Quantitative financial economics stocks bonds and foreign exchage

I Quantitative Financial Economics SERIES IN FINANCIAL ECONOMICS AND QUANTITATIVEANALYSIS Series Editor: Editorial Board: Stephen Hall, London Business School, UK Robert F Engle, University of California, USA John Flemming, European Bank, UK Lawrence R Klein, University of Pennsylvania, USA Helmut Liitkepohl, Humboidt University, Germany The Economics of Pensions and Variable Retirement Schemes Oliver Fabel Applied General Equilibrium Modelling: Imperfect Competition and European Integration Dirk Willenbockel Housing, Financial Markets and the Wider Economy David Miles Maximum Entropy Econometrics: Robust Estimation with Limited Data Amos Golan, George Judge and Douglas Miller Estimating and Interpreting the Yield Curve Nicola Anderson, Francis Breedon, Mark Deacon, Andrew D e r v and Gareth Murphy Further titles in preparation Proposals will be welcomed by the Series Editor L Quantitative Financial Economi Stocks, Bonds and Foreign Exchange Keith Cuthbertson Newcastle upon Tyne University and City University Business School Chichester JOHN WILEY & SONS New York Brisbane Toronto Singa International (+44) 1243 779777 e-mail (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on http://www.wiley.co.uk or http://www.wiley.com Reprinted December 1996, August 1997, September 1999 All Rights Reserved No part of this book may be reproduced, stored in a retrieval system, o in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, ex terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by Licensing Agency, 90 Tottenham Court Road, London, U K WIP 9HE, without the permission in pub1isher Other Wiley Editorial Ofices John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, USA Jacaranda Wiley Ltd 33 Park Road, Milton, Queensland 4064, Australia John Wiley & Sons (Canada) Ltd, 22 Worcester Road, Rexdale, Ontario M9W 1L1, Canada John Wiley & Sons (Asia) Pte Ltd, Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 Library of Congress Caf~ging-in-PublicafionData Cuthbertson, Keith Quantitative financial economics : stocks, bonds, and foreign exchange / Keith Cuthbertson cm - (Series in financial economics and quantitative p: analysis) Includes bibliographical references and index ISBN 0-471-95359-8 (cloth) - ISBN 0-471-95360-1 (pbk.) Investments - Mathematical models Capital assets pricing model Stocks - Mathematical models Bonds - Mathematical models Foreign exchange - Mathematical models I Title 11 Series HG4515.2.C87 1996 95 - 48355 332.6 - dc20 CIP British Library Cataloguing in Publicafion Data A catalogue record for this book is available from the British Library ISBN 0-471-95359-8 (Cased) 0-471-95360-1 (Paperback) Typeset in 10/12pt Times Roman by Laser Words, India Printed and bound in Great Britain by Bookcraft (Bath) Ltd, Avon This book is printed on acid-free paper responsibly manufactured from sustainable forestation, for which at least two trees are planted for each one used for paper production Dedication To June I This page intentionally left blank Contents Series Preface Introduction Acknowledgements Part Returns and Valuation Basic Concepts in Finance 1.1 Returns on Stocks, Bonds and Real Assets 1.2 Utility and Indifference Curves 1.3 Physical Investment Decisions and Optimal Consumption 1.4 Summary Endnotes The Capital Asset Pricing Model: CAPM 2.1 An Overview 2.2 