Stylised facts of financial time series and hidden Markov models in continuous time

Hidden Markov models are often applied in quantitative finance to capture the stylised facts of financial returns. They are usually discrete-time models and the number of states rarely exceeds two because of the quadratic increase in the number of parameters with the number of states. This paper presents an extension to continuous time where it is possible to increase the number of states with a linear rather than quadratic growth in the number of parameters. The possibility of increasing the number of states leads to a better fit to both the distributional and temporal properties of daily returns.     

Empirically based modeling in financial economics and beyond, and spurious stylized facts

The discovery of the dynamics of a time series requires construction of the transition density. We explain why 1-point densities and scaling exponents cannot determine the class of stochastic dynamics. Time series require some sort of underlying statistical regularity to provide a basis for analysis, and we construct an exhaustive list of such tests. The condition for stationary increments, not scaling, determines the existence of long time pair autocorrelations. We conjecture that for a selfsimilar process neither the pair correlations 〈x(t)x(s)〉 nor the 2-point density scales in both times t and s except in a pathological case, and give examples using three well-known Gaussian processes. An incorrect assumption of stationary increments can generate spurious stylized facts, including fat tails. When a sliding window is applied to nonstationary, uncorrelated increments then a Hurst exponent H_s = 1 / 2 is generated by that procedure even if the underlying model scales with a Hurst exponent H ≠ 1/2. We explain how this occurs dynamically. The nonstationarity arises from systematic unevenness in the traders' behavior in real time. Spurious stylized facts arise mathematically from using a log increment with a ‘sliding window’ to read the series. In addition, we show that nonstationary processes are generally not globally transformable to stationary ones. We also present a more detailed explanation of our recent FX data analysis and modeling.     

Applying the method of simulated moments to estimate a small agent-based asset pricing model

The paper takes a recent agent-based asset pricing model by Manzan and Westerhoff from the literature and applies the method of simulated moments to estimate its six parameters. In selecting the moments, the focus is on the fat tails and autocorrelation patterns of the daily returns of several stock market indices and foreign exchange rates. It is argued that it may be meaningful to abandon the econometrically optimal weighting matrix in the objective function and instead invoke the moments' t-statistics in an intuitively appealing way. This modification gives rise to estimations whose moment matching, given the model's parsimony, can be largely considered to be satisfactory. Also the parameter estimates across different markets make good economic sense.     

Financial markets in the laboratory: an experimental analysis of some stylized facts

This paper provides experimental evidence explaining a number of stylized facts associated with the behaviour of financial returns, in particular the fat tailed nature of their distribution and the persistence in their volatility. By means of a laboratory experiment, we investigate the effect of the quantity and quality of information present in a financial market upon its stylized facts, showing how both the quality and quantity of information might have an impact on volatility clustering and the emergence of fat tail returns.     

Tests of technical trading strategies in the emerging equity markets of Latin America and Asia

This study examines the potential profit of ten Variable Length Moving Average (VMA) technical trading rules in ten emerging equity markets in Latin America and Asia from January 1982 through April 1995. The average difference in buy − sell returns after trading costs for each rule and country are compared to a buy and hold strategy. Taiwan, Thailand and Mexico emerge as markets where technical trading strategies may be profitable. We find no strong evidence of profitability for the other markets. However, we find that 82 out of the 100 country–trading rule combinations tested in ten emerging markets, disregarding their statistical significance, correctly predict the direction of changes in the return series. These findings may provide investors with important asset allocation information.     

Entry, exit and trading profits: A look at the trading strategies of a proprietary trading team

We examine the behavior of a 15 strong proprietary stock trading team and show how consistent intraday trading profits were generated. The team, who worked for a large US direct access trading firm, executed over 96 thousand trades in 3 months in 2000. Profitable intraday trading occurred in an anonymous dealer capacity, on both long and short positions, especially when volume and price volatility were higher. The traders rapidly entered long (short) positions when the number of dealers and size become greater on the bid (offer) side of the spread. Profits were taken early against the trend.     

Against the tide: the commencement of short selling and margin trading in mainland China

China's recent removal of short‐selling and margin trading bans on selected stocks enables testing of the relative effect of margin trading and short selling. We find the prices of the shortable stocks decrease, on average, relative to peer A‐shares and cross‐listed H‐shares, suggesting that short selling dominates margin trading effects. Contrary to the regulators' intention and recent developed market empirical evidence, liquidity declines and bid‐ask spreads increase in these shortable stocks. Consistent with Ausubel (1990), these results imply that uninformed investors avoid the shortable stocks to reduce the risk of trading with informed investors.     

