the yield curve and shows
evidence of a degree of predictability in the form of mean-
reversion. We construct portfolios of Eurodollar futures which
are immunized against the first two factors but exposed to the
third and use both linear and nonlinear techniques to model the
expected return on these portfolios. The third factor is found
to be predictable by nonlinear, but not by linear, techniques.
Using daily Eurodollar futures closing prices between 1987
and 1994, we construct a portfolio which is immunized against
parallel shifts and rotations of the yield curve. There are weak
indications that the value of this portfolio is mean-reverting,
which if correct gives rise to arbitrage opportunities. We use an
NN to model the changes in the portfolio value, on a weekly
basis. A significant risk-free return can be obtained by actively
resetting the portfolio at the predicted turning points.
B. Experimental Setup—Term Structure of
Interest Rates and the Yield Curve
Today’s value of a portfolio of risk-free interest rate securi-
ties is determined by the market interest rates for each relevant
point in the future. For example, the value of a portfolio
comprising a five-, ten-, and 15-year zero-coupon bond is a
function of today’s observed five-, ten-, and 15-year spot rates
of interest. The “spot” rate is defined as the return demanded
by the market for an investment of a given maturity.
The spot rates depend on current (short-term) spot rates
as well as anticipated future spot rates, which in turn are a
function of market risk premia for different factors and interest
rate volatility. If a portfolio contains multiple securities, its
value will be a function of the spot rates for all maturities
included in the portfolio, or the term structure of interest rates.
A common way of referring to the term structure is the yield
curve, which plots spot rates as a function of time to maturity.
Thus, when a portfolio contains most or all maturities traded
in the market, its value will be a function of the yield curve.
Fig. 15(a) shows some examples of different maturities
contracts for the Eurodollar futures. Overall our data consists
of daily high, low, open, and close prices for Eurodollar
futures over the time period August 1987 to July 1994, giving
1760 daily observations in all. The problem of discontinuities
is avoided by effectively ignoring any data which crosses a
changeover point (by setting the “return” to zero for any such
period), this is a harsher approach than simply matching the
levels of the spliced series and was intended to reflect the
possibility that not only the price itself but also the dynamics of
the price changes might be discontinuous across the different
contracts. The size of each contract is $1 million and at expiry
the futures are settled for a cash amount based on the London
interbank offer rate (LIBOR) for dollar time deposits of a
duration of three months. The prices as quoted in the form
of 100—annualized yield, e.g., a price of 91.35 is equivalent
to an annualized yield of 8.65%. Each basis point move in the
quoted value is equivalent to $25. The margin requirements
are $500 or $250 for a spread (long in one future, short in an
equivalent future of a different maturity). The small margin
requirements allow for very high gearing (one million/500
2000) and hence the key target of any trading strategy is not
profitability per se but rather consistency and smoothness of
the equity curve.
The three different curves shown in Fig. 15(a) depict daily
closing prices for the shortest maturity (90 days) contract
(close 1), a medium maturity contract (close 2; 450 days)
and the longest maturity contract (close 3; 720 days). Note
the high correlation in daily movements. This reflects the
similarity of the underlying assets, a long or short position
in any of these futures is equivalent to a deposit or loan for
a given duration and it would be surprising for the prices
to diverge greatly given that the loan durations differ only
by three-month increments. It is this property which induces
us to search for “statistical arbitrage” opportunities because,
although in the short term price anomalies could occur, we
would generally expect them to be rectified in due course.
This rectification is not guaranteed and is thus a statistical
(or risky) proposition rather than a traditional (or riskless)
arbitrage condition. Another way of viewing this is that the
assets are cointegrated [38] in some way.
Fig. 15(b) shows four examples of the yield curve; the yield
curve is constructed at each point in time by joining the prices
of all contracts with term to maturity ranging from less than
three months at the short end to three years at the long end.
Considering cross-sectional “snapshots” of the yield curve on
four different dates we obtain some clues as to the likely
structure of the relationships between different contracts. The
yield curve can be flat, upward-sloping, down-ward sloping,
and may also have a “hump” at some maturities. Samples of
this are clearly shown in Fig. 15(b). The yield curve on 12
June, 1988 (marked *) is generally flat. On 13 July, 1987,
the yield curve (marked is upwards sloping, etc. The most
striking fact about the curves is simply that they are smooth
curves rather than jagged lines. Contracts tend to have a yield
which is similar to that of neighboring contracts. Comparing
the yield curves on the different dates we note that they differ
primarily in level but also somewhat in slope and some of the
curves are very smooth while others exhibit some kinks and
curves. Most of the curves are upward sloping reflecting the
fact that longer term loans are more risky and hence under
normal circumstances require a higher premium.
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
(a)
(b)
Fig. 15. Sample futures contracts and yield curves. (a) the closing prices of three contracts of different maturities. (b) Different types of yield curve shapes.
Fig. 16. Scree plot for principal components of changes in the yield curve.
In order to better understand the structure of the relationship
between different maturity contracts, let us conduct a factor
analysis on changes in the yield curve using the method of
principal components. The scree plot in Fig. 16 shows the
percentage of the total variability which can be attributed to
each factor.
The first factor accounts for almost 90% of the total vari-
ability. The second factor accounts for just under 8% of
the variance. Together, these two factors account for almost
1251
98% of the total variance and thus conceptually our results
are largely consistent with theoretical two-factor bond-pricing
models such as those in [67] and [41]. However, our analysis
also suggests the presence of a third factor which accounts for
almost exactly 2% of the total variance. Analysis of the factor
loadings (eigenvectors), see Fig. 17, shows that the first factor
represents a parallel shift in the curve. The second factor cor-
responds to a tilt in the yield curve. The loadings for the third
factor suggest that it relates to a flex or bend in the yield curve.
1252
Fig. 17. Factor loadings (eigenvectors) for first three principal components.
The results of this factor analysis of Eurodollar futures bear
some resemblance to those of Litterman and Scheinkman [49],
in which three similar factors were found to be primarily
responsible for the price changes of different maturities of
U.S. government bonds.
Our expectation is that, due to widespread awareness of
the theoretical two-factor models, the markets are likely to
be efficient with respect to the first and second of these
factors, but that some predictable inefficiencies (such as mean-
reversion) might exist with respect to the third factor. This can
be tested with a number of tests for “omitted” nonlinearity.
Barnett et al. [3] compare a number of such tests one of
which uses the approximating ability of NN’s. The modeling
strategy we describe in the next section attempting to capture
the dynamics of this third factor, can itself form the basis of
such test.