Portfolio Diversification, Efficient Frontier and the Transformation Line 2.3 Derivation of the CAPM 2.4 Summary Appendix 2.1 Derivation of the CAPM Modelling Equilibrium Returns 3.1 Extensions of the CAPM 3.2 A Simple Mean-Variance Model of Asset Demands 3.3 Performance Measures 3.4 The Arbitrage Pricing Theory (APT) 3.5 Testing the Single Index Model, the CAPM and the APT 3.6 Summary Valuation Models 4.1 The Rational Valuation Formula (RVF) 4.2 Summary Endnotes Further Reading 5.2 Implications of the EMH 5.3 Expectations, Martingales and Fair Game 5.4 Testing the EMH 5.5 Summary Endnotes Empirical Evidence on Efficiency in the Stock Market 6.1 Predictability in Stock Returns 6.2 Volatility Tests 6.3 Summary Endnotes Appendix 6.1 Rational Bubbles 7.1 Euler Equation and the Rational Valuation Formula 7.2 Tests of Rational Bubbles 7.3 Intrinsic Bubbles 7.4 Summary Endnotes Anomalies, Noise Traders and Chaos 8.1 The EMH and Anomalies 8.2 Noise Traders 8.3 Chaos 8.4 Summary Appendix 8.1 Appendix 8.2 Endnote Further Reading Part The Bond Market Bond Prices and the Term Structure of Interest Rates 9.1 Prices, Yields and the RVF 9.2 Theories of the Term Structure 9.3 Summary Endnotes 10 Empirical Evidence on the Term Structure 10.1 The Behaviour of Rates of Return 10.2 Pure Discount Bonds 10.3 Coupon Paying Bonds: Bond Prices and the Yield to Maturity 10.4 Summary Appendix 10.1 Is the Long Rate a Martingale? Appendix 10.2 Forward Rates Endnotes Further Reading 11.2 Purchasing Power Parity (PPP) 11.3 Interrelationships between CIP, UIP and PPP 11.4 Summary Appendix 11.1 PPP and the Wage-Price Spiral 12 Testing CIP, UIP and FRU 12.1 Covered Interest Arbitrage 12.2 Uncovered Interest Parity and Forward Rate Unbiasedness 12.3 Forward Rate: Risk Aversion and Rational Expectations 12.4 Exchange Rates and News 12.5 Peso Problems and Noise Traders 12.6 Summary Appendix 12.1 Derivation of Fama’s Decomposition of the Risk Premium in the Forward Market 13 The Exchange Rate and Fundamentals 13.1 Flex-Price Monetary Model 13.2 Sticky-Price Monetary Model (SPMM) 13.3 Dornbusch Overshooting Model 13.4 Frankel Real Interest Differential Model (RIDM) 13.5 Testing the Models 13.6 Chaos and Fundamentals 13.7 Summary Further Reading Part Tests of the EMH using the VAR Methodology 14 The Term Structure and the Bond Market 14.1 Cross-equation Restrictions and Informational Efficiency 14.2 The VAR Approach 14.3 Empirical Evidence 14.4 Summary Endnotes 15 The FOREX Market 15.1 Efficiency in the FOREX Market 15.2 Recent Empirical Results 15.3 Summary Endnotes 16 Stock Price Volatility 16.1 Theoretical Issues 16.2 Stock Price Volatility and the VAR Methodology 16.3 Empirical Results 16.4 Persistence and Volatility Appendix 16.1 Returns, Variance Decomposition and Persistence Market’, Department of Economics, University of Newcastle, mimeo Cuthbertson, K and Taylor, M.P (1987) Macroeconomic Systems, Blackwell, Oxford Cuthbertson, K., Hall, S.G and Taylor, M.P (1992) Applied Econometric Techniqu Wheatsheaf, Hemel Hemstead Cuthbertson, K., Hayes, S and Nitzsche, D (1994a) ‘The Behaviour of UK Stock Returns: Is the Market Efficient?’, Newcastle Discussion Papers in Economic University of Newcastle Cuthbertson, K., Hayes, S and Nitzsche, D (1994b) ‘Are German Money Market Behaved?’, Newcastle Discussion Papers in Economics No 94/04, University of Ne Cuthbertson, K.,Hayes, S and Nitzsche, D (1996a) ‘The Behaviour of Certificate of D in the UK’, Oxford Economic Papers, forthcoming Cuthbertson, K., Hayes, S and Nitzsche, D (1996b) ‘Interest Rates in Germany and th tegration and Error Correction Models’, Manchester School, forthcoming Cutler, D.M., Poterba, J.M and Summers, L.H (1989) ‘What Moves Stock Prices? 