Linear factor models in finance

299 Pages·2005·1.418 MB·English

by  John Knight, Stephen Satchell

Linear Factor Models in Finance
Elsevier Finance
aims and objectives
• booksbasedontheworkoffinancialmarketpractitioners,andacademics
• presentingcuttingedgeresearchtotheprofessional/practitionermarket
• combiningintellectualrigourandpracticalapplication
• coveringtheinteractionbetweenmathematicaltheoryandfinancialpractice
• toimproveportfolioperformance,riskmanagementandtradingbookperformance
• coveringquantitativetechniques
market
Brokers/Traders; Actuaries; Consultants; Asset Managers; Fund Managers; Regu-
lators; Central Bankers; Treasury Officials; Technical Analysts; and Academics for
MastersinFinanceandMBAmarket.
series titles
ReturnDistributionsinFinance
DerivativeInstruments:theory,valuation,analysis
ManagingDownsideRiskinFinancialMarkets:theory,practice&implementation
EconomicsforFinancialMarkets
PerformanceMeasurementinFinance:firms,fundsandmanagers
RealR&DOptions
ForecastingVolatilityintheFinancialMarkets
AdvancedTradingRules
AdvancesinPortfolioConstructionandImplementation
ComputationalFinance
LinearFactorModelsinFinance
series editor
Dr Stephen Satchell
Dr Satchell is the Reader in Financial Econometrics at Trinity College, Cambridge;
VisitingProfessoratBirkbeckCollege,CityUniversityBusinessSchoolandUniversity
of Technology, Sydney. He also works in a consultative capacity to many firms, and
edits the journal Derivatives: use, trading and regulations and the Journal of Asset
Management.
Linear Factor Models
in Finance
John Knight and Stephen Satchell
AMSTERDAM•BOSTON•HEIDELBERG•LONDON•NEWYORK•OXFORD
PARIS•SANDIEGO•SANFRANCISCO•SINGAPORE•SYDNEY•TOKYO
ElsevierButterworth-Heinemann
LinacreHouse,JordanHill,OxfordOX28DP
30CorporateDrive,Burlington,MA01803
Firstpublished2005
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Contents
Listofcontributors xi
Introduction xv
1 Reviewofliteratureonmultifactorassetpricingmodels 1
MarioPitsillis
1.1 Theoreticalreasonsforexistenceofmultiplefactors 1
1.2 Empiricalevidenceofexistenceofmultiplefactors 5
1.3 Estimationoffactorpricingmodels 5
Bibliography 9
2 EstimatingUKfactormodelsusingthemultivariateskewnormal
distribution 12
C.J.Adcock
2.1 Introduction 12
2.2 Themultivariateskewnormaldistributionand
someofitsproperties 14
2.3 Conditionaldistributionsandfactormodels 17
2.4 Datamodelchoiceandestimation 19
2.5 Empiricalstudy 19
2.5.1 Basicreturnstatistics 19
2.5.2 Overallmodelfit 21
2.5.3 Comparisonofparameterestimates 23
2.5.4 Skewnessparameters 24
2.5.5 Tauandtime-varyingconditionalvariance 25
2.6 Conclusions 27
Acknowledgement 27
References 27
3 Misspecificationinthelinearpricingmodel 30
Ka-ManLo
3.1 Introduction 30
3.2 Framework 31
3.2.1 ArbitragePricingTheory 31
3.2.2 MultivariateFtestusedinlinearfactormodel 32
3.2.3 AverageFtestusedinlinearfactormodel 34
vi Contents
3.3 DistributionofthemultivariateFteststatistics
undermisspecification 34
3.3.1 Exclusionofasetoffactorsfromestimation 35
3.3.2 Time-varyingfactorloadings 41
3.4 Simulationstudy 43
3.4.1 Design 43
3.4.2 Factorsseriallyindependent 45
3.4.3 Factorsautocorrelated 48
3.4.4 Time-varyingfactorloadings 49
3.4.5 Simulationresults 50
3.5 Conclusion 57
Appendix:Proofofproposition3.1andproposition3.2 59
4 BayesianestimationofriskpremiainanAPTcontext 61
TheofanisDarsinosandStephenE.Satchell
4.1 Introduction 61
4.2 ThegeneralAPTframework 62
4.2.1 Theexcessreturngeneratingprocess(whenfactorsare
tradedportfolios) 62
4.2.2 Theexcessreturngeneratingprocess(whenfactorsare
macroeconomicvariablesornon-tradedportfolios) 64
4.2.3 Obtainingthe(K×1)vectorofriskpremiaλ 65
4.3 IntroducingaBayesianframeworkusingaMinnesotaprior
(Litterman’sprior) 66
4.3.1 Priorestimatesoftheriskpremia 67
4.3.2 Posteriorestimatesoftheriskpremia 70
4.4 Anempiricalapplication 72
4.4.1 Data 73
4.4.2 Results 74
4.5 Conclusion 77
References 77
Appendix 80
5 SharpestyleanalysisintheMSCIsectorportfolios:aMonteCarlo
integrationapproach 83
GeorgeA.Christodoulakis
5.1 Introduction 83
