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The Econometrics of Financial Markets

The Econometrics of Financial Markets

John Y. Campbell
Andrew W. Lo
A.Craig MacKinlay
Copyright Date: 1997
Pages: 632
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  • Book Info
    The Econometrics of Financial Markets
    Book Description:

    The past twenty years have seen an extraordinary growth in the use of quantitative methods in financial markets. Finance professionals now routinely use sophisticated statistical techniques in portfolio management, proprietary trading, risk management, financial consulting, and securities regulation. This graduate-level textbook is intended for PhD students, advanced MBA students, and industry professionals interested in the econometrics of financial modeling. The book covers the entire spectrum of empirical finance, including: the predictability of asset returns, tests of the Random Walk Hypothesis, the microstructure of securities markets, event analysis, the Capital Asset Pricing Model and the Arbitrage Pricing Theory, the term structure of interest rates, dynamic models of economic equilibrium, and nonlinear financial models such as ARCH, neural networks, statistical fractals, and chaos theory.

    Each chapter develops statistical techniques within the context of a particular financial application. This exciting new text contains a unique and accessible combination of theory and practice, bringing state-of-the-art statistical techniques to the forefront of financial applications. Each chapter also includes a discussion of recent empirical evidence, for example, the rejection of the Random Walk Hypothesis, as well as problems designed to help readers incorporate what they have read into their own applications

    eISBN: 978-1-4008-3021-3
    Subjects: Finance

Table of Contents

  1. Preface
    (pp. xvii-2)
    JYC, AWL and ACM
  2. 1 Introduction
    (pp. 3-26)

    Financial economics is a highly empirical discipline, perhaps the most empirical among the branches of economics and even among the social sciences in general. This should come as no surprise, for financial markets are not mere figments of theoretical abstraction; they thrive in practice and play a crucial role in the stability and growth of the global economy. Therefore, although some aspects of the academic finance literature may seem abstract at first, there is a practical relevance demanded of financial models that is often waived for the models of other comparable disciplines.¹

    Despite the empirical nature of financial economics, like...

  3. 2 The Predictability of Asset Returns
    (pp. 27-82)

    One of the earliest and most enduring questions of financial econometrics is whether financial asset prices are forecastable. Perhaps because of the obvious analogy between financial investments and games of chance, mathematical models of asset prices have an unusually rich history that predates virtually every other aspect of economic analysis. The fact that many prominent mathematicians and scientists have applied their considerable skills to forecasting financial securities prices is a testament to the fascination and the challenges of this problem. Indeed, modern financial economics is firmly rooted in early attempts to “beat the market,” an endeavor that is still of...

  4. 3 Market Microstructure
    (pp. 83-148)

    While it is always the case that some features of the data will be lost in the process of modeling economic phenomena, determining which features to focus on requires some care and judgment. In exploring the dynamic properties of financial asset prices in Chapter 2, we have taken prices and returns as the principal objects of interest without explicit reference to the institutional structures in which they are determined. We have ignored the fact that security prices are generally denominated in fixed increments, typically eighths of a dollar orticksfor stock prices. Also, securities do not trade at evenly...

  5. 4 Event-Study Analysis
    (pp. 149-180)

    Economists are frequently asked to measure the effect of an economic event on the value of a firm. On the surface this seems like a difficult task, but a measure can be constructed easily using financial market data in an event study. The usefulness of such a study comes from the fact that, given rationality in the marketplace, the effect of an event will be reflected immediately in asset prices. Thus the event’s economic impact can be measured using asset prices observed over a relatively short time period. In contrast, direct measures may require many months or even years of...

  6. 5 The Capital Asset Pricing Model
    (pp. 181-218)

    One of the important problems of modern financial economics is the quantification of the tradeoff between risk and expected return. Although common sense suggests that risky investments such as the stock market will generally yield higher returns than investments free of risk, it was only with the development of the Capital Asset Pricing Model (CAPM) that economists were able to quantify risk and the reward for bearing it. The CAPM implies that the expected return of an asset must be linearly related to the covariance of its return with the return of the market portfolio. In this chapter we discuss...