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Index Akaike information criterion, 339 Anomalies, 169, 185 Anti-inflation policy, 207, 250 Arbitrage, 63, 172, 259, 268-271 61-67, 74, 75, Arbitrage pricing theory (APT), 129, 401 Arbitrageurs, 174, 179 ARCH model, 43-45, 183, 202, 375-380, 389, 398-415,438-442 ARIMA models, 286, 287, 398, 420-442 ARMA models, 117, 126-127, 151-153, 161, 339, 382, 421, 422, 426-437 Asset demand, 54-57 Augmented Dickey Fuller test (see DickeyFuller test) Autocorrelation, 421, 422, 426 Autocovariance function, 422, 426 Autoregressive models (see ARMA models) Bankruptcy, 177, 201 Bearish, 182, 183, 203, 204 Beta, 24, 41-46, 57-61, 70-73 Bid-ask spread (see also spread), 124, 173 Big-Bang, 174 Black Wednesday, 256, 257 Bond, 3-10, 178, 208, 211-227, 234, 250, 297, 309, 311, 313, 375, 401, 402, 407-41 corporate, 207, 212, 237, 272, 379, 392, 393 coupon paying, 8, 212, 246, 249 government, 189, 207, 212, 326, 392, 393, 397, 398 zero coupon, 212, 229, 234, 340, 402, 413, 414 pure discount, 7, 212, 213, 241, 245, 249, 331, 402 Bond market, 207-214, 234, 249, 315, 332, 344, 374,376,402-411 Bond price, 211-218,246-247 Box Jenkins methodology, 422, 43 Bretton Woods, 255, 256, 290, 299 Bubble, 156-168, 193, 195, 301, collapsing, 157, 162, 163, 167, exogenous, 157, 161, 302 explosive, 156, 162 intrinsic, 157, 163- 167, 360 rational, 156-163, 167, 195, 30 Budget constraint, 49, 223, 391, 39 Budget deficit, 393 Bullish, 182, 183, 203 BZW equity index, 367 Capital asset pricing model (CAPM 82-88, 96, 97, 103, 122, 127 177, 178, 190, 221, 222, 248, 373-377,381-412 consumption (see consumption post-tax, 72, 73 zero beta, 48-54, 69, 234, 248, Capital gaidloss, 345, 363, 364, Capital market, 19, 187 Capital market line (CML), 37-39, Capital mobility, 291 -293 Central bank, 207, 266, 271, 280, Chaos, 169, 176, 195, 196, 205-29 Chartists, 174, 179, 194, 198-201, 331 Chi-squared distribution (see distri Closed end fund, 170-173, 185 Cochran-Orcutt transformation, 452 Cointegration, 162, 302, 328, 329, 434 -438 Commercial paper, 353, 356 Consol (see Perpetuity) Consumer Price Index, 368 Consumption, 294, 353, 355, 368, 408 Consumption CAPM (CCAPM), 128, 133-140, 408 Cost mark up equation, 431 Covariance conditional, 409-413, 438 Credit limit, 271 Currency, 255, 261, 292, 305-307, 376, 444 Data, 237, 277-284, 302, 328, 403, 444 Debt-equity ratio, 379 Detrending, 344, 425, 426 Devaluation, 270, 282, 283 Diagnostic test, 129, 342, 351, 430 Dickey Fuller test (DF test), 435 Discount factor, 136, 344, 373, 380, 381 Discount rate, 346-350, 360-367, 378 Discounted present value (DPV), 3-21, 76-88, 104- 112, 136- 147, 178, 188, 208-216, 311, 350, 363-365, 378-381 Distribution, 58, 71, 100, 111, 126, 152, 168, 182, 183, 321, 386, 392, 418, 419, 434, 441 Dividend, 9, 10, 346-352, 359-368, 372, 380-387, 434 Dividend price ratio, 346-354, 359, 360, 366-369, 375, 377, 387 Dornbusch overshooting model, 293-295 Dow Jones index, 130, 161 Duration, 217 Earnings, 360 Earnings price ratio, 355 Economic fundamentals (see