On the persistence and volatility in European,American and Asian stocks bull and bear markets

In this paper we examine the statistical properties of several stock market indices in Europe, the US and Asia by means of determining the degree of dependence in both the level and the volatility of the processes. In the latter case, we use the squared returns as a proxy for the volatility. We also investigate the cyclical pattern observed in the data and in particular, if the degree of dependence changes depending on whether there is a bull or a bear period. We use fractional integration and GARCH specifications. The results indicate that the indices are all nonstationary I(1) processes with the squared returns displaying a degree of long memory behaviour. With respect to the bull and bear periods, we do not observe a systematic pattern in terms of the degree of persistence though for some of the indices (FTSE, Dax, Hang Seng and STI) there is a higher degree of dependence in both the level and the volatility during the bull periods.     

Stock market volatility, excess returns, and the role of investor sentiment

Using the Investors' Intelligence sentiment index, we employ a generalized autoregressive conditional heteroscedasticity-in-mean specification to test the impact of noise trader risk on both the formation of conditional volatility and expected return as suggested by De Long et al. [Journal of Political Economy 98 (1990) 703]. Our empirical results show that sentiment is a systematic risk that is priced. Excess returns are contemporaneously positively correlated with shifts in sentiment. Moreover, the magnitude of bullish (bearish) changes in sentiment leads to downward (upward) revisions in volatility and higher (lower) future excess returns.     

The profitability of pairs trading strategies: distance,cointegration and copula methods

We perform an extensive and robust study of the performance of three different pairs trading strategies—the distance, cointegration and copula methods—on the entire US equity market from 1962 to 2014 with time-varying trading costs. For the cointegration and copula methods, we design a computationally efficient two-step pairs trading strategy. In terms of economic outcomes, the distance, cointegration and copula methods show a mean monthly excess return of 91, 85 and 43 bps (38, 33 and 5 bps) before transaction costs (after transaction costs), respectively. In terms of continued profitability, from 2009, the frequency of trading opportunities via the distance and cointegration methods is reduced considerably, whereas this frequency remains stable for the copula method. Further, the copula method shows better performance for its unconverged trades compared to those of the other methods. While the liquidity factor is negatively correlated to all strategies’ returns, we find no evidence of their correlation to market excess returns. All strategies show positive and significant alphas after accounting for various risk-factors. We also find that in addition to all strategies performing better during periods of significant volatility, the cointegration method is the superior strategy during turbulent market conditions.     

The optimal bid-ask price strategies of high-frequency trading and the effect on market liquidity

We propose a model for determining the optimal bid-ask spread strategy by a high-frequency trader (HFT) who has an informational advantage and receives information about the true value of a security. We employ an information cost function that includes volatility and the volume of the asset. Subsequently, we characterize the optimal bid-ask price strategies and obtain a stable bid-ask spread. We assume that orders submitted by low-frequency traders (LFTs) and news events arrive at the market with Poisson processes. Additionally, our model supports the trading of the two-sided quote in one period. We find that more LFTs and a higher exchange latency both hurt market liquidity. The HFT prefers to choose a two-sided quote to gain more profits while cautiously chooses a one-sided quote during times of high volatility. The model generates some testable implications with supporting empirical evidence from the NASDAQ-OMX Nordic Market.     

The intertemporal risk-Return relation,investor behavior,and technical trading profits: evidence from the G-7 countries

The intertemporal risk-return relation and investor behavior are both important pricing factors that jointly determine the expected market risk premium. Using the price adjustment process as a control variable, we find that the intertemporal risk-return relation is positive conditional on bad market news, but is non-positive conditional on good market news. This implies that good (bad) market news weakens (strengthens) the positive risk-return relation. The pattern in the distortion of the risk-return relation is consistent with short-term mispricing in which investors overvalue (undervalue) the stock market in reaction to good (bad) market news. We also show that ignoring the price adjustment process in the estimation of the risk-return relation leads to model misspecification and induces an upward (downward) bias in estimates of the relative risk aversion parameter conditional on good (bad) news. Our model of the asymmetric risk-return relation along with the price adjustment process is capable of generating the return dynamics that is attributable to technical trading profits. We suggest that the profitability of technical trading rules is not a violation of market efficiency, but a consequence of trading rules exploiting the asymmetric effect of price changes on the risk-return relation, along with the persistence property of price changes.     

