John Y. CamPgeU
AndrewW.Lo
I
A. Craig MacKinJay
We.t
Su~t"X
1'1'''. Cltid,,,t<,.
tion Data
(:"U1l'lwl\, John Y.
'rhr t'"conolHt"trin of Hnan d.,\ 1Il
. rkt,t!\o / John Y. C;.nnphtU
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W. 1.0. A. Cr.i\\ MacK.inlay.
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Contents
List of Figures
List of Tables
Preface
xiii
xv
xvii
Introduction
3
1.1
Organization of the Book
4
1.2
Useful Background. . . .
{)
1.2.1 Mathematics Background
{)
1.2.2 Probability and Statistics Background
(j
1.2.3 Finance Theory Background
7
1.3
Notation................
H
1.1
Prices, Returns, and Compollnding .
9
9
1.1.1 Defmitions and Conventions.
1.4.2 The Marginal, Conditional, anclJoint Distribution
of Returns. . . . . . . . . . . . . . . . . . . . . . .. 13
I.:)
Market Efliciency . . . . . . . . . . . . . . . . . . . . . ..
20
1.5.1 Efficient MarkrL~ and the l.aw of Iterated
. . . . . . 22
Expectations .. . . . . . . .
Is Market EffIciency Testable?
24
TIle Predictability of Asset Returns
2.1
The Random Walk Ilypotheses . . . . . . . . . . . . .
2.1.1 The Random Walk I: lID Incremenl~ . . . . . .
2.1.2 The Random Walk 2: Independent Increment!!
2.1.3 The Random Walk 3: Uncorrclated Increments
Tests of Random Walk I: lID Increlllents .
2.2.1 Traditional Statistical Tests . . . . .
2.2.2 SCf)uences and Reversals, and Runs
27
2R
31
32
33
viii
COII/m!.1
2.~
..... .
Test s of Ran doll l Wal k :\: Ul\c ond
.\led Incr emc nts
2.4.1 Aut ocor rela tion Coe flici ents
2.4.2 Port man teau Stat istic s
2.'1.3 Vari ance Rali m . . . .
. . .
Lon gIl oriz on Rell lrBs . . . .
. . .
2::>.1 Prob lem s with LOllg1 [oriz
on Infc renn :s
Test s For Lon gRa nge Dep end
encc . . . . . . .
2.ti.l Exal llple s of I.on gRa ngc lkpc
/lclc ncc .
2.6.2 The Hur slM ancl clbr ot Resc
aled Ran gc Stat istic
Uni l ROOl Test s . . . . . . .
Rec cnt EmpiriC<l\ Evid ellce .
2.S.1 AUl Oco rrcla tion s ..
2.8.2 Vari ance Rati os . . .
2.8. 3 Cro5 sAu toco rrch lliol lS '\Il(\
Lead Lag Rc::IatiollS
2.8,4 Test s Usin g Lon gH oriz on
RCll IflIS
Co nc lu sio n.. ... ...
... ... ...
2,4
2.!:i
2.G
2.7
2.H
2.n
3.2 I
I
I
3.3
!
I
'j
I
3.4
'} r,
.
1
mal I'crfOnll'<lIlCC
Con stan tM can Retu rn Moc kl
Mar kct Mod el . . . . . . . . .
... .
41
IH
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!",!l
li2
li4
Ii:>
titi
ti8
74
7H
KO
83
\H
K:>
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!)~)
W\
lin
107
10K
114
122
12H
12K
I:H
1:I!i
144
ix
CCJllifll 1.1
4..1
4.:>
Hi
4.7
4.K
4 .~l
4.10
:1. I
S.~
:>.:~
:>.4
5.:>
S.li
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?i.H
:).~l
G.I
(;.2
I:)~
15ti
[57
15H
159
IGO
IG~
1U3
ltiG
107
IGH
172
173
175
175
176
177
178
181
IHI
184
IH8
IH9
1%
203
204
208
211
211
21~
213
215
217
219
219
222
223
224
226
.22H
IU
li,4
1i5
li.li
1i.7
7
PresentValue Relations
253
7.1
~:I1
7.'2
HA
291
2~l:\
2%
:10,\
:1(Hi
:q 4
:11:.
:1 I Ii
10 FixedIncome Securities
10.1 Basic Concepts .
10.1.1 Discount Bonds
10.1.2 Coupon Bonds
10.1.3 Estimating the ZeroCoupon Term Structure
10.2 Interpreting the Term Structure of Interest Rates
10.2.1 The Expectations Hypothesis . . . . . .
10.2.2 Yield Spreads and Interest Rate Forecasts
10.3 Conclusion . . . . . . . . . . . . . . . . . . . .
395
396
397
401
409
413
413
418
423
11 TermStructure Models
11.1 AffineYield Models .
11.1.1 A Homoskedastic SingleFactor Model
11.1.2 A SquareRoot SingleFactor Model
11.1.3 A TwoFactor Model . . . . . . . . .
11.1.4 Beyond AffineYield Models . . . .
11.2 Fitting TermStructure Models to the Data
11.2.1 Real Bonds, Nominal Bonds, and Innation
11.2.2 Empirical Evidence on AffineYield Models
427
428
429
435
438
441
442
442
445
xii
11.3
11.4
12.1
467
11iK
470
47:)
479
4HI
490
494
49K
!",oo
:)02
504
!i07
:)12
512
:) I Ii
51H
!ilK
51\1
:)~:{
:,24
Appendix
A
Linear Instrumelllal Variablcs . . . . . . . . . .
Generalized Mcthod of MOlllcnts . . . . . . . .
A.2
A.3 Serially Correlated and f Icteroskeoastic Errors.
A.4
GMM and MaximulII Likelihood . . . . . . . .
References
541
Author Index
587
Subject Index
597
List of Figures
1.1
I.~
<~.l
:t2
:).:)
~.1
'1.1
4.2
1.3
4.4
:),1
:i.~
(i.l
12
II:!
NontradingInduced AutocolTelations . . . . . . . .
Histogram of Daily Price Fractions and Price Changes for
Five NYSE Stocks from January 2, I~)~)O to December 31.
1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..
2Histories of Daily Stock Returns luI' Five NYSE Stocks from
.Ianuary2, 1990 to Deccmber:ll, 1992 .. . . . . . . . . . .
TIll: Ordered Probit Model .
96
III
113
125
157
165
171
176
187
189
FOIII' Ilv\lollH'~(,s
'lUI
7.1
7.'2
7.:1
H.I
H.2
H.~
!I. I
!I.'2
I.og Real Slock 1'1 ice and Dividend Series, An""al US Data,
lH72 to I ~)~ltl . . . . . . . . . . . . . . . . . . . . . . . . . .
Log Real Stock Pric(' and Estimated Dividend Compo"e"t,
Annual US Dala, I H7/i 10 I !'!H . . . . . . . . . . . . . . . ..
I.og DividendPric(, Ratio and ESlimaled Dividend COlllPO1I('nl, Annual US d;lIa, IH7G 10 Iq!H . . . . . . . . . . . . .
(a) MeanStandard Deviation Diagram for Asset Returns;
(h) Implied Sla"c\arc\ Deviatio,,Mean Diagram for Stochaslic Discount Factors . . . . . . . . . . . . . . . . . . . . . .
(a) MeanStandard Dcviatio" Diagram for a Single Excess A~
set Return; (h) Implied Standard DeviationMean Diagram
for Stochastic Discount Factors . . . . . . . . . . . . . . ..
Feasible Region for Slochastic Discounl Faclors Implied hy
AnllllallJS Dala, I H~J\ to I ~'~J1 . . . . . . . . . . . . . .
Salllple Path of a Discret('Tillle Random Walk. . . . .
Salllple Path and Conditional Expectation of a l\rownian
Motion with Drilt . . . . . . . . . . . . . . . . . . . . . . ..
~H~
'21':\
'2~1
2~'9
:\02
~O.'l
~12
:\4:.
10.2
10.:1
lOA
I lUI
11.1
11.2
4;,()
4!'H
471
41'2
'IH()
r.ol
10.1
12.1
1'2.2
12.:\
:\~)H
'100
402
40/
41 Ii
:.(n
o. \ ()
:d:1
:; 1:1
:d 1
!llfi
:.~tl
:.21
List of Tables
l.l
2.1
2.2
2.3
2.4
29
109
25
2.fi
2.7
2.H
2.9
3.1
3.2
4.1
4.~
Abnormal returns for an event study of the information contelll of earnings <lnIlOllllcemeIllS . . . . . . . . . . . . . . "
POW('f of evelltstudy test statistic JI to reject the null hypothesis that the abnormal return is zero. . . . . . . . . . . . "
xv
~
67
69
71
73
75
77
112
118
119
120
131
1::12
13:~
13H
141
142
164
170
xvi
I.isl oj '['abil's
5.1
5.2
5.3
6.1
7.1
7.2
8.1
H.:.!
9.1
9.2a
9.2h
9.3
9.4
9.5
9.li
10.1
10.2
10.3
211
no
30l:\
:no
Pr efa ce
.lye
AWl.
,\(:M
1
Introduction
FINANCIAL ECONOMICS
B<", ml .. in (I ~J~:l) provides a highly, c.ulab,," '''"("'H'''I "I Ih .. inl<rpl y h.lween theory and
social sciences, although it has been the hallmark of the natural sciences
I()r finite some tillie, Il is ont' of the mosl rewarding aspens of Iin<lnci,lI
('(ollolll('trics, so IIlllch so thaI we fell impellcd to writc this graduatelen'l
textbook as a n)('ans or introducing otht'rs to this cxciting lide\.
Section 1,1 explains which topics we (over in this hook, and how we have
organized the material. WI' also sugg('st sOllie ways in which the hook might
he used in a OI)('S('II)('st('r cours(' on financial econolllctrics or ('mpirical
finance,
III Senioll 1.2, W(' desnihc the kinds of hackground material that ;Il e
1I\0st IIScful for financial (TOnOlll('trks and suggcst refcrcnces for thos('
read('rs who wish to review or karn slI('h matcrial along the way, In 0\11'
eXperil'lKe, students an' oftI'll more highly Illotivatcd to pick up the Ill'(essary background Ilf/rr th('y se(' how it is to be applied, so we encourage
reaclers with a serious interest in financial econometrics btll with somewhat
less preparation to tak(' a crack at this material anyway.
In a hook of this magnitud(" notation becomcs a nontrivial challenge
of coordination; h('n('(' Section 1,:\ descrihes what method there is in our
notation;11 1I\;l(lness, v"'e urgl' rca(krs to review this carefully to lIIillimi/('
the ("(mfllsioll that 1';\11 arise whell ~ is mistakell for fl al)(\ X is illnnrt'cllv
assulllcd to he the sallle as X.
Senion I A extends onl" discussion oi" notation by presenting notational
conventions for and definitions of so III I' of the fundamental obje('fs of ollr
stud),: pricl's, ('('turns, lIH'thods of compounding, and probability distributions. Although IIIl1ch of this material is wellknown to finance students and
invcstment prof(.'ssionals. we thillk a hrief review will help many reaelns,
III Scctioll U"), we tmll om attention to fluitc a different sul~jc(\: 'hl'
Eflkicnt Markels Hypothesis. Because so milch attcntion has been lavished
Oil this hypothesis, oftell al the ('XI}('IIS(' of othcr more Sllbst<llllive isslles,
we wish 10 dispcns(' with this isslle first. Milch of thc debate involves theological tellets that are elllpirically un(kcidablc <Incl, therefore, beyond th\'
purview of this t(,xt. But for completen('ssno selfrespectillg fillallce text
could olllit llIarket efficiellcy altogethnSenion 1,5 bridly discusses tIl!'
topic
1,1
Or~ani7.ation
of the Book
In orgallizillg this hook. we 11;1\,(' ",lIowed two gelleral prillciples, First, tIl<'
('ady chaptns nlll('('lItrat(' ('xdllsivdy Oil stock markets, Although many 01
the IIl('thO(\s discllsse" c<llIl)(' "}lplie" equally well to other ass('t markets, til"
t'lnpiricallil('l"alllrt' 11I1 slllck JIlark(,ts is particnlarly large and hy f()('usillg Ol\
thesl' lIIark\,tsw(' an' able til k('C), the discussioll connell', III bIn chapin"
we cover dni\'atin' _,,'('wities :ltapt('ls ~l alld 12) alld fixe<\incolIH' S(Tllri
;5
ties (Chaptcrs 10 and II). Thc last chaptcr of thc book prescnts nonlin~ar
methods, with applications to both stocks and derivatives.
\
Second, we start by presenting statistical models of assct returns, and
then discuss more highly structured ecollomic models. In Chapter 2, for
example, we discuss mcthods for predicting stock returns from their
past history, without much atlention to institlllional detail; in Chaptcr 3 we
show how the microstructure of stock markets affecL~ thc shortrun behavior
of returns. Similarly, in Chapter 4 we discuss simplc statistical models of the
crosssection of individual stock returns, and thc application of these models
to evcnt studies; ill Chaptcrs 5 and G we show how the Capital Asset Pricing
Model and multifactor models such as the Arbitrage Pricing Theory restrict
the parameters of the statistical models. In Chapter 7 we discuss longerrun
evidence on thc predictability of stock returns from variables oth~r than
past stock returns; in Chaptcr 8 wc explore dynamic equilibrium models
which can gcncratc persistent timcvariation in expcctcd returns. We use
the samc principle to divide a basic treatmcnt of fixedincome securitics
in Chapter 10 from a discussion of equilibrium termstructure models in
Chapter II.
We havc tricd to makc each chaptcr as scll~o[\tained as possiblc. While
SOIllI' chapters naturally go together (c.g., Chapters 5 and G, and Chapters
10 .mll II), there is certainly no need to read this book straight through
frolll heginning to cnd. For classroom usc, most teachcrs will find that there
is too much matcrial hcrc to he covcrcd in onc semcstcr. Therc are scvcral
ways to usc thc hook in a oncsemcster coursc. For cxamplc onc teachcr
might start by discllssing shortrun timeserics bchavior of stock priccs using
Chaptcrs 2 and 3, then covcr crossscctional models in Chaptcrs 4, 5, and 6,
then discuss intcrtcmporal cquilibrium models using Chaptcr 8, and finally
(over dcrivative securitics and nonlinear methods as advanced topics using
Chapters 9 and 12. Anothcr tcachcr might first prcscnt the cvidence on
short and longrun prcdictability of stock returns using Chapters 2 and 7,
then discuss static and intcrtcrnporal equilibrium thcory using Chaptcrs 5,
{i, and R, and finally covcr flxcdincomc securities using Chapters 10 and II.
Therc arc somc important topics that wc havc not been able to include
in this texl. Most obviously, our foclls is almost cxclusively on US domestic
asset markcts. Wc say vcry littlc about asset markets in othcr countries, and
we do not try to covcr intcrnational topics such as exchangeratc bchavior or the homcbias punic (the tcndency for each country's investors tei
hold a disproportionatc sharc of their OWJl country's assets in their portfolios). We also omitslIch important economctric subjects as Bayesian analysis!
and frequencydomain methods of timeserics analysis. In many cases our
choice of topics has becn influcnccd by the dual objectives of the book:l
10 ('xplain the methods of financial cconoIllctrics, and to review the ("IIl'
piric .. 1 literature in finance. We havc tended to conccntrate on topics that
0"11
I
I
inv~lve
cconometric issucs, somctilllcs at (hc expensc ofo(her equally ill('/'IHuch rcccHt work ill hchavioral !inan('t'that
is ccbllollletrically more straightforwanl.
cstill~ l1Iatcrialindudill~
multiple intcgration
multivariate constrained optimization
matrix algeura
basic rules of matrix difti.'rentiation.
In addition, optiun and other dcrivativ{:pricin~ models, and contillllollStime asset pricing models, require somc passing familiarity with the Illi or
.I/or/untie ((l/eu/us. A lucid and thorough treatment is provided hy Merion
(1!190), who pioneered the application of stochastic calculus to lin.uH"ial
economics. More mathematically inclillcd readers fIIay also '''ish to {"O!lSuit
Chllll'fand Williams (1990).
1.2.2 "lOllIlhilitv
111111
SllItisliLl i!tlfi<gwwlIi
Basic ill"ohahility theory is a prerequisite f(,r any disci pi inc in which u!l{"{'rt<limy is inl'olved. Althou~h prohahility theory has varying de~rees oflllathematic'il sophistication, frolll coillIlippin~ l:alcuhltions to measuretheoretic
foun<l1ltions, perhaps the most IIseful approach is one that cmphasi/.('s tlte
\
illluilion alld suhllclies or deillclltar), I'rohahilistic rcasollin~. An amazillgly dmable t'lassic that ta"es just this appn><\ch is Fe\ler (I ~I(;H). nrielllan
(I ~)~)~) provides similar intuitioll hut al ;1 IIlGlslllctheoretic level. Key COIIc('pts incillde
Sialistics is, of course, the prilllal)' engine which drives the illferences
that fillallcial ecollolllt:tricians draw from the data. As with probability theory, statistics can be taught at various levels of mathematical sophistication.
Moreovcr,unli"e the narrower (and sOllie would say "purer") focusofprobahilit)' theory, statistics has increased its breadth as it has matured, giving birth
1(> nWlly welldelined subdisciplines such as lIIultivariate analysis, nonparalIlelrics, tillieseries allalysis, order statistics, allalysis of variance, decisioll
Ihcor)" Ha)'esian statistics, etc. Each of these subdisciplines has been drawn
upon by financial econometricians at on(' tilllc or another, ma"ing it rather
difficult to provide a single rderellct: for all or these topics. Amazingly,
sllch ;1 rdercllce does exist: Stuart alld Ord's (I ~)H7) threevolullle lour de
jil/ce. A lIIorc cOlllpacl reference that contains most of the relevant material
lor 0\,1' purposes is the elegant IIlollog,aph by Silwy (197:'). For topics ill
ti,"eseries analysis. Hamilton (\ !l94) is an excellenl comprehensive text.
Key concepts include
NeymanPearson hypothesis testin~
lint'ar n:gression
IIl<lximlllll likelihood
hasic lillieseries analysis (stationarit)" alltoregn.'ssi\e and ARMA pro,"('sses. vc("(or alltoregrcssiollS, unil rools, etc.)
('I"III('lIlar), Bayesian illferellcl'.
F()r ("(JlIi ill1lOmlilIlc financiallllodds, an additional dose of stochastic pron'ss('s is <I l\Iust, at least at the level of eo x and MilicI' (1!)(i5) ,lIld Hoel, Port,
~\lld SIOIll' (1~ln).
Since lhe mi.l()11 drlrf of financial c("onOllll'trics is the t'mpirical ill1plelllen1~lIioll and cvaluation of financial Illl)dds, a solid \);ld.grolllld ill finance
III('()'), i, Ill(' most in,portant of all. Scvcral texis pro\'id(' exccllent coveragc
1.3 Notation
We have fimnd that it is 1;lr rmm silllple to devise a consistcnt notational
schellle lilr a hook or Ihis scope. Thc dirricllity cOllies rmlll thc fan thai
linancial econometrics spans s('\'('I'al \'ery different strands of the financ('
literature, ('ach replch' with its own lirlllly estahlished sct of potational
('OIl\'('lltiollS. I\llt till' COllVl'lltiollS in Ollt' litcrallll'C orten conflict wilh Ihe
convcntions ill another. Ilna\'oidahly, tll('ll, WI' IIIl1sl sanifice either ill\('Illal notational (,(lIlsistl'ncy across dilli'n'llt chapters of Ihis tcxt or cxtcrIlal
cOllsisll'lH'Y with the 1I0tatioll used ill th(' professional lit('ralun~. Wc hav!,
chos('n Ihl' mll('r as Ih(' kS'lT ('\'il, hUI we do mainlain Ih(' )\Iowing COII1'('lliions throughout lilt' hook:
We IISC holell;\("(' for \'cctors alld matriccs, and rq.(ular race for scalars.
Where possihle, W(' US(' hold IIppercase for lIIatrices and hold lowcrcase
filr vcctors. Thlls x is a \'('ctor while X is a matrix.
Where possihle., we lise IIppercase letters ror thc levds or variahles aJ:<1
lowercase ktters for thc lIatllrallogarithllls (logs) ofthc sallie variabks.
Thlls ir I' is an assct price,/! is th(' log asset price.
Our stalldard notation filr all innovation is thc Creek IclI('1' L When'
we nced to defille se\'eral dilfl'l'I'lIt illnovations, we IIS(' the alternalivc
(;rl'l'k 1I'1I1'rs 'I, l;, alld (.
Wher(' possihle, WI' IIS(' (;n'l'k 1e1l('rS to dellote paranll'ters or parallll'tl'l'
\'('('\ors.
WI' uS(' 1iJ(' (;n'l'k II'th'r" to <I('I\OIl' a v(,ctor of OJIl'S.
'''''(' US(' hals 10 d('llOh' sa III 1'\(' ('slimal('s, so if fJ is a parallH'l('r, fo is ;111
('slimall' of fJ.
\\'h(,11 WI' lise sllhsnipls, W(' al\\',,,'s liS(' IIPI)('I'I'a,,' kllers for Ihl' IIppl'r
lilllits of the suhsnipts. WII('I"I' possihle', we lise thc same kllers "
IIppt'l' lilllits as for titc suhsnipts thl'lIIselvcs. Thlls sllhsnipt I nms
from I to T, sllhscript Ii IIIIIS frOll1 I to K, alld so Oil. All exception is
tItat WI' willll't snhscript i (lIsllally d('lIoting all as"'t) nlll fronl I to ,\'
hCCIIISC this notation is so COlli 111011. We lise I alld r for tillle sllhscript,;
j for asset subscripts; k, m, and n for lead and lag subscripls; and j as a
{!c.Dc.riC subscripl
.. M~' J.tr.. JlDllt;!' GIIIW!':llllU'1 u.:u.':...;, ;ur.mitt": *' cia!rri.1 lifru'I~
the end of period t. DllIs RI dcnotes a rcturn on an asset held from the
end of pcriod /1 to the end of pcriod t.
In writing variancecovariance matrices, we use n for the variancecovariance matrix of asset returns, L for the variancecovariance matrix
of residuals from a timeserics or crosssectional model, and V for the
variancecovariance matrix of parameter estimators.
We usc scriptlellers sparingly. N denotes the normal distribution, and
L denotes a log likelihood function.
We usc Pr() to denote the probability (lfan event.
n,
H,
1',
I.
P'I
(1.4.1 )
Tht" silll/Ill' {!!OH rp/um on the asset is just one pillS the net return, 1 + R,.
Frolll this definition it is apparent that the asset's gross return over the
most recent k periods from date /  k to date t, written I + ~(k), is simply
p<~'~":': ;~Jt .
,: 10 ..
I. Ill/mt/ue/illll
1+ R,(k)
+ I?d . (I + /{,I)'"
+ I?,k+d
(I
==
..."
(l
I',
1',1
I',_.~
I',H I
1',1
I',_~
P':I
I',k
I',
J',k
( I.U!)
and its net rcturn over the 1I1osl recent k periods, written /{,(k), is simply
cCjualto iLS kpcriod gross return minus olle. These llluitiperiod returns are
callcd com/Jound rcturns.
Although returns arc scalefree, it shollid he emphasized that they are
1I0t IIl1illess,'uut are always defined with respect to some tilllc intcrval, e.g.,
onc "pcriod." In fact, R, is lIIore properly called a rale of retlll'll, which is
mon "jcullluersomc tcrminology butlllore accurate in refcrring to HI as a rate
or, in! cconomic jargon, a flow variable. Thereforc, a return of 20% is not
a coniplete dcscription of the invcstmcnt opportunity without specification
of the retllrn horizon. In the academic literature, the relllrn horizon is
generally given explicitly, oftell as part of the data description, e.g., "The
CRSP monthly returns file was used."
14owever, among pr~ctitioners and in the limlIlcial press, a returnhoriz{lII of one ycar is usually assumed implicitly; hencc, unless stated othcrwis<t. a rcturn of20% is generally takcn to mcan an annual return of20%.
MorC\lVer. multiyear returns arc oftcn anllualized to make invcstmcnts with
differbll horizons comparable, thus:
\
\
Annualized[RI(k)) ==
[Hn(l +
R'_j)
Jl/k
I.
(1.'1.3)
j:O
l~ingleperiod
Sincc
rcturns are gencrally slllall in magnitudc, the following a~proxilllation bascd on a firstordcr Taylor expansion is often used to
annu~lize multiyear returns:
Anllualizl'd[U,(k)] ~
AI
k L Iltr
(1.'1.'1)
j=1l
,.~
j:.
1.1.
C0mfruUIlfLillg
11
,dso has important implications for modeling asset returns; this is the notion
or con tin uous COlli pounding. The (Oll/jlluowly COIII/lOlllllil'd rflum or {ogrelum
r, ofan asset is dclined to be the naturallogaritlilll o('its gross return (I + H,):
( 1.4.5)
\"here h == log 1',. When we wish 10 ('lllphasiJ.e the dbtinl'lion between R,
and rl, we shall refer to R, as a sim/)ifo return. Our notation here deviates
slighLly from our convention that lowercase letters denote Ihe logs of uppercase lettel>, since here we have rl == log(l + lll) rather than log(/l,); we
do this to maintain consistency with standard conventions.
The advantages of continuously compounded returns become clear
"hen we consider multi period I'eturns, since
1',(11)
==
logO
+ R,(h)) ==
logO
r,
logl
+ HI)' (1 + RI _ I ) (1 + U'H1)
( 1.4.ti)
Ii,
Ii",
J',
1+ I
I Jil'idl'lld I'mll/PIII "'ill/il/~ CIIIIl'rIIlill/!
Fi}.,"In' 1,1,
'i,' ""
L:t lfIll"i"~
Oil
lhe individual
a~scts:
For ;\.sSI'ls which IIIake periociic ciivicielld paYl11l'nlS, we I11I1SI IlIociil)' our
ddinilions or 1'('1 II rns anci compounciillg, lknole hy /), the assel's divicielld
pa)'IIIelll al dale 1 alld aSS"IlIe, lIlrly as a malleI' or COnV('IIlioll, Ihat Ihis
di\'idcnd is paidjllst herore Ihe cialeI price 1', is recorded; hence 1', is lakell
10 be Ihl' (',\'dir,it/I'IIII price ;11 dall' I, AlIel'llalivcly, one Illight dl'snihl' I', ;"
all elldol~period assct price, as showII ill Figure 1,1, Then Ill!' IIet silllpk
l'('UII'Il at dall' 1 1ll;1)' 1)(' dc/illl'd as
f{,
1'1 + /),
I.
1',1
(J.oI,7l
~I
U,'/un/.\
II is oftcn COII\'I'lIit'lIl 10 work willI ;111 assel's exccss return, c1dincd as III<'
dini.'n'lIl,(, hl'IW(,I'!I Ihl' ;lss('I\ rl'llIr!l and the retllrll Oil S01\le refl'I"'IlC('
aSSl'!. Thl' n'f(on'!I((' ;ISSl'1 is ofl('!1 ;Issulllcci to Ill' riskless alld ill pranicc i,
IIsllallya shorll<T!ll Tn';lSlIrl' hill n'lmll, Workillg with silllplc retllntS, thl'
I
:.',,, \1", hmt1 \d"'"'1i''H'l'''
I
,lIIlw
IIHtlllIHHI",ItO\
,11111
{.(BH\\~,.(H"'4."u"i.,,(.'<l
!
Thr joiJl ( lJistn"blltion
\
COllsider a collection of N assets at date t, each with return R,/ at dat9 t,
where I = 1... , T. Perhaps the most general model of the collection lor
returns I a,ll is iL~ joint distribution function:
I
!
( 1.4.10)
,
where x is a vector of slale variables, variables that summarize the economic
{,llvirol1ment in which asset returns arc determined, and (J is a vector of
fixed parameters that uniquely determines C. For notational convenience,
we shall suppress the dependence of G Oil the parameters (J unless it is
Ill'l'ded.
,
The probability law G governs the stochastic bebavior of asset returns
alld x. and represents the SUIll total of all knowable information about tbem.
WI' lIIay then view financial econolJletrics as the statistical inference of
giv{,Jl (; and realizations of IR"l. Of course, (1.4.10) is far too general to
e,
I. Illlroliuriio/l
he of any lise for statistical inference, and we shall have to place further
restrictions on G in the cOllling sections and chapters. Ilowev(~r, (1.'1.10)
docs serve as a cOllvenient way to organize the many models of asset returns to be developed here and ill latcr chapters. For exalllple. Chapters ~
t11}ough 6 deal exclusively with the joint distribution of (ll'll, leaving additi9nal state variahles x 10 be considered in Chapters 7 and H. We write this
joim distribution as Gil.
I Many asset pricing models, sllch as the Capital Asset Pricing Model
(cArM) of Sharpe (1964), Lintner (1965a,b), and Mossin (l%li) considcred in Chapter 5, dcscribe the joint distrihution of thc cross section of r('tIIfns lUll' ... , ){Ntl at a single date I. To n~duce (1.4.10) to this essentially
stalic structure, we shall have to assert that returns arc statistically indepcn<leut through timc and that the joint distrihution of the crosssection of
rct\lnlS is idcntical across timc. Although such assumptions seem cxtrcme,
th1 yield a rich sct of illlplications for pricing fmancial assets. The CAPM,
forrxample, dclivers an explicit formula for the tradeoff between risk and
ex~ec(cd return, the celebrated security market line.
\
?'he; Conditional Dislribulion
In ~hapter 2. we place anothcr set of rcstrictions on Gn which will allow us
to f~cus on the dynamics of individual assct returns whilc abstracting li'OlU
croSssectional relations bctween the as,5ets. In particular. cOllSider the joint
distribution F of I R", ... , R'TI for a given asset i. and observe tli,1I we may
always rewritc F as thc following product:
lilTI .
.fl,d.
R,2. R,d
(1.'1.11)
Frolll (1.4.1 I). the tcmporal depeudencies implicit in {R'II are apparent.
Issues of predictability in asset rcturns involve aspects of their fOlUliliOIl(l{
distributions and. in particular, how the conditional distributions evolve
Ihrough time.
By placing further restrictiollS on the conditional distributions 1';,(), we
shall be able to estimate thc paramcters 0 implicit in (1.4.11) and examinc (he predictability of asset retuflls explicitly. For example, one versioll
of the randomwalk hypothesis is obtained by the restriction that thc conditional distribution of rcturtl /lit is equal to iL~ marginal distributioll, Le .
l'il(1l/l I .) = Jo;I(1~iI)' If this is the case, thcn returns are temporally indqll'ndent and thcrcfore unpredictahle using past r('(urns. Weaker versions oftlH'
randolll walk are obtained by illlposing weaker restrictions Oil I';,(ll/l I . ).
The UllfOllliilioll(l{ Distributioll
In cases where an assct f(~tllfll'S conditional distribution differs from its
llIarginal or IIlIconditional distriillttioll. it is dearly'the {"(mdilional distrihlt
15
tion that is relevant for issues involving predictahility. However, the properties of III(' unconditional distribution of returns may still be of sOllie interest,
l:~pc('i;dll' ill cases where we expect pn'dictability to be minimal.
One or Ihc most cOlllmon models for asset returns is the temporally
inde[Jelldel1tly and identically distrii>uteo (liD) normal 1Il0del, in which
returns arc assumed to be indepellden I (lvel' tillle (although perhaps crosssectionally correlated), identically distributed over time, and normally disIributed. The original formulation of tlw CAPM employed this assumption
of' normality, although returns were only implicitly assulllcd to be temporall), liD (since it was a static "twoperiod" model). More recently, models
of asymllletric information such as Grossman (19H9) and Grossman and
Stiglilz (1980) also use normality.
While the temporally lID normal modclmay be tractable, it suffers from
al leasltwo important drawbacks. First, most financial assets exhibit limited
liability, so that the largest loss an investor can realize is his total investment
and no more. This implies that the smallest net return achievable is 1
(,r 100%. But since the normal distributioll's support is the entire real
lill':, this lower bound of 1 is clearly violated by normality. Of course, it
Illay be argued that by choosing the mean and variance appropriately, the
probability of realizations below I can be made arbitrarily small; however
il will never be lero, as limited liability requires.