C. Modeling Strategy
The purpose of our strategy is to identify opportunities for
statistical arbitrage in the sense of predictable price corrections
which occur to eliminate short-term anomalies or deviations
from long-term relationships. Following the results of our
factor analysis we wish to investigate whether portfolios of
bonds constructed specifically to be exposed to the a factor
would exhibit a degree of predictability, perhaps in the form
of mean-reversion effects. In particular, we expect the markets
to be efficient with respect to the first two factors and hence
we concentrate our efforts upon modeling the third factor.
The first step in our modeling procedure is to isolate the
effects of the first two factors. In other words, using the
12 available contracts we wish to construct a
portfolio whose value we denote by and weigh with weights
in such a way that its sensitivity to parallel shifts and tilts
of the yield curve is set to zero. i.e.,
and find weights such that
(41)
PCA PCA
Since the two principal components PCA and PCA are
linear combinations of the 12 contracts this is easy to do. In
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
(a)
(b)
Fig. 18. Immunization to parallel shifts (a) and tilts 9b) of the yield curve
with a simple butterfly portfolio. If the yield curve shifts up by an amount x,
the portfolio appreciates by 23 x on the outside positions but simultaneously
depreciates by 23 x on the center contract. A similar effect is achieved for
the tilt.
practice however, we do not wish to turnover a portfolio of
12 contracts. Due to the high degree of colinearity between
adjacent contacts, the same effect can be achieved by a much
smaller portfolio, with three contracts: at the short, middle,
and long end of the yield curve (see, for example, [26]). To
avoid liquidity effects at the long-end of the yield curve and
volatility effects at the short end we decided to only consider
and Thus, if we construct a portfolio
(42)
with and we achieve the
desired effect. This is illustrated in Fig. 18. By holding two
outside positions in equal sizes and twice the opposite position
on the center contract we simultaneously immunise against
both parallel shifts and tilts of the yield curve.
Any fluctuations in the value of this portfolio depend solely
on changes in the third factor. Fig. 19 depicts the value of the
portfolio over time.
The value of the butterfly portfolio appears to be stationary,
supporting our original hypothesis that the third factor might
exhibit mean reversion. If this was truly the case then it
would be possible to generate excess profits using a simple
long–short strategy (buy the portfolio if the current value is
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
Fig. 19. Value (over time) of butterfly portfolio (13 Long on contract c2 ; 23 Short on c5 ; 13 Long on c8 ).
Fig. 20. Value of butterfly portfolio, adjusted for discontinuities.
below average, sell the portfolio when the current value is
above average). However, it turns out that the mean-reversion
is simply an artifact of the periodic expiry, and consequent
shifting along, of the contracts. Adjusting for discontinuities
we obtain the price series shown in Fig. 20 (the series has been
inverted so that it is appreciating rather than depreciating in
value):
Clearly, the adjusted series is not mean-reverting, but it
does appear to exhibit some structured behavior, notably in
the persistence of both upward and downward trends.
The second step in our modeling strategy is to attempt
to model the dynamics of this price series and to com-
pare neural and linear regression models; however, first it is
necessary to identify suitable input variables. Because it is
not clear which, if any, exogenous factors might influence
an asset as abstract as the “third factor of the Eurodollar
yield curve” we are confined to taking a purely time series
modeling approach. However, past experience in a variety
of financial time-series applications has shown that simply
using lagged values of the price as informative variables may
lead to models with unstable performance. A better option
is to exploit the predictive ability of “technical indicators”
such as “moving averages” and “oscillators.” However, most
technical indicators are parametric; this instantly creates the
possibility of “overfitting” the technical indicators themselves
by choosing parameter values which are predictive during the
training period but which fail to generalize to subsequent
data. Instead, we shall adopt the approach of generating
a limited set of candidate variables and then applying a
variable selection methodology. This provides a set of 16
1253
candidate variables, all of which are derived from the port-
folio price. The candidate input “variables” are shown in
Table XVIII.
The next step in our modeling procedure is to construct a
reliable estimator of weekly changes in portfolio value using
the variables in Table XVIII. If we denote the portfolio value
at time as then our target variable is simply .
It would appear that there at least two possible approaches
to the variable selection problem as described in the previous
sections. However due to the high degree of correlation and
colinearity within the data set in Table XVIII the techniques
are not ideal in this case. The approach we shall follow is
one which explicitly removes the correlations within the data
set—namely principal components analysis. The scree plot for
the principal components analysis of the candidate variables
is shown in Fig. 21.
The PCA indicates that much of the information in the
16 variables is actually redundant and that 98% of the total
variability within the candidate inputs can be represented by
the first six principal components. By simply transforming the
data and using the first six principal components as inputs to
the models we reduce both colinearity and model complexity
while losing very little information. In fact, by observing the
values of the principal components over time (see Fig. 22), we
note that the first PC is clearly nonstationary and has captured
the overall drift of the portfolio.
Interestingly the other five PC’s are all stationary and
appear to be derived from higher frequency components of
the portfolio dynamics. On the basis of this we chose only to
include the stationary PC’s (numbers 2–6) in our predictive
1254 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997

Fig. 21. Scree plot for principal components of all 16 candidate variables.

TABLE XVIII
CANDIDATE “VARIABLES” FOR ESTIMATING Pt+5 0 Pt

(a)

(b)

models of the third factor in Eurodollar futures. In the next TABLE XIX
section we use regression and neural analysis to model the LINEAR REGRESSION RESULTS (INSAMPLE)
weekly changes in this factor.

D. Modeling the Third Factor in the Yield Curve

In this section we construct both linear and neural regression
models using 252 weeks of data for training and the final 100
weeks as a testing period. The results for the regression model These results indicate that the linear model is weak if
insample are shown in Table XIX. not nonexistent, Factor 4 with a value of 1.71 is (just)
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
Fig. 22. The charts show the time series which represent the first six principal components of the 16 original variables (a mixture of technical and
time series variables).
significant at the 90% level while the other variables are not
at all significant.
Out-of-sample the linear model behaves as might be ex-
pected from the statistics above: It predicts the correct di-
rection in 53 out of 100 weeks and the magnitude of the
correctly predicted moves is four basis points more than the
magnitude of incorrectly predicted moves. The total volatility
of the portfolio is 614 basis points so the predictive ability of
the linear system is clearly insignificant.
To test the hypothesis that changes in this third “unknown”
factor might be partially deterministic but in a nonlinear sense
we use a standard multilayer perceptron. The model uses tanh
activation functions and shortcut connections from input to
output layer; the principle being that the shortcut connections
learn the linear component of the input–output relationship
1255
while the indirect connections (through the hidden layer) learn
the nonlinear component of the input–output relationship. The
number of hidden units is specified a priori as two; this
gives a network with a total of 18 parameters—roughly three
times the representational capacity of the linear model but still
satisfying the heuristic condition that we have more than ten
times as many training examples as network parameters (e.g.,
[33]).