fundamentals) Economic model, 417, 427, 431, 432 Economic theory, 417, 431 -433 Economic time series (see time series) Efficiency (see informational efficiency) Efficient frontier, 25, 29-33, 37 Efficient markets hypothesis (EMH), 44, 93-100, 105-129, 134, 143-152, 169-181, 194, 201, 208-215, 231-234, 249,265, 269-288,309-315,338-368, 377, 387,438 Efficient portfolio (see portfolio) EMU 257 Employment, 207, 256, 293, 294, 303 Error correction model, 306, 342, 343, 434-437 Errors in variables method (EVM), 443-452 Estimation stage least squares (2SLS), 272, 275, 403, 443-452 Generalised least squares, 443, 445, 452 Ordinary least squares (OLS),1 242, 244, 253, 272, 276, 27 324, 325, 373, 435, 443-45 Seemingly unrelated regression (SURE), 276, 324, 334, 39 Euler equation, 77-85, 138, 154- 302 Eurocurrency market, 268 Eurocurrency rate, 269, 271, 397 European Monetary System (EMS) Excess holding period yield (see H Excess volatility (see volatility) Exchange rate, 194, 200-207, 255 290-307, 376,417 fixed/floating, 255-257, 271, 28 real, 262-265, 292, 298 Exchange Rate Mechanism (ERM) 290, 300 Exchange rate overshooting, 256, 291 -295 Expectations mathematical, 100- 102, 114 Rational (see Rational expectati revision to, 363, 364 Expectations hypothesis (EH), 208 219-232, 237, 240-252, 309339-340, 348, 403-408, 443 Extrapolative predictor, 447-449 Factor analysis see APT) Fads, 175, 183, 185, 202, 342, 360 Fair game, 77, 94, 96, 100-104, 15 Federal Reserve, 244, 404 Feedback trader, 118-120, 179, 38 Fisher hypothesis, 226, 265, 292, Flex-price monetary model, 290-30 Forecast, 311-316, 323-335, 346-3 359, 360, 380, 410, 424, 425, 444,449 conditional, 422-426 multiperiod, 320, 334, 339, 342 unconditional, 415 Forecast error, 242, 250, 283, 310, 341,353,363,365,377-391,40 422,427,438-447 Forecasting chain rule of forecasting 311, 32 Forecasting equation, 311, 312, 318 359, 364 288, 334, 337 Forward premium, 252, 253, 275-278, 289, 303, 305, 334-340 Forward rate, 251, 252, 259-268, 273-280, 288, 334-340 Forward rate unbiasedness (FRU), 264-268, 272-289,334-342 281-288, 293-300,304-30 397 testing, 268-289 Internal rate of return, 6-21 International Fisher hypothesis (se hypothesis) International Monetary Fund (IMF Investment appraisal 6, 15-20 GARCH model, 183, 301, 377, 383-389, 400, 406, 415, 438-442, 452 Gaussian error, 418, 426 Gearing, 190, 389, 393 Geometric random walk (see random walk) Gordon’s growth model, 135, 164, 347, 359 Granger causality, 325-330, 348-354, 433-438, 449 January effect, 123, 129, 169-173 Johansen procedure, 434, 437 Herding, 156, 175, 176, 190, 202 Holding period return yield (HPY), 9, 10, 208-253, 331, 345, 353, 358, 368, 376, 397-414 Hyperinflation, 262, 292, 298, 300 Lag operator, 418-421 Leverage, 379 Likelihood ratio test, 309, 315-31 336, 396,411 Linear combination Linearisation, 363, 368 Liquidity preference hypothesis, 219-221, 228, 231-237, 252 Liquidity premium (see risk prem London Interbank Rate (LIBOR, L 326-328 Indifference curve, 3, 10-18, 38, 39, 50, 55-57 Inflation, 54, 108, 130, 207, 218, 226, 252, 256, 263-267, 272, 295, 300-307, 378, 393, 400-406, 431 Information set, 261, 312, 327, 330-341, 348-369,386,396,404-411,423,426, 433, 443-452 Informational efficiency, 105- 117, 138- 142, 147-150, 159,265, 283, 309-310, 315, 368, 404, 406 semi strong form, 105 strong form, 105 weak form, 105, 117, 128, 133 Insider