Second, if singleperiod returns arc assumed to he normal, then multiperiod returns cannot also be normal since they arc the produrtsoflhe singleperind returns. Now the sums of norlllal singleperiod returns arc indeed
normal, hut the slim of singleperiod silllple rellll'IIS does not have any economically meaningful interpretation. However, as we saw in Section 1.4.1,
the slim of singleperiod continuously COlllpOlllHlcd rclllrns docs have a
meaningful interpretation as a llIultiperiod continuously compounded return.
l: ndt:r the lognormal model, if' tltt 11I(,~\l1 and V~II'i;\llCC or r,l arc 111 alld a/,
respectively, tilen the mean and variance of simple returns are given by
(1.4.13)
(1.4.14 )
AIII'matinh', if \\'1' ;1.~~II/lJ(' that Ihl' /lIl'an and variance orsimpk retllJ'll' a'l
arc III, and I;, rl'sp('ctin'II, thl'lI IIlHkr the IO):(lIorlllallllodt'llill' Ill!'all ,llld
\'"ri;l/l('c of 1;1 arl' gin'II bl'
111,+ I
log ;:=====
I I ( ~
" )~
log [I
\\111',11
(_S'
)~].
111,+
I
(J..l.1 til
'1'111' 10):(nonll;1I Illodl'l has till' added adl'antage of IIot violatillg lilllil!'d
liability, sincl' limilt'd liability ddds ;1 low('\' hound of /.no on (I + I?'II.
which is satisficc! h)' (I + No) = 1,1" whell I;, is assllnwc\ to 1)(' normal.
The IO):(lIormalllllldd has a long alld illustrions history. hegillnill):( with
the dissl'rtation ort hI' Frl'nch III;\thl'llIatician l.otlis nachdin (I ~lO(), wili(h
contained the lIIathematics or Brownian lI\otion and hcat conduction, Ii\"('
years prior to Eillstl'i" 's (I !l()!"l) ElIllOIIS paper. For other reasolls that will 1)('1'0111(' appalTnt in later chapters (SI'(', I'specially, Chapter !l), the lognonllal
model has bl'('ollw tIll' workhorse or the fillancial asset pricing litnaturc.
nllt as attractivl' as thl' IO):(lIortllallllodcl is, it is not consistent with al\ the
properties or histol"ical stock returns. At short horizons, historical retllrns
show weak evidence of skewness "nd strong evidence or exn'ss kurtosis. The
Jkntlnr.f.\, or norlllali/l'c1 third IllOIll('nt, or a randolll variahl(' ( with IlIl'al1 /1
alld \'arialKI' (J ~ is ddilwt\ by
( 1.4. Ii)
The
lil/r/llli.I,
Thl' \lonl\al disirilllitillll 1,,1' S\....'WIIIS' "'111011 10 l.l'J"(I, as do all othn ': IllIIll'tric distribllli""s. Th .. "Orlll,1i dislriblltioll has kurtosis l'ljl\al 10 :1. IlIll
.!',IIaifl'/{ dist rihlltiolls wit h <,xll;\ Iliohahility IIlass ill t 11(' tail art'as lIaw highn
or 1'\'('11 illli"it!' kurlosis.
Skcwllt'ss alld kurlosis I ;111 hI' t'SI illlatni ill ;\ salllpk of (bt;l hI' COllstl1 /( till!!: till' ,,11\ioll' sallll'l,' ;I\ ... ra~,': IIll' ,a III ph 1\1 ('a II
/1
( 1.1. I (I)
I .. /.
1.7
a~  TI '\'((
,.)2
L''" ,
1:1
I",
3
(1.4.21)
1=1
L
T
l\." == I4
Ta
(E,  Ii) 1 .
(1.4.22)
1=1
III lar~e samples of normally distrihuted data, the estimators ,~and k are
lIormally distributed with means 0 and 3 and variances 6/ T and 24/ T'
respectively (sec Stuart and Ord [ 1987, Vol. I]). Since 3 is the kurtosis ofth~
normal distribution, sample ex(f'SS kurtosis is defined to be sample kurtosis
less 3. Sample estimates of skewness for daily US stock returns tend to be
IIq!;ative for stock indexes hut close to zero or positive for individual stocks.
Sample estimates of excess kurtosis for daily US stock returns are large and
positive for hoth indexes and individual stocks, indicating lhat returns have
more lIIass in the tail areas than would be predicted by a normal distribution.
Stable Distributions
Early studies of stock market returns attempted to capture this excess kurtosis by modeling the distribution of continuously compounded returns as
a memher of the stable class (also called the stable Parf'icrLivy or stable Parefilm), of which the normal is a special case. 3 The stable distributions arc a
natural generalization of the norlllal in that, as their name suggests, they are
slahlc under addition, i.e., a sum of stable random variables is also a stable
random variable. However, nOllllorl11al stable distributions have more probability mass in the tail areas than the normal. In fact, the nonnormal stable
distributions arc so fattailed thaI their variance and all higher moments are
infinile. Sample estimates of variance or kurtosis for random V<\riablcs with
"The Frenrh probabilist raul Levy (1924) was porhap' the Ii ... t to initiate a genel4l inve,ti
gation "("table di.tributions and proVided a complete characterization of them Ihrough their
log~ haranrristic functions (,e~ Iwlow). l.evy (192: .Iso ,howed Ihal the tail probabilities
01 st"hlt db{r,hut~on~ approximat{" those of the Part'to distribution, hence the t~nn "stable
}';II"('lol.(\,y" or "s[ahl(, rarrli<lll" fiil\trihlltion. For appli(~lioru to financial autt T~tum~. ~e
IIbttl>l't ~ ,tnd (;onedes (1974); Failla (196:'); Fam. and Roll (1971); Fieliu (1976); Fielitz and
HOII'll (1~1H:1); (;ran~rr atld Mor~e"'l.rn (1970); IbRennan (197H); Ihn, Miller, and Wichern
(I <17\); ~bt"klhrot (I%~,); Mandell>rol3l,,1 Taylor (1%7); OfTicer (1972); Samuelson (1967,
I '17Ii); Silflklll,'ill and Ik.,II,'., (I')HO); and Tttrker (11)92).
J~
1. Introductioll
,
\
,,"
\
\
"
n.lo
"
Cauchy
'.
I
II
3
Figure 1.2.
2
I
these distributions will not converge as the sample size increases. but will
tend to increase indefinitely.
Closedform expressions for the densilY functions of stable randolll variables are available for only three special cases: the normal, the Cauchy, ami
the Bernoulli cases. 4 Figure 1.2 illustrates the Cauchy distrihution, wilh
density function
j(x) =
T(
y2
+ (x 
<5)~
,len."",
19
almost always rcquires finite second IIlOnJents of returns, and often fmitc
highcr moments as well. Stablc distriblllions also have sOllie counterfacIllal implications. First, thcy illlply thaI sample estimates of the variance
,md higher lIlomcnts of returns will tend to incrcasc as the sample sizc increascs, whereas in practice thcsc cstimalcs sccm to convergc . .sccond, they
imply th,\t longhorizon returns will he just as nonnormal as shorthorizon
returns (s'nce longhorizon returns are SUIllS of shonhorizon returns, and
these distributions arc stable undcr addition). III practice the evidence
for nonnormality is much weaker for longhorizon returns than for shorthorizon returns.
Recent rcsearch tends instead to llIodel returns as drawn from a fattailcd distribution with finite higher moments, such as the I distribution,
or as drawn from a mixture of distributions. For cxample the return might
bc conditionally normal, conditional on a variance parameter which is itself
random; thcn the unconditional distribution of rcturns is a mixture of normal distributions, somc with small conditional variances that concentrate
mass around the mean and others with large conditional variances that put
mass in thc tails of the distribution. The result is a fattailed unconditional
distribution with a flllite variance and finite higher moments. Since all
momcnls are (initc, the Central Limit Theorem applies and longhorizon
rcturns will tend to bc closer to the norlllal distributioll than shorthorizon
rcturns. It is natural to model the conditional variance as a timeseries
process, and we discuss this in detail in Chapter 12.
All
J~'IIlIJl'riCllllllllslmliuTl
Table 1.1 contains some samplc statistics for individual and ap;gregate stock
rcturns from thc Ccnter for Research in Sec\IJ'ities Priccs (CR.SP) for 1962
to 1994 which illustrate some of the issues discussed in the previous sections. Sam pic moments, calculated in the straightforward way described
ill (1.4.19)( 1.4.22}, arc reported for value and equalweighted indexes
of stocks listed on the New York Stock Exchange (NYSE) and American
Stock hchange (AMEX), and for ten individual stocks. The individual
stocks wcre selccted from marketcapitalization deciles using 1979 endofyear markct capitalizations for all stocks in the CRSP NYSE/ AMEX universe,
whcre in[em'llional Business Machines is the largest decile's representative
and Contincntal Materials Corp. is the smallcst dccilc's rcpresentative.
Panel A reports statistics for daily rcturns. The daily index returns have
('xlrelllcl)' high sample exccss kurtosis, :11.!) and 2(i.O respcctively, a clear
sign of fat tails. Although the exccss kurtosis estimates for daily individual
stock returns arc p;cncrally less than those for thc indcxes, they are still large,
r'lngillg 1'1'01\1 3.35 to 59.4. Sincc thcrc are H179 obscrvations, the standard
error for thc kurtosis estimatc undcr thc lIull hypothesis of normality is
J24/H 179 = 0.0;)4, so these estimalcs of excess kurtosis arc overwhelmingly
1o
JltjlfJtl/l11l1J1I
statistically si!!;nificant. TIl(' skcwncss ('stilllates are ne!!;,lliV(' lill' lhe daily
index retllrns, I.:B ;lnd O.!I:~ respectively, but gCII!'rally positive 1'01 Ihe
individual stock retUrIlS, rangillg from O.IH to 2.25. Many of Ihe ske\\'n('~s
estimates art' also statistically sign ifirall t as the standard error ullder lhe null
hypothcsis of nonllalit)' is /ti/H 17!) = 0.027.
Panel B reports salllplt' statistics f(lI' lIlonthly returns. These arc COIlsiderably less leptoklll'tic than daily rcturnsthe vallle and eqllalweighled
CRSP monthly indt'X returns haw' excess kurtosis of only 2.12 and 4.11, ITspeclively, all orcin of magnilude smaller than the excess kurtosis of daily
n~tllrns. As Ihert' are ollly :~90 ohs('l'valions the slandard error for Ihe kurtosis estimate is also Illllch larger, O.21H. This is olle piece of evidence Ihat h,ls
led researchers to usc hllIailcd distrihlllillns with linile higher moments, f()r
which Ihe Centrall.illlil Theorelll applics and drivcs longnhoril.oll rt'lmIlS
lowards normality.
I
I
I
II
\
Tht' origins or Ih(' EHici('nt Markt'ts II),polhesis (EMH) can he tra('(~d hack
at least as far as tht' pion('('I'in!!; thcort'tical cOlltrihlltioll ofBachelit'r (I!JO())
and the empirical research of Cowles (I!J:\:\). The modern literature in economics hegins with Samuelsoll (I!Hi!',), whose contrihution is neatly Sllllllll<lril,e(\ hy tht' titlt' of his articlt': "Proof that Properly Anticipaleo Prices
Fluctllate Ralldolllly":' III an illrol'lll<ltiollally t'fficient llIarketlIot to b('
confused with all alloraliollally or I'aretoeflicielll markelpricc chan~es
IIlllst he IInfoJ'('c;lstahk if tll('Y arc proP(~rly anticipated, i.e., if they l\dly
incorporate the ('xp('n<ltions and inforlllation of all market partiripants.
Failla (1!170) stlnllllarizcs this idea ill his classic survey hy wriling: ",\
markel in which pritTs always 'ftllly rdlcCl' availahk' information is called
emcient'." Failla's IIS(' of Cjuotation marks around the words "fully rcflcct"
indicales thalthes(' words art' a rOrlll orshorlhand anclneed to he explained
lIlon~ flllly. More re('ently. Malkiel (I !)!12) has offered lhe fi.lllowing llIOIT
('xplicit cklinition:
A capital mark('t is said to ht' ('fficienl if it fully anc! correClly rd1cns
all relevant inhmnatioll in cielennining sccurity priccs. Formally. Ihe
lIlark(,t is said to h(' cffici('nt wilh respcct to SOlllC inforlllalioll sct ... if'
s('ctlrit)' prin's \\'ould II(' unafkn('d hy r('v('alin~ thaI inflll'lnation 10 all
participants. Mor('o\'('\". ('f'lici(,Il(Y with !'C'spect 10 an informalion s('\
11\("IH"'.\t'tl1 ( I ~t~I'.!\ di,( U"t"' Ill(" (01111 ihu1iuH' (ll Itl("hc:li<"I. (:o\\"1t:Ir\. S,\llltu:l~on uul",.",,
o,I\\"1" ... ;.nt\" a\l1hol'_ I"IH" .ntH k, H'P'\Hl\od \1\ loU (lq~H,) indHd(' somt' of ,itt" mos.\ impolt.ulI
p.'I)t'rs
ill
1his
httOLHUI to.
I.).
M(lTkt'1
21
Jll'rinley
1abk 1.1.
Standard
Deviation
Exce",
St'rurit)'
M~an
Valllt'Wt'i!(htt'd Index
0.044
O.R2
1.11
14.92
111.\0
1I.1I7
EqllalW~i!(hted
(um
0.76
0.'1:\
26.03
14.19
9.83
Om!)
1.42
I.f,f,
0.11l
12.48
22.96
11.72
0.054
(Ull
3.3:'
13.46
9.43
0.072
1.45
f).OO
11.03
18.67
11.89
Interiak .. Corp.
0.041
2.16
0.72
12.35
R"ylrrh Corp.
AlIlpcol'ill,bllrgh Corp.
0.050
0.053
0.054
0.070
B9
2.41
1.41
2.79
2.35
5.24
2.2:'
0.66
0.27
0.74
59.40
5.02
5.91
6.18
7.13
6.49
17.24
57.90
19.05
12.82
23.53
16.67
26.92
7:'.00
19.18
11.11
22.92
19.07
50.00
SkCWIIt'\S
Kllrtosis Minimum
Maximum
Index
Intefnati(Hlal Bw;inc5..o;
Machines
Crr1l"r,,1 Si!(n,,1 Corp;
Wri!(lt'yCo.
Encrgt"n Corp.
0.079
COlitint"nt,,1 Materials Corp. 0.143
0.72
0.93
23.08
Index
EqllalWeighted Index
Intt"rnational Business
Machillt"s
(;"n"lal Si~n;\1 Corp.
Wrigley Co.
Intcridke Corp.
R;lylech Corp.
0.96
4.33
0.29
2.42
21.81
1651
1.25
:'.77
0.07
4.14
26.80
33.17
0.81
6.IR
0.14
0.83
26.19
18.95
1.17
R.I'1
6.68
9.311
14.IIR
0.02
1.87
36.77
29.73
1.31
4.09
22.70
2.04
12.47
1.11
20.26
30.28
45.65
36.08
24.61
29.72
54.84
142.11
46.94
38.05
42.8fi
ETlt"Jgell Corp.
1.10
~'.7:'
I.:n
II.fi7
0.30
0.67
2.7:l
0.77
1.47
OY,
Garall Inc.
1.64
11.30
0.76
2.30
35.48
51.f>O
17.76
1.13
3.33
58.09
84.78
Al1\p("nrilt.c:..hllr~h
Corp.
I." I
0.H6
O.R:!
1.06
IO.M
48.~fi
SllInllJary statistics for daily ami monthly returns (in percent) of CRSP equal and valueweighted SlOck indexes and ten individual securities continuously lisled over the entire sample
p<,riod frolll.!"ly~, 19fi2 to Derember 30,1994. Individual securities are selected to represent
'torks in each SilO decile. Statistics are defined in (1.4.1~)(L4.22) .
22l
I. Ill/mi/w/iol/
rna kel pilrticipanlS and mcasuring thc rcaction of sccurity prin's. If prices
do \101 rnove when information is revealed. thell the market is dlicil'llt with
reS~)CctlO thaI information. Although this is clear conceptually. it is hard to
carty out such a tcst in practice (except perhaps ill a lahoratory).
Malkicl's third sentence suggesL~ an alternative way to judge the dliciellcy of a market, by measuring the profits that can bc made by tradillg Oil
information. This idca is thc foundation of almost all thc cmpirical work
011 market efficieucy. It has heen lIsed ill two main ways. First, lIIallY 1'1'searchers have tried to measure the proliL~ carncd by markct proiCssionals
such as mutual fund managers. II' thcse managers achicve supcri(Jr rcturns
(after a<ljlistmcllt for risk) then the market is lIot dficient with respcClIO the
information possessed by the managers. This approach has thc advantage
that it concentrates on rcaltrading by reallllarkct panicipanL~, hut it has the
disadvantage lhal olle cannot dircctly ohservc the inform<ltioll used hy the
llIanagers in their trading str;llegies (sec Failla [1970, I ~l~lll for a thorough
review of this literature).
As an alternative, one CIII ask whether hypothetical trading hased <Ill
an explicitly specified infcHlllation set would carn superior returns. To
implement this approach, onc must first choose an information set. Thc
classic taxonomy of information sets, due to Roberts (1967), distinguishes
among
1.5.1 Ffficif'll/
MtlTkrl.1
The idea that efficient security returns should be random has oftcn caused
confll~ion. Many people scem to think that ;lnefficicllt security price shollid
t'fflnil't'ly:
:\ perren lIlarket for a stor\;. is olll' ill whidl then' arc Ill) proliL~ to
he made by people who haw no special inforlllation about thc company, and in which it is dilIicult eVl'1I for people who do havc spccial
inlill'mation to make profits, beGIllS(~ the pritT a(ljusts so rapidly as the
information becomes available .... TilliS we would like to see randomness
ill the prices of successive transactions, rather than great continuity ....
Randomness means that a series of slllall upward lIIovelllellts (or slllall
downward movcments) is very unlikely. Ir the price is going to move up,
il should move lip all at OIlCC, rathcr than in a scries or small steps ....
I .;lrge price movcments arc desirable, so long as they arc not cOllsistently
i(lllowed by price movemcnts in the opposite direction.
Underlying this confusion lIIay be a bclief that retunts cannot be randolll
if security prices are dctermincd by discounting future cash 1I0ws. Smith
(1968), for examplc, writes: "I suspect that even if the random walkers announced a pcrfcct11lathematic proor ofrandolllncss, I would go on believing
tha, in the long run future earnings influencc prcsent value."
III fan, the discounted presentvaluc model of a sccurity price is entirely
consistent with randomness ill security returns. The key to understanding
lhis is the socalled Law oj Iterated Hxpe(/aliufIJ. To state this result we define
information scts I, and j" where I, C J, so all the information in I, is also in
J, bUl JI is superior bccausc it contains some extra information. We consider
cxpcn,\lions of a random variable X conditional 011 Ilws(' illrormatioll S{ts,
wrillcn E[ X I I,] or E[ X I J,j. The l.aw of Iteratcd Expectations says that
E(X I ILl = E(E[X I jLl I I,]. In words, if one has limited information
II> the best forecast one can make or a random variable X is the forecast
of the forccast one would make of X if one had superior information J"
This can be rewriuen as ~:[X  E[X I J,] I I,J = 0, which has an illtuitive
interprctation: Onc cannot lise limited information lito predict thc forecast
crror one would make if one had superior information J,.
Samuelsou (1965) was the first to show the relevance of the Law of
Iterated Expectations ror sccurity market analysis; I.e Roy (l9H9) givcs a
lucid review of thc argulIlent. We discuss the point ill detail in Chaptcr 7,
hill a brief sllllllllary may be helpful here. Suppose that a security price at
lime I, /'" can be wrillen as the rational expectation of some "fundamental
value" 1", conditional on information I, available at tillle t. Then we have
P,
:=
(\.5.1)
I =
E'l I \,'.
( 1.5.2)
filiI Ihen Ihe ex(>eclalioll of III(' chan).!;e in the price over the next period is
1:,1/'1+11',1 = E,IE,tIIV'jF./[V'))
0,
Iwcallse I, C l,t I. so E,I 1:/ + II \"11 = E,I V' J hy Ihe I.aw of Iter;\!ec\ ExpectaliollS. Thlls rl';lli/ell ch;lIIgl's in plin's arc IInlilrcr;lslable ).!;iven information
ill the sci 1/.
25
market efficiency is an ideali7.ation that is economically unrealizable, but
that serves as a useful benchmark for measuring relative efficiency.
For these reasons, in this book we do not take a stand on market efficiency iL~e)f, but focus instead on the statistical methods that can be used
to test the joint hypothesis of market efllciency and market equilibrium.
Although many of the techniques covered ill these pages are central to the
marketdflciency debatetests of variance bounds, Euler equations, th
('APM and the APTwe feel that they can be more profitably applied to
measuring efficiency rather than to testing it. And if some markets tuI"it
oUI to he particularly inefficient, the diligent reader of this text will be wel~
prepared to take advantage of the opportunity.
!
I
f
I
I
"
2
The Predictability of Asset Returns
and most enduring questiollS of financial econometrics is whether linancial asset prices are forecastable. Perhaps because of
the obviolls analogy between financial investments and games of chance,
Ill<lthelllaticalmodels 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
0(' current interest, discussed and debalecl in journal articles, conferences,
and at cocktail parties!
In this chapter, we consider the problem of forecasting future price
changes, lIsing only past price changes to construct our forecasts. Although
restricting ollr forecasts to be functions of past price changes may seem too
restrictive to be of any interestafter all, investors are constantly bombarded
with vast quantities of diverse informationnevertheless, even as simple a
problem as this can yield surprisingly rich illSights into the behavior of asset
prices. We shall see that the martingale and the random walk, two ofthe most
important ideas in probability theory and flnancial economics, grew out of
this relatively elementary exercise. Moreover, despite the fact that we shall
present more sophisticated models of asset prices in Chapters 49, where
additiollal economic variables are lIsed to construct forecasts, whether futllre price changes can be predicted by past price changes alone is still a
~\lhjl'([ or cOlltroversy and empirical itlvestigatiotl.
III Section 2.1 we review the variolls versiolls of the random walk hypothesis and develop tests for each of these versions in Sections 2.22.4.
l.onghoril.OtI returns playa special role in detecting certain violations of
the randolll walk and we explore some of their advantages and disadvantages in Sectioll 2.5. Focusing Oil \ongilori/oll retllrns leads naturally to
ON!:: OF TIlE EARLIEST
(:01'1 I( r, l. g( r, \ ~)I
CU.!)
ror all I and 1'01' ko;fO. For appropriately chosen !(.) and K(). virtually all
versions or the random walk and lI1artingale hypotheses an.' captured bv
(2. I ,I), which lIlay he interpreted as an orthogo7lality condition.
For ('Xalllple, if I(') alld g(.) an' ('('striucd to he arhitrary /illPllI' fULl"
lions,then (2.1.1) implies th.ll returns arc serially uncorrc1atec1. corresponding to the Ufl/II/om Walk J lIlodel described in Section 2.1.3 h .. low. Alternatively, ir !() is unrestricted but g() is restricted to be linear, then (2.1.1) i,
equivalent to the marling'lle hypothesis Ilescribed in Sectioll ~.I. FilJ;llly. if
(2.1.1) holds I()!' all functions!(.) and ~(.), this implies that returns art' 11111wally independellt, COIT('SI)(l\\(iillg to the /lam/om Walk I ;lIld /law/om Hfdh 2
l1lodels discllssl'I\ in St'ttiolls 2.1.1 and ~.1.~. respectively. This dassilicatioll
is sUIIIIll;lrized ill Tahle 2.1,
AhhouV;h there an' several other ways to characteri7.e the various ralldOI1l walk alld marlingal(' lIlodels. COllditioll (2.1.1) and "nIhil' 2.1 are pankIIlarly rdevallt 1(11' ('('ononli!' hypotheses sinct' almost all eqllilibriulll asselpricing lIIodels can he reduced to a sct or orthogonality cOllditiolls. This
interpretation is explored ('xtl'lIsively in Chaptl'l's Hand 12.
Thl' MtlTlillKillt' M(I(itl
}'erhaps the ear/il'st III1Hkl oflillallrial asset prices was the mrlTlil1Ka/r 1ll00kl.
whose oriv;in lies in tIll' hi~tory or gallles or chance and till' hirlh of prohahility theor\,. The pr<llnilH'nt It.dian lIlathelllatician (;irolalllo Cardall"
proposed all cI('l\Icntar\, tll('or\' "I' galllhiing in his I :)II:ll1lanllSlTipt l.ilwr tfr
Table 2.1.
Co\'[j(r,), g(T,+.)
=0
Cuusificalion of random
'l'f1{p.
g(T,+.).
g(r, ),
Yg(.) Linear
'V g(.)
Uncorrelated Increments.
Random Walk 3:
Martingale/Fair Game:
fer,). Vf()
E[r'HIT,] = J.L
pdf(r'Hir,) = pdf(r, )
"Proj[.y I xl" denote, the linear projection of J onto x, and "pdfC)" denotes the probabit:t)' densit), function of its
argument.
30
Uptuml
ll<'r ,\('t;,i\"
1Se~ Sam llet ."" (I
!Iii,>, I !In , \'IT \) , R"h
trt, (1\)1,7)
form
market effIciency.
}1("
~'s~('1
malKet to he .\,mi.um
ll):fontl
Il'I'fl h'
.HH t "IOU!["{mm
(2.1.4)
wile re J1 i~ t he exp ecte d pric e chan
ge or drill, and 11( 0, 17~) dcn otes
thai f, is
illde pend elltl y and iden tical ly dislr
iilut ed Wilh IIICi lll () an<i .vari ance
a 2. The
effici eilt if the cond ition al l'xpec
t~llioll of flllufC.' prin flJ~'l1
gt'~ is It'rO, cOJld itione d
011 all
puhlic infor malio n, and all (iv,lil
ahlc pllhli c .tlld pri\';tlt illltH
lIlClli oll. respl'ctinly.
!itT Chap lt'r I lor fUflli er
di,'\nl~.. ioll of".."It'.\c ("(HI< cpb.
~,\'.,il;thk
1:1/',
/'01
(:1.1.1; )
which /illlows frolll r('cursin' suhSlilulion oflagged 1', in (2.1"1) ;lIlIllh(' IIll
ilHT('m('nls assumplion. From (2.1.:1) and (2.1.0) il is apparenl Ihal Ihe
ralldom walk is lIollslalionary alld Ihal ils conditional IIIcall and variance
art' hOlh lint'ar inlimt'. Tht'st' implicalions also hold for Ihc IWo olher lill'lllS
or lilt' random walk 1I~'P0IIH'sis (RW2 and RW~) dcsnihcd helow.
I'l'rilaps 111(' moSI CIIIIIIIIOII dislribulional assumplion for III(' inllo\';Itions or in('J'(,llIl'nls f, is normality. If t hc f /s arc liD N (0, a ~), Ihcn (2.1.'1)
is l'lJllivaknl III all flrilh/llt'/i,. Hmwl/;'lII /II 01 i'lI/, sampled at rq~ularly SP;ll'l'd
unil inlervals (Sl'l' Sl'('liou ~1.1 in ChapIn 9). This dislrihuliollal assumption silllplifies lIIany of Ihe calculations slIIToulHling the randolll walk, but
suffers frolll Ihl' same problclII Ihal afIlicts norlllally distrihuted returns:
\'iolalioll or\imiled liahilily. Irlhe condilional distrihution of 1', is normal,
Ihcn therc will always he a posilil'l' prohabililY thai 1', <0.
To avoid viola ling limiled liabilily, we may use Ihe salllc device a, in
Section 1.4.2, namely. 10 assert Ihal Ihe nalural logarithm of prices /It ==
loj.{ 1', follows a random walk wilh llorlllallY distrihuled inCl'cmcllls; hence
I', ==
/1
+ /It_I +f"
(2.1.7)
2.1.2
nil' NIII/I/OIII
II'II/Ii 2: ftlth'l"'lIt/pl/lln(/'PIIII'I//I'
simpl~
Although RW2 is weaker than RWI (sec Table 2.1), it still retains the
most interesting economic property of the lID random walk: Ally arbitrary
transformation of future price increments is unforecastable using any arbitrary transformation of past price incremenL~.
2.1.3 The Random Walk 3: Uncomiall'd incremmts
An even more general version of the random walk hypothesisthe one most
often tested in the recent empirical literaturemay be obtained by relaxing
the independence assumption of RW2 to include processes with dependent
but un correlated increments. This is the weakest form of the random walk
hypothesis, which we shall refer to as the Random Walk J model or RW3,
and contains RWI and RW2 as special cases. A simple example of a process
that satisfies the assumptions of RW3 but not of RWI or RW2 is any process
for which Cov[( to Etkl = 0 for all k '" 0, but where COV[E;. E;_kl I 0 for
some k j O. Such a process has uncorrelated increments, but is clearly not
independent since its squared incremenl~ are correlated (see Section 12.2
in Chapter 12 for specific examples).
Since the assumptions ofIID are so central to classical statistical inference, it'
should come as no surprise that tests for these two assumptions have a long ':
and illustrious history in statistics, with considerably broader applications i
than to the random walk. Because of their breadth and ubiquity, it is virtually \
34
impossible to catalog all tests of 110 in any systematic fashion. and we shall
mention only a few of the most wellknown tcsts.
Since liD are propcrties of random variables that arc not specific I', .1
particular parametric family of distributions. many of thcse tests fall uillin
the rubric of nonparamelrir tcsts. Some examples arc the Spearmall rallk
correlation tcst, Spearman's footrule tcst, the Kendall r correlation test,
and other tests based on linear combinatiolls of ranks or Rstatistics (5('('
Randles and Wolfe [1979] and Serflin~ [1980]). ny using information contailled solely in the ranks of the observations. it is possible to develop tests
or ~ID that are robust across parametric familics and invariant to changes ill
Un\L~ of measurcment. Exact sampling theories for such statistics arc generally available but cllmbersome. involving transformations of the (discrete)
uniform distrihution over the set of permutations of the ranks. llowever, fill
mo~t of these statistics, normal asymptotic approximations to the samplillg
distributiolls have been developed (sc(~ Serfling ( 1980]).
; More recent techniqul's based on the empirical distributioll fllllnioll
of the data havc also been used to construct tests of lID. These tests of~
ten :require slightly stronger assumptions on the joint and lIlar~inal distribut\on functions of the datagcncrating' proccss; hellcc they fall illto the
clas~ of umiparametric tesL~. Typically, such tcsts form a direct rDlllpariSOli (between the joint and marginal empirical distribution functions or an
indirect comparison using the (juantiles of the two. For these test statistics,!(~xact sampling thcories are generally unavailable, amt we must rely on
i
asymptotic approximations to perfilflll the test.~ (see Shorack and Wellner
[ 19H6]).
~nder paramctric assumptions, tests of lID arc gencrally easier to COIIstruCt. for example, to test fiJr indepcndcncc among k vectors which Me
jointly normally distributed. several st;lIistics may be used: the likelihood
ratio statistic, the canonical correlation, eigellvalues of the covariance matrices, etc. (see Muirhead 11 !)83]). Of course, the tractability of sitch [csts
/IIust be traded ofT against their dependence 011 specific paramc[ric assumptions. Although these tests an~ oftcn more pownful than their nonparametric counterparts, evell small departures frOI\1 the hypothcsized parametric
family can read to large difTcrl'lIces hetwecn the actual alld nominal sizes of
the t('st.~ in finite samples.
2.2.
Tflls
35
)IlC1I'IIlflll.1
to
develop
SOIllC
lIIachillery that
flIul Unwna!.s
V','e begill with the logarithmic vClsion or RW I or geol1letric Brownian 1110lion ill which the log pricc proccss PI is asslllllcd to li)lIow an lID random
walk wil/LUul drift:
(2.2.1 )
and denote by I, the following r;III<!O!ll variahle:
I,
==
if
1',
/1, 
/'tI > 0
if
1'1 
/'t 
P,I
<
(2.2.2)
O.
~'!Il('h like the classical Bernoulli coinlOss, I, indicates whether the <iateI
cOlllinliously compounded return 1', is positive OJ' negative. In fact, the coinl'lssing analoh'Y is quite appropriate as lIIany of the origin;titests ofRWI were
based Oil silllple cointossing probabilities.
Olle or the first tests of RW 1 was proposcd by Cowles and Jones (I937}
;ln1l consists of a comparison of the frequency of .lfqumcl'.l and lfVerJ{lLI in hiswried stock rcturns, where thc formcr arc pairs of consecutive returIls with
lhe salllc sign, and thc laller arc pairs of consecutive returns with oppositc
signs. Specifically, given a sample of n+ I returns 1'1, . , 1',,+1, the number
of sequcnces N, and reversals N, may be expressed as silllplc functions of
the I, 's:
N, 
2:" Y
I,
1'1 
II I(jj
+ (I
 / / )(1  IItd
(2.2.3)
'~I
N, ==
11
(2.2.4)
N,.