Due to the relatively small size of the NN its ability to
overfit is severely limited and hence we simply train the
network to the point where the error is no longer decreasing.
In fact, this occurs quite quickly in around 200 epochs of batch
learning. Then we employ the technique described in [13] to
perform a statistical analysis of the estimated neural model.
The insample results are shown in Table XX.
1256 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
TABLE XX
NEURAL-NETWORK RESULTS (INSAMPLE)
The model has a predictive correlation of almost 0.4 with
an adjusted of over 8%; the overall value for the model
(with the full set of 18 potential parameters) is significant
at the 99% level of confidence (NB: this is without making
any adjustments for the effective number of parameters which,
if anything, would increase the significance of the result).
The Durbin–Watson statistic is not significantly different from
two, indicating that there is no problem with autocorrelated
residuals. Within the model factors 2, 3, and 6 are significant
at over 95%; factor 4 presumably still has a linear effect
but does not make any use of the additional parameters and
hence is insignificant overall; only factor 5 appears to lack any
predictive ability. Clearly the dynamics of the third factor in
the yield curve appear to be predictable by nonlinear, but not
by linear, techniques.
While the above results are significant in a statistical sense,
it is the out-of-sample test which is critical because it indicates
whether the results are stable or whether they are invalidated
by nonstationarities in the underlying process. The networks’
performance out-of-sample is very promising: it predicts the
correct direction in 60 out of 100 weeks and the magnitude of
the correctly predicted moves is 192 basis points more than the
magnitude of incorrectly predicted moves. The total volatility
of the portfolio is 614 basis points so the predictive ability of
the NN is sufficiently large to be significant.
E. Economic Ex-Ante Evaluation of the Results
In order to evaluate the performance of the NN from a
financial rather than a statistical perspective it is necessary to
analyze the properties of the equity curve which the system
generates and to compare this to the buy and hold performance.
The performance should also be evaluated with respect to the
other factors involved—such as transactions costs and gearing
effects.
Fig. 23 shows the equity curves for the network and the
buy and hold strategy. The buy and hold strategy is to
simply maintain a Long position in the butterfly portfolio
(Short contract 2, Long 2*contract 5, Short contract 8). In
contrast, the network strategy alternates between long and
short positions in the butterfly portfolio according to the
direction of the price change predicted by the network.
The network clearly outperforms the buy and hold strategy.
During the out-of-sample period (roughly July 1992 to July
1994) the network continues to be profitable, making almost
200 basis points, while the performance of the buy and hold
is almost flat. The added value of the NN is even more
apparent if we look at the chart of out-performance over time
[see Fig. 23(b)]. In fact the ratio of average weekly return
to standard deviation of returns is 0.270 in-sample and 0.255
out-of-sample; testing against the null hypothesis that the true
average return is zero we find values of 4.32 and 2.55,
respectively. Thus both in-sample and, more importantly, out-
of-sample performance is significantly better than zero at the
99% level of confidence.
The results so far are interesting from a theoretical and
modeling perspective, however the true test lies in whether
they can be used in a practical setting to “beat the market;” do
they provide further evidence against the EMH? This requires
us to calculate the returns which the system can generate in
financial terms, taking into account transactions costs and an
appropriate level of gearing. It is only really meaningful to
measure the performance during the out-of-sample period. This
consists of 100 weeks of data from July 1992 to July 1994.
First, let us review the various costs and returns involved.
The transaction cost is £1 sterling per contract which we
approximate in dollar terms as $1.50. The value of a price
change in a contract is $25 per basis point. The largest draw-
down during the insample period is approximately 100 basis
points or $2500. we will assume an initial account of $5000 as
this would require a drawdown twice as large as the historical
maximum in order to wipe out the account.
During the out-of-sample period the system makes total
profits of 192 basis points $4800; the number of transactions
is 32 caused by changing predictions plus 7*2 caused by
switching contracts in all; each transaction includes buy-
ing or selling four contracts (the constituents of the butterfly
portfolio) giving a total cost of 46 * 4 *$1.5 $276. Thus
during the out-of-sample period, the system makes profits of
$4800, net $276 costs giving net profits of $4524 on an account
of $5000 in a period of just under two years. This equates to a
rate of return of approximately 47% per year. Note, however,
that this figure is sensitive (both upwards and downwards) to
the level of gearing which is assumed.
In summary, the factor analysis of the Eurodollar yield curve
from August 1987 to July 1994 indicates that the first two
factors, which can be viewed as a shift and a tilt of the curve,
respectively, jointly account for just under 98% of the total
price variability. This is consistent with the two factor bond-
pricing models in the theoretical literature. However, a third
factor, which the factor loadings identify as a flex of the yield
curve, is also indicated. This third factor represents almost
exactly 2% of the total price variability.
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
(a)
(b)
Fig. 23. (a) Equity curves for network and holding strategies. The RHS of the vertical line (i.e., the last 100 weeks constitute the out-of sample
period). (b) Relative outperformance.
Assuming that the markets are efficient with respect to the
previously known first two factors, we attempted to model
changes in the third factor. A butterfly portfolio was con-
structed which is immunized against shifts and tilts in the
yield curve but exposed to the third flex factor. A time series
modeling approach was adopted using technical indicators,
such as simple oscillators and moving averages, as informative
variables. In order to avoid over-fitting the parameters of the
technical indicators while also avoiding excessive intercorre-
lations of the variables, a variety of indicators were generated
and subjected to principal components analysis. The first six
factors were found to account for 98% of the variability in
the original set of 16 variables. Of these the first factor repre-
sented the underlying trend of the portfolio and, being clearly
nonstationary, was excluded from the subsequent modeling
procedure. The second through fifth principal components
were used to build both linear and nonlinear predictive models
of price changes in the butterfly portfolio.
The linear model was found to be of marginal statistical
significance at best and this was reflected in an out of sample
test with results which were no better than random. The NN
model, however, was found to be significant overall with no
less than three variables being significant at the 95% level
of confidence. The out-of-sample test showed the NN to
generate consistent profits which were statistically significant
1257
at the 99% level. Translated into cash terms, and allowing for
transactions costs, the out-of-sample performance was found
to result in an average annual return of 47% per year, at a
fairly conservative level of gearing. This is sufficient evidence
to conclude that the third factor of the Eurodollar yield curve
appears to be predictable by nonlinear, but not by linear
techniques.
