QUANTITATIVE FINANCIAL ECONOMICS

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1 Ill. i,t.,. QUANTITATIVE FINANCIAL ECONOMICS STOCKS, BONDS AND FOREIGN EXCHANGE Second Edition KEITH CUTHBERTSON AND DIRK NITZSCHE HOCHSCHULE John Wiley 8k Sons, Ltd

2 CONTENTS Preface Acknowledgements 2.1 Lognormality and Jensen's Inequality Xlll xv 1 Basic Concepts in Finance Returns on Stocks, Bonds and Real Assets Discounted Present Value, DPV Utility and Indifference Curves Asset Demands Indifference Curves and Intertemporal Utility Investment Decisions and Optimal Consumption Appendix: Mean-Variance Model and Utility Functions 33 2 Basic Statistics in Finance Unit Roots, Random Walk and Cointegration Monte Carlo Simulation (MCS) and Bootstrapping Bayesian Learning Efficient Markets Hypothesis Overview Implications of the EMH Expectations, Martingales and Fair Game Testing the EMH Using Survey Data Appendix: Cross-Equation Restrictions 71 4 Are Stock Returns Predictable? A Century of Returns 73

3 VIII CONTENTS Simple Models Univariate Tests Multivariate Tests Cointegration and Error Correction Models (ECM) Non-Linear Models Markov Switching Models Profitable Trading Strategies? 5 Mean-Variance Portfolio Theory and the CAPM An Overview Mean-Variance Model Capital Asset Pricing Model Beta and Systematic Risk International Portfolio Diversification Mathematics of the Mean-Variance Model International Diversification Mean-Variance Optimisation in Practice Appendix I: Efficient Frontier and the CML Appendix II: Market Portfolio Empirical Evidence: CAPM and APT CAPM: Time-Series Tests CAPM: Cross-Section Tests CAPM, Multifactor Models and APT Appendix: Fama-MacBeth Two-Step Procedure Applications of Linear Factor Models Performance Measures, CAPM and APT Performance Measures 169, 7.2 Extensions of the CAPM 176 c 7.3 Single Index Model 179 r 7.4 Arbitrage Pricing Theory 181 " Event Studies Mutual Fund Mutual Fund Performance 'Stars'? 10 Valuation Models and Asset Returns The Rational Valuation Formula (RVF) Special Cases of the RVF Time-Varying Expected Returns Stock Price Volatility Shiller Volatility Tests Volatility Tests and Stafionarity Peso Problems and Variance Bounds Tests Volatility and Regression Tests Appendix: LeRoy-Porter and West Tests 12 Stock Prices: The VAR Approach,

4 CONTENTS IX 12.1 Linearisation of Returns and the RVF Empirical Results Persistence and Volatility Appendix: Returns, Variance Decomposition and Persistence SDF Model and the GCAPM Consumption-CAPM C-CAPM and the 'Standard' CAPM Prices and Covariance Rational Valuation Formula and SDF Factor Models Appendix: Joint Lognormality and Power Utility tj C-CAPM: Evidence and Extensions Should Returns be Predictable in the C-CAPM? Equity Premium Puzzle Testing the Euler Equations of the C-CAPM Extensions of the SDF Model Habit Formation Equity Premium: Further Explanations Appendix: Hansen-Jagannathan Bound Intertemporal Asset Allocation: Theory Two-Period Model Multi-Period Model SDF Model of Expected Returns Appendix I: Envelope Condition for Consumption-Portfolio Problem 369 Appendix II: Solution for Log Utility Intertemporal Asset Allocation: Empirics Retirement and Stochastic Income Many Risky Assets Different Preferences Horizon Effects and Uncertainty Market Timing and Uncertainty Stochastic Parameters Robustness Appendix: Parameter Uncertainty and Bayes Theorem Rational Bubbles and Learning Rational Bubbles 17.2 Tests of Rational Bubbles 17.3 Intrinsic Bubbles 17.4 Learning Behavioural Finance and Anomalies Key Ideas Beliefs and Preferences Survival of Noise Traders Anomalies Corporate Finance

5 X CONTENTS 19 Behavioural Models Simple Model Optimising Model of Noise Trader Behaviour Shleifer-Vishny Model: Short-Termism Contagion Beliefs and Expectations Momentum and Newswatchers 468 I 19.7 Style Investing Prospect Theory Appendix I: The DeLong et al Model of Noise Traders 485 Appendix II: The Shleifer-Vishny Model of Short-Termism Theories of the Term Structure ' 20.1 Prices, Yields and the RVF Theories of the Term Structure Expectations Hypothesis The EH-From Theory to Testing Alternative Representations of the EH VAR Approach Time-Varying Term Premium-VAR Methodology Empirical Evidence on the Term Structure Data and Cointegration 22.2 Variance Bounds Tests Single-Equation Tests Expectations Hypothesis: Case Study Previous Studies SDF and AffineTerm Structure Models SDF Model Single-Factor Affine Models Multi-Factor Affine Models Appendix I: Math of SDF Model of Term Structure Appendix II: Single-Factor Affine Models The Foreign Exchange Market Exchange Rate Regimes PPP and LOOP Covered-Interest Parity, CIP Uncovered Interest Parity, UIP Forward Rate Unbiasedness, FRU Real Interest Rate Parity Appendix: PPP and the Wage-Price Spiral Testing CIP, UIP and FRU Covered Interest Arbitrage Uncovered Interest Parity Forward Rate Unbiasedness, FRU Testing FRU: VAR Methodology Peso Problems and Learning

6 CONTENTS XI 26 Modelling the FX Risk Premium Implications of /? < 1 in FRU Regressions Consumption-CAPM Affine Models of FX Returns FRU and Cash-in-Advance Models 27 Exchange Rate and Fundamentals 27.1 Monetary Models 27.2 Testing the Models 27.3 New Open-Economy Macroeconomics Mapping Assets: Simplifications Non-Parametric Measures Monte Carlo Simulation Alternative Methods Appendix I: Monte Carlo Analysis and VaR 648 Appendix II: Single Index Model (SIM) Volatility and Market Microstructure Volatility What Influences Volatility? Multivariate GARCH Market Microstructure-FX Trading Survey Data and Expectations Technical Trading Rules ,, Market Risk 28.1 Measuring VaR fix. - ^. > "H." 1 References..^ Recommended Reading 711 Index 713 ' " :.*.,i..u l:> '.T: /*

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