If log prices follow a driftlcss lID random walk (2.2.1), and if we add the
further restriction that the distributioll of the increlllclll.S ( I is symmetric,
then whether rl is positive or negative sho\lld be equally likely, a fair cointoss
with probability onehalf of cither outcome. This implies that for any pair of
consecutive returns, a sequence and a reversal arc equally probable; hence
the C:ow\cs:Joncs ratio
N,I N, should be ;lpproxilllatdy equal to one.
More formally, this ratio m<ly be interpreted as ~l cOllsistent estimator of the
ratio q of the probability Jr, of a seqUl'llCe to the probability of a reversal
I  IT> siuce:
q ;::
(J _
N,
N,
N,fn
N,/n
Jr,
I, 
n,
..
I"
Jr,
I  Jr,
2
1
q
== I.
/"
where "" d('lIo\('s cOllvngclKl' ill prohahility. The fart that this ratio
(xn((hi\ Olll' Ii)r mall)' hislOriral stock returns scries kd Cowlcs andJolH'S
(1!1:l7) to cOllrl\J('" Ihallhis "reprCsl'lIls conclusivc evidellcc orstrllCiIllC ill
stock pritTs ... :1
II0wcVl'r. Ihe assumption of a I,ero drift is critical in dctermining the
vallll' of q. In particular. q will l'xITcd Olle for an liD randolll walk with
drift. sincc a driftcil her positive or negativec1carly makes sefll I l'Jl( cs
lJ\ore likely than n\'l'Isals. To sce this. suppose that log pritTS f()lIo\\' a
normal random walk with dril't:
/', = /1
+ 11,_1 + ~,.
Theil the illdicator variahle I, is uo IOllger a fair cointoss hut is hiased ill
Ihe direclion orlhe dril't. i.c ..
I,
{Io
with prohahility
7T
wilh prohahility I 
(2.2,:i)
7T.
where
rr
=:
I'r(r, >
0)
l (;;').
(2.2.1i)
If the drift JA is posilive Ihen Jr > ~. and ifil is ncgative Ihcn Jr < ~. Under
Ihis 11101'1' gt'n('ral spccification. Ih .. I'alio of Jr, to I  Jr. is given hy
Jr~+(IJr)2
2Jr (I _ Jr)
::: 1.
A~
long as the drifr is 1I0nl.ero. it will nlwllYS be the case that sequcllc('s are
more likely thall reversals. simply because a nonzero drift induces a trend
in the process. It is ollly for Ihe "fairgame" case of 7'( == ~ that CJ achi<. ves
ils lower hound of OIlC.
To sec how large all cflen a 1I0llzero drift might have Oil q. suppose
thai /1 == O.OH alld f1 == 0.21. values which correspolld ronghly to anllual US
stock ITltll'llS indexes OWl' Ih(' 1;lsl hal fl'Cn tllry. This yieJ!ls the folJowill~
estimate of'rr:
IT
O,OH) == O.fi1R4
(1.~1
Jr,
ir~+(IIT)~
J.I!J.
0.5440
:\111 a late .. siudy. (:owl('s (I!Uifl) (OIIC'C" tor hi;\."i('s ill linH'~aV('r;lg('<1 price.' ".ata ;111<1 . . [I!)
(;J lali,,, ill c'Xc C'" of 01iC'. I h"'."'\'c'I, hi, (1I1l( hl,jnn i.Ii sOlJlt'what mOl"(, H".II(\(''': .... ,. whIle
fillfJ..
y loward."
mO\'(,IIH'lIh.,
Ihi.Ii ~lIlIici('1l1 10 pJurick 11100e' Ih.tII II('gligihlt" I)lolif~ aher p.IY"U'1I1 orhrnJ..c'I.lgc
which is close to the value or 1.17 that Cowles and Jones (1937, Table II)
report ror the annual returns or an index or railroad stock prices rrom 1~35
to 1935. Is the difference statistically significant?
.
i
To perform a formal comparison of the two values 1.19 and 1.17, ~e
reqllire a sampling theory ror the estimator
Such a theory may be ~h.
tained by noting rrom (2.23) that the estimator N, is a binomial random
variable, i.c., the sum or n Ikrnoulli randolll variables YI where
CJ.
y = {I
I
+ (I
 rr)2;
Jf,
Var[N,)
+ 2nCov[Yf, YHd
rr,) + 2 (rr 3 + (1  rr)~  Jf;).
mr,(1  rr,)
nrr,(1 
(2.2.7)
Applying a firstorder Taylor approximation or the delta method (see Section AA of the Appendix) to
== N,/( n  N,l using the normal asymptotic
approximation for the distribution or N, then yields
(2.2.8)
where ,,~" indicates that the distributional relation is asymptotic. Since the
Cowles andJones (1937) estimate or 1.17 yields JT, == 0.5392 and JT == 0.6399,
with a sample size n or 99 returns, (2.2.8) implies that the approximate
standard error of the 1.17 estimate is 0.2537. Thererore, the estimate 1.17 is
not statistically significantly different from L 19. Moreover, under the null
hypothesis rr
has a mean of one and a standard deviation or 0.20 10;
hence neither L 17 or L 19 is statistically distinguishable rrom one. This
provides little evidence against the random walk hypothesis.
On the other hand, suppose the random walk hypothesis were ralsewOllld this he detectable by the CJ statistic? To see how departures from the
randoJll walk might affect the ratio CJ. let the indicator II be the following
= 4, q
<I 
=1I
Y'1
= I) = <p" +
\
I,
I (I .
()
(j
Ii
Oil
(.). ==
(I 
Oil
O'}fl + (I
n.:!\)
0.:10
0.'10
O.!)O
lI.tiO
0.70
II.HO
0.10
!l.OO
:),:!~)
li':'O
:),(;7
r).~:)
5.00
I XI
4,71
4.1;~
O.!lO
'U)(i
1.00
4.:,0
!Ui7
:1.17
2.:1:1
J.!1'2
1.1;7
'2.:n 1.:)0
'2.'21 1.:iH
'2.1 :1 1.'29
'2'()(; 1.'2'2
'2.00 1.17
Ii
(:!,~.l 0)
'
\',JlII("
Il.I 0
 fJ)a
'J
II
_0'/,
1.~1'2
0.:)0
:).00
'!..:)O
l.ti7
1':'0
1.~:}'
1.~:}
1.00
OXI
0.71
0.1;:1
'!..7:)
I.OH
o.'IIi
0.H7
O.HI
0.7:,
IU)li
0.:)0
0.70
O.HO
11.~IO
1.llI)
1.71
'2.21
1.:IH
0.%
0.71
O.!):)
0.1:1
0.:1\
II.:I~I
1I.'!.7
O':\:I 0.'21
!.I,:I
151;
'!..(lIi
I.'!.'!.
O.HI
0.:)1;
O.:I!I
0.'27
O.IH
n.11
150
'!..oo
1.17
0.7:)
0':'0
O.TI
O.'!.I
O.I'!.
D.I)('
0.00
0.1i0
IXI
'!..:n
1':'0
I.OH
OXI
0.1i7
0.:,:)
0.\1;
2.1 :~
1.2~)
O.H7
O.li:1
OAIi
0.:"1
0.'2:)
O.IH
Il.I '2
lUll;
Allot her cOllllllon test for RW I is th(' fllII.1 11'.1/, ill II'hidl tht' llullliln 01
Sl'qlll'tH,(,S ofcol\s('clltin' posili\'(' ,tilt! n('g,lIi\'(' ntlllll~, or runs, i~ tahulated
and t'O\l\IMITd against its sa\llplill~ distrilllJliOIl ulldn tht' ralldom II'dlk
hypothesis. For cxalllpk, \lsillg tht' inclicalor \'ariahlt' I, ddill('d ill (~.~.~).
a partir\llar s('qucnce or 10 l('tunlS Illa\' he rqll('~('llt('tI b\' 10011 \0\00.
Clllltaillill!,: thrl'(' rllIIS or 1~ (JrI(,Il~1 It I. :\. alld I. \'("IH'r\ ill'II') ;IIHllhn'(' 1I11l'
2.2.
'1'1'.1[.1
o/fill/lli(J/Il'Walk I: /If)
39
/111'11'1111'111.1
or
Li
E[N,,",,(i)]
1IJr,( I  Jr,)
IIlf,(l 
Ilf,
+ If/
(2.2.11 )
+ (;If,~
 :~lf;l)
+ 2lf,
(2.2.12)
+ 37(i Jrj)
 5Jri Jr,).
Mor('( 'vcr, Mood (I D40) shows thal the distribution oj' the lIumber of nlIIs
converges to a normal distributioll aSYlliptotkally whell properly lIormaliLccI. III particular, we have
N,,,,,,(i)  Illfi( I  If,) 
x,
If /
fit
N(O,
(2.~.14)
(2.2.15)
N,,,,,,  11(1 L,lf,~)
==
fit
(2.2.16)
1lI;1)' (itcll
Tahle 2.2.
1,000
1,000
1,000
I,OOIl
1,000
I ,DOll
1,000
1,000
1,000
1,000
1.000
/1
0
'2
1
Ii
H
10
I:?
rr
0':'00
O.:,?tH
0.:>7Ii
IUil:?
0.li4H
O.liH:\
0.7lfi
J.I O.71H
IIi 0.777
IH O.HO\
20 O.H:\O
ErN",,,,]
SOO.:>
497.ti
'IH~).I
47:>.'2
4:>C>':'
4:n.ti
407.2
:nH.I
:\47.:'>
:~ I :>.:,
2H:t:>
EXPt'{"I('d lotallillmht'f of III"" il1.I ... ;tlHP!c oln ind(I)t,)(It."nl8~rnoulii (rials rt'I)J('s('lIting po,,
iti\'('/lIc'gati\'(' fOlllinlloll.lril\' fOIU}lOlllHlt'd r('lurn" fCu' a GillI.~"iian gromerri(' I\rowllial1 mOlioJl
wilh II .. in/1 = Of:k .... ~O'.)'r, allli !'Il.lIUi;lId d('viation n == ~1 %.
(2.2. Hi), an<llhl' prohahilil ics rr, lIIay he ('slim'lled directly frolll lhl' d;tl.t as
11ll' ralios if, == /li/ II, whl'I'(' II, is of Ihl' nll1111>rr of rullS in lhl' sample of 1/
lhal an' Iht' ilh l)'p('; Ihlls 1/ =
II,.
To dn'dop SOI1l(' S(,IlS(, of Ih(' h('havior or Ih(' tolal nlllllb('r or rullS,
consider Ih(' B('rnolilli caS(' /( = 2 corr('sponding 10 lhe indicalor variable
I, dcfined in (2.2.2) or S('nioll 2.2.2 wh('rc rr dCIIOICS lh(' prohahilit: tllal
I, = 1. In Ihis caSt', Ill(' ('XIW(\('(IIOI.tllllllnher of nllls is
L,
(2.2.1'7)
()hserV<' Ihal for an)' II :::: I, (2.2.17) is a glob'llly concave quadralic rUllllioll
illlT Oil 10, I J whirh ,lIlaills a maximlllll value of (11 + 1)/2 allT :::: ~. Th('1'('/1m', a driftkss ralldolll walk maximil(,s Ih(' exp('cled lotalnlllllbcr or rllm
for all)' (ix('d s~u\lpk sill' /I or, ait('ntaliVl'ly, Ihl' pres(,llce or a drift o( (,ither
sigl1 will (kcH'as(' Ih(' ('''I"'rll'd 10lal \lumber of runs.
To S('(' Ih(' Sl'lIsilivill' or El NIII/,'] wilh r('sp('('( 10 Ih(' clrift, ill Tahle 2.~
we r('port 11)(' ('"1'('('((''' IOI,t\ 11111111)('1' or runs for a sarnpl!' or II == I.(JO(J
ohs('rvaliolls fil!' a J.:l'oll)('lric ralldolll walk wilh lIormally dislrihul('d ill<T('1ll('nlS, drift II = 0'1." ... , ~O'Yc" ;\lId siandan( d('vialioll r1 == 21 'Yc, (which is
calihral('d 10 mall'll .lIlIlual liS SIOI'k ind('x r('lurns); hl'lI('(' rr = <1>(11/0).
Frolll Tahk ~.~ WI' S(T Ihal ;tS Ihl' drift in('l'('ases, Ihl' ('X 1)('('\ ('{I lolal ntlllllH'r
or I tillS dnlil\('s (ollsidnahly, (rolll :)()().:) 1'01' l('roilrirl 10 21\:1.:) ror ;t 21l(.~.
drirt. Ilo\l'('n'I, all or Ih('s(' \'ah\('~ an' slill COJlsistt'nl wilh 11)(' ralldOiIl \\;dk
hvp()1 h('sis.
41
To perform a test for the random walk in the Bernoulli case, we may
calculate the following statistic:
z ==
and perform the usual test of significance. I\. slight adjustment to this statistic is often made to account for the fact that while the normal approximation
yields different probabilities for realizations in the interval [Nun.. Nrum + I),
the exact probabilities are constant over this interval since Nruns is integer.
valued. Therefore, a continuity (orrection is made in which the zstatistic is eval
uated <It the midpoint of the interval (sec Wallis and Roberts [1956j); thus
z ==
NJlln1
+~ 
2nrr(l  rr)
2.Jnrr(lrr)[I3rr(lrr)
N(O, I).
Other aspects of nms have also been used to test the lID random walk,
such as the distribution of runs by length and by sign. Indeed, Mood's
(I !140) seminal paper provides an exhaustive catalog of the properties of
runs, including exact marginal and joint distributions, factorial moments,
centered moments, and asymptotic approximations. An excellent summary
of these resulL~, along with a collection of related combinatorial problems
in probability and statistics is contained in David and Barton (1962). Fama
( I !I(5) presen ts an extensive empirical analysis of runs for US daily, four<iay,
ninc;:lay. and sixteen;:lay stock returns from 1956 to 1962. and concludes
Ihat, "... there is no evidencc of important dependence from either an
investment or ~ statistical point of view."
More recent advances in the analysis of Markov chains have generalized
the theory of runs to nonlID sequences, and by recasting patterns such
as <I run as elemenL~ of a permutation group, probabilities of very comple~
patterns may now be evaluated explicitly using the jir;tpassagr or hitting time
of a random process defined on the permutation group. For these morr
recent rcsulL~, see Aldous (1989). Aldous anc! Diaconis (1986). and Diaconi~
(I !)HH).
/{dllnl.1
/lIrrl'llll'IIi.1
43
more frequellt trading, Fallla and IIlullle (I !)(j(j) show that evcn a 0.1 %
roulldtrip transaction cost is enough 10 eliminale the prolils from such 1iII(T rules.
2. J. 2 Ife/wiml Ibwly.,i.l
:\s ;\ measure of predictability, til(' (iller rule has lhl" ;I<IV;II\I<ll\e of prafliGl1
n:lev;lllceit is a specific aud n:adily illlplelllentablc trading strateh'Y, and
the metric of its sllccess is total retllrIl. The filtn nde is jllst one example of
a much larger class of trading rules arising from /I'r/Illim/ Ilnalysis or charling.
li:chnical analysis is an approach to investlllenl manal\elllclll based 011 the
bdid lhat historical price series, trading volulIle, all<l other market statistil'S exhibit reguiaritiesoften (but 1I0t always) in the form of geometric
p;lllerns such as double bolloms, headlIlu[:,lwuldeIJ, alld Jul'porl and resistance
levelsthat can be profitahly exploited to extrapolate future price moveIlIl"JlIS (sec, for example, Edwards and Magee [ I DGG 1 and Murphy [19H6).
'lithe words of Edwards and Magee (1966):
Technical analysis is the science of recording, usually in graphic form,
Ihe actual history of trading (price changes, volume of transactions,
elc) in a certain stock or ill "the averages" alld then deducing from
lhat pictured history the probable future trelld.
Hislorically, technical analysis has been tlw "bbck sheep" of lhe academic
finance community. Regarded by many academics as a (pursuit that lies somewhere between astrology and voodoo, technical analysis has never enjoyed
the 5ame degree of acceptance thaI, for example, fundamental analysis has
received. This state of affairs persists today, even though the distinction between technical and fundamental analysis is becoming progressively fuzzier. 5
Perhaps some of the prejudice against technical analysis can be attributed to semantics. Because fundamental analysis is based on quantities
familiar to most financial economistsfor example, earnings, dividends,
and other balancesheet and incomestalement itemsit possesses a natural bridge to the academic literature. In contrast, the vocabulary of the
tcchnical analyst is complelely foreign to tile academic and often mystifying
to Ihe general public. Consider. for example, lhe following, which mighl
be found ill any recent academic finance journal:
The magnitudes alld decay pattern of the first twelve alllocorreiations
;lnd the statistical signilkance of the goxPierce Qslatistic slIgl\cst the
prescnce of a highfrequcncy pr('dina!Jle COIllPOIiClll ill stock returns.
"'hll' l"X~lIlIple, 1Il.'IlY It'Chllir.tl analysL' 110 IOllge!" bas(' ,heir tOf(,CdM.\ ~oldy un past prict"s
alld \'olulII(, bUI abo use earnings and divideJld illtOriliatioll ~lI1d othel" "'hllulamental" d.tta,
i.HIII a~ lIIallY fUlld.lIl1t'lJliJl iJl1aly!'ils now look at past prin.' ;uHI \"011l1l1t' piJUt'rwi ill addiliull In
11101(' tI.lditioll.d
variables.
_.
~ ' . . . IfHII
HIIIIIII)'
f~1
J"',Uf'/ J{t'/lIrll.\
1
1
I
()nl' or the 1II0st direct alld illlllilivl' tests or the ralldolll walk ,lIl(illlanillgale hypotheses iill' all individual lilll(, series is to check ror .Inial (on"rlnlioll,
correlatioll hctw('cn two ohservations of the S,III1C series at difkrelll dates.
Under the weakest version of the /'<lndOIll walk, RW3, Ihe inCrelll(nL~ or
flrstdifrerences of th{' kvel of the randolll walk are ullcorrclatetl at allleacls
and lags, Therefore, we may test RW3 hy testing the nult hypothesis that ,he
autocorrelation coemcients of the lirstdilTerenccs at variolls lags arc <III zcro.
This sct~lIIingly silllplc approach is the hasis for <I surprisillgly l<lrge variety or t('SI.~ of the ralldolll walk, and we shall deVelop these tests in thi.~
chapter. For l'X,Ul1plt. tests of the ralHlom walk may he based 011 the autocorrdation ('()cf[kiellts thcmselves (Scnioll 2.4,1), More powerru\ tesls may be
cons.lructcd I'rontthe slim ofsl(uarl'd alltocorrclatiolls (Section 2.4,2), Lin(,ar comhinations of II", ;lIltocolTdations lIIay also havc rcrtain advantages
ill d('I('cting parlicu\ar departures fromtlw random walk (Sections 2.'1.3 <111(1
~':;), Tlwre/ill'C, 11'(' shall dcvole ('ollsid('l'ahlc allelltioll \0 the propenies of
autocorrdalioll coefficicnts ill the cOllling sections,
2. .J. / II lI/oml7l'/((lio/l {;ol'/jiril'n/J
The alltocorrdatioll cod'lici('1I1 is a lIatllraltimescri('s eXlellsion oftl\(' w('l1klloll'n correlat ion cod licienl h('IW('I'1I IWO randolll varia hies x and .1':
COIT/x .1'1
==
(:ov[x, ),J
JVar!xl.jVar[y!
(2.4.1 )
, 45
COV[T,.
y(k)
T'H1
Cov[r,.
p(k)
(2.4.2)
T,Hl
Cov[
==
r,. r'Hl
Var[ rtl
y(h)
yeO)
(2.4.3)
y(k)
T 2:)r,  fr)(Tt+A 
==
TT).
0 ::; k < T
(2.4.4)
,=1
p(k)
==
TT
y(k)
(2.4.5 )
yeO)
1 T
TLT,.
(2.4.6)
,=1
The sampling theory for y(k) and p(k) depends. of course. on the datagenerating process for I rtl. For example. if r, is a finite<>rder moving average,
M
T,
== LakE,b
.=0
JT[ y(O)y(O)
(2.4.7)
where
v ==
[Vi]
v,)
1
00
[y(i)
y(fi+j)
(:;:00
+ y (l+ j)
y (l i) ] .
(2.4.8
v'T[ p(O)p(O)
p(l)p(l)
(VUI)
where
00
g'j
'I
[p(e) p(l'i+ j)
+ p(l'+ j) p(l'i)
(=00
rI
(2.4.10)
For purposes of testing the random walk hypotheses in which all thc population autocovariances are l.ero, these asymptotic approximations reduce
to simpler forms and more can be said of their finitesample means and
varia~ces. In particular, if hI satisfies RWI and has variance o~ and sixth
mo~ent proporlionalto 0 6 , then
I
Tk
.
(2.4.1 I)
E[p(k) 1
+
O('r 2 )
T(Tl)
\
Cov[p(k), p(m
I;;J. + O( r2)
,.
{ O(T2)
if k
I'
otherwise.
i: 0
(2.4.12)
From\ (2.4.11) we see that undcr RWl, where p(k)==O for all k>O, the sample
autocprrelation coefficients i>(k) are negatively biased. This negative bias
comer from the fact that the autocorrelation coefficient is a scaled sum of
crossp,roducts of deviations of T/ from i\.~ mean, and if the mean is unknown
it must be estimated, most commonly by the sample mean (2.4.6). But
deviations from the sample mean sum to zero by construction; therefore
positive deviations must eventually be followed by negative deviations on
average and vice versa, and hence the expected value of crossproduc\.~ of
deviations is negative.
for smaller samples this eITecl can be significant: The expected value
or p(l) ror a sample size of 10 observations is )0%. Under RWI, fuller
(1976) proposes the following biascorrected estimator p(k):7

p(k)
==
p(k)
+ ,'{It
" ( I
( fI)<
2)
 p (I,) .
(2.4.1:1)
7 NIlI Ihal pIA) i~ nllt IInbia",,": 11ll' I<'nll "hias<olT.. ctcu" rcfers lU Ihe fan Ih.1I
Etp(h)I=Orr~).
47
Ullmnl'/a/I'I/IIIOI'1Il1'll1.1
Wilh IIllililr!lIf)' houtlded sixth 1II01lletltS, he shows Ihat the s.\llIl'le autororrelatioll coefficicnts arc asymploticall), independcnt and normally distribilled wilh distribution:
Nw.
(2..1.14)
I)
(2.4.15)
N(O, I).
~II
'"
TLp~(lC).
(2.4.16)
h=1
Ullder the RWI nlill hypothesis, and using (2.4.14), it is ea~y to sec that
c1.. = 'I"';~I P(lc) is asymptotically distrihuled as X~,. qUllg and Box
(197H) provicle the (ollowing finitesample correctiotl whirh yidds a helll'r
(it lO the X~, for slIlall sample sizes:
'"
fl'
"''II
2(k)
Tk
(2.4.17)
By summing the squared autocorrclations, the BoxPierce Qstatistic is designed to detect departures from zero alllOl'orrclatiom in either direction
anel al all lags. Therefore, it has power' against a broad r'angt> or alternative
hypotheses to the random walk. However, selecting the \l\lInber of autucorrelations III re'l"irc~ SOlllC careif too /CW arc used, the prcsencc of
highcrorcler autocorrelation lIlay hc IIIbsccl; if too lllallY arc IIsed, the test
Illa), lIol have lllllCh power due to insignificant higherorder aUlOcorrelalions. Therefore, while sllth a portlllanteall st,l\islir does have sOllle appeal,
IWlLcr tesL~ of thc random walk hypothcscs lIlay he availahle when spedne
allcl'Il;lIiVl' h)'I)otheses can be identified. We shall lui'll to slIcll examples ill
III<' /ll'xi sCl'lions.
L.,
2, I, }
\{II1I1//(/'
IIn/io,1
An important pl'Opnl\' of allthn'(' randolll walk hypotheses is th,1\ thl' \'alianft' of ral1dom walk iIHT('I111'nIS ""ISI Ill' a Iin('ar rUllclioll or Ihc lilllC
il1tt'rvaJ. H For ('"ample. Ulldl'l' RW I 1<11' lo~ prices wher(' conlillll()IISI~' COIIIotllllied r('tlll'\lS I,"" lo)!; I',Io)!; I', I alT liD, the varialllT of 1",+1"" I mllst
he twin' the \'ariaIHT or 1'" Thneiorc, thc I'Jausihilit)' or til(' ralldolll \1';r1k
modcllllay I)l' r\1('('k('d In' l'IlIIlparill)!; III(' variallcc of 1,+Ii_1 10 tll'ice (he
varianc(, or r,,!' Ofcoltrsc, ill practicl' thl'Sl' will not he 1l1l111l'ril"ally idclltical
('\'I'n if RW I were trill', hut their rat io shonld be statistically indistinguishahll'
from OIH', Tl1l'rl'fon', (0 rOllslnlcl a slalislical I('SI or IIH' ralldoll1 walk 11\'pOlhcsis usin~ I'arianrc ratios, liT n'quirc Ihcir samplillg distrihulioll under
tIll' ralldolllwalk nlill h\'jlotill'sis,
VOId I, + Ii I I
~ V;ld 1',1
~
VR(2)
C~.4,IH)
+p(l).
propPllV j, iliOn'
difli, lilt
(I!I!I:\). .11111
Killl;1\
(PIXX).
'J:I~~II.
I'ott'rha
Ric
h,llcI"'fllI
49
oneperiod returns will he larger dian the sum of the oneperiod return's
variances; bel.ICe variances \ViII grow faster than linearly. Alternatively, in
lhl" presence of negative firstorder autocorrelation, the variance of the slim
01 two oneperiod returns will he smaller than the sum of the oneperiod
r('IIII'Il's variances; hence variances will grow slower lhan linearly.
For comparisons beyond one and lw(}period returns, higherorder autocorrclatio!lS come into play. In p,lrticuiar, a similar calculation shows that
the gener;'!1 qperiod variance ratio statistic VR(q) satisfies the relation:
VR(q)
==
Var[r,(q)]
q. Varlr,l
== 1 + 2
L.
'II (
LI
k)
I   p(k).
q
(2.4.1\)
VR(q)
Relations sllch as this arc critical for constructing alternative hypotheses for
which the variance ratio tesl has high and low power, and we shall return lO
I II is isslle below.
Srull/dinK lJislribulioll of VD(q) (Il1d W(q) lmdrr HWI
To cOllStrllct a statistical test for RWI we follow the exposition of 1,0 and
MacK.illla), (19HH) and begin by stating the null hypothesis Ho tinder which
Ih(' samplillg distribution (lfthe test statistics will be derived.'" Let p, denote
lile log pric(' pr()Ct:~s and r, == /Ir /J,_I ,ol1till\lOIlSly [ompounded returns.
'''For ,"'1'111,11;,,(' c,po,itiolls ,,c Call1pll<'l1 allci ~1;,lIkiw (I<lK7), Codlrdne (ICJKK). FA,,"
( I CI~I:'>). l'otC'. Ita .111(1 StllIlI"''''', (I !IHK). Rirhanholl (I!I(I:I) .\I,d RirhAj"on A",I Stuck (19K!I).
50
/(1'1/1 m.1
Ho :
Let our data cons ist of 211+ I obse
rvat ions of log pric es {f~). 1'1 . ....
I'l" \. 'IIU\
cons ider the follo wing estim ator
s for p and a~:
'2'1
[J.
cr;
'2
b
~II
L (I'.  1'.1 )
"i""II (/'2"
"'I
 1~1l
(2.<I.~O)
'l.u
211
,~
(2.4.21 )
L" ({'!. 
{'l. ~  2/~) 2 .
.~t
(2.4.~~)
a/,
I'
i
I
I
,j'j;;(a/,a~J
:.:. NJ ,4a 1 ).
(2.'1.24)
cr,;
n;;  n,;.
TIll' Illll1 hypothesis" can then he t('stnlusillg (~ .. I.~: alld allY cOllsistcnt
('stilll;llOr :!a'i of 20'1 (for example. :2(a~)~): COllstrud the standardized
sl;ltistic \'1)(:2)1 ~ which has a lilllitill~' standard lIoml;d distrihutioll 1111dn RW I. and reject the null hypothcsis at th(' :if;;, hoyd if it lies outside the
illt(,ly;dlI.%,I,%j,
The as),lllptotic distrihutioll of the t,,'olwriod v;lriaIK(' ratio statistic
\"71\(2) == a,~
now follows directl), fmlll (:2A,2!i) usillg a (irstonierlil),lor
applOxilllatioJl or the delta Illethod (se(' SeClion/\..J of the Appendix):I:1
In,;
'I'll< 111111 !!y(>othesis 110 can he t('stnl Il)' ("ollllllilillg the standardized statistic ~(VR(2)I)/~ which is asynl()tolic;dly st,lIHttrd Jlormalif it lies
()llIside the illtnval 11.~l(i. I.~HiJ. RWI Ilia), 1)(' rl'jnwd at thl' :)'}{, kvd of
si~Jlili(allce,
AlillOugh litl' vari,III('C ratio is ,,1"1 ell pn'krrl'd to Ihe \',lIi,III("(' dint'n'll(T
1)('("'\\ls(' Ill(' ralio is scalcfret", ohserv(' Iltat ir~(a,;)~ is IIsed 10 eSlilllale 2a I.
lhell lite sl,llllbrd sigllilicalHT ll:Sl ofVD=() lor tilL' dilkrelllT will yidd lhl:
saille inferellces as the correspollding test ofVRI=O (l!' lhe ratio SiIlCl':
~VT)(2)
ff,i(a,;  a,;)
JET,}
~a,;
Tltnt'i"ure, ill Illis silllple cOlltexl th(' IWo tesl statistics arl: ('ljuivaklli. Ilow('\"l'r, 111('1'(' ;11"(' othl:l" reasolls that Illake tll(' I'ariallcc ratio Illore appealing
\'.!
HI il'll}, 11.111'1111.111 (I ~)7H) c.'xploib III(' LH t 11,,11 ,IllY .I:'I~ IIIIHllllf.dly dlidc.'11i
I..':.lilll.lIor
01
Ii,., 1II11:.t I't):.~c.s., the.' p"oP('II~' Ih.11 it i~ 'I'~ IIIpIOlit';dly unfOI n'lo"t:d with
Iill' 11111"1 ('lit"(' (i"  (i,. where: (itt i~ au)' olher (~lilll.ltor 0111. II lIot, dlt:1I tllC.'''''' t"xi!oots a liue.n
("Ollibill.tlillll (II (i,. ,lIltl (ill fir IhOit is iliOn.' c.'Hi("it'lll IIi.lllli, (CJlllr.uli< lillg Illl' '',.'IIIH,'d l'Ilirielu"y
.1 p.II'IlIl('Ic.'1 (I,
~.I\"
0111,
,'\',III,i,,1 '"
,,\';11
=>
,'\',11 I Ii,
,I\'a'IO" 
,'\';111';" I
Ii,
,'\',III,i"  ,i, I
 ,1\';11 \Ii, I,
"pCI ;11111'.
\'~111 p.lIlirlll.tr, apply Ihl" ddt.llIlethod to I({il.,i'.!l:::;(i,/fi',! \\liel"(' fjl=n/~n,;. fi,;!:=(j,;. aud
oh,cl \"(" [h.1I r1f~
,11111 n,; ,II (' a.,YIIIIHCJ!i( all~ 1111( 011 (,l.lIcd IIt'( .111'(' n,! j,;111 dfifi('1I1 {".,lim:.tlol".
r.:;
and tll<'s(' arc disnlss{'d ill (;ochr,lIIe (l~lHH). Falls\ (19~1~), ',1I1d 1.0 and
MacKillla), (I!IHH, I!lH!I).
The I'aliall(,(' elilklt'llIT anel lalio sialislics elll })(' easil)' gcnl'r;di/l'd
Itl IIllihipnioC\ ITllirIlS. I.t'! 0111' salllpll' cOllsist of IIq+ I ohsl'I"l'aliollS 1/~1o
/1\, ... ,/1",,1. wh('l'(' '/ is "III' illtl').(('J' J.(lc"tcr than one "lid define Ihl' eslim,,lors:
1/11
.
II
L
/1'1
(Ilk 
11.  I )
(I'k 
/1.1 
'=1
(II,,,,
/~I)
(2.4.:2H)
1/({
III/
"
(1,;
11,/ k,I
L"
/~(q)
//11
\'1)(1/)
(/'"k 
,~
II)
/1"*_,, 
(:~. 1.:2!I)
'
qll) ~
C~.I.:W)
k~1
0/; (1/)
G,;,
VR(q)
Cr/;(q)
0'1.