So far we have used a modeling approach which attempts
to develop estimators for expected returns in the context of
(3). We have argued that careful problem formulation is in
many cases a key to success. In the next section we take
this approach one step further and argue that even if security
price fluctuations are largely unpredictable, it is possible that
investor behavior may not be. By using a simple model of
investment strategy performance and switching in and out of a
simple investment style we show that it is possible to produce
excess returns.
V. META-MODELS OF INVESTOR BEHAVIOR
A. Overview
The target of traditional predictive modeling approaches
have been price fluctuations on “real” assets (e.g., stocks,
bonds, derivatives, etc.). These assets can be purchased or sold
and their prices can be observed on the market. The motivation
1258 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
behind the “metamodeling” we describe in this section is that if
asset prices can not be forecasted, there might nevertheless be
a way to predict the performance of particular investment (or
fund management) styles and strategies. The basic idea behind
“metamodeling” is that an investment strategy (or a trading
rule) can be dealt with in much the same way as an asset
because it can be seen as a synthetic asset. The return of this
synthetic asset is the profit and loss made by the strategy, when
applied on an underlying asset or a portfolio of (underlying)
assets. Subsequently, metamodeling handles a class of objects
(i.e., investment strategies) which are abstracted from the
“real” assets. The returns of these strategies are not directly
observable in the markets, but have to be computed by the
modeller and correspond to the equity that would reach a
virtual investor if he were using the strategy to take a position
in the underlying “real” assets.
The concept of analyzing investment strategy performance
is not entirely new. It has been used in one form or another
by several researchers and practitioners. Active investment
style management, which is a specific case of metamodeling
has become increasing popular among practitioners (see, for
example, [23]). Of particular relevance to our approach is the
work of Palmer et al. [54] and Refenes and Azema [60]. Using
a large scale simulation in an evolutionary framework, Palmer
et al. describe a model of a stockmarket in which independent
adaptive agents can buy and sell stock on a central market. The
overall market behavior is therefore an emerging property of
the agents’ behavior. The simulation starts with a predefined
set of investment strategies in which investors make their
decisions on the basis of technical and fundamental “analysis.”
Through an evolutionary process of mutation (i.e., random
alteration of the decision rules) and crossover (i.e., creation of
new investors by systematic combination of existing ones) the
study attempts to emulate the way in which markets evolve as
a direct result on investor behavior. The analysis also identifies
the type of variables that successful investors are observing in
order to generate excess return. Typical variables which enter
the decision process are changes in the stock’s fundamental
value (measured by an appropriately discounted series of
expected future dividends), a technical indicator signifying
mean-reversion in prices (measured by an oscillator), and a
technical indicator signifying trends in prices of the underlying
(measured by a moving average crossover).
Refenes and Azema [60] describe an approach for dynam-
ically selecting trading strategies from a predefined set of
trend-following and mean-reversion based trading strategies.
The key idea is to predict (on the basis of past performance)
which of two alternative strategies is likely to perform better in
the current context. The expected returns of the two strategies
are conditioned on their relative prediction error. If the error
in one of the two strategies is decreasing while the error in
the other is increasing the metamodel switches strategies. In
many respects this approach is analogous to a hidden Markov
model and does make use of other potentially informative
variables that could explain the performance of a particular
strategy. The approaches of Palmer et al. [54], [60] and our
own are not mutually exclusive. Subsequently it would be
desirable to develop nonlinear models of investor behavior
which take advantage not only of the time structure (e.g.,
cyclicity) and historical performance in a trading strategy but
also make use of exogenous variables. It is entirely plausible
that the expected returns of a particular investment style may
be conditioned not only on a single measure of fundamental
value as suggested by [54] or historical performance alone as
suggested by Refenes and Azema [60] but also on the current
economic environment (e.g., interest rates) as well as market
expectations (e.g., estimated growth of earnings per share), or
they may vary according to the country or sector in which the
investment style is applied.
In this section we take these approaches one step further by
combining results from [54] and [60] and introducing other
variables suggested in the literature. We utilize a stepwise
procedure of modeling investment strategy returns which
builds upon these results and also the results described in
earlier sections on model identification and variable selection.
Within this framework, we construct a metamodel of investor
behavior using a dataset composed of financial data on 90
French Stocks drawn from the SBF250 index. We compare
two metamodels of investment style performance: a linear
regression and a neural model. Both models provide small
but consistent incremental value with the NN outperforming
its linear counterpart by a factor of two. This suggests the
presence of nonlinearities probably induced by the interac-
tions between some of the technical, economic, and financial
variables and which are undetectable by standard econometric
analysis.
B. Experimental Setup—Modeling Investor Behavior
One of the dominant themes in the academic literature
since the 1960’s has been the concept of an efficient capital
market [27]. According to the EMH, security prices fully
reflect all available information and therefore can not be
forecasted. However, if asset prices are unpredictable, investor
behavior might not be. In other words, if asset prices can not
be forecasted, there might nevertheless be a way to model
the performance of fund management styles and investment
strategies. In that context, metamodeling is useful because it
models an element of investor behavior.
From a more practical point of view, metamodeling provides
a method of quantifying the conditions under which a certain
investment strategy should be used. Let us consider for exam-
ple a commonly used investment strategy based on screening,
whereby the professional fund manager dynamically maintains
a portfolio of “value stocks” i.e., composed of say the 10%
of stocks having the lowest price/earning (PE) ratio. The
investment strategy can be seen as a synthetic asset that has a
dynamic composition but a single and constant characteristic
(e.g., “low PE”). In contrast, a stock with a low PE ratio has a
fixed composition but no constant and single characteristic. It
encompasses a collection of aspects: for example, Air Liquide
has a large capitalization, it is also a blue chip stock, has
low volatility, high PE, average dividend yield. Modeling
such a stock in isolation would give very little information
about the behavior of high/low PE stocks, but modeling the
performance of the fund manager who does have a constant
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
Fig. 24. Asset price and P&L of a trend following strategy. The P&L can be seen as a cyclicity indicator: Negative values correspond to sideways
movements, positive values to trending periods.
characteristic might be more predictable. It is entirely plausible
that the market may reward low PE stocks under certain
economic conditions but not under others. Variations in the
performance of such manager may therefore be attributable to
factors which are exogenous to his decision making. If it were
possible to develop a predictive model of the performance
of the investment style, then excess returns could be made
by buying the portfolio recommended by the strategy when
the prediction is positive, and selling the portfolio when its
expected return is negative.