  7. 6 Multifactor Pricing Models
    (pp. 219-252)

    At the end of Chapter 5 we summarized empirical evidence indicating that the CAPM beta does not completely explain the cross section of expected asset returns. This evidence suggests that one or more additional factors may be required to characterize the behavior of expected returns and naturally leads to consideration of multifactor pricing models. Theoretical arguments also suggest that more than one factor is required, since only under strong assumptions will the CAPM apply period by period. Two main theoretical approaches exist. The Arbitrage Pricing Theory (APT) developed by Ross (1976) is based on arbitrage arguments and the Intertemporal Capital...

  8. 7 Present-Value Relations
    (pp. 253-290)

    The first part of this book has examined the behavior of stock returns in some detail. The exclusive focus on returns is traditional in empirical research on asset pricing; yet it belies the name of the field to study only returns and not to say anything about asset prices themselves. Many of the most important applications of financial economics involve valuing assets, and for these applications it is essential to be able to calculate the prices that are implied by models of returns. In this chapter we discuss recent research that tries to bring attention back to price behavior. We...

  9. 8 Intertemporal Equilibrium Models
    (pp. 291-338)

    This chapter relates asset prices to the consumption and savings decisions of investors. The static asset pricing models discussed in Chapters 5 and 6 ignore consumption decisions. They treat asset prices as being determined by the portfolio choices of investors who have preferences defined over wealth one period in the future. Implicitly these models assume that investors consume all their wealth after one period, or at least that wealth uniquely determines consumption so that preferences defined over consumption are equivalent to preferences defined over wealth. This simplification is ultimately unsatisfactory. In the real world investors consider many periods in making...

  10. 9 Derivative Pricing Models
    (pp. 339-394)

    The pricing of options, warrants, and otherderivativesecurities—financial securities whose payoffs depend on the prices of other securities—is one of the great successes of modern financial economics. Based on the well-known Law of One Price or no-arbitrage condition, the option pricing models of Black and Scholes (1973) and Merton (1973b) gained an almost immediate acceptance among academics and investment professionals that is unparalleled in the history of economic science.¹

    The fundamental insight of the Black-Scholes and Merton models is that under certain conditions an option’s payoff can be exactly replicated by a particular dynamic investment strategy involving...

  11. 10 Fixed-Income Securities
    (pp. 395-426)

    In this chapter and the next we turn our attention to the bond markets. We study bonds that have no call provisions or default risk, so that their payments are fully specified in advance. Such bonds deserve the namefixed-income securitiesthat is often used more loosely to describe bonds whose future payments are in fact uncertain. In the US markets, almost all true fixedincome securities are issued by the US Treasury. Conventional Treasury securities make fixed payments in nominal terms, but in early 1996 the Treasury announced plans to issueindexed bondswhose nominal payments are indexed to inflation...

  12. 11 Term-Structure Models
    (pp. 427-466)

    This chapter explores the large modern literature on fully specified general-equilibrium models of the term structure of interest rates. Much of this literature is set in continuous time, which simplifies some of the theoretical analysis but complicates empirical implementation. Since we focus on the econometric testing of the models and their empirical implications, we adopt a discrete-time approach; however we take care to relate all our results to their continuous-time equivalents. We follow the literature by first developing models for real bonds, but we discuss in some detail how these models can be used to price nominal bonds.

    All the...

  13. 12 Nonlinearities in Financial Data
    (pp. 467-526)

    The econometric methods we discuss in this text are almost all designed to detectlinearstructure in financial data. In Chapter 2, for example, we develop time-series tests for predictability of asset returns that use weighted combinations of return autocorrelations—linear predictability is the focus. The event study of Chapter 4, and the CAPM and APT of Chapters 5 and 6, are based on linear models of expected returns. And even when we broaden our focus in later chapters to include other economic variables such as consumption, dividends, and interest rates, the models remain linear. This emphasis on linearity should...