(2.4.:\1 )
"
N(O,'2(qI)IT' I )
JIif/(Vlt(q)  I)
N(O,'l(qI)).
(2.4:1:\)
Two illlportalli ll'iin('nH'nts of these statistics can improve their finitesample propntics slIhstantially. Th(' first is to lISC OlIIT/aNlinK qperic,d rcIlIrns ill estimaling Ih(' variances h)' dellning Ihe following alternative l'slimalor for IT ~:
.. "
I'~
IT,Utl = '7
/Ill
L (I'k k~"
.... J
Ilk"  'Ill).
This eslimalor conlaills /1,/ q+ I t('J'IIlS, whereas the l'SlimalOro;; ('I) (ontains
only 1/ tl'l'Ins. Using overlappillg 'I(l('l'iod rCllll'lls yields a lIlore effici('nt
cSlimalor and hell('e a Illore pownflll Il'SI.
The s('('olld rdill<'m('1I1 im'Olves ((lIT((ting lh(' bias ill Ihe valiant'{ eslimators 0,; alld h,~ herOIC dividing OIl(' hy Ihe olher. Denole the IInbiased
estimators as i1~ and
(II), whnl'
n;
,"/
""
  L (II. /1.1
'''/  1 k~ I
",
' ~
Jl)
. ,
..... UV
53
...
(2.4.36)
VD(q)
J1lii (VR(q)  I)
( 2(2ql)(ql)
N 0,
a
3q
(0,
1)
2(2 ql)(ql)).
3q
(2.4.38)
(2.4.39)
These statistics can then be standardized ill the usual way to yield asymptOlically standard normal test statistics. A5 before, if 0 4 is estimated by ~in
standardizing the variance difference statistic, the result is the same as the
stanclarclized variance ratio statistic:
Vr (q)
J1lii(VR(q)  1)
(2(2 Q,I)(qI))1/2
$q
r;;4
ya!
)1/2
(2.4.4P)
I
N(O. 1).
3q
54
nq
1:::01
VR(I"
j) ==
+28
L
'~I
(I  ;k) p(h).
(VI Al)
j, 110
1,{JI/~lllJriwll
2, 5,
1&llLm.l
Secolld, II' ,It' Ihal undl'J' 1I~ (conditioll (114 the autocorrelation coelEel,':11 estilll(k) are asym(ltotkally uncorreiatedY' II' the aSYllJptotic
\\lri.1J1Ce O. (
" of the p(k)'s call he obtai lied Ul\dn II;,. the asymptotic
\'~Iriallre (}(q) oj \'R('1) lIlay he calnilated as the weil(hted SUIII 01' the Ilk's,
whne Ihe weigh Is arc simply the weighL~ ill relalion (~.4.41) squared. Denote by Il. and U(q) the asymptotic variances of Ii(k) and VR(q), respectively.
Then ullder Ihe lIull hypothesis II~ Lo and MacKinlay ( I UHH) show that
I, The slatistics VD(q), and VR(q)1 converge almost surely to zero for all
q as 11 increases without bound.
') The following is a heleroskedastirityn)Jlsistenl eSlimator of Il.:
(2.4.42)
8(q) 
,.
4L (I  ~). 8.
~~t
(2.4.43)
10
lesl
il,~
J1zij(VR('/)  I)
fii
N(O,i)
(2.4.44)
ill\(',
\",illl"'" lilt' lilllitillg ';tri"Jl(e f) of VR(q) vi" (~,~,'II), Allhollgh thl' r,'slIilillg estimator of II
\\(lIdd he 1110)"(' c.:olllplicatcd than equdliou ('2AA.:\). ill~ coun'pln.lIly Mlaigilllorw.... d dud lIIay
I(,adily IH' forlll('d .d()l1~ the lines of N,w('y .uHI \t\'(.'~t (I ~JH7). All ('\"('11 III()((~ Kt'llC'lal (and pos~
:.ihly won.' t'xart) sampling thew), ftH"lht' v,lriillln' r~llio~ m;IY he olHailJ('d IIsing the result'" uf
nll"",r (I ~IH I) alld 1)1I1<,"r ""d Roy (IYW,), Again, lhis wo"ld ",nili",' IlIlIrh of till' ,implicily
of (lur ;1.'Ylllptotir u'.'HIL,.
larger fllr statistil'S hased Oil longhorizon returns. Hut for some a\lertlati\'es
to the randolll walk. longhoril.on returns can he 1II0re informative than
their shorterhorizon ('Ollllterparts (sec Scction 7.2.1 in Chapter 7 and 1.0
ami MacKinlay I 1~IH9j),
One motivation flu' using longhorizoll returns is thc permancnt/transitory componcnts alternativc hypothesis. lirst proposed hy Muth (1!)(iO) in
a macroC(,(l11omic context. In this model. log prices arc c0111posed of 1\\'0
componcnls: a rando111 walk and a stationary process.
W,
)i
)',
+ 11',_.1 + f,.
and (w,1 and \),,1 ;\1'1' 1111\111ally indcpendcllt. Thc common interpretalion
h)r (2.:1.1) as a nlOdc! of stock prices is that II', is the "fundamental" COIllponent that r('lIe('\s the efficient markets pricc. anc! _v, is a ZCfOl11ean ~ta
tiouary COI11POllCIH Ihal rdkrls a shortIerm or transitory (\eviatioll from
the e('fi('ienllnark('ls price II'" il11pl)'ing the prescnce or "fads" or othef market inefficiencies. Sin('c )', is slationary. it is mcanrcvcrting by delinilioll
and revcrts to its 111ean of zcro in the 10llg rUII. Although there are sevcral
difficulties with such an illtnprctatioll of (2.5.1 )lIot the least of which
is the 1;I('t that market efficiellcy is talltological without additional rt'IlII(ill1i(
strlll:tllrtncvcrthdess. sllch an altcrnative provides a good bhorat()ry for
studying the variance ratio's perilll'mance.
While VR(q) can behavc in l11any ways under (25.1) for small If (<1<:pending on the cOlTdatiol1 structure of)',). as q geL~ larger the hehavio, of
VR( ,,) becol11es less arhitrary, ) II partirular. observe that
1',
Ji,Ji,
= II+f,+.v,,~'1
,/1
1',( II)
L'
qI
t ,
If)L
L f,k +
,y,  .V''I
(::!,:,,:I)
k=()
,...=:/I
Val'l 1',(1/) I
(~,c),~)
(:!,:l'I )
wh('1'C y,(q)= COVi.v, . .v1l ,/1 is IIH' aulol'ovariance runctioll of .y,. Thncrol('.
ill this case the poplllatiol1 valll(, of the variance ratio he('()n](',~
VR(If)
l/a 1
+ 2y\.(O) 
If (a~
+ '2y,(O)
'2y\(q)
 '2y\( I)
.,
0
a~
+ 2y\(O) 
2y\(I)
as
q + 00
(2.5.6)
2y\(O)  ~y,(I)
1o~
+ 2y,(O)
 2y,(I)
Var[ l'.y]
I  'Var[l'.y] + Var[l'.w]
VR(q)
+
1
Var[l'.y]
Var[l'./J]
(2.5.7)
1
I
VR(I/)
+
Varl.6.yJ
Var[l'.tuJ
(2.5.8)
IIn<\('I" the RW I nnll hypothesis. Observe lhal for all q>2, the bracketed term
in (25.R) is hounded hetween ~ and I and is monotonically increasing in
q. Therefore, for fixed n, this implies upper and lower bounds for V are
,i,; and
respectively. Now since variances cannot be negative, the lower
t"
58
hound for VR(q)1 is I. Buttilcn the smallest algebraic vallie thaI the test
statistic (VR(q)l)/.fV can tak(' on is:
.
Mill
VR(I/)  I
"'V
"V
I
r.;
== ,,'211 =
Min.fV
~)'I'I
'11"'11 11,
~.
suprlOSC that If is set at twothirds oj" the salllple sill' 'f' so that TI '1= This
implies that the lIormalized lest statistic VR(q)/,fV can never he less thall
1.73; hence the test will nnWT n~ectthc lIull hypothesis at the 9:>% level or
significance, regardless or the data! or course, the test statistic can still rt~jen
the lIull hypothesis by drawing from the right tail, but against alternative
hypdtheses that imply variance ratios less than one for large IIsuch as the
pernbanent/transitory compOnenL'i model (2.5.1 )the variance ratio test
will II ave very lillIe power whclI If / T is not close to zero.
~ \\lore explkil illustration oj' the prohlems that arise when III T is largc
may ~)e obtai lied by perrorllling an alternal(~ asymptotic analysis, olle in
which q grows with 'j'so that q( T)I Tapproachessome limitS strictly between
zero ~nd one. In this case, Hilder RWI Richardson and Stock (1989) show
that ~he un normalized variance ratio VR(q) converges in distributioll to the
following:
I
\
.
"
Xs(r)
111
'J
X;(r)
tir
(25.10)
(2.:>.11 )
In our ('arlier example where Ifl T = ~,the alternative asymptotic approxiIllation (2.5.10) implies that EIVR(q) I ~'onvtTges to ~. considerably less than
Ollt' despite the ract that RW I holds.
.
These biases arc not unexpected in light of the daunting demands we
are pbcing on longhorizon returnswithont more specific economic strllc\\Ire, it is extremely difficult to infer llIuch abollt phenomena that SP;lI\S a
signiflrallt portioll of the entire dataset. This problem is closely related to
olle ill spectr;ll analysis: estilll~lling thl' ~pcnral density function n('ar frcqUl'llCY 1 ('ro. Fr('qu(,IH'il'~ Ileal' len) COlTcspmHI !O ('xtrnl1cly IOllg pnio(h..
59
.11)(\ it i~ llotoriou~ly difticult to draw illkrCflce~ ahout periodicities that excCl'd :), ": ',111 uCthe data. 17 We ~ha!l M'e explicit l'vil\eflce orsudl difficultics
ill lhl' l'11'i,11 ir.tI resulL~ orSectioll ~,H, llowcvcr. ill ~OJll{' ca~es lon~horizon
1t'llll'IlS call yield importallt in~ighls. <,specially Wlll'll other ecollomic vari'lhks slid I as the dividendprice ratio COIlIC illto playsc(' Scctioll 7.2.1 III
CllaptlT 7 for further discussiofl,
2.6.1
A typical example of longrange dependence is given by the fractionally differenced time series models ofGran~er (19t:lO), Granger andJoyeux (1980),
and Hosking (!9t:ll), in which PI satislies the following dificrence equation:
<I ~ IID(O, a/),
(2.6.1)
I"here I, is the lag operator, i.e., I./'t = /Itl. Clangcr and Joycux (1980)
and I1usking (19H I) show that when the quantity ([  L)d is extended to
nOllil\tt'~cr powers of Ii in the mathematically natural way, the result is a
17 ~t't tilt' di~r\l~~iull ;,uHl allJlysis ill Se( 11011 L.h lUI further clr.[.lib.
ll'iThi:"l biblir.ll aualoK)' is Hot (Omplt'ldy 'I i\'O!OIl."I, _.,inn' IOl1gl~lllge depend.ence h.lS been
doculIlenled in variolls hydrological Silldi"., nol th .. It'd" of whirh was lIurst's (1951) seminal
OIl lIlt:a~lII ill~ the IOJlglcnn sloraKt' cap.H:ity of n.,~t~l"'\'o~rs. hulleel. much of )furst's
rt:'~earch Wi.l." motivated by his erupiricdl ohs.t'rvations oj the Nile. Ihe \'{'ry saIBt' river Ihat
played:\o prolllill('lIt a rolt' in.Jo~tph\ J)J'opiln it,\.
~(Udy
'0'
J"
or
(I  /.)"
d(dl)(d2)(dk+ I)
Ii!
10
(2.1;_2)
III:
00
LAk/llk ==
flo
(2,(i,3)
k~tJ
Ak =
(I)
k(d)It
\'(11 
d)
nli + d}
J'(d} ['(Ii
+ I)
d,'I'("""'"1,
\11
Table 2.3.
PI,(k)
Pp(lt)
[d==~ ]
[<1==  ;]
[ARO)'.p == .5]
(l.::~:)()
:)
0.500
0.4()0
0.350
O.3IH
O.29!i
0.015
0.500
0.250
0.125
0.0[,3
0.031
10
2:)
:)0
100
0.235
0.173
0.137
0.109
0.00:;
0.001
3.21 x 10 4
1.0~ x 10 4
0.001
2.98 x 10"
R.RR X 10 1
7.89 x 10;31
l.at:
k
3
1
0.071
(l.03e)
tum
+ f"
'"
series have first{)rder autocorrelations of 0.500, at lag 25 the AR( 1) lcorrelation is 0.000 whereas the fractionally differenced series has correl~tion
0.173, declining only to 0.109 at lag 100. In fact, the defining characteristic
of longrange dependent processes has been taken by many to be this slow
decay of the autocovariance function.
More generally, longrange dependent processes (1',1 may be definc:d to
be those processes with a~l\ocovariance functions Yp(k) such that
.
(k)
Yp
kV JI (k)
for
E (1.0)
{ _kv Ji (k)
for
E (2, I)
or,
as
4
00,
(2:6.6)
where 11 (k) is any slowly varying function at infinity.20 Alternatively, I~ng
range dependence has also been defined as processes with spectral density
functions seA) such that
IX
(1,1),
(2.6.7)
~"t\ function
I fl.
(0).
fix) is sait!
The (unction
lo~
{(tlllm.1
function and spectr,t1 density near frequency zero of the fractionally dillerenced process (2.6.1) is
Yp(k)
I  ell
(Vi.H)
\I
\
+
n.
\
I~here dE (~, ~). Dqll'llding on whether Ii is nq:;ative or positive, th('
spectral demity of (2.ti.l) at frequt'Jlcy lero will either he I.ero or infinite.
/{lIllge
Slali.llil'
The importance of longrange ,kpl'ndl'llct' ill asset llIart.:ets was tirsl sllldied hy Mandelbrot (1971), who proposl'd \I~ing tltl' range over standard
deviation, or R/S, statistic, also called tlte rr.\CIlled range, to deten longrangt'
dependence in economic time sl'ries. The R/S statistic was originally dl'\'doped by the English hydrologist Harold Edwin lIurst (l 951) ill his studies
of river discharges. The R/S statistic is the range of partial SlIllIS of deviations of a time series rrolll iL~ mean, rescaled by its standard deviation.
Specifically, consider a sample of continuously compounded asset rl'turns
{Tl, T2 Tn} and let Til denote the sample Jnt'an ~ L, ']. Then tlte classical
rescaledrange statistic, which w(~ shall call ~" is given by
(2.(j.lll)
whc~c
I "
[
;;
(~.().ll
The first term in brackets ill (~.(j.1 0) is the maximulIl (over k) of Ihe panial
sums of the first k deviations or ri from the salllple mean. Since the slim
of all n deViations of T, 's frolll their Illean is zero, this maximulIl is always
nonnegative. The second lerlll in (2.li.IO) is the minillllllll (over k) or this
same sequence of partial SIIIllS, ami hence it is always nOllposilive. Tht'
differellce of the two quantities, calkd the rallgr for obviollS reasollS, is
always nonnegative and helHT <1,:::(J.~1
11The hehavior or
~t\\dil'S
)
I
03
III sncral sCJllillal papers Mandcl lm)(, Taqqll, alld Wallis demons
trate
lite sllJ>criorily of R/S analysis to lIIore nJllvclll iollal JIlelhod s
of detenni llillg IOllgrallge depend ence, such as allalyzil lg alllOcor relatioll
s, variance
Lllios, and spectral decomp ositiolls . For exampl e, Malldcl hrot
and Wallis (I ~)(j~)I show by Monte Carlo simlliali oll llial Ihe R/S statistic
call delen IOllgrange depelld ence ill highly IlollGaussiall lillie series
with large
s!ewlless alld/or kllrtosis . III f~ICl, Malldd brot (I!)7:!, 1!175)
reports the
allllOSISlIre converg ellce of the R/S statistic fi)! stochasl ic process
es with
infinite variance s, a distinct advanta ge over <tutocol Telation s and
variallc e
ratios which Ileed not be welldef ined for infinile variance processe
s. Furth,r aspects of the R/S statistic 's robustn ess arc develop ed in
Mandel hrot
alld T.lqqll (I !17!)). Mandel brot (197:!) also argues thai, ulllike spectral
analysis which de(ccts periodic cycles, R/S all~tlysis CIlI detect IWlljJeriu
liir cycles,
("yclts with periods equal to or greater thall Ihc sample period.
Altitoug h these claims may all be ("(>Iltested to sOllie degree, it
is a well,slablis hcd fact tliatlon grange depelld ence ell I indel"d he detecte
d by the
"cLlssical" R/S statistic. Howeve r, perhaps the lIIost illlporta nt shortco
llling
01 tile rescaled range is its sensitivi ty to shortra
llge depend ence, implyin g
tlLlt allY illcoIllp atibility betweel l the data and the predicte d
behavio r of
tIle R/S statistic under the null hypothe sis need not COIIIC from
longra nge
depeIld cIIce, but Illay merely he a symptol ll or shortte rIIl Illeillory
.
III particul ar 1.0 (199 I) shows that under RWI the asympto tic
distribution of (I/.[ii) Q,. is given by the randoIll variable V, the
range of a
firownia ll bridge, but under a stationa ry AR( I) specific ation
with autoregressive coeffici ent the Ilormali Led R/S statistic converg es
to ~ V where
~ == .j( I +) /( I). For weekly retums of some portfoli
os of com IlIon stork,
i> is as large as 50%, implyin g that the !Ilcan of C6./.[ii may be biased uI}
III11S1 he eli",en 10 allow ti)r tlllcillalio ll.' ill Iii .. supply of IVal
.. r abm.. IIie dalll while .Iill
Ill~lillt;ljllillg a relatively cunstant flow ofwatc.'r
below the dalll. Siufr dam rOJlsrfuctiun costs
al to illllllt.'ll~e. IIH~ ililportdn ce of e~[ill1aliIIK Ihe reservoir rapacity
Ilt"cessary to meet longterm
slOra,;" Ilted., is apparellt. The nUlKe is all eslilllale of ,his quanlity.
If JS i. the riverflow
(per ,,"it lillle) a/Jove Ihe dam and X n i. Ihe d,,,ired rivedlow
below Ihe dalll, Ihe brackeled
'I' .... ltily ill (\!.6.1 0) is Ihe capacilY oflhe reservoir n("~ded 10 tm
....e lhis .Illoolh How Kiven Ihe
p.lllnll of Ilows ill p .... iuds I IhrouKh n. For exalllple, Sllpp"S"
'"lllllal river How. are ""'"ll1ed
to I,, 100, ;,0, 100. alld :,0 ill years I IhrollKh 4. If a cu,,,WlIl
allllllal flow of 75 below the dam
i~ d(,~1I"l'd c.'arli yc:ar, a reservoir must have a minimuJI
l total CiJMrity of~:, since it must store 25
111111., ill y.. ars 1 alld:{ 10 provide for Ihe rt"/alivt'ly chy y.. ars:l ,,,"1~.
Now slIl'l'ose inslead Ihal
Ill .. "'llllrall" 'll'fIl of riverflow is 100,100, :,0, :,0 ill Y",I" I tilr<l"t:"
4 .. ", ,""m! a flow of 7:,
belu\\' the dam ill thi." Cif.!<.C, the minimulII r.tJMfity 1Il1I . . ' illrr('a~("
10 ;)0!10 as to aCCOIIlIJlu<.ialt'
tlit" l'XU':':' ~[()r ..t~( Jlt"t'(kd ill years I and ~ to Mlpply
\Y~Her during tile "dry spell" ill yean j
,lilt! 4. St'CIl in thi., rOlltt'xt. it is clcar (hat;,tll illtTCJSt' ill pc.&rsi:.tc.&n
ct will increase the required
stor,lgc.' capacily a.'i lllt'dSured by the fiHIKc. irult"td.
it W~tS Iht' "ppau'ut pcrsi.'Hcnce of "dry
.,"
"1'''111""".,
" / ,1'111.\111111/.
ward II)' 7:\'X,! Silln' tilt' IIlt'all 01 V is Jrr72~ 1.2:), the "wall or !Ill' classical
n's('ah'd rangl' would Ill' '2. Hi ror slll'h an AR( I) process.
1.0 (I!I!II) dl'\'l'Iops a Illodilicatioll or the R/S statistic to ;1I'1'otllll lilt'
the clfl'l'ls or shortrallgl' dqll'lHletllT, ckrivl's an asymplolic s;lI11pling lhl'or\' under sl'\'I'l'al nllil anei altl'rtJatin' hypotheses, and demonslr;ttl's yi;t
!\lonte Carlo silllllbtions alld I'lllpirical examples drawn rlOm rl'Cl'lIt hi""rical stock llIarkl't data that the Inoeiilil'd R/S statistic is I'onsidcrahh' nlOl'('
accurate, often I'idding infi'rl'lIct's that contradicllhose of its classical cotlntl'rparl. In particllbr, II'hal Ihc I'arli(,r lilcrature had asslIllIed was 1'\'id('IIIT
of 10llgrangl' dq)(,lIeil'lICI' ill ltS stock retllrns Illay well he Ihl' 1'1"1111 of
quickly decal'illg shollr;lIIge dq)('ndl'nce inste;lIl.
~,
/1
1.\',
+ f"
('27.1 )
X, /il = <p(X,
where
f,
I . /1(/1))
t
<p
f"
E (1.1),
() <
"
(J,~
lim E
I ., '
[~(tf')~]
I
<
(Xl,
,=1
0, IIH'
lilt,
r.
IIIH,{,lt;lilll\' ill
IH'.I \1'1'\' lI,dllllllCUld 01 1.111(1(1111 I" ic (' d~II.lIlIi('..;,. All ('xall1plt' 01 !'i1tch ;\ pr()('('~' j, all f\1,\( I)
Wilh,llIlIitloell.i.t' .. (/;; ,], '1, I.WIHIC'II,i,whil(noisc.
II tile' p.III1.&I '11111\ \.III.llle c' \\'('11' 10 glO\\, 1.1'"'' th.1II
~o that till' lilllil ill (~.7.:q \\'('1(' "X.."
,hi ... \\'0'11,\ hi' .111 ,"U\lph 01 IIIII.I.! HIli,!!" d"',,IlIt,Hft'. ill whirh tlu: ~\\lh)( 01 .. \'I,uio" hUH ti(lll (II
IIII' , / \ clcCI\ ... \C., \ ,Ie 1\\ h .. \11 (".Hllpll' I I' '"1'11 ,I plon's!'i i~ a fr.ulioll.II" dill"I(,lIn'd I" ell c'"
II 'I,. \\ IH'II' 'I, I .... \\ Iliit' lie li . . e. \cc' SCTIIIJlI ~.ci ;1IIc1I.o (I~,q I) 101 1IIIIh('1 eli" 11"11111
or,
I,", /
pre(~ictability in asset returns is a very broad and active research topic, and jt
~pecific.ity
the
of these examples, the empirical resullS illustrate many of the
issufs that have arisen in the broader search for predictability alllOIlf.: assel
retu\rtls.
2.8. I 111l/ocorrela/iulO
Table 2.4 reporlS the means, standard deviations, alltocorrelations, and Hox
Pierce Qstatistics for daily, weekly, and llIonthly CRSI' ~lOck retlll'lls indexes
fl'OmJuly 3,1962 to Deccmher 31, 1~\l4.~~ During this period, panel A of
Table 2.4 reporlS that thc daily equalweighted CRSP index has a firstordcr
autocorrelation p(l) of 3~.O%. Recall rrolll Section 2.4.1 that under lhe I[l)
random walk nu1\ hypothesi~ RW I, the asymptotic samplinf.: distribution of
.0(1) is normal with mcan 0 and standard deviation I/JT (sce (2.4.14.
This implics that a sample siJ.e or 8,179 observations yields a standard error
of 1.11 % for p( I); hcnce an <llltocorrclatiOlI of 3~.O% is clearly statistkally
significant at al\ conventional levels of significance. Moreover, the BoxPierce Qstatistic with fivc aULOcorrelations has a value of 2G:~.:~ whit:h is
significant at all the conventional significance levels (recall that this statistic
is distributed asymptotically as a
variate ror which the 99.5percclltik
is 16.7).
Similar calculations for the valueweighted indexes in panel A show
that both CRSP daily indexes exhibit statistical\y significant positive serial
correlation at the first lag, although the equalweighted index has hight'r
autocorrelation which decays more slowly than the valueweighted index.
The subsample alltocorreiations demonstrate that the signiiicallce of the
autocorrelations is not an artifact of any particularly influential subset of the
data; both indexes are strongly positively autocorrclatcd in each subs<\mple.
To develop a sense of the pconomir significance of the alltocurrelations
in Table 2.4, observe that the f{2 or a regression of returns on a cOllstant
and itS first lag is the square of the slope coefficient, which is simply the
firstQrder autocorrelation. Therefore, an autocorrelation of 3:>.0% implies
thaI 12.3% of the variation ill the daily CRSP equalweighted index return
is predictable using the preceding day's index return.
X;
,~
POlltoliu
returns ~re raldtlated first from sirupit' returlls and tht"n are converted to a (outilllluu.;,ly
compo"nded relllm, The weekly H'I"rn of ""ch St'cmilY i, colllpllletl a5 Ilw retllrn III>Ill
Tuesday'I' closing price \0 Ihe followill~ TII""lay's dosill); price. If Ihe t()llowillg TIIl'M!;,Y's
price is Illi"ing. Ihell Wednesday's pri('e (01 MOllddy'S if Wednesday's is also Illissill~) i, \lSl,d,
If hOlh ~Ionday's and Wednesday's prices are missing. Ihe relurn for Ihal week is "'1',,,1,,,1
..., mi",iol!!; llois occurs ollly ,,,,ely. To com pUle weekly relurns Oil sileSOrled pOrliotios. tor
each week all slOcks wilh nonmissinK relllrn, Ihal week are "'Signed 10 ponh)lios hased Oil Ihe
lJeKillllirlK of year market value. If Ih< \>C)lilllliIlK "fY"ar lII.lr\c.c1 value is missing.lhell Ihe .<H\
01 "ear \,thlt" is used. If both markel ""lu,', ;Ut' ",i"inK llo, ,10l1e. is 1101 ""i);ne<l \0 a pOrllotio.
I
,,' 2.4.
S.IIUple
Period
Sample M
Sil.e
call
SI)
(t,
A. [hill' RCllll'llS
0.1 O.H
4.ti
~.~
2.\l :\5
21i:D
2695
:~2\1.4
~435
695
72.1
~J.:\
1:\.0
4.\)
H5
1,>.3
2.0
CRSI'
Vahll~Wt'igh\ed
In(h',.
CRSP
:15 0.7
I.li
:>.H
I.t; :>.:\
H.H
'J.O
!l.3
36.7
215
2!l.2
I.H
ti.1
2.2
!14.:{
tiO.4
33.7
IO!I.3
tiH.5
!ll.3
ti.H
3.'J
7.5
12.5
'J.7
14.0
12.H
75
21.3
12.t\
14.2
EqllalWci~hled
Iudex
ti.1
75
4.:~
\l.I
11.\)
:).:)
C. Monthly RcLUms
CRSP
ValllcW"i~hl .. d
ludex
ti:!:07::{194: 1:!::lO
li'2:07::{ 17H:m):29
7H: I (I::{ 1\14: 12::\0
li~:07::\I\H: I ~::{()
H,9
l\'II>I'I>'"'\'\\i,," H)('fti. i., lib (ill p('rrelll) ;,,1<) II .. ,Pi ...... (l,t.lli,lir, 101 t:/{SI' dJily, weeki)',
alld IlIollllrly val 11(' alld (,<)lIJIw('ighl('cI 1('1\ II'll indexes I()r tire ,.11111'1,' period frolllJllly :{, IYI;~
10 ))"'II1IJ<'1' :1O. I!)!H and slIbperiods.
i.
j hI' j'mlidllhility
oj AUft
/{I"tll/I/.\
CIlSP hllll'Xf.1
The alltocorreiations ill Tahle 2.4 sllggest variance ratios greatn thall Olle,
and this is confirllled ill 'nlhk 2.:' which reporL~ variallce ratios VR defilled
in (2.4.:\7) alld, in parenth('ses, hewroskedasticitynl!1sistellt aSYlllptoticallv
standard normal test statistics 1/I'(If} defined in (2.4.44), for weekly CRSP
eljualand va It Iewei gh ted market retllrn indexes. 2t\ Panel A (olltains results
lilr tl\(' ('qllalweighted indl'x and panel n contains results !i)r Ihl' \"011111'wd~hted index. Withifl each pand, the first row presents the variall(e
ratios afld test statistics fi,r the elltire l,fi!I!iweek sampk and the lIext two
rows presl'nt silllilar results lin' the two suhsampks of H4H and H47 w('eks.
rand A shows that the r;llldolll walk null hypothesis RW3 is rejected at
all the usual si~nifkal1("e levels for th(' entire time period and all ,ubperiods fOl' the equalweight(,d index. Moreover, the rejections are not !III(" to
changing varianc(,s sinc(' til(' ",'('1)\ arc heteroskedasticitycollsistenf. Th('
estimates ofth(, variance r,ltio arc {((rgrr thau olle for all cases. For example,
the entries ill thl' Iirst cohunll of panel A corresponoto varianc(' ratios with
an aggrl'g;lIioll valu(' 'I of~. Invi('w of (2.4.18), ratios with '1=2 are approximately ('(]lIal to I plus th(' lirstor!ln autocorrelation coefficient estim,llor
of weekly retunts; hellc(', [he elltry ill the first row, ) .20, implies that th('
firstorder autocorrelation fi,r we(,kly returns is approximately 20 'f.! , which
is consistent wilh Ih(' \'alue rqHll\ct\ in l;lh\c 2.1. With a corresponding
1/1' ('I) stat ist ic of '15:1, the randolll walk hypot hesis is resoundingly rejected.
The suhsamplc r('sults show that although RW3 is easily n:inlet! over
Imth halves of 111t' sa III pit' period, Ihe varian('c ratios arc slightly brgcr ,\Ild
the rejections sli~hllv strollger ovn th(' first haIL This pallerll is re)leated
in Tahle 2.li and in other eUlpirical studit's of predictahility in l;S siock
:!liSinc c' ill 0111 ~alllplt'
;II\\'ays
\pan'
W(' I('POII
olily rhc'
((lIi.\("
\';ui\"c :"ot;lIi"lic~,
69
Table 2.5.
Sample period
1.695
848
847
1.20
(4.53)*
I.n
(:'.17)*
1.19
(2.%)*
1.42
(5.30)
1.47
(4,44)
1.35
(2.96)"
1.65
(5.84)
1.74
(4.87)
1.48
(3.00)
I. 74
(4.85)*
1.90 I
(4.24)+
154 "
'(255)~
1.02
(O.!'>I)
1.06
(1.11 )
0.98
(0.45)
1.02
(0.30)
1.08
(0.89)
0.97
(..(J.40)
1.04
(0.41 )
1.14
(1.05)
0.93
(..(J.50)
1.02
(0.14) 'i
1.19 :
(0.95),
0.88
(0.64)
1,69:)
848
847
VJri:lIlrlratio test of the random walk hypothesis for CR5P equal and valueweighted indexe
for the sample period from July 10. 19fi~ to December 27.1994 and subperiod . The variance
ratios VR(q) are reported in the main rows, v..ith heteroskeuasriciry<onsislent le~t statistics
""(q) give" in parentheses immediately below each mJin row. Under the random walk null
hypothesis. the dlue of the variance ratio is one and the test statistics have a stAndard normal
distribution asymptotically. Test stAtistics marked with a.qerisJ<.. indicate that the corresponding
variann: ratios are Matistically dinerent from one at the :,% It"vei of .5iRoificance.
VR(2q)
 =
VR(q)
1+ fJq(l)
(2.8.1 )
70
IH%.
SizeSorled Pori/olio.!
Thc fact that RW3 is rcjc ctcd by
Ihe eCJualweighled inde x but IlOI
by Ihe
valu ewe ight cd illde x SllggesL~ Ihat
mar ket capi taliz atio n or size lIlay
play a
role in the bcha vior of the val'i
ance ratio s. To obta in a bell er
sellSc or Ihis
intu itiol l, Tahl e 2.6 presenL~ vari
ance I'alios fol' Ihe relul 'lls of
sil.eSO/'l('(l
porl foVo s. We com pute wcekly
retu rns for live sizeSOrice! pOrl
f()lio
s from
Ihe Cl~)P NYSEAMEX daily relU
/'llS file. Stoc ks wilh reili ms f()J'
any give n
wcek ;ll'e assig lled to port folio s
base d on whic h <[llilftile thei r
begi nllil fgof~year"/Ilarket capi taliz atiol
l belo lfgs to. The pOr lfoli m are
equa lwe ight ed
and ha.\.e a chan ging com posi tion
Y Pane l A ofT ahle 2.6 repo rts
the resu lts
for the, port folio of Sill all firm s
(Iil'sl quin tilc) , pane l B repo rts
the rcw lts
for the;p ortfo lio of med ium size
finm (thir d Cfuinlile), alfd pane
l C r('po lls
the resu lts for the port folio ofla
rgc linn s (fift h quin lile) .