In this section, we describe a methodology for developing
such predictive models. The modeling procedure consists
of two steps. The objective in the first step is to define
a universe of commonly used investment strategies and to
quantify their expected returns. Since these returns are not
directly observable in the market we need to compute them
from historical data; they correspond to the equity that would
reach a notional investor if were using the strategy(ies) to
take a position on the underlying assets. This is easily done
by simulating the notional investor. The second step consists
of building a metamodel of these expected returns which are
conditioned on a number of variables which are exogenous to
the investment style and selecting those variables that are the
most significant (in the statistical sense) in explaining varia-
tions of the investment styles’ performance. By treating these
investment styles as synthetic assets it is easy to see how they
can be used in the framework of active portfolio management
as described in (3). However, since the number of possible
investment styles is practically unlimited and the purpose of
this section is to describe the methodology, we shall focus
our study on the second step of the procedure. To facilitate
clarity we shall, without loss of generality, restrict our analysis
to a single (and rather simple) investment style, whereby the
notional fund manager invests in a set of underlying assets
by utilizing a cyclicity indicator. There are several indicators
that can be used to measure cyclicity such as the variance
ratio [50], drift-stationary tests inspired by the unit root test
[22] and various measures based on spectral analysis. These
measures suffer from two limitations. First the amount of data
required to measure cyclicity is prohibitively large. Second,
1259
these measures are sometimes only remotely related to the
equity that would reach an investor with a trading strategy
based upon them.
In this study we shall adopt a simple measure of cyclicity
which is directly related to the equity that would reach an
investor if he were using the spread between two moving
averages to (i.e., moving average crossover) to trade the
underlying (see [5] for a rationalization). To do so he uses
a simple decision rule whereby given a time series of prices
on the underlying asset he computes two moving
averages for the th point. If the short moving average
intersects the long moving average from below he purchases
the underlying and conversely if the short moving average
intersects from above he (short) sells the underlying.
Fig. 24 shows the prices on the underlying asset over 300
days (single line), as well as the weekly returns (i.e., profit
and loss) of the notional investor (shaded area). This simple
investment style performs quite well when the underlying asset
is in a state of trend but rather poorly when the underlying
is moving sideways. Notably, there are persistent periods of
trending followed by persistent periods of mean reversion. This
is reflected in the cyclicity of the manager’s expected return
(shaded area).
In an earlier paper [60] described a technique for alternating
between investment strategies as the market changes from a
trending into an oscillatory behavior. The key idea is analogous
to a hidden Markov process, whereby the underlying asset is
modeled as the composite of two distinct states. The decision
to switch over strategies is made on the basis of monitoring the
error (i.e., profit/loss) that each state model is producing and
choosing the one in which the error is decreasing. There are
two main disadvantages of the approach: first the measures of
profitability may not be sufficiently responsive. For example,
the underlying might have entered a trending period for some
time already, while the measure might still indicate some
mean reversion due to the delays in constructing the averages.
Essentially the approach is one of error tracking rather than
predictive modeling.
The second reason is more important and relates to the
inability of the approach to make use of exogenous variables
1260
that might be useful in explaining variations in the perfor-
mance of the investment style. For example, it is entirely
plausible that trending periods are induced by extreme moves
in interest rates, while sideways moves may be induced by
frequent revisions on earnings expectations for the underlying
by financial analysts. It is therefore desirable to develop
predictive models of investment style performance which
make use of such exogenous variables.
We examine monthly variations in the performance of
the investment style applied to a universe of 90 French
Stocks drawn from the SBF250 stock index. The dataset
covers the period from January 1988 to January 1995. We
select our universe of exogenous variables on the basis of
their availability to the investor at a specific point in time
and the variable’s relevance to explaining variations in the
investor’s performance.4 We start with set of 16 variables
(see Table XXI) that could potentially have an influence in
explaining variations in a fund managers performance. We
then select those that are significant in explaining variations
in the performance of this particular investment style through
a simple procedure described in Section V-C.
Among others Elton et al. [24] found that the performance
of a stock might be influenced by its growth characteristics.
High growth stocks might move in trends more often than
low growth ones. The growth characteristics of the underlying
might in turn influence the performance of the investment
style. These are captured by five variables (see Table XXI).
The EPS growth rate is the growth rate based on a least
squares calculation of moving four quarters actual earning of
the latest 20 quarters. The stability of actual EPS (i.e., the
stability in detrended earnings) is likely to be a key factor and
it is computed as the mean absolute difference between actual
EPS and the trend line in EPS growth (previous variable) for
the past 20 quarters. A large increase or decrease in the markets
expectations for earnings growth might trigger a trend. This
effect is captured by two variables: current year’s expected
percentage growth in EPS i.e., ([E(EPS(t))/EPS * feasible to include all possible variables in our model purely
100) based on the analysts’ estimates for this years earnings
and EPS(t) is the actual earnings in the last reported fiscal
year. Likewise, the one year expectation in percentage growth
of EPS, i.e., ([E(EPS(t))/EPS * 100) is also based
on analysts’ expectations.
It is possible that extreme movements in a stock’s ex-
pansiveness might provide useful information in triggering
trending periods. Several authors have linked the performance
of a stock to financial ratios. For example, Fama and French
[28] found that the book/market value of equity ratio and
firm size, measured by the market value of equity emerged
as variables that have strong relations with the cross section
of average stock returns during the 1963–1990 period. Five
variables are used to measure expansiveness: earnings yield
both in absolute terms and relative to the market as a whole
and the interaction between earnings yield and earnings growth
as a single variable earnings\_yield * earnings\_growth, and
4 Some of the variables are computed from data provided by Datastream,
others are computed from data provided by I/B/E/S (Institutional Brokers
Estimate System).
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
the commonly used ratios cash\_flow/price, dividend-yield,
price/book\_value.
To capture any nonlinear effects that are due to the size of a
stock its market capitalization is used as an additional variable.
Finally the following two variables are used to capture any
mean-reversion effects that frequent revisions of expected
earnings might induce: the percentage of EPS estimates raised
and the percentage of EPS estimates lowered over the past four
months. They are computed from data provided by I/B/E/S.
It has also been argued that the expected returns of a
particular investment strategy might be conditioned on the cur-
rent economic environment or the may vary according to the
country or sector within the investment style is applied [23].
To capture any effects due to the economic environment we
use two variables: the yield on the ten-year French government
bond is used to capture long interest rate effects while the three
month interest rates are use to capture any dependencies on
the short rate. We use four dummy variables to specify the
sector in which a stock belongs: cyclical is a dummy variable
encoded as one for stocks in the chemical, building materials,
autos and equipment, and basic industries and encoded as zero
elsewhere; noncyclical is similarly encoded as one for stocks
in the food, household products, retailer and utility industries
and zero elsewhere; growth is encoded as one for stocks
in the cosmetics, drugs, electronics, entertainment, hotels
and restaurants, computers, and publishing; and financial is
encoded as one for financial institutions and zero elsewhere.
