Ill. i,t.,. QUANTITATIVE FINANCIAL ECONOMICS STOCKS, BONDS AND FOREIGN EXCHANGE Second Edition KEITH CUTHBERTSON AND DIRK NITZSCHE HOCHSCHULE John Wiley 8k Sons, Ltd
CONTENTS Preface Acknowledgements 2.1 Lognormality and Jensen's Inequality Xlll xv 1 Basic Concepts in Finance 1 1 1.1 Returns on Stocks, Bonds and Real Assets 1 1.2 Discounted Present Value, DPV 7 1.3 Utility and Indifference Curves 13 1.4 Asset Demands 19 1.5 Indifference Curves and Intertemporal Utility 25 1.6 Investment Decisions and Optimal Consumption 28 1.7 32 Appendix: Mean-Variance Model and Utility Functions 33 2 Basic Statistics in Finance 35 35 35 2.2 Unit Roots, Random Walk and Cointegration 36 2.3 Monte Carlo Simulation (MCS) and Bootstrapping 40 2.4 Bayesian Learning 47 2.5 50 3 Efficient Markets Hypothesis 53 53 3.1 Overview 54 3.2 Implications of the EMH 56 3.3 Expectations, Martingales and Fair Game 59 3.4 Testing the EMH 65 3.5 Using Survey Data 66 3.6 70 Appendix: Cross-Equation Restrictions 71 4 Are Stock Returns Predictable? 73 73 4.1 A Century of Returns 73
VIII CONTENTS 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 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 5.1 5.2 5.3 5.4 5.5 An Overview Mean-Variance Model Capital Asset Pricing Model Beta and Systematic Risk International Portfolio Diversification 6.1 6.2 6.3 6.4 Mathematics of the Mean-Variance Model International Diversification Mean-Variance Optimisation in Practice Appendix I: Efficient Frontier and the CML Appendix II: Market Portfolio 82 85 95 100 103 106 109 113 8 Empirical Evidence: CAPM and APT 189 8.1 8.2 8.3 8.4 CAPM: Time-Series Tests CAPM: Cross-Section Tests CAPM, Multifactor Models and APT Appendix: Fama-MacBeth Two-Step Procedure 189 189 190 195 202 203 115 9 Applications of Linear Factor Models 205 115 115 119 132 134 138 141 141 142 152 156 163 164 167 7 Performance Measures, CAPM and APT 169 169 7.1 Performance Measures 169, 7.2 Extensions of the CAPM 176 c 7.3 Single Index Model 179 r 7.4 Arbitrage Pricing Theory 181 " 7.5 187 9.1 9.2 9.3 9.4 Event Studies Mutual Fund Mutual Fund Performance 'Stars'? 10 Valuation Models and Asset Returns 205 206 209 227 243 245 245 10.1 The Rational Valuation Formula (RVF) 245 10.2 Special Cases of the RVF 248 10.3 Time-Varying Expected Returns 249 10.4 254 11 Stock Price Volatility 255 11.1 11.2 11.3 11.4 11.5 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, 255 257 261 267 268 269 270 273 273
CONTENTS IX 12.1 Linearisation of Returns and the RVF 274 12.2 Empirical Results 280 12.3 Persistence and Volatility 291 12.4 295 Appendix: Returns, Variance Decomposition and Persistence 296 13 SDF Model and the GCAPM 303 13.1 13.2 13.3 13.4 13.5 13.6 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 303 304 309 314 315 315 317 318 14 C-CAPM: Evidence and Extensions 323 14.1 14.2 14.3 14.4 14.5 14.6 14.7 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 323 323 327 332 336 346 350 353 354 15 Intertemporal Asset Allocation: Theory 355 355 15.1 Two-Period Model 356 15.2 Multi-Period Model 362 15.3 SDF Model of Expected Returns 368 15.4 368 Appendix I: Envelope Condition for Consumption-Portfolio Problem 369 Appendix II: Solution for Log Utility 370 16 Intertemporal Asset Allocation: Empirics 375 375 16.1 Retirement and Stochastic Income 375 16.2 Many Risky Assets 381 16.3 Different Preferences 383 16.4 Horizon Effects and Uncertainty 386 16.5 Market Timing and Uncertainty 389 16.6 Stochastic Parameters 390 16.7 Robustness 391 16.8 392 Appendix: Parameter Uncertainty and Bayes Theorem 393 17 Rational Bubbles and Learning 397 17.1 Rational Bubbles 17.2 Tests of Rational Bubbles 17.3 Intrinsic Bubbles 17.4 Learning 17.5 397 397 401 404 409 420 18 Behavioural Finance and Anomalies 423 423 18.1 Key Ideas 423 18.2 Beliefs and Preferences 428 18.3 Survival of Noise Traders 430 18.4 Anomalies 433 18.5 Corporate Finance 447 18.6 449
X CONTENTS 19 Behavioural Models 451 451 19.1 Simple Model 452 19.2 Optimising Model of Noise Trader Behaviour 454 19.3 Shleifer-Vishny Model: Short-Termism 460 19.4 Contagion 463 19.5 Beliefs and Expectations 466 19.6 Momentum and Newswatchers 468 I 19.7 Style Investing 470 19.8 Prospect Theory 475 19.9 484 Appendix I: The DeLong et al Model of Noise Traders 485 Appendix II: The Shleifer-Vishny Model of Short-Termism 486 20 Theories of the Term Structure 489 489 ' 20.1 Prices, Yields and the RVF 490 20.2 Theories of the Term Structure 494 20.3 Expectations Hypothesis 498 20.4 500 21 The EH-From Theory to Testing 21.1 21.2 21.3 21.4 Alternative Representations of the EH VAR Approach Time-Varying Term Premium-VAR Methodology 501 501 502 506 511 513 22 Empirical Evidence on the Term Structure 515 22.1 Data and Cointegration 22.2 Variance Bounds Tests 515 516 518 22.3 Single-Equation Tests 520 22.4 Expectations Hypothesis: Case Study 523 22.5 Previous Studies 532 22.6 536 23 SDF and AffineTerm Structure Models 537 23.1 23.2 23.3 23.4 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 537 537 541 543 544 545 546 24 The Foreign Exchange Market 549 549 24.1 Exchange Rate Regimes 549 24.2 PPP and LOOP 552 24.3 Covered-Interest Parity, CIP 560 24.4 Uncovered Interest Parity, UIP 561 24.5 Forward Rate Unbiasedness, FRU 562 24.6 Real Interest Rate Parity 562 24.7 563 Appendix: PPP and the Wage-Price Spiral 564 25 Testing CIP, UIP and FRU 567 567 25.1 Covered Interest Arbitrage 567 25.2 Uncovered Interest Parity 572 25.3 Forward Rate Unbiasedness, FRU 574 25.4 Testing FRU: VAR Methodology. - 581 25.5 Peso Problems and Learning 586 25.6 589
CONTENTS XI 26 Modelling the FX Risk Premium 591 26.1 26.2 26.3 26.4 26.5 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 27.4 591 592 593 597 598 605 607 607 607 617 624 625 28.2 Mapping Assets: Simplifications 635 28.3 Non-Parametric Measures 638 28.4 Monte Carlo Simulation 641 28.5 Alternative Methods 645 28.6 647 Appendix I: Monte Carlo Analysis and VaR 648 Appendix II: Single Index Model (SIM) 650 29 Volatility and Market Microstructure 653 653 29.1 Volatility 654 29.2 What Influences Volatility? 656 29.3 Multivariate GARCH 665 29.4 Market Microstructure-FX Trading 672 29.5 Survey Data and Expectations 674 29.6 Technical Trading Rules 679 29.7.,, - 681 28 Market Risk 28.1 Measuring VaR 627 627 628 fix. - ^. > "H." 1 References..^.-. 683 Recommended Reading 711 Index 713 ' " :.*.,i..u l:> '.T: /*