EI'(dcllC(' agai nst the rand olll walk
hypo thes is for Ihe port folio of
COIUpani cs ~n the slllall('st <]Uilllile is
siro llg f()!' the ('nli re sam ple and
for
b011t
sllhs,UI~l'lcs: ill pane l A alltl
te '1,'('1) Slalistics arc well abov e
the :)% niti ral
I'allll' or 1.!J6, rang ing frolll 1.li7
10 10.71. The l'<lri;IlICC ratio \ are
all grea ter
.... ;\\'c t,ll .. o f't'rlo l"llit'd our
1t'~I~ U\llIg \.dlll" weig hted pOlll l}lio\ ,tlHI
ohl.li llcd ('~"(IIII.lih
Ihe "".1I11t.' I(,!'ouil.'i. The only
dillt' n'll( (' ,IPPC;U"!\' III lilt,
LlIgr. 'i( qllill liie (If the \';liu(
portlolio~ lor which tht' r.uuio
',wciglllt'cI
lH w.tlk laypotile!loi!\ W;I~ gt'IH'
I.tll)' not l"C.'jc.'ftnl. This.
is not !FIll. pi i!\oil\~. Kivt'll that
01 fOIl!. \t',
the.'
tilC'
\'.1 II It'
71
Table 2.6.
NliJIlh"r
of has"
ohservations
NlIIlIl)('r
I{
1111
ralio
I(i
l,ti9:1
H4H
H47
I.:{:I
(7.1:1)'
1.:14
(:1.47)*
U7
(4.67)*
1.77
(9.42)*
1.7(;
(7.:t1)*
I. 7~J
(f).\J 1)*
2.24
( 10.74)*
2.'!.'!.
(H.O::I)*
2.22
(Ul!I) *
2Ati
(9.:1:\)*
2.4fi
(G.Y7)*
2.49
(6.60)*
I 2:27
1,695
I 07H: 10:0:'1
H4H
H47
li~:07:
1.20
(4.25)*
1.21
(:1.2:,)*
1.19
(2.7~)*
I.:{!J
(4.H5)*
1.4:1
(4.0:{)*
1.:1:'1
('2.71)*
1.59
(5.16)*
1.66
(4.27)*
1.41
(2.6:1)*
1.65
(4.17)*
1.79
(3.67)*
1.47
(2.14)*
1#):,
H4H
H47
I.(H;
(1.71 )
1.11
('2.0:)*
1.01
(0.'2')*
1.10
( 1.4ti)
1.'21
('2.1 :,) *
1.00
(!.Of, )
10
1.14
(UH)
1.:10
('2.1'2)*
O.'/H
(0.1:1)
pOI,rolin,.
1.I1
(0.76)
l.3'2
( 1.59)
O.\J'!.
({HI)
Blain rows, with ht"tt"ro~kl"d.l:.licily("Ollsislt'nt te:.( statist irs "'.(q) Kiven ill
illlllU.:didtdy ht'luw cach lnalll l"tn\'. Ullder lht' f.llltioill \\r~llk Hull hYPOlh~sis. the
\";1111(' 01 Iht" \',IIj;IIlCt' ratio is one and the.' le.'M st~ltiMin, h~\\l' ~\ ~\~\1Hl"lI"tl lloJ'lllal ciiMrihutioll
p.lrcllIlil'st':o.
a_'Ylllpl(Jlic;dly_ T(':\1 :\t"ti~ti("s lII.uked with ;.1Mt"rbks indicate tllat tilt, (orrt'spondinH varid.nre
r;ttiu:\
,1I"e
ll\'lT
TIll' rl'snlls lill' sitl'hased pOr\lillios art' gem'rally ('ollsislelll ",illl those
fi/!' Ihl' Illarkel indexes: varian('e ralios an' gcnerally grealer than onl' and
increasing in ", implying posilil'e serial corrdalion in IIIl1lriperiod r('llIms,
sial iSI il'ally sign i fici III Ii n' pori Ii II ios
all 1>111 IhI' largl'sl ('ompa \l it'S, .\IId
1l10re sigllili('anl during Ihe lirsl Iialf of Ihe sampll' period Ihan IiiI' S(,(,OIlc!
half.
or
Illditlit/llul SI'I'//lili",1
Ilavillg shown that Ihe rallc\olll walk hypothesis is in('onsistellt wilh th(' behavior of the equalweighted index and portlillios of Sill. tll .l1\d IlIcdiulllsi/,t'
('ompanil's, 1\'1' 1I0W IIIJ'IIIO Iht, cast' orin<iividual sc(urily rl'lurns, Table '2,7
l'I'por\s till' l'I'ossse('\iollal al't'l'agt' or till' variam'c ratios of individll'll siocks
Ihat have compicll' 1'1' \II I'll Iiislories ill the eRSP datahasl' 1(lr our t'llIirl'
I ,1i9:1W(,l'k salllph'()('riod, a sample of 111 companies, Panel/\. contains Ihl'
crosssl'ftional al'l'r;lgc or thl' variance ratios of the 411 siocks, as well ;IS of
Ihl' 100 slIIallcsl, 100 in\('rt\\('t!ia\(', and 100 largl'sl sto('ks,~H ClOssseClional
slanllaul deviations arc gi"I'n in parl'nlheses helow Ill(' lIIain rows, SinCl' IIil'
variancl' ralios an' ('1t:11'ly 11IIt lTOsssc('\ion.llly int\cpl'Ilt\I'llt, these s!;\lHbnl
dl'l'iatillns ('allliol 1)(' IIsed 10 lill'llI Ihl' IIslial tests of signilic;)IIC1'IIII'\' art'
reported ollly til provide sO\lle illdi('alioll of thc ITOS,,,'(tiOIl'11 di'IH'1 ,ioll
of the varialll'(' ratios,
The averagl' variall(,(, ralio wilh q='!. is O,~l(i ror Ihl' 411 illC\ividllal '('('11rities, implyillg that there is lIegatil't' sl'l'ial COlTcblion on al'nag(', For .111
siocks, Ihe averagc ~nial cOlTdalioll is 4';;" and :1% lill' tIll' slllalll'si 100
stocks, IloWI'I'I'l', Ihl' sl'Iial correlation is hoth stalislically and I'cOIHlIllirallv
insignificant and prlll'ides lillie ('vidcncc <I){ainst the randoll\ walk 1I:'P0tll('sis, For exalll!'\(', till' largcst avnagc I/I'(q) statistic oVC'r all slock~ ocelilS
ror 1]=4 and is (I.~lO (willi a crosss('('\ional standard deviation or I, I~l); l!il'
/;lr!!;CSI al't'I'age 1/"(11) lill' rill' 100 smallest stocks is 1.(;7 (fill' ,/='2, \\'iill a
(')'osssenional standard dl'viation or 1,7:1), Thl'sc rcstllts are ('ollSislCIII "'illl
Frcnch and Roll's (1IJH(i) linding that daily retmlls or individ\lal st'cmili('s
are slightly negativcly alilocOlTelalt'l1.
For ('ollljMrison, panl'! B rl'ports the variance ratio or el]lIal alld l';lItWweighted portlillios of Ihe 411 s('('Ilrilies, The rcslllts are cOnSiSIl'1I1 ",ith
Ihos\' in Tallies :U') allrl '2.1;: sigllili('anl posilivl' allll)('olTcialioll for 111(' 1''1l1al\\'I'i!!;hl('d porlf lio, alld alll()(,()ITciali()1I d()se 10 I,ITO {ill'lhe v.III1I'\\'I'ighl('d
pOll" Ilio,
ThOlt IIII' 1'\'1 II I'IIs ()J' illdivid \1.11 sec lIIi t iI'S have stat isti('ally i nsign i lieOlIl I 01\1IO(,Of'lT\arioll is nol slIrprising, Illdividllal retllrns conlaill nllich f(lIlIpalll'spI'cili(' or idim)'/In/llir noise tll.llmOlkl's il diflictlllio Ilttl'('\ Ihl' Pl'l'SI'lllT (If
prcdicraJ.1c ('OIIlP"III'II", Sillcl' IIII' idiosyntTatic lIoise is largely alll'III1;II('1I
Table 2.7.
:'umbcr
Sample
nq of base
observations
16
1.695
0.96
(0.04)
0.92
(0.07)
0.89
(0.11 )
0.85
(0. (4)
Small stocks
(100 stocks)
Medium stocks
(100 stoc ks)
Large stocks
(l00 stocks)
1,695
0.95
(0.06)
0.96
0.90
(0.09)
0.93
(0.07)
0.91
(0.06)
0.88
(0.12)
0.90
(0.09)
0.89
(0.11)
0.85
(0.15)
0.B5
0.86
(015)
1.29
(1.99)
1.695
(0.04)
l.fi95
0.95
(0.03)
(0.13)
1,695
/.11
(2.75)*
1.20
(2.83)"
1.30
(2.88)'
Valueweighted portfolio
(411 stocks)
1,695
0.99
(0.26)
0.97
(0.43)
0.96
(0.12)
0.93
(0.53)
Means of variance ratios over all individual securities with complete reCum histories during the sample period from July 10.
1962 to December 27, 1994 (411 stocks). Means of variance ratios for the smallest 100 stocks. the intermediate 100 MOCks.
and the largest 100 stocks are also reported. For purposes of comparison. panel B reporu the ,,,riance ratios for equal and
valueweighted portfolios, respectivdy. of the ~ II stocks. Parenthetical entries for average, of indi\idual securities (panel A)
ar~ ~tandard dniauons of the cros.s section of variance ratios. &cau't' lhe ":Jriance ratios are not cro~~ctionall}' independent. the sI.1ndard deviation cannot be used to perform the usual si>:nificance tests; they are reported onl)' to pro\ide an
indication of Ihe ,,,riance ratios' cro.'>Hectional di.'persion. Parenth~ticaJ entries for portfolio \"riance ratio, (panel B) are
the heteroskedasticil)'<omistent ""(9) ~~siic,. A..ti:'n.L:..rndlc;iI~\'i'rlii\cE"ra1.ionhal are statistically'different from I at the
5% levd of significance.
74
2.
'J'III'
by forming portfoli os, we wOlild expect to IIIICOVCl ' the predicta hle .IJltl'/lU/t
i,
compon ellt more readily wh('l1 securitie s arc cOlllbin ed. Neverth
eless. tht'
weak negative autocor rclatioll s ofthe individu al securitie s arc
an intnesti ng
contrast to the stronge r positive ".\lIt()(.:orrd;ltion of the por'th)li
o returns.
2.8.3 Cros5A lltO(ondl ltiullJ
not ""
I Cov[ Hmt  I II mt J
'
= Cov
rL;::; 'tv
L'Rt]
L'R t _ 1
=:
LT(I)L
N~
(~.H.2)
,Umt 
I,
U,.II
\, ar! fl,.,]
LT(I)
LT(O)
LT(!)
tr(1'(I))
 +  .
LT(O) L
LT(O) L
L 
11'(1'(1
('nu)
where 11'(') is the trrt(l'opc ralo)' which SIIIIlS the diagoll;t1 entries
ofils s<ju;I)'('malrix argulJle nt. The first 11'1111 of Ihe ri~hl side of (2.H.3)
(olliain s only
(A 1) illi IlIJ(h' 101 IIl1l.lIlI)lI.11 ~illll'lH Ily. ~ill( (' jOint ("O\'~II i.1I1n~t~ul
olI.1I ily .11.
to t"iimill.Ht' til1le:IIH'ext:~ 110m popul.ltio IlIllOI1ll'Il l\ such ~lS}i. awl r(kL
the qll~\hl.tli\'t
tt'dt\lrl'~ of our rt."sU'L\ win not (hange ulHlt'r the
weakt"f a.'i~uJllplion~ of weak.ly dqH.'n<il"JlI
htttrn~t'nt."\)U~\)' dis\ribut('"c.\ \'ertor~ HI' This would
IHt'rdy reqllire replacing lxfW(tJtion."
wilh II r~'p()l\di!lK probabilit y !imiL\ or"lit"bly ,ktilll,llil
llt'",, .... /l,s. Sl'~ 1.0 ;\111\ M.l<Killby
:.... , t\1i\lllllpti oll
lnw.,
\I,
1~'/11I,i1i((jl
2.8. Rnm/
Tablr 2.8.
II"
(I."''
H"
O.!l:1H
O.H!)':.!
O.H:1\)
0.7'2H
H:lI
111
11."
nil
II,.,
N~I_'
11:11 
Il;i\
I~,,\
/(~,~
n,,_~
/{1I . l
Ilr.,_~
U: I/ . ,
1l;'.4
I~.,_,
fI.
"
0.171
O.IK':.!
0.1\17
0.201
0.IK7
[{"
0.11:;
O.I':.!\)
0.147
0.1:;3
0.147
H.W,li
H.\) 14
H.\lti I
1.000
Ilr"
00")
o.o:n
0.0:,:1
0.059
0.057
11:"
Il;,
I~"
0.141
0.1:15
0.121
n.OK4
0.tl:1':.!
O.O':.!\)
0.0:12
0.02K
0.111 ':.!
0.010
'0.005
0.006
0.016
C""
0.141
n.14:1
0.1:17
O.I':.!O
[I,~,,
1l.~)H
on")
0.0:,7
O.O!) I
0.0:,1
O.lHli
0.02:;
C
flit
14
tl.W)t;
0.9\4
0.\17\)
I.oo(l
o. \Hi I
Nli
N~,_,\
11,,4
0.\).\1
1.(lOO
0.97 1 )
O.OK\)
0.07K
0.07\)
0.071
0.04:,
I55
11."_,,
1l.~)7ti
0.~)7ti
1/,.,
/III
/(,,_:1
Il;,_,
//'.,:1
[{II
O.H:\~)
0.3:10
O.3':.!4
0.310
0.':.!ti5
/("
Y"
f(.\,
O.HI)~
O.':.!':.!li
0.':.!:1':.!
0.':.!44
0.'242
O.':.!2:1
N,,_~
U::!I
II~,
C'"
/IO,.(/oli(l rf'/unu.
1).lnH
1.\lOIl
/("
11,, \
Y\
75
Hl'itimfr
rIO'
OJl97
U.UY!'!
0.100
0.094
lIu
11.1,
[1,4,
O.IOli
I>.lOO
0.105
0.\04
O.0\)3
0.o7l
0.071
0.077
0.07\)
0.074
Il.W,O
1),0:,0
0.0:,8
O.Olll
0.061
flll
/(,,,
0.063
0.062
II.I)(iO
O.Oti7
0.Oli4
0.0:16
O.O:lti
0.033
O.O:l\)
O.03H
n"
0.016
0.017
lUll :,
0.023
0.025
Iun<l)
I~.,
127 )
<1'
O.\l:\I
0.03Y
0.044
0.047
Ilr.,
<10<>7
0.006 )
11.011
11.004
0.001
I cOllt;lius
Ut/~EI(X'_'I'J(X'I')')Dt/~
llC('lIJlht 'J':n. I!J!H (1.(i!J:.ob, nV'dlioJlS ). Notelh'd ll(k) '"
correlatio ll hetweenll ll_1t dnd
\\'I1t"l"e D == cliag(o: . .... 0::); thus tht (i. j)th element is tht:"
Jatiolls under all Ill) lluB hypothesi~ are given
/(,1. A";YllIptotic stalldanl errurs for the alHo("orre
h\'
I/./'T
= O.O:!4.
anccs. If
crossau toco\,ar iances and the secolld term ollly the OIvllau tocovari
ariance
autocov
index
and
,
ncgative
y
generall
are
ances
ocovari
the ownaut
er. the
Moreov
.
is positive, thell the cr05sau tocovari ances must bc positive
of the
sum
the
exceed
to
as
large
so
cross'<lutocovariances must be large,
.
ances
tocovari
oWIlall
n(~gative
,rr,;)
Table 2.9.
Y(I)  Y'(I)
II,
HI
fir,
0.104
0.153
0.19:)
0.241
C"""
HI
III
R2
R,
f4
f~
(""00
0.052
0.079
0.OH9
(1.094
HI
YCI)  Y'(3)
HI
U2
R,
U4
1Ir,
(00"0
(l.03S
0.069
0.087
(l.093
HI
II,
112
Y(4)  Y'(4)
U,
f4
fir,
COOO
0.033
0.059
0.084
0.102
/I~
I~
0.104
0.000
0'{)61
0.113
O.IHI
II,
0.153
0.061
0.000
0.0:,4
0.134
R..
0.195
0.113
0.054
0.000
0.088
/12
0.052
0.000
(l.029
0.042
0.0:)5
H,
0.079
0.029
0.000
0.014
0.029
R..
0.089
0.042
(1.014
(1.0(10
0.018
0.035
0.000
O.O:H
0.054
0.062
H,
0.069
0.024
0.000
0.022
0.035
0.OH7
0.054
0.022
(),(l00
0.018
/12
0.033
0.000
0.024
0.050
0.070
H,
0.059
0.024
0.000
0.023
0.049
R..
llo
0.084
0.050
0.023
0.000
0.030
OJ02)
/I~
R..
02<1 )
0.11l1
0.134
0.088
0.000
llo
om,)
(l.O55
0.029
O.UIH
0.000
Il"
O@')
0.062
0.035
0.018
0.000
0.070
0.049
0.030
0.000
Diflcrenccs between autocorrelation matrices and their transposes for the v("Clor of !izeX,  I III, II~, II" 11." /lo, J' where Fl., is Ihe week, retUrn on
Ihe e'l"alweighled portfolio of .rocks in Ihe ilh qllintile, i= I, ... ,5 (quintile 1 contains Ihe
smallcst 'lOeb), for Ihe sample of NYSEAMEX stocb from July 10, 1962 10 December 27,
1994 (I,W!l' ohservalions). NOle Ihal Y(k) = O1/ 2 EI(X,_.  jl)(X,  I,)')D I/', where
D 0= di'I~la~, ... ,a~;J.
7M
2. Till' Pre dirl abi lily 'if
An l'i
lll'i llrl ll
No wh ere is it reCJuired
th~tt the sto rk ma
rke t ove rre act s, i.e.,
vid ual ret urn s arc neg
(ha t ind iativ elv aut oco rr( 'lat ed.
Th
ere for e, the fan tha t
cO lltr ari all str ate gie s
son ic
h;I\"(' jlositive exp ect
ed pro Jits lIe ed not
ma rke t ove rre act iol l.
ilil
ply
sto
ck
In f~lIl, for the par tic
ula r con tra ria n strat('h
and Ma cK in lay (19!Hk
,)' tha t 1.0
) eX~lInine, ov er hal f
of the exp ect ed pro
to cro ss eff ect s and no
lils is du e
t 10 lIe gal ive aut oco
rre lat ion in ind ivi dua
ret urn s.
l s'T llri ty
Th ese cro ss eff ect s In,l
), ;1\sO exp lai n til(' app
are llt pro fita bil ity ofs
oth er tra din g str ate gie
l'v('f;11
s tha t hav e rec ent ly bec
oil le po pu lar in the
(om lnu nit )'. Fo r exa
fin anc ial
mp le, IUII!!,/slwrl or
IIltL rkl' ll/l 'lllm l str ate
lon'f, pos itio ns arc off
gie s in wh ich
set dol lar fo Hlo lla r by
sho rt pos itio ns GU I ear
reu frn s in exa ctly the
n snp eri or
bsh ion des cri bed abo
ve, des pit e the f~tClt
des ign ed to tak e adv ant
hal
llley arc
age of ow nc llc us, i.e"
pos itiv e an d neg ;lli ve
ofi ,)d ivi dua l sec uri tie
fon 'l'a sh
s' ('x p(' dn l ret urn s.
Th e per for ma nce of
or pai n tra din g str ate
/lIIIII'II/'d/mok
gie s '~1I1 als o 1)(' alt l'ib
llle d 10 cro ss cll ecb
owncfrecls.
as well as
.
i\lt ho ug h sev era l slu di(
,s ha\'(' all l'lI Ipt ed to
exp lai n the se slr iki ng
lag qft e(\ s (se e, for exa
Ica dmp le, Ha dri nal h, Ka
le, and No e [1! '!': Ij,
Rich1anlson, am i Wh
Bo ud ou ldl ,
itel aw lI9!141. Jeg ade
esh and Swamin~ttll<lll
Co nl'a d, Kalil, and Nil
[I !'!':I!.
lla len dra n [19 !1l ], Hr
enn an, Jeg adc esh , and
nal h\m [19 93] . Jeg ade
Sw;uniesh and Tit ma n [19
%] , and Me ch [1!1!l:1
stilll~tr fro m hav ing
lJ, w!' arc
a com ple te un der sta
nd illg of the ir nat ure
\
all d SO IIlT "S.
\I
79
slIiJslalltiaIIlH'allrev<Tsion in stock Inarkel priccs at long<'f horizon
s, which
llll:)' :llirilllll e lo the presenc e of a "Iramito ry" compol lent such
as the y,
C()lllpOIICnl ill (~.5.1).
There is, however , good reasoll to hc wary of slich illlC:rellces when
they
arc based Oil longho rizon returns. Perhaps the most obvious concern
is the
extreme ly small sample size: Frolll I ~J~(i to I ~JH:), there arc ollly
1~ nonover lapping fiveyear rei urns. While overlap ping returns do provide
sOllie illnc!llenlal illfoJ'lJlalioll, the results ill I\oudou kh and Richard soll
(1994), 1.0
allri MacKin lay (19H9), Richard soll :u1<1 Smith (19~J I), and Richard
son and
Stock (I9H9) suggest that this increme nt is lIIodest at hest and
mislead ing
:11 worst. In p:lI'licuiar, Richard soll alld Stock (I~JWJ)
propose all aSYlllptotic
approxi lllation which caplure s th(: spiril ofoveri apping longho
rizon return
c;J!cula tionsth ey allow the return horizon '/ to in<Tease with
the s<lmplc
size T so that '/1 T converg es to a fillite vahle 8 IlCtween zero
and onewhich shows that variance ratios call be severely biased when
the return
hori/.oll is a sigllific allt fractioll of the total sample period.
For exampl e,
.Ising thei r aSYlllptotic approxi matioll (~.5.IO), discusse d ill Section
2.5.1,
Ih,' expecte d vahle f()r the variallce r:llio with overlap pillg returns
is given
by 12.5.1~) under RW I. This express ion illq>lies that with
a return horil,on
of % 1Il0nths alld a sample period o/" (iO years, o=Hj(iO =O.133
hence the expeeled variance ratio is (I 8 )2=0.7:> I , despite IIIC fact thal RW
I is assulJle d
to nol<l. Under RW2 alld RW3, even more dralllati
c hiases can occur (see,
fo, exam pie, ROlllano and Thom hs [ I ~J9(i 1),
These difficult ies arc reflecte d in the llIagnitu des of the standar
d elTOI'S
associat ed with longhoI"izon return :lutocor relation s and variance
ratios
(~(T, f(>r exallipl e, Richard soll alld Stock (19WJ,
'Elhk! ), which are typically
so large dS to yield zstatistics close to l('l"O regardle ss of the point
estimate s.
Richard son (199:1) and Richard son and Stock (19H~J) show that
properly
adjustin g 1'01' the Slllall salllple sizes, alld for otl)('~' statistic al issues
associat ed
Wilh 10nghoriLol1 returns, reverses many of the inferenc es
of Fama and
French (I9HHb) and I'oterba and SUlIlme rs (I YHH).
Moreov er, the point estimate s of autocor relation coeffici enlS and
other
time series parallle ters tend to exhibit conside rable samplin g
variatio n for
longho rizon returns. For exampl e, silllple hi:ls a<\justm enlS
can change
the signs of the autocor relation s, as Killl, Nelson, and Startz
(19HH) and
Richard son and Stock (I9H9) demons trate. This is not surprisi
ng given the
extreme ly slIlall sample sizes that longho rilOn returns produce
(sec, for
example , the lIlagnitu de of the bias adjllsln) ('nls in Section 2.4.1).
Finally, Kin), Nelson, and Stanl (PIHH) sholl' Ihallhe IIcg:llive serial
cor~
Icbtion ill longho rizon returns is ('xtrelllc ly sensitivc to the saJllple
period
and lIIay hc largely dlle to the first tell years of lhe I ~J~(; to
19H5 salllple.
Althoug h ten years is a very signific ant portion of the data anci
cannot be
exclude d withollt careful considc ration, Ileverth eless il is trollhlin
g thaI the
lH
2.3 Characterize the set of all twostate Markov chains (2.2.9) that do not
satisfy RWI and for which the CJ statistic is one. What are the general properties of such Markov chains, e.g .. no they generate sequences, reversals.
etc.?
2.4 Derive (2.4. I 9) for processes with stationary increments. Why do the
weights decline linearly? Using this expression. construct examples;ofnonrandomwalk processes for which the variance ratio test has very low power.
2.5 Using daily ami monthly returns data for ten individual stocks imd the
equal and valueweighted CR.',!' market indexes (EWRETD and VW1lliTD).
perform the following statistical analysis using any statistical package;ofyour
choice. Note that some of the stocks do not have complete return histories.
so be sure to lise only valid observations. Also. for subsample analys~s, split
,
the available observations into equal subsamples.
a.
2.5.1 Compute the sample mean i<. standard deviation and firstorcier
autocorrelation coefficient p(l) for daily simple returns over the entire
1962 to 1994 sample period for the ten stocks and the two innexes. Split
the sample into four equal subperiods and compute the same statistics in
each subperiodare they stable over time?
a.
2.5.2 Compute the sample mean il, standard deviation and first()rder
autocorrelation c"efficient p(l) for continuously compounded daily returns over the entire 1962 to 1991 period, and for each of the four equal
subperiods. Compare these to the results for simple returns<an continuous compounding change inferences substantially?
2.5.3 Plot histograms of daily simple returns for VWRETD and EWRETD
over the entire 1962 to 1994 sample period. Plot another histogram
of the normal distribution with mean and variance equal to the sample
mean and variance of the returns plotted in the first histograms. Do daily
simple returns look approximately normal? Which looks closer to normal: VWRETD or EWRETD? Perform the same analysis for continuously
compounded daily returns and compare these results to those for simple
returns.
2.5.4 Using daily simple returns for the entire 1962 to 1994 sample period. construct 99% confidence intervals for [L for VWREtD. EWRETD.
and the ten individual stock return series. Divide the sample into fOllr
equal subperiods and construct 99% confidence intervals in each of the
four subperiods for the twelve serics{io they shift a great deal?
2.5.5 Compute the skewness, kurtosis, and studentized range of daily
simple returns of VWRETD , EWRETD, and the ten individual stocks over
the entire 1962 to J ~1(11 sample period, and in each of the four equal
82
subperio ds. Which of thc skewncss, kurtosis, and sllldent ized ran~e
estiIljates are statistically differen t from the skcwness, kurtosis, and
s!tll!entifecl range ofa norma! random variable at thc 5% level? For these
twelve
s(/rics, perform thc samc calculat ions using monthly data. What
do YOll
c911c1ude about thc normali ty of these rClllrn serics, alld why?
3
Market Microstructure
the case that sOllie features of the data will bc lost in the
process of modeling economic phenomena, determining which features
to focus 011 requires some care and judgmcnt. III exploring the dynamic
pmpcrties of financial asset prices ill Chapter 2, we have taken prices and
returns as the principal objects of interest without explicit reference to the
institutional structures in which they arc determined. We have ignored
thc fan that security prices arc generally denominated ill fixed increments,
typically eighths of a dollar or tirks for stock prices. Also, securitics do not
tra(ic at evenly spaced intervals throughout the day, and on sOllle days they
dOllol trade at all. Indeed, the very process of Ira ding can have an important
;llIpact 011 the statistical properties of financial asset priccs: In markets with
designated lIlarketmakers, the cxistence of a J!nmd betwcclI the price at
which the marketmaker is willing to buy (the bid price) and the price at
which the markctmaker is willing to sell (the oJJ/'( or as" price) can have a
llontrivial impact on the serial correlation of price changes.
For some purposcs, such aspects of thc market's micTOstructure can be
safely ignorcd, particularly when longcr investmcnt horizons arc involved.
For example, it is ulllikely that bidask bounce (to he de filled in Section
:~.~) is responsiblc for the negative autocorrelation in the fiveyear returns
of US stock indcxes such as the Standard and Poor's ;)00, t even though
the existellce of a bidask spread c10es induce negative autocorrelation in
returns (see Section :{.2.1).
Ilowever, for other purposesthe measurement of execution costs and
Ilurket liquidity, thc comparison of allernative lIIarkelmaking mechanisms,
the impact of competition and thl' potelltial li'r collusioll among marketmakcrsmarkct microstructure is central. Indeed, market Illicrostructure
is IlOW olle of the most active research areas in {'COllOlllics and finance, spanISt:~ ~c((iOIl ~.!) ill Ch"pl~r:1 "nd Section 7.2.1 ill Ch"PI'" 7 lor ""lher <li,ells.;iun (If
IOlll{horil.oll rc:tllrll.~.
".1(
( I II~I,I) ,
lIlIlil li 11
".10;),
J.1.
HUII'YIIUIIUIWIO I/llUlIlg
~S.... , for .. xample, ('.ohell, Haw'"wini, Maier, Schwaru, and Whitcomb (1983a, b), Dimson
(1~)7~1),
q'~:' .,
B6i
3. Markel Mirroslmrlu/'r
~hiS
Therefore~
in
model).5
this nontrading process can be viewed as all
IlQ sequence of coin tosses," with different nontrading probabilities across
sec~rities. By allowing crosssectional dificrcnces ill thc random IIOIlII
ingi processes, we shall bc able to capture the effects of 1l01ltratiil1).! "
ret~lrns of portfolios of securities.
iThe observed return of security i, fj~' depends 011 whether s('cmil), i trades
in ~eriQ(l/: Ifsecurity i does nottradc in pcriod t, let its obsCl'ved retllrll be
zcnr,ifno trades occur, then the closing price is set to thc prcvious period's
el0tin g price, and hence ri~ = log(jJI///Jjt_l) = log 1 = 0, II', on the other
han ,security i docs trade in period I, let its observed return be the SIIlIl of
the I irtual returns in period I and in all prior r01l5eculiue periods in which i
did ;not trade,
'For example, consider a sequence of five consecutivc periods in which
security j trades in periods I, 2, and 5, and docs not trade ill periods 3 and
4, The above nontrading mechanism implies that: the observed return in
period 2 issimply the virtual return (T,2 = Tj2); the observed returns ill period
3 and 4 arc both zero (Ti~~ = Tj1 = 0); and the observed return ill period !i
is the sum of the virtual returns from periods 3 to 5 (f,~, = T,~ + f,4 + f ,).7
"
This captures the essential feature of nontrading as a source of spurious
autocorrelation: News affects those stocks that trade more freqnently first
and influences the returns of more thinly traded securities with a lag, III this
framework the impact of news 011 returns is captured by the vi"tllal retllrtJ~
process and the impact of the lag induced by lIontrading is captured hy the
ohserved returns process f,~,
To complete the specification of this nontrading model, slIppose that
virtual returns are governed hy a onefactor linear model:
rll
/1,
+ fJ,/t + E,t
I, .. ,' N
CU.I)
with the spirit or the n01111"1uling a:\ it killd of 1I1(';IStll"t'UlerH error. In tlU" IJlt ... (lIt ('
of priv4ltc informalion ant' Mratt"~ic h{'havior, trading anivily does typically dqu:nd on \'i(I\1,\\
l('l\ln\~ (~uit",bly defincd>. ;,uld ~trat{'gi(" Iradill~ COlli indllt:e ~crial correlation ill 01,'('1 \('<1
H'turm, hUl ,uch corr('lalioll fall hardly hl' ,li~1I\i",'d as 'pminus. Set' St'rlioll :I.I.~ lor
furl I..... di'Cll",ioll,
';Thi, "''llmpli<lll may he ldaxl'd 10 allow for slal""kpt'lldelll probabilities, i.t'., '"lIo( 0'rel"I('(~l()nlrading; s('e Ihe disCIl",ioll ill Section :I.I,~,
7 p, riotl I', relmn obviously depends Ull how lll<lny COllScfulive periocis prior 10 p .... io" I
Ihallh .ecurity did lIollracic. If illraded in prriod n, lh"l1 til .. period'l r(,~uIll is silllpl)' ('qu<ll
10 it' vi{lual return; if il did nOllr"d., ill perioc\ n hul dicilr,,",' in period I, lh(,l1 P"! jotl 1__
oh~'f\"'~' u'turn "11w !i.1I1l1 of 1'(,1 ioel 0\ alld 1)('1 iotl I 's \'inll.tll('turns~ (te.
il1colI~istcnr
,\
H7
(",., for all i, I, and k.x Each period's virtual retlllll is ralldom
alld capture s
m()Vl'lll ents c;lIlsed by informa tioll arriv;t1 ;IS well as idimync ratic
noise. The
p<lrticul ar lit 11111.1< ling and rclurnc umuLui oll process wc assume
capture s
til<' lag with wilicil lIews and noise is illcorpo rated illto security
prices dUl" to
illl'rcqu enllradi llg. The dynamic s oi'slIch a styli/ed lIIodel
an' surprisin gly
rich. and they yield several importa nt elllpiric al illlplicat iolls.