To account for country effects we use the leading indicator
for France as published by the OECD over the past two years.
It is, however, possible that further exogenous factors may
be at work such as for example financial gearing, exposure
to international competition, etc. which are not accounted
for in the set of variables above. Indeed, the debate as to
which variables have the strongest influence on explaining
stock returns is still ranging in the finance literature (see, for
example, [2], [6], and [28], among others). In our case it is not
for reasons of data availability, but to account for any residual
effects we shall use lagged values of the target variable. Past
cyclicity is simply and lagged passed
cyclicity is We shall also include
the relative difference between two moving averages. A large
value (in absolute terms) for this difference means that the
stock price has moved strongly in one direction. It is possible
that this might trigger trending periods.
The dependant variable is the (marked-to-market) profit an
investor would make by using a trend following strategy on
the relative price of each stock for the 12 coming months. The
cross over of two MA constitutes the buy or sell signal. A long
position is taken in the stock after a buy signal, a short position
is taken after a sell signal. The lengths of the MA are three
and 12 months, respectively. All variable values are expressed
in prices which are relative-to-market. The reason for this is
because the procedure is evaluated against a benchmark, i.e.,
the market. Besides, positions on the market as a whole can
easily be taken through future contracts. Finally, much of the
noise in individual stock prices are due to the market itself.
Taking relative prices filters this noise out.
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
TABLE XXI
SUMMARY OF ALL VARIABLES
The fact that the performance of an investment style is
not constant over time has two possible explanations. The
first is randomness. After all, the strategy’s performance is
a result of the fluctuations in the underlying stock prices.
If these fluctuations are random, there is no reason why
investment performance should not be random. However, it
is also possible that under certain conditions, stock prices are
more probable to be in a certain state than in the alternative
one. For instance, it is entirely plausible that stocks of com-
panies that are highly exposed to international competition are
moving in trends for extreme exchange rates between their
domestic currency and the dollar. Another example is provided
by companies for which earning prospects are difficult to
forecast and are frequently revised by financial analysts. Their
stock prices are more likely to move sideways. This notion
that cyclicity in the performance of an investment strategy is
influenced by exogenous variables, rather than merely caused
by the randomness of the stock price, suggests that a model
of a strategy’s performance could be built. The existence of
such a model could then reject the first explanation, i.e., that
investment strategy performance is a random series.
Unfortunately, traditional linear models are only weak tests
of this hypothesis. Failure to find any linear relationship
between cyclicity and potential explanatory variables does not
imply that there is no relationship at all. Trending periods
might well be triggered by a combination of factors. These in-
teraction effects cannot be explored with a linear model unless
they are explicitly taken into account by a composite variable.
However, such explicit modeling is only possible if strong a
priori knowledge is available. Often in financial forecasting
this is not the case. Besides, extensive search of interactions
is merely impossible, especially when the number of potential
explanatory variables is large. NN models do not suffer from
such insufficiencies. Their powerful universal approximation
abilities allow them to model nonlinear functions, in particular
conditional (“if”) relationships. In other words, the influence
of some variables in the model can vary arbitrarily and it could
1261
be a function of other variables in the model. Therefore, NN
models constitute far stronger tests for rejecting relationships
than linear models but due to overfitting, they can easily be
misleading in finding relationships that reflect a temporary
market anomaly.
Furthermore this experimental setup gives us the opportu-
nity to test several prevailing beliefs among some investors.
For instance, we investigate whether using constantly a trend
following strategy is profitable. We also test whether past
performance of a strategy is related to future performance. In
this framework of market efficiency, the concept of conditional
cyclicity becomes particularly relevant. Constant stock cyclic-
ity would be relatively easy to detect by traditional methods,
and therefore would be rapidly discounted in the market. In
contrast, conditional cyclicity is more difficult to model and
therefore might provide an economically feasible framework
for applying nonlinear methods such as NN’s to financial
modeling.
C. Modeling Strategy
Our modeling strategy consists of three basic steps. The first
step is essentially a data preparation step for the independent
variable. The second step attempts to identify time structure in
investment strategy returns while in the third step we attempt
to obtain incremental value by testing the hypothesis that these
returns are conditioned on exogenous variables.
1) Simulating investment strategies: Unlike prices of
real assets (e.g., stocks, bonds, currencies, derivatives,
commodities, etc.), returns from an investment strategy
are not directly observable on the markets, and have
to be calculated by a simulation procedure. In order to
generate the time series for the profit and loss of the
strategy, it is necessary to use historical data to simulate
the investment strategy and obtain its marked-to-market
returns
(investment\_style, asset (43)
1262 IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
where is a function of the particular investment style
applied to a particular (group of) underlying asset(s). In
the case that is explicitly quoted this step can be
omitted by using publicly available data. In the study
presented here, for each stock in the index, we need
to generate the series of returns that would reach the
investor had he applied it to each stock. The procedure,
, for doing so is given in Section V-D.
2) Identifying time structure in investment strategy re-
turns: Using univariate time series analysis investigate
the time structure of the returns and identify significant
lags
(44)
(45)
In principle, the Box–Jenkins identification procedure
can be used to identify time structure for the linear
model. In practice, however, because the returns are
often serially correlated one has to be cautious when
fitting ARIMA models. In Section V-E, we describe a
simple ad hoc procedure for overcoming this difficulty.
3) Identifying exogenous influences: Construct well-
specified models of conditional cyclicity for each of
the investment styles/instances under consideration
(46)
(47)
where is the vector of exogenous variables defined in
Table XXI and is the vector of network parameters.
In principle, this can be done using any of the variable
selection methodologies described in the previous sec-
tions, but in this application the significant exogenous
variables are selected using a combination of linear and
nonlinear tests as described in Section V-F to overcome
some special difficulties arising from serially correlated
data.
The estimates of expected returns given by the meta-
models in (46) and (47) can be used in the context of
(3) in the obvious way. For simplicity, however, in this
section we shall use a simple asset allocation strategy
whereby we purchase the investment strategy if our
estimate of future return is positive and sell
the strategy otherwise.
Because some of the variable distributions have heavy tails
and consequential outliers, the estimated parameters might
be strongly influenced by a small number of observations.
There are many ways to deal with such influential observations
including robust estimators as described in the Section III.
In this section, however, we shall use a procedure based on
ranking as an alternative. Therefore, we shall also rank the data
in each month and estimate the models on this ranked data.