5.2 Methodology 84
5.2.1 ABayesiandecision-theoreticapproach 85
5.2.2 EstimationbyMonteCarlointegration 86
5.3 StyleanalysisintheMSCIsectorportfolios 87
5.4 Conclusions 93
References 93
Contents vii
6 Implicationofthemethodofportfolioformationonasset
pricingtests 95
Ka-ManLo
6.1 Introduction 95
6.2 Models 97
6.2.1 Assetpricingframeworks 97
6.2.2 Specificationstobetested 98
6.3 Implementation 99
6.3.1 MultivariateFtest 99
6.3.2 AverageFtest 100
6.3.3 StochasticdiscountfactorusingGMMwithHansenand
Jagannathandistance 102
6.3.4 Alookatthepricingerrorsunderdifferenttests 103
6.4 Variablesconstructionanddatasources 104
6.4.1 Datasources 104
6.4.2 Independentvariables:excessmarketreturn,sizereturn
factorandbook-to-marketreturnfactor 105
6.4.3 Dependentvariables:size-sortedportfolios,beta-sorted
portfoliosandindividualassets 109
6.5 Resultanddiscussion 114
6.5.1 FormationofW 114
T
6.5.2 Model1 115
6.5.3 Model2 123
6.5.4 Model3 133
6.6 Simulation 138
6.7 Conclusionandimplication 146
References 148
7 Thesmallnoisearbitragepricingtheoryanditswelfareimplications 150
StephenE.Satchell
7.1 Introduction 150
7.2 151
7.3 155
References 156
Listofsymbols 157
8 Riskattributioninaglobalcountry-sectormodel 159
AlanScowcroftandJamesSefton
8.1 Introduction 159
8.2 Recenttrendsinthe‘globalization’ofequitymarkets 161
8.2.1 ‘Homebias’ 162
8.2.2 Theriseandriseofthemultinationalcorporation 165
8.2.3 Increasesinmarketconcentration 167
8.3 Modellingcountryandsectorrisk 170
8.4 Theestimatedcountryandsectorindices 176
viii Contents
8.5 Stockandportfolioriskattribution 181
8.6 Conclusions 188
8.7 Furtherissuesandapplications 189
8.7.1 Accountingforcurrencyrisk 189
8.7.2 Additionalapplicationsforthisresearch 190
References 190
AppendixA:Adetaileddescriptionoftheidentifyingrestrictions 193
AppendixB:Theoptimizationalgorithm 197
AppendixC:Gettingthehedgeright 199
9 PredictabilityoffundofhedgefundreturnsusingDynaPorte 202
GregN.GregoriouandFabriceRouah
9.1 Introduction 202
9.2 Literaturereview 203
9.3 Methodologyanddata 204
9.4 Empiricalresults 204
9.5 Discussion 205
9.6 Conclusion 207
References 207
10 Estimatingacombinedlinearfactormodel 210
AlvinL.Stroyny
10.1 Introduction 210
10.2 Acombinedlinearfactormodel 211
10.3 Anextendedmodel 213
10.4 Modelestimation 214
10.5 Conditionalmaximization 216
10.6 Heterogeneouserrors 217
10.7 Estimatingtheextendedmodel 218
10.8 Discussion 220
10.9 Somesimulationevidence 221
10.10 Modelextensions 222
10.11 Conclusion 223
References 224
11 Attributinginvestmentriskwithafactoranalyticmodel 226
DrT.Wilding
11.1 Introduction 226
11.2 Thecaseforfactoranalyticmodels 227
11.2.1 Typesoflinearfactormodel 227
11.2.2 Estimationissues 228
11.3 Attributinginvestmentriskwithafactoranalyticmodel 229
11.3.1 Whichattributescanweconsider? 230
11.4 Valuationattributes 231
11.4.1 Whichattributesshould weconsider? 231
Contents ix
11.4.2 Attributingriskwithvaluationattributes 236
11.5 Categoryattributes 237
11.5.1 Whichcategoriesshould weconsider? 239
11.5.2 Attributingriskwithcategories 240
11.6 Sensitivitiestomacroeconomictimeseries 241
11.6.1 Whichtimeseriesshould weconsider? 241
11.6.2 Attributingriskwithmacroeconomictimeseries 241
11.7 Reportingrisk–relativemarginals 242
11.7.1 Casestudy:AnalysisofaUKportfolio 244
11.8 Conclusion 245
References 246
Appendix 247
12 Makingcovariance-basedportfolioriskmodelssensitive
totherateatwhichmarketsreflectnewinformation 249
DandiBartolomeoandSandyWarrick,CFA
12.1 Introduction 249
12.2 Review 250
12.3 Discussion 253
12.4 Themodel 254
12.5 Afewexamples 257
12.6 Conclusions 259
References 259
13 Decomposingfactorexposureforequityportfolios 262
DavidTien,PaulPfleiderer,RobertMaximandTerryMarsh
13.1 Introduction 262
13.2 Riskdecomposition:cross-sectionalcharacteristics 264
13.3 Decompositionandmisspecificationinthecross-sectionalmodel:
asimpleexample 269
13.3.1 Industryclassificationprojectedontofactorexposures 269
13.3.2 Incorporatingexpectedreturninformation 270
13.4 Summaryanddiscussion 273
References 274
Index 277