'IiI derive all explicit expressi oll lill' the observe d retlll'llS process
and to
d('(luCl' its tillieser ies propcrt ies wc illtrodll lT two related randolll
variable s:
8"
X,,(II)
I (no trade)
{ o (trade)
(I8i1)8i'_18/,.~
.. 8,,_.,
If,
(:\.I.:!)
I: > ()
(:1. 1.3)
r/~ =
L X"Ud 'i,.
I.,,,,N ,
(:U .4)
.~()
==
~ { ~J tI"_1 }
n,
Althoug h
I .'1) will prove to be Ilion' (,Ollvl'lIiellt IiII' suiJsequ ent ('aleulaliollS, Ii, 111<1)' be IIs('d to give a sOllu'wIi;1I 1110)'(' illtlliti\'( ' defillilio
ll of the
XTh('~(' ... Irullg ;t~."iIlIllPIi()Il~ ~ll'(' IIl.Hlc' plilll.llil}' f"l
("oll,idt'rahl),. S('(' Scnioll :\.I.~ for hlllhl'l III"
1l'1.1~(d
11\'11111.
he
........
I. .\I(/tllI'I.\li"' ...I/nIl1,m
ohs('rv('d
1I'llIrll~
procl'ss:
I,
,."
L'"
"
CU.!)
I .... N.
J.:~II
When'as (:\.1"1) shows Ihal ill Ii II' presenct' of nonlrading Iht' ohservt'd
n'llInlS procl'ss is a (siochaslic) fllllclion of till pasl ITIIII'lIS. Iht' t'C)lIi,'al('lll
rdation C\.I.li) rl'wals Ihal /';; Ilia), also ht' vit'wt'd as a ralldolll SIIIII wilh a
randolll nllllll){'r of 1I'I'lllsY
A Ihinl alld pnhaps llIost naillral way to view ohserved rt'llIrns is the
followillg:
0
rtf
1'"
'~t
,,"
+ 1'", I
I
1",1_ I
+ r,,_~
(~.1.7)
"
1 "", k
1:1 ",I
==
I  Jr ,
Varlk,l ==
Jr,
C~,I,H)
(I  Jr,)~
If Jr,== ~ IhI'li S('(,II ri Iy i gOt'S wi Ih01l1 Iradin/{ lill' olle pniod al a Iilll(, on
;1\'('1"
\1)
rq)l"('st'litalion 01 oh:\('I"\'('" 1I'llInl'. although \\'t' do 1101 rt':\trin tilt' trading lime's
in
1101.
lix('cI
lilill" illl('n,ll.
\\'itll
~tllf,lhlt, nonl1~lli/~"ioIlS il
(0
Iilkc' \';dll("~
3.1.
.vul/.\.\"lIdIlUIIUII.\
nat/iug
=0, both
(3.1.9)
/1,
t
21T;
t
0+/1
Var[r;~l
I
,
I 
11;
(3.1.10)
~;rr:
11".)11"1)
I ".",
= j,
n>O
for i =1= j,
n~O
for i
fJ fJ
(3.1.11)
1/
' J Of 1Tj
(3.1.12)
n > 0,
0/
These momenL~ also allow liS to calculate the maximal negative autocorre1'lliOll attributable to nontrading in individual security returns. Sincei the
autocorrelatioil of observed retllrns (3.1.12) is a nonpositive continuous
function of 11; that is zero at IT;=O and approaches zero as IT; approaches
unity, itlJlustattain a minimum for some IT; in [0,1). Determining (his Iqwer
bound is a straightforward exercise in calculus, and hence we calculate it
only for the firstorder alllocorrelatioll and leave the higherorder cases to
the reader.
IIITo ("OIlM'I"\'(" span'. w(" sllllIl1Iaril.t'
rt"adt"n 10
90
3. Market Miovslmrlurr
M In Corr l
Tit'
,n,1
where ~j
1=
T,I+I
 (I~il)
rn
I + v21~;1
+ ./21~,1
~i E (00, +(0),
I",,~,I
we have
I
= ;.
2
(~.I.I:)
whic I is lhe limit of (3.1.13) as 1~,1 [nneases without bound, bllt is never
allail{led by finite ~;.
Although the lower bound of  ~ seems quite significant, it is virtually
It' unattainable for any empirically plausible parameter values. For exalllple,
if we\ consider a period to he one trading day, typical values for II; and
~ (1j ar1.05% and 25%. respectively, implying a typical value or 0.02 for ~,.
t Acco 'ding to (3.1.13), this would induce. a spurious autocorrehnioll or at
It most 0.037% in individual security returns and would require a nontradillg
prob bility of97.2% to allain, which cOITesponds to an average nontradillg
~ durat on of 35.4 days!
~.
lese results also imply that nontradinginduced autocorrelation is
~ magn fied by taking longer sampling intervals since under the hypothesized irtual returns process, doubling the holding period doubles J1.; bllt
i" only
ultiplies (1; by a factor of ./2. Therefore more extreme negative alltocor elations are feasible for longerhorizon individual returns. However,
this iSlnot of direct empirical relevance since the effects of time aggregation hflve been ignored. To see how, observe that the nontrading process
(3.1.2)(3.1.3) is not independent of the sampling interval but changes in
a nonlinear fashion. For example, if a period is taken to be olle week,
Ihe possibility of daily nontrading and all iL~ cOllcomitant cffecL~ all weekly
observed returns is eliminated by assumptioll. A proper comparison or ohserved returns across distinct sampling intervals must allow for lion tra<ii 11 14 at
the linest time increment, after which the implications for coarsersampled
returns may be developed. We shall postponc further discussion of this and
olher isslles of time aggrcgation ulltillatcr ill this sectioll.
J. l.
!11
NUIIS.yndlHJ/UIll.I 'J/1UliIlK
Ii';
alld
r;;+11
for allY
H>
st~curily
weighted average ofal! past virtllal retllrns r,I+/I_' (with the Xil~lI(k)'s as random weights), of which one lerm will he the l"llncnt virtual returll 1',1' Since
the cOlltemporaneous virtual returlls 1"" and 'l ' ;Ire UIITl'iatl'ti (beGl\lse of
the common factor). 1':; can forecast ';;4 /I' IloIVevcl", ,.;; is itself unforecastablc
bccallse 1';; = Ti' for all t (since 7r, = 0) ,Illt! r,l is II!) by assumption. thus Ij';
is uncolTdatcd with ";;+11 for any 11 > n.
The aSyllllllcll)' of (3.1.11) yields all empirically testahle restriction on
the crosS;l\llOcovariallces of returns. Since the only source of asymmetry
ill (:\.1.11) is crossscClional differences in the probabilities of Ilolllrading,
:nforlll<ltion regarding thcsc probabilities ilia), be extracted from sample
moments. Spccifically, denotc b), r;' the vector [ 1';', 'J, ... r~1 J' of ohscrvc(\
r('.urns of the N securitics and define the <Il1toc()vari<lnce lIIatrix I'll as
IL "= E[ r;'I.
Dellotillg !l,e (i,j)th clelllellt of 1'/1 hy
Y,,(ll) =
Y'j(II),
(I  lli)( I  ll,)
Ill,ll,
we
h,IVl'
OU.Hi)
hy defillition
(:1.1.17)
"
Ir Ihe lion trading probabilities ll, differ across securities, 1'/1 is asymmetric.
From (3.1.17) il is cvidel1llhat
(3.1.18)
II :\11 ;thCIII.lliv(' illtcrprct;lIioll or Ihis ;ISYIlIIHt'll y 111;1)' he 101ilid ill IIII' ,illH"~s("l if'S literaluu'
cOlln"rlling Cr~lIlgt'r. <:allsality (!\ee (;rangl'r II!Jh~)j}. ill whirl, ,;; IS :."id 10 (;ranK"((IIL" r;; if
Ihe relllrn to i predicts Ihe retllrn to j. III lilt, ,,,hove.' example, s{'("urily i (;'flnK"<m.Hr.~ ~cllriry
j when j is s\l\~jc(t to nontrading but i is noL Sillce our HOlllTddillg prO(Ts..~ fUlly he vi{"w{"d a.1Ii.
(\ form of \lll'a:o\l1Tllwllt error, Ihe taCi Ihal Ih(' I"('11II1I."i 10 ollc "i('('111 i1r III;')' he l'xogellotl.,\ wirh
l'e:opeC't to
1~)77).
the
;I
(I!J71,
{I,
h.
where the summatio/l is over all securities i in the set of indices I, whirl,
t'omprist' pmtli)lio 1<. Tht' rl';lson (:\.I,19) is 1l0lexaCI is th;\! hoth o\)seryt'c\
and virtual retllms art' assumed to he continuously compounded, and tht'
logarithm of a sum is 1101 the sum of the logarithms. 12 Ilowever, if r:; t;lkt's
Oil slIIall vahlt,s allll is 1I0t too volatileplausihle ,lssumptiollS for the shm I
returt! int!'l'vals thaI /lollsYllchrollous trading models typically focus 011'
the approximatioll !'I'ror ill (:\,I,19) is IIl'gligible,
The timl'seril's properlies of (:{.1.19) may be derived from a Sill'l,l,'
asymptotic approximation that exploits the crosssectiollal ill<iepl'llt\cIl(,('
"fill<' dislllrhall('t's f". Similar asymplolic argulIll'lIlS ("all 1)(' /ClIlIle! ill lIlt'
Arhitrage I'ricillg Theory (APT) literature (see Chapter Ii); hellce ollr as
sUlllption of illdept'lltlcllcl' lIIay ht, rt'laxt~rl to the same extent that it lIIay
he relaxed i/l studies of the APT in which portfolios are rcquired to he
"welldiversifil'd,"I'\ 1/1 sud. caSt'S, as the numher of securities in portfolios
A alld JJ (delloted hy N" alld N,,, respectively) intTeases without h'lUlld, the
'(Illowillg equalities ohtain almost surely:
00
LlT:frk,
('I.I~()
k=O
where
CU~I)
i,,'
I:!.\ PIC"
i'
all 11I1'\'C'lghh'd g"UIIH'lIil' ;I\'('lagt' 411 tht' ("(HIlPOllt'JH St.'flilitits' prin's, TIH' t'Xp('r!I'cI n'lllIll
~\\fh .., pontuhu \\,m ht 10\\'\'1" 1h.m ,h . " t)f .\\\ t'(}\1/,\'~wt',ghtt't\ pontnho \... hn~t' u'\urn' ~\1t'
""kulah',l ;1.' IIH' arililllu'lil tIIe'HI.' of lilt' "implt' r('turns 01 Iht (ompont'lll ~(nlrili('s. This
i",,~ is ,x;""i ..... t ill ~n';""1 d",,,il hv Mod.,s' ;"HI Sll,,,\;ort's,," (1'lH:I) ;"I<tl\,,," alltl I Lorl''''
(I~JHh) III tilt' ("01111",\1 01 liu' \'"hlC' l.illl' Indt'x whid. Wtl" all lIlIWI'ighlt'd g('olllc'lrir an'l ;I~(I
01"
IIlllii I~'HH.
(I!II.I:\). Th('
ht, applic'd
In
('."C'II( t'
IIII'
;1\'c'l;tgl' III
"'11'1111
gun\,.
II",
almo",
\111 (,1\'
E[r:/ ]
Var[r:/l
Cov[r:1' r: lh 1
Corr[r:l r:l+ n)
= E[r./]
11.
2C]'(')a~
ft.
a
(3.1.22)
1 +]'(.
(3.1.23)
C]'(.)
2
fJ.2   ]'(.n aI'
1+]'(
.!!.
7r,," ,
(l]'(a)(I]'(b)
2 n
fJafJbal ]'(b'
1 ]'(a]'(b
n ~ 0
(3.1.24)
(3.1.25)
(~.1.26)
I
where the symbol ~;;" indicates that the equality obtains only asymptotically.
From (3.1.22) we see that observed portfolio returns have the same
mean as the corresponding virtual returns. In contrast to observed i?dividual returns. the variance of 1 is lower asymptotically than the variarce of
iL~ virtual counterpart ral since
!
r:
ral
:<:::
n
1
Lril
Na lEI,
11. +
(J.It,
ie/.
(~.1.27)
II
(3.1.28)
where (3.1.28) follows from the law of large numbers applieq to tte last
term in (3.1.27). Thus Var[ rad ~ fJ;a which is greater than or equal to
Var[r: I ]
Since the nontradinginduced autocorrelation (3.1.25) declines geometrically. observed portfolio returns follow a firstorder autoregressive process with autoregressive coefficient equal to the nontrading probability. In
contrast to expression (3.1.11) for individual securities. the autocorrelations
of observed portfolio returns do not depend explicitly on the expected return of the portfolio. yielding a much simpler estimator for ]'(.: the nth
root of the nth order autocorrelation coefficient. Therefore. we may easily
estimate all nontrading probabilities by using only the sample firstorder
ownautocorrelation coefficients for the portfolio returns.
Comparing (3.1.26) to (3.U1) shows that the crossautocovariance between observed portfolio returns takes the same form as that of observed
individual returns. If there are differences across portfolios in the nontrading probabilities. the autocovariance matrix for observed portfolio returns
will be asymmetric. This may give rise to the types of leadlag relations
empirically documented by Lo and MacKinlay (1988) in sizesorted portfo
J,
!J4
J.
M(lJ"krt M;n'U.IIl'llrlll/l'
III
(rr/~
)"
n.I.:l~l)
If"
I~a{iing 1lI0del,
11011
slll~'e
I
I
==
(lflo)"

n.I.:)()
If.
for 6ny arbitrary sequence of distinct indices KI. K2 . K,. !l I b. r ::: N,,,
whdre
N" is the number or distinct )lOrti()lios and YK< I (11) == Cov[r"/. ,.u1<" ," n I.
\
II{,
Th9refore. although there arc N,; distinct autocovariances in r ll the restrictiolls implied by the nOlllrading process yield far fewer degrees of freedom.
TinT Aggregation
.
Th~discretetillle framework we have adopted so far docs not require the
specIfication of the calendar length of a "period." This advantage is more
apP'Irent than real since any empirical implementatioll of the nOll trading
mod~1 (3.1.2)(3.1.3) mllst either implicitly or explicitly define a period 10
be a panicular fixed Gllentlar lime interval. Once the calendar tillle interval
has been chosen. the stochastic behavior of coarsersampled data is rcslrict('d
by the parameters of' the most finely sampled process. For example. if the
length of a period is taken to be one day, then the rnomen L~ of observed
monthly returns may be expressed as fUllctions of the parameters or the
daily observed returns process. We derive such restrictions in this sectioll.
To do tflis, denote by li~(f{) the observed return of security i at time r
where one unit of Ttime is equivalent to q units of Ilime. tlIlIS:
'q
/=(,llq+1
E[r;,(q)]
q/l;
.)
qa;
'2 IT ;(\
IT ()
.)
+ (\ _ rrY 11;
nI.:\:\)
3. 1. NOIlJy"dmmuu.\. 'li"fUlillg
= J1~ ITII/
I
II'ill
(I I 
" > (I
(3.1.34)
I 
==
IT,
 
X(IlT?)~
where~,
rr?)~
i of
IT,
j,
1/
> 0,
I(;/Oi as hefore.
or~lO%.
"0"
"H'
~;,k('
illCltx('.\ I;lill("
"
/'/ V.
/.
~ "~
I;
In
'.If
'"
:~
,,'
'"
Nil
III
'III
;'11
"~
)'i)
'"
:f
+:
/;
'~
,
I
..
r:
"
iI
.'
I" <
j
III'
;.tI
1.11
1II,'lq.III"OI'III\
'"
'.11
111
l.u
1.1r
1I",wl,II.'MIII\'
t u
'.11'
The effects of increasing ~ are traced out in Figures 3.1 band 3.1c. Even
if we assume ~ == 0.21 for daily data, a most extreme value, the nontradinginduced autocorrelation in weekly returns is at most 8% and requires a
daily nontrading probability of over 90%. From (3.1.8) we see that when
= .90 the average duration of nontrading is nine daysl Since no security
listed on the New York or American Stock Exchanges is inalive for two
weeks (unless it has been delisted), we infer from Figure 3.1 that the impact
of nontrading for individual shorthorizon stock returns is negligible.
rrj
r:r(q) 
r:,t
(3.1.37)
1=(rl1q+l
r:,
where
is given by (3.1.19). Then under (3.1.2)(3.1.3) the obselVed
portfolio returns processes (r;, (q)) and (rb' (q)) are covariance5tationary
with the following first and second moments as N. and Nb increase without
bound:
i
a
E[ r:, (q)]
Var[r:, (q)]
Cov[r:,(q), r:,+n(q)]
(3.1:.38)
qfLK
[ 2rrK Irr!]
I_rr K 13 22
[Irr.]
[I rr!r
l+rr.lrr.
q
K al
nqq+ 1 f32
xrr
Corr[ r:,(q), r:r+ .. (q)]
[I
Cov[ T,:r(q),
(l  rr!)2 rr;qq+1
q(l 
rr;)  2rrK
(l  rr!) ,
T ,+II(q)]
".(1":)(1",)%+,,,(1":)(1"01']
(I"e)(IJf,)
IIf.",
for
==
fl,
n > 0
al ,
(IIf.)(I",)
[~]
1",
rr
nq  q+1
P.P'''t
I".If,
f3 f3 a 2
n
for
n == 0
for
n > 0
(3.1.42)
98
3. Mmlifl Minollrurllln'
Equation (3.1.40) shows thattillle a~~re~ation also affecls Ihe '1II\oCO!"relation of observed portfolio relurns in a highly nonlinear f;lshion. 111
contrast to the alltocorrelation for ti/llea!{~regated individual securities,
(3.1.40) approaches unity for any fixed I{ as 1(. approaches unity; IIIen,rol"('
the maxim,11 autocorrelation is one.
To investig.lle the behavior of the portfolio autocorrelation we plot il
as a function of the portlolio nontradin~ probability 1( in Figme :t Id Itll'
q = !i. 22. G6. and 244. Besides differing in sign. portfolio and individual autocorrclations also differ in absolute magnitude. the former heing
much larger than the bner for a givell nOll trading probability. If the nontrading phenomenon is extant. it will be most evident in portfolio returns.
Also, portfolio autocorrelations arc 1JI00IOtonically decreasing in if so titat
lillie aggregation always decreases nontradinginduced serial dependence
ill portfolio relurns. This implies thaI we .Ire lIIostlikely to lind evidcllfc of
non trading in shorthorizon returns. We exploit both these illlplicatiolls ill
Ihe empirical analysis of SeCiioli :1.4.1.
3.1. 2 l~xlensions and GPIleraliwlions
tli.'nl~.,,(d (';U1it'l, ,OIlU" Itll III (II t rO~.'~l"t licltl.tl wc.".,}.;, dCptl1thlIet 11111."1 he illlJ)('~('cl
so thai (tht' as\"tuptotic ~1I"~lltnltlt~ of the port(oliu r('suh~ s.till ubtain. of ("UUt"S(', 'l1rh ,\t\
.\X\n1l1ppUI\ In.W nn1 alw.w'\ \w ,\pplilpri.\\t, .l~. tor t',,\.ul1ph.ln the ra~p of n))npallit'~ "ilhil11lie
~.IIIW il1(lll~tly. whOM' n~id\l.tl ri~k~ W(' l1lig.ll1 ('Spt'ft 10 Ilt' pn~ilin'l~ rnrnble(t. TIlC'Itltu t, till'
.,'\1\1\,\(:\\\\' ~'ppn.,\.in\.\ti\ln ,,'ill bt' 1\\n~t .\r(\\L\~\' hn \\THi;\\\\\ ... 1tltl\ punt'oHo ....
'\\"iWt'
!I!I
tOll\orrow dqwllds 011 whellwl' 01' lIot ~I trad~' o<"nll'S tod"y, Ahl\()ugh this
specificatioll docs adlllit cOlllpact and cI('g~1I1i ('xpressions Ill!' the lIlonJents
of the obsel'ved r('tUI'IIS proccss, w(' shaillcave their derivalion to the rl'ael('1'
(Sl'(' Problelll :t:I), However, a bl'i('f slIlllm.II'Y of thc illlplications for the
lilllesnies properties or observed Idlll"\lS lIIay lit' worthwhile: (I) Individual SCCIII'ity retums lIIay he positively '1l1t()cond;ltcd and ponfolio IClllrns
ilia), be nq~alively aUlocol'l'c\alcd, hUl these possibilities arc unlikely given
empirically relevant paf'alllctcl' valucs; (2) It is possible, but IInlikely, 1(,1'
autocorrelation matrices to be sYlllllletric; alltl C\) Spurious index autocorrelation illtluced by nontrading is higlll'r (or lown) whcn there is pIJsitivl'
(01' negative) persistence in uOfltrading, In principle, propeny (:{) might
be sufficiellt to explaill tlte lllagnitu(1c or index aUIO('olTdatiolls in f'Ccenl
stock market dala, However, sevcl'al calibralioll experilJlcllls illdicatc the
dq.;rce or persislellce in nontradill~ required (0 yield weekly aUlocorrclatiollS or :{O% is empirically impbllsihlc (sec \.0 alld MacKill]ay [1990c] 1'01'
details),
Olle (illal directiofl for fllnher invcstigation is the possibility of depelldence betweefl the nontrading and virtual retuf'flS processes, If virtual rctUf'flS are taken to he new inforfllation thell the exteflt to which traders
exploit this information in deterflliniflg whell (and wh'lt) to trade will show
itsc\f as correlation between r,( anti ,5 ,(, i'vLllly stralt'gic cOllsidn;ltions are
illYolwcl ill l1\odels of ifl(orfllaliollhased tr<ldillg . \lld ,\II empirical '1II;llysis
or such iss lies prolllises to he as challengillg as il is ('xciting,lh
Ilowcvcl', ir it is indeed the case that returfl autocolT('latiofl is iflduced
by illro)'matiolli>ascd llol11r.ulillg. ill what ,,'liS" is this .1ll\o('oIT('latioll SPIlriolls? The prclllis~~ or the extensive literature Ofl flUfls),flcilrouolfs lradiflg
is that fI()fltrading is an outCOfllC or institutional features sllch as lagged adjllslIlll'llts anel nonsynchl'()flously reported prices, I\ut if nOJlsYllrhrollicilY
is purposeful alld illlorlll<ltiollally llIotivated, thell tltc serial dependencc it
induces ill asset returns should he considered gelluil\(', since it is the result
of C(OllOfllic fill'ces rather than mcasurCfllent elTor, III stich rases, purely
st~llisli(,<I1 fll()(lcls of nontrading are dearly iflappropriatc .IIHI an econolllir
Illotil'l of'stratl'gil' illteraniolls is Ilceded,
IIoSOIlH'
helm ""lIall'gi."
("oll\idt'l ;llioll~ .If"(' (oillaillt'd ill Adlllali ;11111 PI1t'id(,f(,1" , I~.HH. I~.H~)). Ikll\llII;l.\ ;111(\ 1.0 (1~~lh).
b"I",' ""d 0'11.",. (1!IH7, I!J!JO), K)it, (I!JH.'>l. ""d \I'",,~ (I'I!U, I!I!IIJ,
qualllilil'S oj a sl'nu ill I(lIiddr, '1I101l),IIHlllsly, and wilh rehllivl'l), lillie pricl'
illlpan. 'Ii) mailllaill liqllidity, lIIallY oq~allized exchanges USI' marketlllakl'I'S, individuals who stand rl'ady to lilly or sell whenl'ver the pllhlic wishes
Itl sl'll or hllY. III rl'11I1"II for providing liqllidity, markctlllakt'rs art' grallter!
mOllopoly righls hy Ihl' I'xchallgl' 10 post dilTerent prices for purchases alld.
sail'S: They IIuy OIl Ihl' hit! pricl' "" alld sl'lI al a higher fll/( price I~/ This
ahility to huy low alld sl'lI high is Ihl' Illarkeimaker's primary SOlll'Cl' of rOIll)ll'nsatioll /(11' providing lilluidil)', alld although the hidask spread I'"  Ph is
rardy larger thall (HIl' or two ticksthe N}'SI'; Fad /look: lCJIJ.I /)ala reports
Ihat the slHl'ad was $0.'2:) or Il'ss in 90.Kt;:, of the NYSE hidask qllott's frolll
I~)\Ho\'er a large nlllllhl'l' or trades Illarketlllakers can earn ellollgh to
comp('IISall' Ihl'lII for Iheir sl'I'vicl's,
Thl' dilllillluivl' Sill' or typical spreads also helil's thl'ir pOll'lItial illlportallcl' ill dell'J'lllillillg Ihl' lillieseries propl'rties of asset relurns. For
l'xaIII pll', Phillips alld SlIIith (I !'KO) show that lIIost of the ah II llI'lII a I r('turns associated with particlliar options lrading slrategies art' dilllin<lled
whl'n thl' costs associated with Ih!' hidask spre;ul arc inl'illckd, Blllme
alld Slalllhallgh (I!)ltl) argll(' Ihal the hidask spread creall'S a sigllificallt
upward bias ill 11)('.111 )'('IIII'IIS cakllialed wilh IntllSanioll prices. More 1'('('('lIllr, Kdlll (1\IH\I) shows Ihal a sigllificalll portioll orlhe socalled./fll/1/my
('frl'nIhe f;Il'1 Ihal slllallncapil.lli/alioll slorks seelJl to olll(ll'rforrll larger
capitalizalioll Slocks OVl'I' lhe It,\\, days SlllTOUIIClillg Ihe IlIrn or Ihe ),earlIIay 1)(' allrihulahle 10 dosillg pric('s recorded OIl thc hid pricc OIl Ihl' clld
of [kcclIll)('r allel dosing prices rCl'(lI'<\('<1 al Ihl' ask prin~ al IIIl' begi1lning of.Jannary. \<:\'('11 ir 1111' hidask spn'ad remains unchallged durillg Ihis
period, Ihe III ()\'C'III ('nI frolll hid In ask is ellough to yield large pOllfolio
rei urns, especially /i)r lowcrpriced stocks for which Ihe /lI'rrPlllagl' hicjask
spreael is larg{'r. Sillce lowpriced slocks also lend 10 he low{'apilalizatiol1
slocks, Kl'im's (f!'H!I) rl'suits do ofrl'l' a partial explallalioll fill' Ihe Janllarv
l'IkCl. 17
The pH'selln' of Ihl' hidask spread cOlllplil'aleS lIIallns ill sl'Vl'ral ways.
[lIsl('ad of 0111' pric(' for ('ach s('('lIrity, Ihne <Ire 1I0W Ihn~e: Ihl' hid pricl',
till' ask priel', alld Ih(' Ir'lIIsanioll price which need nOI be eilher Ihe bid
or Ihl' ask (all hough ill SOllll' caSt'S il is), 1101' J\eed it lie in helween Ihe Iwo
(all hough ill II illS I las('s il dol'S). Ilow shollld relurns he calculaled, rrolll
hidInhid, as);lohid, ('Ie) 1\lol<'o\'l'I', as ralldolll huys alld sells arrivl' at
IIIl' lIlarkel, pritTs CIII houlI('(' hack alld fi)rlh helween Ihe ask alldlhe hid
prices, crealing spurious vol;lIilily and sl'I'ial corrl'lalion ill relurns, eVl'1l ir
Iht' e('(I\IIIIlIic value or the sl'('\lrit\' is n\lch.lllge<i,
(pn'~I) .11 .. 41 dIU I1I1H'II1' 1\1(' Id.llil III h"1\\("I'IIII,hcl f,l}CIU1.11 .llIolllali('.\ (tilt" \\'('(')"'('111\
huht\.'y dk, \ .... l'le) ."u' . . ". . hII\.Hi, m"\\'lIu'ub ht'\wt'c.'l\ lht hill ~\1H' ;\:'\k prin~.
17 ""jm
dlt'\ \,
. '. ..."!i~~
To account for the impact of the bidask spread on the timeseries prop~rties
of asset returns, Roll (1984) proposes the following simple model. Denote
by
the time/ fundamental value of a security in a frictionless econ~my,
and denote by s the bidask spread (see Glosten and Milgrom [1985~, for
example). Theil the observed market price PI may be written as
'
r;
==
II
P,
(3~2.l)
+ 112
lID {+I
I
tra~sac.
P;
(3.2.3)
and under the assumption that II is IID the variance, covariance, and autocorrelation of t.PI may be readily computed
Var[ t.PI 1
Cov( t.PI 
1 ,
s2
l
t.Ptl
Cov[ t.PI _ k
t.Ptl
Corr[ t.PI _ 1
t.PI J ==
(3.2.4)
(3.2.5)
4
0,
k > 1
(3.2.6)
(3.2.7)
Despite the fact that fundamental value P; is fixed, 6.PI exhibits volatility
and negative serial correlation as the result of bidask bounce. The intuition
is clear: If P' is fixed so that prices take on only two values, the bid and
the ask, and if the current price is the ask, then the price change between
the current price and the previous price must be either 0 or s and the price
change between the next price and the current price must be either 0 or So
The sallie argument applies if the current price is the bid, hence the serial
correlation between adjacent price changes is non positive. This intuition
102
J. Markd ,HirTU.s/rurturr
applies more generally to cases where the ordertype indicator I, is not IID,IH
hence the model is considerably Illore general than it may seeJJJ.
The larger the spread s, the higher the volatility and the lirsHmll'l'
autocovariance, oOlh increasing proportionally so that the firstonkr autocorrelation remains constant at Observe from (3.2.0) that the bidask
spread docs not induce any higherorder serial correlation.
Now let the fundamental value 1',. change through tillie, 11111 slIppose
that its increments are serially uncorrclated and independent of 1,.19 Theil
(3.2.5) still applies, but the firstorder autocorrelation (3.2.7) is no lonp;er
 ~ because of the additional variance of 6.P,. in thc denominator. Specifically if a 2 (6.I'.) is the variance of 6.1>,', then
b.
< O.
Although (3.25) shows that a given spread.l implies a firstorder alltocovari)nce of _s2 /4, the logic may be reversed so that a givcn autocovariance
codlicient and value of /1 imply a particular value for s. Solving for J in
(3.2~5) yields
= '2)
Cov[M',_I, 6.1',] ,
n'2~)
hOllon' indllces nc~alive ,('rial (onebtioll ill price chall)(e" altholl)(h il do(" .dlnt the
nlOlRni\mle. See Choi, Salandro, ;lI1d Shaslri (19HH) for an explicit allalrsi, of Ihi' C''''.
19Roll (19t\4) argues Ihal pricc chanf(c, IIIlI,t h .. serially lIlIcorrelated ill all illfollnatiollally
elliden! market. Ilowt"ver, I.eroy (1 117:\), \.\lcas ( 1~17H), ami otirers have shown thai Ihi.' 1I("'d
not be the {ase. NeverthelcS""" for ~hnnhnril.()11 It'turns, f".g., daily or inlradaily H'1ur1iS. il
i~ diflicuh to p,,,e all {'mpirirally pbllsihk "'1"ilihrilun 111",,,"1 of ."'('1 "'\lilli' Ihat ('xhihits
~iKnilic;lI1t serial correiation.