information, 105 Integrated GARCH (IGARCH) (see GARCH model) Interest rate, 3-20, 33-73, 130, 207-212, 243, 244, 259-269, 290-298, 309, 315-333, 375 -409 continuously compounded, 3-8, 20, 211-233, 251, 414 real, 104, 257, 290-293, risk free, 10-25, 33, 34, 48-65, 82-116, 121, 146, 214, 220-237 MA process (see also ARIMA mo 123, 420-423,437 Maastricht Treaty, 288 Marginal rate of substitution (MR Market psychology, 156, 285 Market segmentation hypothesis, 219-223, 231, 243, 331, 404 Markov switching model, 127, 16 Martingale, 94, 99-104, 113, 159 244, 249, 250, 301 Matrix companion, 322, 372 variance-covariance, 227, 242, 321-325, 365, 373, 396, Maturity spectrum, 213, 245-249 326, 331, 332, 402 Mean reversion, 172, 178-185, Mean variance criterion, 26, 30 Mean variance model, 179, 375, 399, 405 Measurement error, 397, 401, 407 Merger, 19, 93, 105, 113 Modigliani-Miller theorem, 99, Money market, 293, 294 Money market line, 17 Pure expectations hypothesis (PEH expectations hypothesis) NAIRU, 431 Net present value (see discounted present value) Neural network, 202, 205, 302 Neutrality of money, 291 -294 Noise trader, 118-128, 169-204, 258, 282, 284, 288, 299-307, 375-377, 380, 387-390 Non-stationarity (see stationarity) NYSE, 129, 133, 172, 365, 384,400 OECD, 300,326 Omitted variables, 149, 399, 436, 437, 449 Orthogonality condition, 94- 110, 138- 141, 147-154, 167, 248, 272, 281, 319, 323, 325, 336, 444 Output, 256, 378-380, 431 Pension fund, 170, 173, 176, 207, 332 Perfect foresight rate, 224, 228-234 regression, 331 price, 178, 215, 240, 311, 344, 345, 350, 351, 358, 360 spread, 208, 225, 227, 231, 237, 242, 245, 246, 319, 325-330 Performance index, 25, 47, 57-61, 131, 132 Perpetuity, 9, 212, 216, 240 Persistence, 176, 183, 344, 352, 361-390, 400, 412,413, 440, 442 Peso problem, 147-252, 258, 279, 282-284, 288, 299, 301 Phillips curve, 266, 267, 291-294 Plaza and Louvre accord, 256, 301 Portfolio, 24-89, 121, 172- 178,381-399 efficienthefficient, 26 market, 24, 40, 44, 73, 121, 178, 381, 399 optimal, 22, 35 Portfolio balance model (PBM), 296-298 Portfolio diversification, 22, 25 -31 Predictability, 122, 184, 358, 361-372 Preferred habitat hypothesis, 208, 219, 223 Present value (PV) (see discounted present value) Price competitiveness, 255 Price index, 128, 139, 267, 384 Principle agent problem, 20 Random walk, 94, 104, 105, 122-1 143-150, 162, 183, 194, 195, 299-306, 342,400,419-426 Rate of return, 3-5, 49, 98, 235-24 Rational expectations, 94- 123, 145 201, 227-232, 242, 243, 250, 302-332,350-355,402-406,4 Rational valuation formula (RVF), 116-118, 143-155, 162, 179, 211-215, 220, 223, 311-313, 353-367 Real interest differential model (RI 295 -298 Real interest rate parity (see intere parity) Real interest rate (see interest rate) Redemption yield (see yield to ma Restriction cross equation restriction, 298, 315-323, 335-344, 353,35 linear restriction, 349 non-linear restriction, 324, 349, Return (see also rate of return) excess, 41-112, 128-135, 159, 222, 345,349-357,383-407 expected, 23-104, 124, 149, 152 260,352,363-374,387-400 linearisation, 368, 369 multiperiod, 358-368 Risk, 20-45,54-67, 259,270,357 402-414 default, 212 fundamental, 174 idiosyncratic/specific, 62, 63 market price of, 20, 38, 39, 384 409 measures of, 45, 394, 404-408 reinvestment, 214 risk averse, 3-24, 55, 58, 86, 87 140, 181, 185, 199, 203, 27 391-405 risk lover, 