At each point in time instead of using the value of the
directly we use it to rank the underlying assets with respect to
the of the investment strategy. We then regress this rank
against the similarly computed ranks of underlying assets with
respect to the independent variables. i.e.,
Rank
Rank
Rank (48)
where is the exogenous variable . The variables are
selected if they are significant in both rank-based and non-
ranked models. We apply both a multiple regression as well
as a neural model and compare the results to investigate
nonlinearities in the relationship between cyclicity and its
explanatory variables.
D. Simulating Investment Strategies
In order to generate the time series of the profit and loss of
the strategy, a number of steps are necessary. First, we generate
the sell/buy signals recommended by the strategy for each asset
at each point in time. These signals, , are defined by
if MA MA
if MA MA (49)
if MA MA
where MA being the price of
the asset at time being the length of the moving average in
months. From this we calculate the marked-to-market returns
from the strategy
(50)
Finally, we calculate the profit and loss P and L of the
strategy over the last 12 months
P L (51)
In the first step of our modeling procedure we investigate
whether the constant use of this strategy produces excess re-
turns. Indeed, if we apply this simple trend-following strategy
to a cross section of stocks drawn from the SBF250 it yields
small but significant excess return. The annual average excess
profit after transaction costs (1% per transaction) is 2.4%. The
standard error for this average is 1.1%. The average return is
therefore different from zero at a 90.2% significance level over
this period. The objective of our metamodeling strategy is to
improve on this performance by switching in and out of the
investment strategy based on the predictions of our models.
We start by building a simple univariate metamodel of the
performance of this investment strategy.
E. Identifying Time Structure in Investment Strategy Returns
In principle, the Box–Jenkins methodology can be used
to estimate the time structure of the Investment strategy
returns. In practice, however, because the P&L series are
serially correlated by construction, one has to be cautious
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
F- AND t-VALUES FOR
when fitting ARIMA models. The problem arises from the
fact that although we have 4800 observations, due to the 12-
month overlap the actual independent observations are at best
400. Since we have 90 underlying assets, effectively there
are less than five independent observations per stock. This
is not suitable for traditional ARIMA fitting. Instead, we shall
use cross sectional data and regress the future performance
of the strategy to only a limited number of lags chosen for
practical reasons not to exceed two. Since, due to the overlaps,
we cannot use the in-sample and -statistics5 in order
to evaluate the predictive ability of the models and/or the
significance of the parameters a we chose a simple alternative
based on out-of-sample testing. The models
P L P L P L
P L P L P L
with being a function approximated by a neural learning,
and is the vector of parameters, i.e., weights; are estimated
on 80% of the dataset and are then tested on the remaining
20%. For the neural model, a further validation set (10% of the
in-sample observations, randomly chosen) is used to control
the complexity of the model through early stopping. The out-
of-sample correlations between actual and predicted returns
are: 0.02 and 0.003 for the regression and neural models,
respectively. The frequency of change in sign are on average
one every two years for both models. Therefore the additional
profit obtained by switching on and off the strategy on the
basis of its predicted performance is 1.37% and 0.94%
for the regression and neural model, respectively. The funding
costs for switching in and out of the strategy make this active
strategy management approach less profitable than the passive
(i.e., buy-and-hold) investment strategy. Apparently neither of
the two models seems to be profitable. However, it is entirely
plausible that the expected returns of this investment strategy
may be conditioned not only on historical performance alone,
but also on exogenous influences attributable to the current
economic and market environment. In the next section we
attempt to verify this possibility.
5 It is actually possible to use these metrics but they need to be adjusted for
the overlap if the extend of the overlap was clear.
1263
TABLE XXII
VARIABLES APPLIED TO RANKED AND UNRANKED DATA
F. Identifying Exogenous Influences
We are interested in assessing the degree to which the
exogenous variables in Table XXI have a significant influence
in explaining investment strategy returns, and whether by
using these variables we obtain incremental value over and
above the passive (unconditional buy and hold) strategy and
the time series model. From the possible methods of variable
selection described in earlier sections of this paper ANOVA
appears to be the most suitable in this application. The main
reason for this is that our interest lies in identifying the
conditions under which to purchase or sell the investment
strategy. This is likely to occur due to multiplicative effects
(i.e., interactions) between these variables rather than simple
additive contributions.
The -statistics for the 11 most significant variables are
(52) shown in Table XXII. According to the -statistics, three
variables seem to have the strongest effect on cyclicity: the
dividend yield (relative to the market), the estimated growth
in earnings for the current year (Fiscal year zero to fiscal
year one) as well as the spread between two moving averages.
The -statistics also show linear or additive effects. Because
ranked data are not normally distributed but uniformly, the -
values significance levels are different than those for normally
distributed data (see -values). Given the large amount of
data points (4800), even small -values are significant (three
is significant at a 99% level). However, if we take into
account the overlap in the data (and adjust the for it),
most variables are unlikely to pass the significance test at a
confidence level higher than 80%. As far as direct dependency
is concerned only those with an higher than ten are
influential. However, because some of these variables interact
with each other it is desirable to retain them in the model.
These nonlinear interactions are illustrated using sensitivity
analysis (Section V-I) but first let us examine if incremental
value can be obtained (both in the statistical and economic
sense) by these metamodels.
G. Statistical Evaluation
Because the data contains both time series and cross sections
of stocks, we split the datasets in two ways. First, in order to
test how well the models generalize to unseen periods a first
dataset is created by splitting the database according to time,
1264
STATISTICAL EVALUATION
Fig. 25. Economic performances for the different models with fixed and proportional positions. Transaction costs of 1% are used.
i.e., the period January 1989 to December 1992 is used to
calibrate the regression, whereas January 1993 to December
1994 is used for testing. Second, in order to test how well the
models generalize to unseen stocks a second dataset is created
by splitting the database according to stock names i.e., the
first 72 stocks (in alphabetical order) are used for calibration,
whereas the next 18 are used for testing. For the NN models a
small cross validation set is used (10% of the estimation set)
are randomly chosen for this purpose. Table XXIII shows the
performance of the models in terms of percentage of variance
explained
The NN model seems to outperform the linear regression
model, both on unseen stocks, and on unseen periods, suggest-
ing the presence of nonlinear relationships in the dataset. There
is a notable difference between the estimation (in-sample)
and out of sample performance for both models suggesting
nonstationarity. This difference is even more pronounced for
the NN which is expected since it uses a smaller estimation
set.
The incremental value provided by the meta models is
small in statistical terms. However, the expected gain from the
strategy does not need to be large in order to ensure excess
returns. The strategy need only provide a positive expectation
net of funding (transaction costs). If we apply the strategy
a large number of times (or alternatively to a large number
of assets) the return should be positive and the risk low. In
the next section we evaluate the economic performance of the
metamodels.