103
effecL~
3.2.2
COIII/m/lt'llil
o!tlu/JidA,/i S/I/md
Although Roll's lIIodel of the bidask spread captllrcs OIlC illlportant aspect
of iL~ crfCu on transaction prices, it is by no lIIeallS a cOlllplete theol")' or
the ecollomic detenninanLS and the dynamics or the spn.'ad, In parlicul;lI;
Roll (I ~l81) takes .\ as given, hut ill practice the sit.l' of the spread is the
single most important quantity that marketm'lkCls cOlltrol in their strategic
interactions with other market participanL~. In bet, (;Iostl'n alld Milgnlln
(19R5) argue convincingly that .\ is d('lermi ned clldogl'nously and is unlikely
to be independent or P' as we have assumed in Sn:tion :1.~.I.
Other theories or the markcll\laking process have decolllposed the
spread into more fundamental UJIl1pOllellt5, .lIId thcse componcnts often
behave in din'erent ways through lillie and across securities. Estimating thc
separatc componcnts of the hidask spread is critical for properly implcIlIcnting these theorics with transactiolls data. III this sectioll wc shall turn
to somc or the econometric issues surrounding this task.
There arc three primary economic sources for the hid'lsk spread: ordcrpr()ce~~ing costs, inventory costs, and adv('rsc~elcctioll costs. Thc first two
consist of the basic setup and operating COSL~ or trading and rccordkeeping,
alld the carrying or undesired inventory subject to risk, Although these CoSL~
have been the main fucus or earlicr Iiterature,~() it is the adverseselcction
compollcnl that has receivcd lIIuch recent atlention.~1 Adverse selection
cosb arise be calise somc investors arc beller informcd ahollt a sccurity's
valuc [han the markclfllakcr, and trading with such investors will, on avcrage, be a losing proposition ror the lIlarketfllakeL Since IIl<1rketlllakers
have no way to distinguish thc inforllled from the uninfi>nlled, they are
rorced to engage in these losing trades and must be rewarded accordingly.
Therefore, a portion of thc marketlllaker's bidask spread Illay bc vicwcd
as cOllJpensalion for taking the otller side of potcnti;il inforlllationbased
tr;\{!cs. Bccause this information COlllp'1I1enl can have very different stalistical properties from the orderprocessing ;\Ild invelltor)' conlponclIL~, it is
critical to distinguish betwcen them in empirical applications. To do so,
Glosll'n (I 9H7) provides a simple as)'Il11llcU'icill ['onllatiol\ Illodel that captures the saliellt fe'lIllres or adverse sdertion fiJI' the COlllj)()nCllts or [he
bidask spread, ,Illd wc shall present an ablJre\'ia)cd version or his elegallt
analysis hl.'IT (scc, also, (;losl('11 and I larris [ I ~lHH I alld Stoll [ I ~IH~1 J).
"'Sec, 1( ... ""11111'\'" Alllilll"\ alld M(,II(lchOIl (I'IHO). tl.lgd",l (t~171l. Ikln""1 (l'lhll), I I"
'"1(1 Stoll (1~1I1).S',,11 (19711), '"1(1 Tilli\' (197'2).
tt See l\a~,.ltot (1971), (;"1',,\;11111 <111<1 (;,ll"i (I (IKI). Fo,,',,"y "nd 0'1 I.n,\ (I ~11I7), (;\"",'1\
(I ~I!\7), Clm),," "IHI I brri, ( I~IIIII), (;I",,,'n ,11111 Mllgmlll \ I ~III', l. .lIld S,oll \ I !III!I).
J.
,l/tII/{'"
AII/'/wlll/l'llI/1'
1)"
(:\.~.!
(:.,
+ Ad + (COl + C,,),
!)
C).:1.I~)
",line A"+A,, is the ac\verseselection component or thl' spreatl. til Ill' 11tle!'lnilll'd !wlo\\', allli ('>1(;" illtllllil's Ihe onlcrprocl'ssillp; and illvt'lltory
COlllPIHlI'lIts whil'h (;toStl'l\ c;lIls the gmu /m1il compOIH'nt ;\IItI takes as
1')(qp;I'ntlUs.~~ !f II IIi II forml'd ill\'l'stors observe a pllrchase at Ihe ask, thell
they will revise their valliatioll of the ;Issel from /' to /'+A" to aCCOlIlI1 for
thl' possihilitv thaI Ihe tratll' was illlill'lllatiollI\\olivaled. alld Sillli!;lrI:', if;\
sail' at the hid is ohsl'J'\'('d, tlH'1I /' will hI' revised to /'/1", BUI how are II"
alit! AI. delt'l'IlIillnl;
ClostI'll aSSllIlIeS lhat ;111 pOlt'ntia! lIIarketlllakers ha\'(' alTl'SS to (,Olll111(111 iidill'lllalioll 01111', alld he defilles Iheir IIplblinp; rllk ill respolIst' 10
Irallsaniolls at \';lIioIlS possibll' hid alld ask pricl's as
I
I
I
II(X)
1':[ I"~
r[ I"~
Q U {
xl ]
J.
aU',,)  /',
lllllll'l' sllitahle n'slricli<\lIS li,r Ill,) alld f,(.), allt'ljllilihriulll alllollp; (,OIllJll'tJIIal'k"llIIak!'l,s will d('ll'IlIIillt' hid alld ask pric('s so Ihat the t'''pl'l'ted
protils frolll ilia I kt'lllIakill~ aniviti(" will cover all coslS, inchuling (.',,+(.,.
alld tI,,+ . h: 111'11('('
ill~
['"
I',. ==
['(/'J,) ...
:.''!S~'( ,\lIIilllui
,II
lit
= /'
+ '\" + (.~,
aucl Sloll (I!IHI); ,lfld ."iloll 'I~J7H) Itll lIuldl'" 01 these co .. I.\.
(:\.~.
I Ii)
(:\.:1.17)
(I ~)H 11; 110
105
1\
I>'.
= Pal" + Pbh.
(3.2.18)
where I" (lb) is an indicator function that takes on the value one if the transaction occurs at the ask (hid) and zero otherwise. Substituting (3.2;16)(3.2.17) into (3.2.IR) then yields
I>,.
fl"
=

(3.~.19)
(3.2.20)
(3.2.21 )
ell 
{c,.
if buyerinitiated trade
Cb
if sellerinitiated trade
Q,.
{ +1
I
(3.2.22)
if buyerinitiated trade
(3.2.23)
if sellerinitiated trade
where A is the event in which the transaction occurs at the ask and B is
the event in which the transaction occurs at the bid. Observe that PI! is the
common information price lifter the nth transaction.
Although (3.2.20) is a decomposition that is frequently used in this literature, Glosten's model adds an important new feature: correlation between
1'" and Q,. If P is the common information price before the nth transaction
and I'" is the common information price afterwards, Glosten shows that
Cov[!'".
Q"IPl
= E[AIPl
where
Aa
A:; {
Ab
if Q,.
== +1
if Q,.=l.
(3.2.24)
That I'" ,\Ild Q,. mllst be correlated follows from the existence of adverse
selectioll. If Q,.= + I, the possibility that the buyerinitiated trade is informaliollhased will cause an upward revision in P, and for the same reason,
106
3. Market Microstrurlurr
Q,.=I will cause a downward revision ill P. There is only one case in which
Pn and Q,. are uncorrelated: when the adverseselection componellt of the
spread is zero.
Implications fOT Transaction Price Dynamics
To derive implications for the dynamics of transactions prices, denote hy f"
the revisions in 1'.1 due to the arrival of new public information between
tra(y~s nI and n. Then the nth transactioll price may be wrillell as
1'" == 1',,_1
rt~.~:)
+ t" + A"Q".
==
I
\
1\"<2,,
('II
+ ((;"Q" 
(;,,_1 Q,,I),
E(i41
= U(I + yfJ),
Cov( litI,
Tk
1 == 
ys"
(3.~.2H)
where
Pn
Ph
y 
C
C+A '
fJ 
and where [4, Il, arc the perperiod market and true returns, respectively,
and 7. is the continuously cOlllpoullded pcrpcrio(l market return.
These relations show that the presellce of adverse selection (y < 1) has an
additional impact on \l1eam and covariallces of returns that is Ilot raptured
hy other models of the bidask spread. Whether or not the adverseselectioll
2"Specificallr, he ."'llilles Ihac (I) Tnt" n'\lIll" an' ill(\<")I'IH\I'Il\ of all 1''''1 hi.'lor)": (:!)
The ~preact i~ synull("tric ahout (Ill' trut' }It"in'~ ,nul C~) The gr()S~prOlil COlUpOIlt'nl dot's nol
catl~e conditional drift in pri(C~.
107
11,lSl>rolirk (I \)\)1,1. h). Madhavan alld Sillidl (I \1\)1). ,11111 SlolI .tIId II'h,lh'y (1'1\10).
11/0
i. i\ltII/(1'I Mir/Os/nU"/III"t'
Ih('s(' qlll'SliollS an' IH'W 10 Ihl' n'(,(,111 lileralllre, the killd of allswers WI' call
pWl'id,' hal'(' challgl'd dramatically, thallks to transaniolls dala, En'lI the
C\,('lll stlldy, \\'hich traditiollally employs daily rcturtls data, has heclI applied
recl'lIlly to Irallsat'liolls dala 10 sift Ollt Ihl' impact of nl'ws allllOllllCl'mcllts
lI,i/hilllhe dOlI' (s('(', fill' I'sampl(', Barday alldl.itzclI!>ngcr 11!IHH]),
The ric!lIl1'ss of Ihl'sl' d:llascls dol'S 1101 COIlH' withollt a pricl'tr:lIlsat'liollS datascls al'l' cOllsid('raill), 11101'1' diflicull 10 malliplliate alit! all:dv!.('
heCIIIS(' of Iheir ,111'('1' sill'. For cxalllple, ill 1!l!14 the NYSE COllslIllllllat('(1
0\'1'1' ,1!1 IIlillioll lI'alls:lI'liolls, alld li.r 1':1c!1 Irallsaction, Ihe NYSE's Trad('s
alld QIIO((,S (TI\Q) d:llab:lsc )TCOllis sl'wr:l! )licn's of illforlllalioll: Ir'llisaclioll price, lillie of Iradl', VO!t III 11', alld variolls COlldilioll codes dl'scriilillg
Ihl' Irad('. Bidask qlloll'S alld dl'plhs a/'(' also rl'corded, EvclI fi.r illdividual sl't'llrili('s, a S'lIlIplt si/.(' or 100,000 ohst'rvaliolls (i)r a sillglc ycar of
Iralls:lI'liolls dala is 1101 1IIIIIsIIai.
1.
>. I
fIIo/iIlII/illll
.It
I"l( CO,"
I Olllp.tll\ III it
ii,,,
i'~lIt j, tlu' oIl/m/ft I ""~"'I' til di"'I('I('IW", ,dlie II 1J.ll.tlln~ IIil' ("osts of ilHll\t~ihihtit' ag;tin:t Iht
lu'udih lit ii" 1("11'11(''''''. hll ("",lIlIpk. 1l1I11i(' NYSE. tlu minimuJIII)!in' 1Il0\'('IIIC"1I1 flf~lorl,
","h Pl\t\" gU',\h'l Ih;\1\ IH t'l1't.I\
'f.1 i" niH' ,if\.., hUllhi., minimulII jilin' \';nialioll W;\' SC"
\'t',lI~ .'go hdoll' lilt, .lh(,111 III higil'I"'c'" diglt.II ('ollllllllc'l~ ;lIld Ctli n'~p(lildillg ,I"flll !lIil"
Iractillg IIU" h.llli'III'. II j, IlIIt 1",11 ',",WIlIl'1 til IItll ;\11 t'iglllh 01 a doll.ll" i, tilt, oplilll,ll d("~It'c'
ul cli~c u'!t'w'" 10.1,1\ Illckcd, II" "III dl" ""IUII' 1."1\\'1'('11 Ih,' NYSF ;IIHI lIu' lIS . . . ,.( III Iii",
.uul F\f 1I.1IIgl' (:fllHlIlI"itlll """111 II) lIuli,.IIt'.\ 1110\'" IIJ\\';lIlh dn;mlllr:alul1IlIlIdt'r "'''iell 1'1 in',
anc.l '\HOh,'S ,In' (hl\om'l\,\\\'~' HI ~\"\I'. Sn' 1\.\Il. T",uus, ;uHI "~("hot'g' t l~nFl): nll'llIl.HI .lIU'
(:upl'l,lIul ( jl,IHH): 11.1111' t (I)!II L .11111 lilt' "F(:\ ( I!I!I I) l\lmNd .?()(HhlllCh11I1 1111 tllt'l iii" ""1011.
,I)
Motlt'/irl~
J.J.
Transartioll.l /JII/a
Tabid. I.
'lOY
KAB
CHS
CCB
86.750
216500
629.750
7.250
1.375
40.fi25
I 29.()()()
3fiO.25()
2.!l7S
I'
3.353
!i.'i.!l78
173.924
467.H44
4.665
a(/')
O.HII
II.:{HO
I8.H77
53.251
O.Hlfi
21.4:{
fiAH
6.58
4.94
16.13
14.29
5.49
7.H3
9.43
12.50
0.00
3.48
Statistic
MC
APD
/JIIl tX
5.250
J~1II11
1'"", ('Yo)
'"111111
Ii
((X
('Yo)
0.12
0.11
0.02
0.00
a(l/) (%)
4.88
I.!i I
1.45
1.46
SUllImary sialislics for daily relUrns clala from January 2, 1990, to December 31, 1992. for live
NYSE ,Iock>: Me"" Anacom,,; API) = Ah Proc.!uc!.O and Chemic.i.; CBS = Columhia
Broa(k"~lillg Sy~tlm:
CC\\
discreten('ss is less problematic for coarsersampled data, which may be wellapproximated by a continuousstate process. But it becomes more relevant
for transaction price changes, since such finely sampled price changes typically take on only a few distinct values. For example, the NYSE Fact Book:
J99.J nata reporL~ that in 1994, 97.4% of all transactions on the NYSE occurred with no change or a onetick price change. Moreover, price changes
greater than 4 licks are extremely rare, as documented in Hausman, \.0,
and MacKinlay (1992).
j)jlrrfif1lfJs and Prias
DislTetcnt'ss affects bOlh prices and returns, but in somewhat different ~ays.
With respect to prices, several studies have documented the phenome~on
of /nla rlus/nin{;, the tendency for prices to fall more frequently on cerp.in
valucs than on others.:\\' For example, Figure 3.2a displays the histograms
of the fractional part of the daily closing prices of the following five NYSE
slo('ks during the threeyear period from January 2, 1990, to December,31.
1!l92 (see Tahle 3.1 for sUllImary statistics); Anacomp (AAC), Air Prod~cts
and Chcmicals (AP!)), C,oltunbi,l firoa<kasting System (CBS), Capital Cities
'''S.., tI ... <'Xalllp\t', I\an, T"wus, a",1 Tschnt'~l (19H:.); Coodhart and Curcio (1990); H~rri5
Ni"d. .. h"lh" (I'lli: I'lliIi); Ni .. d .... h"Ilt.. and O,ho .... e (19Ii6); and O.horne (I9fi2).
(I~I~I\);
Iy)
3.
Mar/1ft Mi(/IJ.I/Illrllllf
Nk
(CCll), and Kaneb Services (KAll). The histogram for CBS is a paltiluljlrly good illustration of the classic priceclustering pallel'll: Prices lend
to'fall more frequently 011 wholedollar multiples than on halfdollar IIlllltijlles, more frequently on halfdollars than on qllanerdollars, and lIIore
fr quently on even eighths than on odd eighths. Pricecilistering is ('veil
III Ire pronounced for transactions data.
The importancc of these pallerns of discretencss has been highlighted
by the recent controversy. and litigation surrounding the puhlicatioll of
tW) empirical studies by Christie alld Schultz (1 !l(1) and Christie, IlalTis,
al~1 Schultz (1991). They argue that the tendency for bidask quotes Oil
N SDAQ stocks to cluster 1Il0re frequelltly Oil even eighths thall Oil odd
ci hths is an indication of tacit collusion among NASDAQ dealers to maillt<li I wider spre;\(ls. Of COllrse, there are important differences between the
N1SDAQ's market structure and those of other organized exchanges, and
11\()re detailed analysis is required to determine if such differences can exphlill the empirical regularities documented by Christie alld Schult!. (19!H)
anu Christie, Harris, and Schultz (1994). Although the otllcollle of Ihis
controversy is yet to be decided, all parties concerned would agree that
discreteness can have a tremendolls impan on securities markets.: 11
Discreteness and Retums
The empirical relevance of discretellessj<)J" relllrns depellds to a large extelll
on the holding period and the price level, for reasons that we shall discuss
below. For transactions data, discretelless is considerably more problematic
because the price change from one transaction to the next is typically (111)'
one or two ticks. For example, if the millimum price variation is all eighth of
a dollar, a stock currelltly priced at $10 a share can never yield a transactioll
return between lero and 1.25%. In fact, in this case, the transaction return
must fall on a discrete "grid" of integer multiples of 1.25%. For higherpriced stocks, this grid is considerably liner. For example, the transactions
return for a $50 stock will (~\ll on a grid of integer multiples of O.2!i'Yo.
Moreovet, as the price level varies through time, the collectionllftr'llIsaction
returns obtained may seem less discrete because the grid correspolldillf\
to the entire dataset will he the slIperposition of the grids at each pric('
level. Therefore, if price levels arc high alld volatile, or if the timespall or
the dataset is long (which implies higher pricevari.lbility IIncler a ralldolll
walk model for prices), the discreteness of transaction returns will he less
apparent.
Table 3.2 contains a concrele example of this intuition. It reports Ihe
relative frequencies of transaction price changes ror the five stocks in Fig~IOlher cUlllrihllliun5 to Ih. NASDAQ rontll""'r,y indllde Chan. Chri5ti.. anti SrI,"h,
(I Y%). t"",hll,h ;\1\(1 Smilh ( I ~l7ti). (;\l\\tk (1'39\;). (;n",m'l1l. Miller. Fi5chcl. (;"11". allli \{()"
(1Y'.15). II\lan~ ~nd Stull (1!1!1:lh). I\;IIHld ,IIHI Marx (I~I%). anti K1citlun alltl Willi\( (I!l%).
I:!o
lou
Hn
.;:
In
tit)
'211
~r
r
r  r
0
r,r
~ :!O!)
1;,1)
L.L.
1,,0
\I
.;:
l ~l(1
1~\1
~,
_.,
1
II
I'..!(J
I
I
11HI
,
In
.1
:~n
II
K
,
~ III
Ii"
~.~Inn
/I
.1',6
r
r
rr
ooo~
10t,lI
~o
.li~;1
.7:,0 .M7!',
t,LL,ll,.ll,.u.,u.,.u.,.Il,J:t,.J
H
A"I)
:'Utl
~:,D
~
~
h
 1
~
It
I
Ii
I',il" (.h,lIIgt tllt'k ... ) Itll ,\I'n
'LIIO
~ 1;10
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   .    _ _ __
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~ l~11I
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n..lL.,.lL,.LL,..w:::;=O..L.,L.c;:::W,LL,JJ
(I
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5
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() 'Yr''r.''?r9r"Y''''''''"T'9,.''i'r"T'
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r
.'.!~ln .:n~,
.X7!',
,
till
.1Il
:!o
.l '.!:,
5UU
.,;'.!~, .7~IH
(a)
(ill
Figure 3.2. Ili.IIII/''1"IIIIIII/LJllily P,lIP I';wlim/J 1I1/f11'riu (.'/11/111'/' /111 h"f NrSf SllKkJ /111111
January 2. 1991110 f)rmlll"'r ) I. 1 'J'J2
).
Tcll,/., 1.2.
,ll{///wl,UUW.I/IIIl"/ur"
"f/i"f . ,,,,in.
Slllck
NlIIllht'1
.,1"1'",\11<,
:\
:!
1
+1
+:!
+:1
?: +4
,\,\( :
IH,W,li
I),I)~
o.ln
1).17
I:!.J.I
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O.IH
API)
~t}.~'o:,
o.:\:! H.'II
:\.~:!
1:IAH
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I '1.~:1
;1.1'
0..11
H.:N
( :IIS
'2.~
<i.lil
7.V.
7.:!<i
:)~..1~
7.'1:1
7.1:!
li.:11
~.,t:1
(:( :1\
:!:\,I:!H
1:1.7:!
0.70
I.li!I
:\.!lO
:1:'.11
451i
1.1i!} 05H
I:d~:.
"An
~t,OOH
0.01
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(1.1 Ii
11.77
7:1.7!1
IVJ.I
0.00
fl.07
1,:11:,
O.t "
\
\
lttLuin' Irl'(f1H'Jlf~' COIIIII, ill P(,H"t'JlI, lor ,,11 1~)~)1 tr;Ulsactioll prin' challg('.'i in ricks lor Ih'e
NYSE slOt''': AM :~'\II'\I'''ml': ,\I'l1=Air I'rod."", "lid (:hemjc .. I,: (:IIS~( :.. 11 ,,"hi .. llro:ldc,,'ill~
SI'''''''': 1:( :11" (:"l'il 1 I :i'\l" AliI:: K.\I1~ KoII\l'" S.. nice,.
I
"n' :I.~ "sill~:l1I 011111' slocks' 1""IIS:lCliolls dllrill)!; Ihe I!l!ll call',"I",. Yl'a,..
Th .. low<'I'!" il .. d ,It I( ksK,\l\ .1\111 AA( :h,\V(' V.' I)' f.. w l,.allSal'lioll pricl'
I'hall)!;l's "<'\'wld IIII'  I lick 10 + I lick rail)!;"; these thr .. e vallil's aC('Olillt
fCl' !1!1./i';', a"d !I!I.:II;', IIf :111 thl' tr.ldl's (CII' KAn alld AAC, r"spl'clil'dl'. III
(01I1"I.~t, fill' a hi).(hl'lI',icl'd sllIl'k likl' CCH, with all aVlTa)!;(' price or $4(iH
<lmill)!; I!I!II, Ihl' rallW' (Will I lick to
I tick accollllts ror (i:I./;I;',
its
tr;l(l('s. Whill' dislTl'tl'lIl'SS is relalil'e1y Il'ss prollOllllCl'd (II' CCH, il ;s 1IC1'I'rIhl'kss slilll'\'(s\'1I1. EI'I'II 11'111'111\'1' 111m to daily data, Ihl' his(()!;rams u( daill'
pricl' chall).(,s ill Fi).(I1\,( :\.~h shol\' Ihal discr('I('/lI'ss can slill hI' importalll,
('spI'cially lor lowerpricl'd slol'ks SIII'Ii as KAI' alld Me.
MIlI'I'mTr. disn"I<'IlI'SS Illay Ill' mol'l' I'vidl'nt in the ((I1II!iliol/{(! and jail/I
dislrihlltilln 01 hi~h freqlll'ncy l'I'tmn" ('veil if il is dirtlclllt III delect in Ihl'
/I"f/l/ltlili,,"/I! or IIII/Igill/l! distrihlliions. For exalllple, consider Ihl' graphs
ill Fi)!;lIH' :1.:101 ill which pairs of adj'II'I'nt daily silllple '"('I urns (H" /{,+ I) 011'''
plolll'd 1<,,, 1""'11 of 1111" Ii\'(' siocks in 'n,hk ~,I OWl' the thrcl'y .. al' salllpll'
pl'riod. TIIl'sl' 111";1/111';1'.\ (lIl'rl', III = ~) are ortellllSl'<i to detect strllctllre ill
nOllli/II'ar dYllamical SVSII'ms (SI'I' (:hapter ! 2). Thl' scalt,s
Ihe two axes
are id"lIlil'.tI (Cll' ,III lil'e siocks 10 makl'\Tossstllck comparisons mcaningflll,
and rall~1' (rom [,,;', to :.'}{. ill Fi~llrc :t:l;I, 10% 10 I 'X, in Fi~llrl' :\.:Ih,
and 20'}{. to 20'}{. ill Fi~lll'l' :I.:k.
Fi)!;1l1'1' :1.:1:1 sholl's Ihal tlH'\,(' i~ cOllsidl'rahle stnlClllre ill thl' n'llln" of
Ihl' lownpril'ed slocks, KAB alld t\A(:; Ihis is a radially S)'IIII'II'lric Si/'llllll\'('
Ihal is ,~old\' alII ihlll"hlc 10 dis\TI'IIIII'SS. III conlrast, no SII'III'IIII'I' is ('\'idcnl
ill Ih" 2hislOI il's of IIII' l,iglll'l'l'rin'd slOcks, CBS alld (:( :1\. Sinn' "I'D's
illiliall"i ... i, iJlIIl'III'I,(,Jllllosl'ofllic 01111'1' fOllrslo .. ks. il displays less Slrlll'
or
or
.rt /
i ./." , '
!ffiTIJ"
,'..
I;
I ",  ",.. '\
.......
! .: ",
.~ "'~
,;< 1;'
l:~
1
..
...
'. :~ t ~:.':"':';
~../
'"
; .~...~~,~.~~ , .......
_..... : '._'.
,"
",
..
. .
~;.
,",,"
....... 
P = $~B5!1
.:
,'.,,:(.F
,
;:.~:.~~~
..
......  :
f> = $55,878
.
,
I.
J.
. .......  .....
f> = $17S.924
I; ,.::f5~~s~~;::>
','.'
...,_\0
,,:~,
;.,"
......  :
.....
.
l"
,/
"I
"
,",__
1 ~~"'"':.A"'~~.;'u.
.......
.'.,....'.
.. '....
,',
.'
P= $467,844
'
Figure 3.3_
III J)frnllbrr
'
~"""'...:,;;r""""~"If
..
",'
(b)
........  :
f> = $4.665
(c)
2J/is/or1es of Daily Siock llelurns for Fiv, NYSE Stocks from january 2, 1990
3/, 1992
ture than the lower.priced stocks but more than the higherpriced stocks.
Figures S.;!h and S.Sc show that changing the scale of the plots can often
reduct, .mel, in the case of APD, completely ohscure the regularities associated wilh discreteness. For further discussion of these 2histories, see Crack
ancll.ecloit (1996).
114
3. Markrl Miov,llrul'lwl'
LxJ
rxl
least integer
(!Ioor functioll)
(ceiling function),
(:L1.1)
(:l,:U!)
for any real number x. J ) Using (:l.3.1) ,lIId (3.:'\,2), we call express lire three
!lIost common methods of discretizillg 1'1 compactly as .
,nThc question of which prirc is Ihe "In\('" p. in' III"Y lIolh .. (n.ci 1for Ihe ~lalisllr,,1 ~"I)('(ts
(If 't()(II,t~ of lli~rcl(,Il('.s"hcr all, whelher 0111' is .u. "pproxim,'lion 10 lhe olht) III vi. ('\'(" ',I
31th t~ uilly the sign of the approximation ('lTor, nut its f\hsolutt!' magnitudehut it i~ c(,Htral
to t 1e motivation and illtcrprcto.ttiu1\ uf thr Te:mlt'\ (Sl'l' the discllssion dt the l'lId 01 Sl'niott
:I.:t for examples), Therefore. although we ~hall atlopl .111' lerlllinology of this lill'r",,,," luI'
lhc ,noment, the reader is a.c:.ked 10 kt(p thi." amhiguity ill tHind whlle rcadi .. ~ \hi!'i :,\('( 1iol1.
~'\Fur rurther propf'rties and app1ications of tlu.sc intl:gl:f functioJls, see Graham, Knuth,
3nd'l'alashhik (1989. Chapter 3),
I
i
(3.3.4 )
p",
where thc first method rounds dlllol/. the se(,(>IId n>llnds IIfl. alld the third
rounds to the lIearest multiple of d. For simplicity, we shall consider only
(3.3.3), although our analysis easily cxtcnds to the othcr two methods.
Atthc hcart of the discreteness issuc is thc difli:rence betwecn the retllrn
X/ based on continuouSSlate prices and the return XI" based on discretile<1
prices. To develop a sense of just how different these two returns can he,
we shall construct an upper bound for the Ijuantity IXI"  Xtl = Ill;  141.
where H/ and R;' denote the simple net return of the continuousstate and
discretil.ed pritT processes, respectively. I.et x and y he allY two ,lrhitrary
nonlH~gative real nUlnbers such that .v > I, alld observc that
x I
 <
lxJ
lyJ
 <
(3.3.6)

y
lxJ
ly J
x
Y
<<
y(v 
1)
CD.7)
I Max
[x
   , I ].
yI
(3.3.H)
Assuming that 1'/ > d for all t, we lIlay sct x '" 1',1 tI,.r == 1',_11 d and substitute
these expressions into (3.3.H) to ohtain the following upper bound:
(3.3.!1)
where 0,_1 == til P,_I is defined to be the K'rid .Iizr at tillle tI.
Although the upper bound Ct3.!J) is a strict ineCJuality, it is in fact thc
least upper /JO II nd, i.e., for any fixcd d and any f > O. there always exists sOllie
combination of 1',1 and X/ for which III;'  Uti exceeds 1.(0. X/o I',tl  L
Therefore, (:t3.!l) measures the worstrase deviation of II;' from N,. and it
is the tightest of all such measures.
Note tilal (:t:t!l) docs not yield a unif(lI"IlI upper hound in r/, since I.
depends on 'i:
CU. 10)
J, /lilli/Wi MiI7'IJ,I'Il'Ilrllll'l'
Nevel'llwlt,ss, it still provides <I IIseflll gllidelinc for the illlpan ofcliscJ'(,tt'JH'SS
rl'llIl'I\s as prilTs alld retlll'J\S vary, For exalllple, (:t:{,!l) limllalizes Ihe
illtllitioJl that dislTl'tl'Jll'SS is I('ss prohklllalic lill' highnpriccd stocks, sillce
I, is all ill('J'l'asing fliJIlIiOIl or o( , aJld, thercforc, a dccrcasillg funclion
Oil
I',
I)
I /'(
_8_ {
I ]
(JI I
'4 (I> (
,)
log( 18)  /1
n
) 1,
CD.II)
lid ,Ii ....... ')'. hll\ il is '"1'1" isill~lv dimr"l, ,.. tin
','c'lIl(' cli,,'I1~!'\ioll heluw n.~."<li"~ 'Iw llH1Hding ,tlHI
01
gC'lIt'1 .ili1)',
110\\'1'\'1'1,
',H'C IIi,' p.1I ;1111('11 it ;t .... 'IIIIIIHion..; for XIt mun' pttt+."" fh;u;tncri/.lIioll!'l
III;', an' :lv,lil.,hl,',
't:'NolI' Ih" ,illlil.1I j". IWIntTI! rs.:~.II) ;11111 11i(' HlackSrholts ('alluplioll pfidll~ 101"l1l1l1a.
h.1I1 in lIIo,ld'IIIUI('I
01 fht tlisnc'h'IH'!'\'
117
Tahles 3.3ac report numerical values of (3.3.9) for price levels PrI =
$1, $5, $10, $50, $100, and $200, and for values of IJ. and (J corresponding
to anllual means and standard deviations for simple returns fanging from
10% to 50% each, respectively, and then rescaled to represent daily returns
in Table 3.3a, monthly returns in Table 3.3b, and annual returns in Table
:\':k.
Table 3.3a shows that for stocks priced at $1, the expected upper bound
for the discreteness bias is approximately 14 percentage points, a substantial
hias indeed. However, this expected upper bound declines to approximately
O.2:l percentage points for a $50 stock and is a negligible 0.06 percentage
points for a $200 stock. These upper bounds provide the rationale for
the empirical examples of Figures 3.3ac and the common intuition tliat
discreteness has less of an impact on higherpriced stocks. Table 3.3a also
shows that for daily returns, changes in the mean and standard deviation of
returns have relatively little impact on the magnitudes of the upper bounds.
Tahles 3.3b and 3.3c indicate that the potential magnitudes of discreteness bias are relatively stable, increasing only slighlly as the returnhorizon
increases. Whereas the expected upper bound is about 2.5 percentage
points for daily returns whcn PI_ 1 = $5, it ranges from 2.8% to 3.9% for
annual rctllrns. This implics that as a fraction of the typical holding period
relurn, discreteness bias is much less important as the return horizop incrcases. Not surprisingly, changes in the mean and standard deviation of
returns havc.more impact with an annual rcturnhorizon.
ROllI/ding Models
Evcn if E[jR,"  Rtl] is small, the statistical properties of P," can still differ in
subtlc but important ways from tbose of PI' If discreteness is an unavoid~ble
aspect of the data at hand, it ITIay be necessary to consider a more explicit
statistical model of the discrete price process. As we suggested above, a
rounding model can allow liS to infer the parameters of the continuousState
process from observations of the rounded process. In particular, in much of
II\(' roundinv; literature it is assuITIed that PI follows a geometric BroWJ;lian
Illotion ell' = J.l.Pdt + a PdW, and the goal is to estimate J.I. and a fiom
thc obscrved price process P,". Clearly, the standard volatility estimator iJ
based on con tinuously compounded observed returns will be an inconsisten t
Table J.Ja.