Order preferencing, adverse-selection costs, and the probability of information-based trading

Although prior studies offer various conjectures on the causes and consequences of order preferencing, there is only limited empirical evidence. In this study, we show that the extent of order preferencing is significantly and negatively related to both the adverse-selection component of the spread and the probability of information-based trading. This result is consistent with the prediction of the clientele-pricing hypothesis that dealers (brokers) selectively purchase (internalize) orders based on information content. Our results suggest that order preferencing may not be as harmful as some researchers have suggested and offer some rationale for its prevalence in securities markets with heterogeneously informed traders. JEL Classification G18 · G19     

Financial markets,financial dependence,and the allocation of capital

We explore one specific channel through which finance promotes growth: the allocation of capital. Using international industrial data, we find that countries with developed financial markets invest more in growing industries, and pull out more funds of declining ones. Most interestingly, this pattern is more eminent for those industries more dependent on external financing. Various robustness checks show that the results are not driven by reverse causality, omitted variables, specific countries or industries.     

Noise and the Trading Mechanism: the Case of SETS

On 20 October 1997 the London Stock Exchange introduced a new trading system called SETS. This system was to replace the dealer system SEAQ, which had been in operation since 1986. Using the iterative sum of squares test introduced by Inclan and Tiao (1994) , we investigate whether there was a change in the unconditional variance of opening and closing returns, at the time SETS was introduced. We show that for the FTSE‐100 stocks traded on SETS, on the days following its introduction, there was a widespread increase in the volatility of both opening and closing returns. However, no synchronous volatility changes were found to be associated with the FTSE‐100 index or FTSE‐250 stocks. We conclude therefore that the introduction of the SETS trading mechanism caused an increase in noise at the time the system was introduced.     

中国股市开、收盘波动性的比较研究

利用EGARCH模型,对2000年1月至2007年4月间沪深两市具有代表性的股票及指数的开收盘收益率的波动性进行实证分析,结果表明收益率序列有明显的ARCH效应,其波动性具有显著的非对称性的冲击的持续性;在样本期内,上交所的个股和指数未能观察到开盘波动性高于收盘波动性的现象,而深交所个股在2006年7月实施收盘集合竞价机制之后比较明显地观察到开盘波动性高于收盘波动性的现象。     

The global financial crisis and the evolution of markets, institutions and regulation

This paper analyses the recent global financial crisis in the context of the dual processes of market development and regulation. It discusses how, in the absence of a globally integrated financial framework, past and present regulations and interventions in reaction to national and global financial crises did not resolve the cross border regulatory arbitrage. The paper discusses how crises often lead to the emergence of new national and international institutions. It also analyses the proposed “new global framework” that needs to be in place if the policy recommendations contained in the G20 communiqué are going to be effectively implemented. The paper argues that unless international agreements are ratified by all nations and become part of national rules and laws, the presence of regulatory arbitrage and the lack of adequate cross border information and data may prevent the global economy from addressing the underlying causes of the recent global financial crisis. The paper also discusses the evolution of central banks and their new role in contributing to global financial stability. The paper argues that the recent global financial crisis has provided a unique opportunity to go beyond economic data and attempt to capture cross border financial data and other information that could assist international and national institutions to measure and manage financial risk more effectively. Finally, the paper discusses “too big to fail” and argues that only an internationally integrated financial system will make large banks global, both when operational and in the event of insolvency.     

Volatility timing,sentiment, and the short-term profitability of VIX-based cross-sectional trading strategies

This paper explores the profitability of simple short-term cross-sectional trading strategies based on the implied volatility index (VIX), often referred to as an “investor fear gauge” in the stock market. These strategies involve holding sentiment-prone stocks when VIX is low and sentiment-immune stocks when VIX is high and generate significantly higher excess returns than the benchmark long–short portfolios that do not condition on VIX. We show that the profitability of our trading strategies is not subsumed by the well-known risk factors or transaction cost adjustments. Our findings are consistent with the theory of delayed arbitrage and the synchronization problem of Abreu and Brunnermeier (2002).     

The response of the external finance premium in Asian corporate bond markets to financial characteristics,financial constraints and two financial crises

Empirical investigation of the external finance premium has been conducted on the margin between internal finance and bank borrowing or equities but little attention has been given to corporate bonds, especially for the emerging Asian market. In this paper, we hypothesize that balance sheet indicators of creditworthiness could affect the external finance premium for bonds as they do for premia in other markets. Using bond-specific and firm-specific data for China, Hong Kong, Indonesia, Korea, Philippines, Singapore and Thailand during 1995–2009 we find that firms with better financial health face lower external finance premia in all countries. When we introduce firm-level heterogeneity, we show that financial variables appear to be both statistically and quantitatively more important for financially constrained firms. Finally, when we examine the effects of the 1997–1998 Asian crisis and the 2007–2009 global financial crisis, we find that the sensitivity of the premium is greater for constrained firms during the Asian crisis compared to other times.