H. Economic Results from Linear and NonlLinear Models
The statistical performance of the model has an interest
when analyzing the nature of the relationships between the
different variables. However, it does not provide a measure of
how useful the model is in term of prediction. Some models
can have a very good explanatory power, but appear to be
unable to generate profits. Transaction costs are often the
reason for this as well as outliers in the data.
IEEE TRANSACTIONS ON NEURAL NETWORKS, VOL. 8, NO. 6, NOVEMBER 1997
TABLE XXIII
OF LINEAR REGRESSION AND NEURAL MODELS
Two asset allocation rules will be applied to the models pre-
dictions. The first rule is based on the sign of the metamodels’
prediction i.e., if the is positive we buy the strategy, and if the
expectation is negative we sell the strategy in equal amounts.
The second rule consists of weighting the position proportional
to the magnitude of the expected return. The average sizes
of the position taken with the two rules being different, it is
important to adjust (i.e., scale down) individual positions so
that the aggregate economic performances of the two rules
can be compared fairly.
Fig. 25 plots the cumulative excess returns for the two
models with both allocation rules. The passive (i.e., buy and
hold) strategy is also shown (solid line). Transaction costs of
1% are taken into account.
As shown in Fig. 25, trading rules based on positions that
are proportional to the prediction of the models significantly
outperform the trading rules based on fixed size positions. This
suggests that the models have picked up the amplitude of the
profits and losses of the MA strategy, as well as their signs.
I. Sensitivity Analysis
The difference in performance between linear and nonlinear
models suggests that some nonlinearities exist in the dataset.
However, the -statistics in Table XXII only show minor
nonlinear dependencies. These nonlinearities are probably due
to interactions and conditional relationships. To illustrate this
point, let us analyze the relationship between the expected
cyclicity and the estimated growth in earnings per share
(provided by I/B/E/S and measured relative to the market).
This relationship is plotted in Fig. 26 for two different market
capitalization: the bold line represent market capitalization that
are 50% higher than the market average, the dotted line corre-
sponds to capitalizations that are 50% smaller then the market
average. Because the estimated function is multidimensional,
we can only plot a cross section of it. The relationship in
Fig. 26 is obtained when setting all the other variables to their
mean value.
REFENES et al.: NEURAL NETWORKS IN FINANCIAL ENGINEERING
Fig. 26. Conditional relationship between cyclicity and the growth in EPS, relative to the market, for two different market capitalizations. The other
factors are set to their mean value.
As shown in Fig. 26, the effect of estimated growth in EPS
is different for large and small capitalization stocks. For large
stocks, trends in relative prices tend to occur when EPS growth
is extreme. On the other hand, when earning growth is in line
with the market’s earning growth, prices tend to oscillate. For
small stocks, only small or negative earning growth engender
trending (probably downwards) prices.
Unfortunately, because of the large number of variables, it is
difficult to visualise or analyze exhaustively all the interaction
effects. Many relationships are probably conditional to more
than one other variables.
VI. CONCLUSIONS AND FURTHER RESEARCH
We described a collection of neural applications in options
pricing, cointegration, the term structure of interest rates and
models of investor behavior which highlight some key method-
ological weaknesses of NN’s including: testing the statistical
significance of the input variables, testing for misspecified
models, dealing with nonstationary data, handling leverages
in the datasets and generally formulating the problem in a
way which is more amenable to predictive modeling.
We proposed and evaluated a number of solutions. We
described a number of ways for principled variable selec-
tion including 1) a stepwise procedure building upon the
Box–Jenkins methodology; 2) analysis of variance; and 3)
regularization. We showed how model misspecification tests
can be used to ensure against models which make systematic
error. We described how the principle of cointegration can be
used to deal with nonstationary data and generally described
ways of formulating the problem in a manner that makes
predictive modeling more likely to succeed.
The problems and solutions presented and discussed in
this paper represent only the tip of an iceberg. Some of the
solutions, although effective in practise, still require more
rigorous statistical foundations. For example, the stepwise
procedure in Section II is still somewhat ad hoc. Ideally, one
would wish to bypass the Box–Jenkins phase all together
but this is not possible without having a distribution for the
1265
partial derivatives of the function in (9) or at least for the
statistic in (10). The ANOVA methodology on the other hand,
is model independent and does not assume causality. Many
other research issues, particularly model misspecification and
distribution theories remain unexplored, but they are essential
if NN’s are to become commonplace in financial econometrics.
ACKNOWLEDGMENT
The authors would like to thank D. Bunn for motivating
this research and his continuous technical contributions at
various stages in the development of the methodologies. F.
Miranda-Gonzales carried out the initial statistical analysis of
implied volatility. The authors would also like to thank J.-F.
De Laulanié from Société Générale Asset Management for his
useful comments regarding the metamodels for asset selection
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Apostolos-Paul N. Refenes received the B.Sc. de-
gree in mathematics from the University of North
London in 1984 and the Ph.D. degree in computing
from the University of Reading, U.K., in 1987.
He is Associate Professor of Decision Science and
Director of the Computational Finance Program at
London Business School. His current research inter-
ests on neural networks and nonparametric statistics
include model identification, variable selection, tests
for neural model misspecification, and estimation
procedures. Applied work includes factor models for
equity investment, dynamic risk management, nonlinear cointegration, tactical
asset allocation, exchange risk management, etc.
1267
A. Neil Burgess received the B.Sc. degree in Com-
puter Science from Warwick University, U.K., in
1989. He is currently pursuing the Ph.D. degree on
the subject of modeling nonstationary systems using
computational intelligence techniques.
Subsequently, he worked in the Thorn-EMI Cen-
tral Research Laboratories, applying computational
intelligence techniques to a range of problems in
musical analysis, marketing, signal processing, and
financial forecasting. Since September 1993, he has
been a Research Fellow in the Decision Technology
Center at London Business School, where he has published more than 20
papers on the use of advanced techniques for financial modeling. His research
interests neural networks, genetic algorithms, nonparametric statistics, and
cointegration.
Yves Bentz received the M.Sc. degree in physics
from Marseilles National School of Physics, France,
in 1991. Subsequently, he received the M.A. degree
from Marseilles Business School, France, in 1993.
He is currently pursuing the Ph.D. degree at London
Business School on the identification of conditional
factor sensitivities in the area of investment man-
agement.
He is currently a Researcher in the department
of Investiment Strategy at Société Générale Asset
Management, Paris, investigating the applications of
advanced modeling techniques to equity investment management. His present
interests include factor models based on adaptive and intelligent systems such
as the Kalman filter and neural networks.