10-20 risk neutral, 10-20, 76, 82-87, 242, 261-305, 334, 342, 40 risk premium, 7, 214-232, 237, 245-253, 272-279, 289, 33 375-390,402-411 svstematichnsvstematic 41 -43 , d Separation principle, 16, 20, 23, 37, 50, 53 Short termism, 98, 113, 185-190, 204 Single index model (SIM),67-69, 204 Small firm effect, 170, 173 Smart money, 169, 173-204, 243, 303-307, 377, 380,388-389 Spread, 226-245, 309-333, 348, 350, 402-411 Spurious regression, 426, 434 Stability, 353, 430, 438 Standard and P w r s composite share index, 122, 123, 128-130, 161-166, 357, 359, 380-382 Standard deviation ratio, 138, 139, 325, 350, 353, 354 Stationarity, 141, 142, 162, 193, 418-437 Statistical model, 417, 431, 432 Sticky price monetary model, 290-303 Stock return predictability, 122- 134, 184, 353- 357 Stock market, 116-156, 176, 351, 377 Stock price, 116-155, 344-373, 380-390 Structural model, 431-438 Sunspots, 156 Takeover, 19, 93, 98, 105, 113, 148, 149, 186, 188, 202-204 Tax, 52-54, 72, 73, 97, 99, 169, 170, 189, 271,401 Term premium (see risk premium) Term structure, 5-7, 209, 216-230, 249, 251, 312, 315-340, 345, 348, 402-414, 437 empirical evidence, 234-253 Term to maturity, 213, 214, 226, 247-250, 402,408,409 Terms of trade, 292 Time series stationaryhon-stationary,419, 425, 426, 434 univariate/multivariate,415, 417-438 Time varying beta, 402, 406 discount rate, 140, 346, 348, 354, 368 real interest rates, 139 risk/term premia, 152, 209, 219-222, 227-231, 246-249,276, 277, 342-348, 355, 375-377, 387-391,401-414,438 variances/covariances, 221, 368, 375, 376, 383,387-390, 398-401,409-415,442 Tobin’s risk aversion model, 54-57 Trading rule (see trading strategy), 124, 130-135, 202, 309, 380, 385 Transformation line, 25, 33-36, 55 403, 404 Trend deterministic, 139, 143, 144, 16 426, 435 stochastic, 143, 415, 425, 426, Utility, 3, 10-20, 55, 58, 84-88, 391-394 Value line investment survey (VLI VAR, 227, 268, 286, 287, 298, 30 402, 428-438, 449 advantageldisadvantage, 323-32 cross equation restriction, 309336-342, 350 multivariate, 339, 365 Variance conditionaVunconditiona1 373, 383-389, 402, 405-413 438, 439, 442 Variance bounds test, 116, 136, 13 208, 215, 226-234, 246-249 344, 351, 360, 361, 368 Variance decomposition, 352, 365 Variance ratio, 116, 117, 125, 138 160, 178, 229, 246, 248, 309 324-330,337,353-361 Variance-covariance matrix (see m VARMA model, 428-437 Volatility, 134- 146, 169, 178, 183 249, 258, 279-282,300, 327 404,406, 413 Volatility tests (see variance boun Wald test, 315-361 Weekend effect, 96, 123, 169, 170 White noise, 143, 274, 275, 334, 419,427-429,437,446-449 Winner’s curse, 172, 173 Wold’s decomposition theorem, 42 Yield (see interest rate) dividend, 348, 387, 388 spot, 7, 212, 213, 223-234 Yield curve, 7, 207, 226, 231, 250 Yield spread (see spread) Yield to maturity, 8, 208-217, 22 240, 246, 249, 402 ... Caf~ging-in-PublicafionData Cuthbertson, Keith Quantitative financial economics : stocks, bonds, and foreign exchange / Keith Cuthbertson cm - (Series in financial economics and quantitative p: analysis) Includes...I Quantitative Financial Economics SERIES IN FINANCIAL ECONOMICS AND QUANTITATIVEANALYSIS Series Editor: Editorial Board: Stephen Hall,... give authoritative accounts of major ne financial economics and general quantitative analysis The coverage of the seri both macro and micro economics and its aim is to be of interest to practi