1'11
=:
.1=20%
.. = ~O%
,= 40%
14.2895
14.2930
14.2961
14.2991
14.3018
14.2H95
14.2930
14.2961
14.2991
14.301H
14.2H95
14.2930
14.29fi1
14.2991
14.301H
14.2H9:1
14.2930
14.29(i\
14.2991
2.5648
2.56:14
2.5660
2.5665
2.5670
2.5650
2.565:,
2.5660
2.5t;()5
2.:,fi70
2.5li76
2.5672
2.5671
25(i72
2.5fi74
2.5721
2.570\1
2.5701
2.:)t)9!)
2.:>692
25772
0.2511
0.2511
0.2511
0.2511
0.2511
0.2:,16
O.251!',
O.2!l15
0.2:,15
0.2:/11
0.2520
0.2520
0.2519
O.251H
0.2:>lH
O.252!l
0.2524
0.2523
0.2522
O.2!'121
O.2:12!)
0.252H
0.2:127
O.2!'12ti
O.2!'12!'1
0.1254
0.1254
0.1254
0.1254
0.1254
0.1256
0.1256
0.1256
0.1256
O.12:,(i
0.1259
O.12:lll
O.12511
O.125H
(J.1257
0.1261
O.12tiO
0.12fiO
O.12(i0
0.1259
O. 12{j~
O.12ti2
0.1262
0.12(;1
O.12til
O.Ofi27
0.0627
0.0627
O.Ofi27
0.0627
O.O(j2H
0.Ofi2H
(l.Ofi2H
O.()(i2H
O.1l62H
0.0629
0.0629
(1.0629
O.t){WI
O.O(j211
O.O(i30
0.0630
0.Ofi30
0.01;29
O.OG29
O.0/i31
O.()(i:\\
0.O(j3\
$1
10%
20%
30%
40%
50%
1',1
=:
= r,O'Yt,
10%
.<=:
In
.1
._"_.. ._
14.~018
14.2H9~,
14.2!)30
J.).2!Hll
14.2!)!1I
l'UOIH
$5
10%
20%
30%
40%
50%
2.:,7!)!"1
25711
2.57:\0
2.5721
PII = $50
10%'
20%
30%
40%
50%
1"_1 = $100
10%
20%
30%
40%
50%
I~_I = $200
1%
0
I!O%
~O%
~O%
~lO%
1
I
O.O(i:\O
O.Oti:\O
l:xpeclrd upper bound~ for tlisrf((l'nc.~s hi;L' ill siu\I,h.' n.turn~ Ill;'  ntl x 100 lindt,,, a gc.\\11lt'tric.
r;1I~ltlm wdlk fnr prices 1', wilh drill <1",1 lIill'lI,;olll''Ir'lIlIl'I'''' I' anll" c"hh.al(d 10 .1111.",,1111<'''11
all(\ standard devialioll of simp I!' relmn~ In ,11111.1. "'I"l'li\'(ly. ""ch r""Hill!: frolll IH% 10,.0'7<,.
"11(\ lhen rescaled to malch daily 1I,lla, i ... I'/:\r~). 17/J:liiii. LJiscrcli/.('.t prin" I';' E lI',ldJd.
d ~ f). I:!!'" ... c IIscd III fakll!;"!' n'III' ' " U;' : (/';'11';'_ I)  I.
1,.,,11' J. Jb.
III
!',. I
.1
I,'x/lfflnl 1I/'I1t',./1II1I1II1.,
= IWX,
.\ =
~Wy"
1=
== $1
:~O%
10%
!iO%
:\()'J"
14AOI,7
14.:.0M
14.1iOl9
11.'17HH
.1 ~.,
14.(i!I~O
14.7011
14.7HOj
 .. __ .
14.li~I!)
I',. I ':"_$_:,____
....
III'Y.,
.1
__ ._ ..
..
.  
=!,O%
__._14.7(j~I'
ILld 17
ILIiI!')
ILW07
1!.7!m
11.HOHI
J.I.:,.J('~
14.7767
h;m.' /I/lII,lhly,I'II1I71.I.
_.._I,U9\Hi
11.!i011
14.I'OI!i
1I.I'!!1 !I
14.771i7
10%
20%
1m ";11.,,11'//1'.11
14.77~:~
14.7!)44
I4.H~n
JoI.HIiHH
..
_  ..  
2.li:,O I
2.lifi1:,
~.I'7!i!)
~.7004
:1.1i7H~
:1.71110
2.(1:)~J~J
~.liHII'
~.70~7
~.lil'I'1
~.IiH:.')
~.7O:.3
Vi!iH!!
2.(,73H
~.mll
~.70HH
O.~:.44
{).~:.ti!l
(1.~:.!)01
II.~I'I!)
().~(i4~
~O%
0.:6:11
0.~:.71;
O.~I'~I
O.~(;13
30%
10%
O.~:;(j(i
O.~!iH1
O.:I(j~1
(1.~(j1:.
O.~:.HO
O.~!i!I:\
0.:l1;~'1
0.~Ci17
:.O'Yc,
O.~:.93
O.~IiO~
o.:!,.!)!)
II.:I(;(H
0.2(,10
O.21i17
O.:lli:\1
O.~Ii'"
10%
O.I~70
0.I~H3
~O%
0.1~7Ii
O.I~Hli
O. I 2%
0.12!IH
30%
10%
!i0%
O.I~H:I
O.I~!lO
O.I:~OO
O.I~HH
O.I~!I!i
0.1 :m!i
O.I:~OO
O.I:IIH
0.I:m7
0.llI,11
0.1)(,4:1
0.01,1:.
0.01,17
0.I)(i1!1
0.111,,17
O.llIioIH
0.111;:.0
0.111;:,1
1I.III;r,:1
10%
~':'!I4!i
Vi~~H
~O%
:1.li07!i
:~()%
2.(i~~~
Vi300
Vi3H:.
10'7<,
!iO%
2.(,:171
Vi4H~
2.lifi~3
!{)'X,
P"I
_.__.._
= $:.0
1',.1 = $100
._
:10%
40%
!i0%
0.I:H9
O.I:I~O
0.13~1
II.I:~U
0.13~~
0.1 :{I:.
0.1:{2!
O.OW:.
0.01,:17
0.llIi10
0.01,14
0.111;,17
10%
._
11.1 :~IIH
11.1 :\0<)
11.1 :111
0.01;:.:1
O.llIi:I'I
11.111;:.:,
II. Oi;r,(j
0.01;:,7
0,01,:;9
O.llIi"\)
O.OI,IiO
1).0til,1
1).0til;1
Expected uppel" hound., fOI'c1i.~crttl"lIts .., hia.'\ ill o.;illlj)lc n(IIII1 ... tU;' ... /(11 )( 100 Hlult'r il gl'olHl'lI if
randolil walk for pricco'\ 1'( with drift and dillllSilIU p.1I ;11111'1('1.\ II ;11,,1 (1 (,llilu.II,d to 0I1I1H1.111l1t;1II
alld !Iotandard d('viatioll of~illlpk r('turll' m alld \, J( ... ,H(li\(k. (',If Ii r;lIlgIlig Irolll 1orf.., 10 ;)(J'}f"
and tliell
d = O,I~:)"lI(
tI .... l'd
JIIatch mOl/lh~)d.If;t.
i.t,.,
'Ii/MI' J. k
I=
11/
III'Y,.
I'" :.'1l'Y"
..
1. == $1
}',
!!Of}{,
:10%
.IO 'Y"
:1(1(.~)
lillY"
20%
:\0%
10%
0"
2.'11 W.
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IUllin
r)()(,~.
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I~'_I_== S~ UU
I (}(){.
tI.I:IHli
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1I.lx77
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(1.1,12 I
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1I.lli:11
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111%
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I'
htllllul," eli" 1('!c'IU',:\ hi.I' 11I.,illll''' n.turliS IU;' Uti x 100 lIIult .... gt'Ollle'lriC"
h'I pile \, .. /', w'lh ,1I ,h ~'1H1 ,liU" .. ",,, par;Ulwtt'I"SII ;\lul n ('~,lihrahtI10a1\I\\I;t1 \\It'~'1\
and., . lIu1.ln) ct"\i.llic III 01 ,11111'1" Ic'IUl"l1' lII.lIul " n'~p("'fliv('Jy. t'ad. rangillg' from 10'::, 10 ~IO%,
Hi" n'ti,,'" 1'1 Ie C" I';' ,::. t /',1 did. d ..' 0.1 :1:.. ;tf{' ",c'd (0 (aiculalc n'Uull' U;' =: (/J;'/ I';'.
1.
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. ."."lI.mlll
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11.07:>1
II.IIHI:I
H.IIH7Ii
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\ ==
= $:.11
'I(II:{,
== .1f)'Yc,
.1
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2.H:17:!
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I' 
121
( I !lR5), and Harris (1990) all provide methods for estimating 0 consistently
from the observed price process P," .:11;
Ill/nlY)" Mot/fis
A slightly diITerent but closely related set of models of price discreteness has
h('('n proposed by Cho and Frees (I9HR) and Marsh and Rosenfeld (l9RIi)
which we shall call barrier models. In these models, the continuousstate
"true" price process 1', is also a continuoustime process, and trades are
observed whenever P, reaches cerlain levels or barriers.
Marsh and Rosenfeld (I9Rfi) place these barriers at multiples of an
eighth, so that conditional OIl the most recent trade at, say 40~, the waiti.ng
time until the next trade is the firstpassage time of P, to two barriers, one
al 40~ and the other at 40~ (assuming that P, has positive dfin).
Cho and Frees (19R8) focus on gross returns instead of pric.esand define
stopping times Til as
(3.3.12)
Therefore, according to their model a stock which has just traded at time
Til_I at $10.000 a share will tracle next at time Tn when the unohserved
cOlltinuollsstate gross returns process Pt/$IO.OOO reaches either 1.125 or
1/1.125, or when P, reaches either $10.125 or $8.888. If P, reaches $8.88R,
the stock will trade next when P, reaches either $10.000 or $7.90 I, and so
OIL
or
I'(T,,_I)
rt
(1d
d )}
   ,I +  1'(1,,1)
P(T.Il
(3.3.13)
which reduces to lhe Marsh and Rosenfeld (19Rfi) model in which the incrcments of stopping times are 110t lID.
i
:\11110\'0'('\'(''', ~t"f: lh.: diSCII.It'\ioll ,at tlw I:lul of Section :t:t2 for ~om(" C3\'eab about (he mod\\uiUIl for tht's(" mudds.
,,. ...
]22
3. Market Microstructure
Limitations
Although all of thc prcvious rounding and barricr lIlodcls do capturc pricc
discrctcncss and admit cOllsistent cstimators of thc paramctcrs of the IInol)scrvcd continuousstatc price proccss, they suffer from at least three illlportantlimitations.
First, ror unobscrved price processes other than geomctric Browniall
motion, these models and their correspollding parameter estimators becOllie intractable.
Second, the rounding and barrier models focus exclusively 011 prices
alld allow no role for other economic variables thatlllight influcnce price
behavior, e.g., bidask sprcads, volatility, trading volumc, etc.
Third, and most importantly, thc distinction between the "true" and
obscrved price is artificial at best. and the econoJllic interpretation of the
two quantitics is unclear. For example, Ball (lUSH), Cho and Frees (I!IHH),
Gottlicb and Kalay (1985), alld lIarris (I U90) all provide methods rO/" estimating the volatility of a continuOUSlime prke process frpm discrele' 01>selved prices, never questioning the motivation of this arduous task. If lhe
continuoustime price process is an approximation to actual market prices,
why is the volatility of the approximating process of interest? One lIIight
arguc that derivativc pricing models such as the mackScholes/Merton formulas depend on thc parameters of stich continuoustime processes, hut
thost'i models arc also approximations to market prices, prices which exhibit ~iscreteness as well. Thcrefore, a case must he made for lhe ecollomic
~ rc\cv,!nec of the parameters of continuoUsslate price processes to properly
~' motiVate the statistical models or discreteness in Section 3.3.2.
,;~
h~ the absencc of a wcllarticulated model of "truc~ pricc. it secms U\Inatur~lto argue that thc "truc" pricc is continuous, implying that ohserved
discre~e market priccs are somchow less genuine. After all, the economic
dcfini~ion orprice is that quantity oflllllllerairc at which two mutually COliscntif~economiC agents are willing to consummate a tradc. Despite thc f;ICt
that if stitutional restrictions llIay rcquirc prices to fall on discrete values,
as lon' as both buyers and sellers are aware of this discreteness ill advance
and af still willing to engagc in trade, thcn discrete prices correspondi\lg
to ma tct trades arc "true" prices ill every sense.
12~
/Jrl.\ir S/)f'('ijiwlion
r;
= X~rj
+ <k,
0,
CI.:U4)
1';
1';
,\~
y.
J",
if
)"
/I~
(~.:\.15)
if }"k c ;\",>
wherc the sets AI furm a /Hlrliliull of the statc spale S' of 1'; . i.e.,
S' = U;'~ I Aj
and Ai n Aj = 11 for i 'I j, and the ~/s arc the diMTl'le valul's
that compris e
the state space S of J'.,
The motivati on for the ordered probil specific alioll is to ullcover
thc
mappin g lJetween S' and Sand relale il 10 a sel of ('Con 0 lIlic
variable s. In
Hausma n, I.o, and MacKill lay (I~1~12), Ihl' ,\,\ arc defilled as:
0,
k, +k.
"II"
~. +~. and so OIl. For sinl(llicilY, Ihl' slalespan.' partilion ofS' is usually
ddil)('d to 1)(' illft'l va).;:
:1 I
(00 ,
(:L\.Ifi)
;\~
{!XI '
atl
U~ I
(:13.17)
A,
(U,_I , 0', )
CU.IK)
1\ '"
'r!
(0' 111'
(0).
(:t:~. I ~))
Althou~h the ohser\'('d price chall~1' call be allY nUlllber of ticks, posilive or n<'l!;alivl'. WI' aSSllllle Ihal //I in C~,:~,I:)) is finile 10 keep Ihl' Illlmller of
unknClwn parallH'I('I'S Iillil(', This (loses 110 diffICulties sinct.' we Illay always
leI SOIl\(' slall's ill S r"l)J'('s('1l1 a lIIultiple (anc! possihly counlably illlillile)
nlllnlll'r ofvallll's for lIlt' o!ls!'fvl'd prin' change, For example, in Ihe empirical applicalion of lIauslllan, Lo, ;\Ild MacKinby (19~12), .II is deflnec! to be
a price dlangl' of ,I licks orlt'.I.I, ."1 to hI' ;1 price change of +4 ticks or /II0rf,
anc! .I'.! 10 .IX 10 he pricl' changes or :~ ticks to +:~ ticb. respectively. This
parsimollY is ohlaillt'd al Ill<' ('osloI' losillg t,ria 11'.\Olul;OIl. ThaI is, lIlldcr
this spl'('ifil'atioll JIll' onll'n't\ prohil model docs not distinguish hetwel'1l
priCI' changes or +,1 alld price changes grealer thatl +4, sinCl' the +4tick
oUlcOllle anc! Ihe gl'ealer Ihan +4li('k oUlcome have Ileen groupec! logether
inlo a cOlllmon eVt'nl. The same is IrIIC for price changes of 4 licks ;lI1d
price Changes less Ihan 4, This partilioning is illustrated in Figure ~,4
whirh superimposes thl' parlition boundaries lail on the c!ensity funClipn
of
and till' sill'S of the regions enclosed hy the partitions detl'rmine the
prohahililies 71, oflhe discrele ('\'l'nts.
Moreover, ill prillcipll' Ihe resollliion lIlay he lIlade arbilrarily flllCJ' hy
simply introC\willJ.( ilIOn' Siall's, i.e" by illcreasing' 111, A~ IOllg as (~3.14) is
cOITl'nly spt'dlil'll, illtTl'asillJ.( prin' resoilltion wiJlllot allen the ('stilllal(~(1
{J asymptolicallv (allllou).!;h lillill's;\llIpk pmperti\~s may lIilfl'r). Ilo\\'e\'<'r,
ill practicl' 1111' clal;1 will impos(' a lilllil Oil Ihe fllleness of price resolulioll
simplY hecause Ihen' will he 110 ohS<'rv;tliolls in IIII' I'xln'lIl(' siall's \\'111'11 111
is tllO larg(,. ill whirh CISI' a sllhsl'l ollh(' parallH'll'rS is 1101 idclltilkc! alld
call1lOI III' "SliU\;\ll'd.
1';.
f.
125
y'k
Figure 3.4.
a;
a;
Ek
Yo
+ YI
Wlk
+ ... + YL Wu,
(3.3.20)
(3.3.21)
can
(3.3.22)
(3.3.23)
III this case, W k contains only one variable, Ill. (which is also the only
variable contained in X k ). The fact that the same variable is included in
hOlh X k and W k does not create perfect multicollinearity since one vector
while the other affects the conditional
affl'l'ls the conditional mean of
variance.
Y;
126
J. Mmkf'/ AlilTo.l/rttrlw('
1'(
r.
.I,/X., W.)
\ =
r(X~f3+E.
P( 0',_1
1'(
a,._1
::::
0'1
< X~f3
< X~f3
+ <k
Xk,W k
:::: 0',
if i
I X k , Wd
+ f A X k , W. )
=I
if I < i <
if i =
11/
C\.:I.~(;)
III
",(W,)
....
'>'
(u . ,x;f3)
",
aq~umellt
.(.
,
1
1=
Ill,
127
or
M,:xilllllllll.ihrlilwod I~Sli1/llllioll
Let hCi) he an indicator variable whirh takes Oil the value one if the ITalizalioll of' the hth observatioll Vk is the ith state ,Ii, and zero otherwise,
Theil the loglikelihood function C (il!' the vel'lOl of' price changes Y
I 1', y~
l'" j', conditional Oil Ihe expl<lllatory variahles X
I X, X~ '" X" j' ;lIld W = [ WI W 1 '" W" ]" is giv(,11 hy
L(YIX, W)
(3,:t28)
0;
Althmlgh
is "llowed to vary lillcarly wiill Wk. lit('l'(' ar(' SOllie constraints
that 11I1lst be placed 011 the parameters to ;ll'liieV(' idelltilication since, for
example, doubling the o's, the {3\, ;\l1l1 Ok kavcs the likelihood unchanged,
A typical idelltilil'atioll ;lssulIlptioll is to S('t Yo = I, Wc are Ih(,11 1I'l't with
tilrcc issllcs tltat llIlist bc resolvcd hl'll)\(' l'sti\ll~ltioll is possihle: (i) tlie
lIumber or states III; (ii) lhe specifiratioll of' the rcgll'ssors X k ; and (iii) the
spcci licatioll of' Ihe cOllditional varialll'C
In choosillg Ill, we 11I11st ha\an('l' prire rI'SOlllli,," ag~lillst the practit'al
cOlIstraillttilatlOo large all //I will yield 110 observatiolls ill thc I'xltTIllC states
'I alld s"" For ('xample, ir we sct /1/ to I () I alld ddille the stalcs ~I alld 5101
a;,
J. J\!lIrkl'l J\!inmlrwllllf
sYIIIIllItrically to Ill' price dI<IIIW'S of !lO ticks and +!lO ticks. rl'spenively.
Wt' wOllld lind no I'k's alllong typical NYSE stork lransaClion~ falling into
eilher of Iht'st, slalts, .IIHI il wOllld hI' illlpossihie 10 eSlilllale Ihe paralllelers
associaled wil II Iht'se 1\\'0 sl<III's. Perhaps Ihe easiesl nH'llIod for dl'lcrlllininR
III is 10 lise the 1'lIIpiricti I'l'l'tllll'lIry dislrihlllioll of IIII' dalasel as a !!;uide,
Sellilig /1/ as large' as possible, IlIlI lull so largt' that the ('xtn'lIl1' states h"ve
110 ohsl'rvatiolls ill thelll.:\~
The rl'lIIaillilig t\\'o issue's "'list hI' resolved Oil a casl'hyrase hasis silln'
the spl't'ilil'''lioll for lhl' rq!;ressors alld
art' dictaled lar),!;e1y hy lht' particlliar applicllion al han(\. For I'on'raslill),!; pnrposes, lagged price challges
0111(1 ",arkl'l indl'xl's III"Y he "ppropriale regressors, hilt for t'Slilllalillg a
stl'lll'tllral Inodd of llI'IIkl'lm"kcr IIlOlIopoly power, olhcr varia hies mighl
III' IIIOI'l' appropriall'.
a;
1. ,I. I
NI>II\y"rllIllI/lIll.1
TTl/ding
Bt'li l\"(' \'(\I\~idl'l'i 11),\ I hI' \'III pi rica I I'vidl'lIl'I' 1'01' !lOll I raeli IIg clTI'('\s WI' SIIIl \ I\larill' Ihl' qualitativ(, illlplic;Iliolls or thl' lIo11lradillg model or Seclioll :t 1.1,
Althollgh 111;111\'
th('s(' illlplicatiolls are cOllsisl('1I1 wilh olher models of
IIOIlSYlldlrollOllS Iraelillg, Ih(' sharp comparaliv(' slatic r(,sllll.~ alld \'xposi
or
'1"'1"01" ("tllllph. I Lu',IIl:lIl. 1.11, ;11111 i\l.lfl\illl.l)' (I!I~)!!) ~('I III == !J lor Ihe 1;lrgl'r .,Iorks,
implying ('xII 1'111(' SI;t1,'" 01 1 lid., 01 It"", .lIId f1 tid.s or 11101'(', and ,"'" III = :) f(,r 111(' ~I11;1IIt'r
sllll 1..'" illll'lvillg .'\In'III(' '1.lIe', 01
:! Ii. ,,, III Ic'" ;lIul +:! lid;..'i or mon', NOI(' (11;11 ;dlhutlgh
till' fldilllllllil 01 ~1.11c, IIl'"d IItll be '~IIIJlH'lIil ( .. I.IIt' 'I I ;111 I", Ii Ii, k!ll til Ic~!\. illll'l~'iTlg Ihal
Mah' "I j .. f '.! IiI ,,, 01 IIIfll('), lilt, !\yllllllt'!I\' 01 Ihl' hi'logralll 01 prin' (h.,"g('~ ill their d.lla'i('1
~1I~~t'sts;, \\'111111('11 it ddlllilioll 411 III"
\, \.
129
). c10es not alTect the mean of either observed individual or portfolio returns.
2. increases the variance of observed individual security returns that have
nonzero means. The smaller the mean, the smaller the increase in the
variance of observed returns.
3. decreases the variance of observed portfolio returns when portfolios
are welldiversified and consist of securities with common nontrading
probability.
4. induces geometrically declining negative serial correlation in observed
individualsecurity returns that have nonzero means. The smaller the
absolute value of the mean, the closer is the autocorrelation to zero.
5. induces geometrically declining positive serial correlation in observed
portfolio returns when portfolios are welldiversified and consist of securities with a common nontrading probability, yielding an AR( I) for
the observed returns process.
Ii. induces geometrically declining crossautocorrelation between observed
returns of securities i and j which is of the same sign as fJ,flj' This
crossautocorrelation is generally asymmetric: The covariance of current
observed returns to i with future observed returns to j need not be the
same as the covariance of current observed returns to j with future observed returns to i. The asymmetry arises from the fact that different
securities may have different nontrading probabilities.
7. induces geometrically declining positive crossautocorrelation between
observed returns of portfolios A and B when ponfolios are welldiversifted and consist of securities with common nontrading probabilities.
This crossautocorrelation is also asymmetric and arises from the fact
that securities in different portfolios may have different nontrading
probabilities.
H. induces positive serial dependence in an equalweighted index if the
betas of the securities are generally of the same sign, and if individual
returns have small means.
9. and time aggregation increases the maximal nontradinginduced neg:
ative autocorrelation in observed individual security returns. bUl lhi~
maximal negative autocorrelation is attained at nontrading probabili~
ties increasingly closer to unity as the degree of aggregation increases.;
10. and time aggregation decreases the nontradinginduced autocorrelal
\
tion in observed portfolio returns for all nontrading probabilities.
Since tile effects of nOllsYllchrollollS trading are more apparent in securities grouped by nontrading probabilities than in individual stocks, our
empirical application uses the returns of ten sizesorted portfolios for daily,
)30
3, MllIlut MirllJ.ltm(/lIr,.
weekly, and mOllthly data from 1962 to 1994, We use market Glpitali/.alion to group securities because the relative thinness of the market for
any given stock is highly correlatcd with the stock's total J\lark{~t vahl{';
h 'lIce stocks with similar market values are likely to have similar nontraclilll:
p 'obabilities,39 We choose to form tell portfolios to maximi/.e the hOll)og neity of nontrading probabilities within each portfolio while still maintaIning reasonable diversification so that the asymptotic approximation ur
d.1.20) might still obtain, ~o
l
i
T~ble
190nly ordinary cummon shares arc included in this analysis, Exchukd an' Alllni",,"
Depository Receip15 (AORs) and other specialized secllrities where lIsing market val\l~ to d,,"acteri/.e nontrading is Ie.., meaningful.
""The returns 10 these portfoliusarl' n)lltinuOIlslycOIlII)(Hllldcu relurns ofitldividtl.,1 ~il1\I)It
returns arithmetically averaged. Wt' have repeated tht, curr("l;tlion analysi:t. for ('oUtiIl1l0US)Y
con'pounded rf'turn~ of p()rtfolio~ Wh05C value.ra. 4lre calculateLl as unweightC"d RCOlllt.'trir av..
{'rdg{'s of included securities' prices. The result, for these portfolio returns arc pr"rtically
identical to those for the continuously compolllHkd returns of c(l"al.wciglll(d pol"l1011O\.
"We report only a ,ullset of four pnru"lios for the sake of hrevity,
41SIandard error. fm alllocorrl'l,uioll,h,l,.. d probability aud lIotl\r"dinH duration ("ti",,"("
<If" obtained by ;'Pplyill\: a firM,unlt .. 'E,ylor ""I"II"ioll (Sl'" Sl'ction A.4 of the Apl'l'ndix) to
(:1.1.11) and (3.1.40) using heleroskeda,ticity and aUlucorreiatiOlH;unsi'\c1l1 ",,,ul,, ... 1 en ors
I(If daily, weekly, alld llIolithly firsHmlcr autl)(uncl,lIioll coelliciellt. These laner Mand,ml
errors are compllted hy regressing retlll'llS 011 " conslant alld lagHcd returtl~, alllll\sin~ Newl')'
.\lut \\'est"!. (19H7) procedure to fa1clllat< lu"t("H)skc(\C\s\\dty... nel .unororr("!ctliollnHlSi~IllIl
~u~lIulanl errorS for the slupe {ol'Uldt'n\ (",'hid, i~ !FIimply the fiut'''ordC''r ,IUIOlI rt"l.\thm nwfficietu of
r("turn~}.
J.".
7able 3.4.
131
J\
I
Daily
<1
.~~)
.~I
10
,I
7
(""
.11
AO
.:H
.:1!)
.~H
.~~
10
.:H
.:\ti
.:14
.11
.I!>
. I ~)
T'
10
.19
.:11
.:1:1
.19
.1:1
.15
.17
.15
<1
.10
.16
.IV
.IH
.Oti
'>7)
,I
Wcekly
Monthly
.:'11
7
10
.:1:1
.:11
.1:1
.I!)
.~7
.:.!:.
7
10
'("
4
7
10
.:1H
.:10
.:17
4
7
10
.15
.~o
.~ti
1',
.11
.14
.14
(1)
.1:)
.00
.OH
. I ~)
.~O
1'1
10
.0,1
.05
.0:1
.1 ~)
.m)
.00
.1'1
10
")
.~:)
 1'1
.00
i'l  f'1
I
_II') , (""
.00
.0:1
.01
, (""
1'1
I
1'1 i"1
.1:1
.00
.O!)
<1
I/"I/nll.
4
7
10
(""
.IH
.:14
.~ti
.OH
.00
.14
")
.IV
.14
.00
,
I',
,,~O
.:1!>
./IH
.00
.00
.OH
.101
10
.O~I
10
~')
.14
.09
.00
is abo r{'pontd.
'L~ymlJletry
.uHI';; .
t'l
be 2.5 days! The corresp onding daily nontrad ing prohahil ity is
HG.(i% using
monthly returns. implyin g an aver;lge lIolltrad illg duratiol l ofG,:,
days.
For compar ison Tahle 3.5 also reporls estimate s of th\' lIolltrad
illg prohabilities using daily dat,l and using tr;1(1e informa tion from th('
CRSP files. In
the abSCtll'C or timc aggrq~atioll OWIl.lutocolTdatioIlS of porlf(,li
o returns
are consiste llt estimato rs ofllontr ading probabil ities; thus the
clltries ill thc
columll orTable ::I.5lahe lled "rr.(q = I)" arc sill'l)ly takclI rrom
the diagolla l
of the autocov ariallce matrix ill Table :t4.
For the smallcr securitie s, the poilll cstim.lle s yield plausibl e Ilolltrad
illg
duration s. hut the estimate d duratiol ls declille (111)' 'lI;lrgill;l
Ily for larger
.l.
1.~\/iIl/1I1,\
'1lIhle J.5.
fr,
ir,('1=
.~~!")
1
7
III
(11.111:1 )
. :I!II
(O.O:!li)
(IHI7)
.o;.:!
(O.OIH)
.:\.1:1
(0.02:1)
(O.W.)
.01!1
(O.OO:!)
.:I:!H
IO.Oilil
IH~I
.Oll:!
(0.11111 )
.IHH
10.111'1)
I':\lim~'h'~
f.:1 ii, I
I)
ir,(f!=
1~lk,J
5)
ir,(f!
= :!2)
LI h, J
2.:.1
(0.12)
.Hlili
1.0:!!l)
li.!7
(Ui!)
(O.W.!I)
I.:!H
(0.:11)
.1\:17
(11.01:1)
:.. 12
(1.1i I )
(fI.o1)
.I!I7
(O.Oli:!)
O.!I!I
(O.:!:.)
.HI!I
(O.OIH)
1.:.2
(I.lli)
II.:!:I
(0.0:1)
.I:I!I
(O.i:!li)
O.lli
(11.17)
.!") I:)
(ll.lti I )
1.IIIi
(I.'IIi)
(IN
.717
(O.O:H)
.:.1iI)
O.:,!!
II/a/Ii,,/ MU'/m/m(/w"l'
(c.'1\
r""i,'\ '" lin ('ulumn l~\I)C.'tlc.(t "rr ... ~Ul' ~\\(r~,~(\ofthc. harti(ltl of
,to, \U','it'~ '" pUllluhu /rt, lh.u ,1ill lin' tLH\t uU \'~U h 'ra"in~ ,t,y. Wht'H' tht ~\"t'ri\At' ,\ rnmp\1h't\
U\Tr "~II lr.uhng Il.,y, h om.}u\\:t EU)~ to' h'n'mlu'r :\U. 14J94. Enll't'~ in tht "rr .. ,,/ = 1)" fplumll
~'n' 1ht Iii \H lICit, aHtonJlIt'1.lIion fodlidt'llb of (lail), ponfoHn f('\nrl\!'\, \"hit h "ft' fOJ)!'oisu'ut
("!\lim;lIu"~
1"1111111""
,It" ('~lilll,IIt!\.
monthly
~k('lioli :\,~
('1
:1 101
==
~~) ..
'I =
~~
"!'Iillg Iht'
lilll(,
aggu'g'lIioli rd.llion'
III
fr.ulillg 1I;t\'s ill a \\'((k awl,lllIullth, n"IH'( li\'t'ly), Enlrit';o. ill (Ohllllll."i l;tlwlled
male.'s of Ih,' e.'Xp('fu'd IIl1mh,'" of nHt",'nlli\"(' days withour Ifading" implic.'d hy lilt' prohahility
('Mim;,"';o. ill rUIIlIllIl!\ to lIu' illlllu'di;III' Itfl. Standard ('nors an r('porle'lI ill pal(11111(;o.(": all
;an' hC.h'I'Js"((Ia.,IHily ;'1111 illlltH', In(l;lticIIH(HI.'ii.... I(,11.
sil(' portli.lios. A dllral iOIl of lIt'ad)" Ollt' lillirth of a day is IIIlIch 100 Iarl!;c
II' s('cllriti('s ill til(" lall!;t'sl portJ(,li, . More direct evid(,lIc(' is provided ill
th(' ("{)hllllll lahdltd n" which rqlllr\s the awrage !i'actioll ofs('cllritics ill
a giv('n portfolio Ihal (10 not Irade dllring ('acll trading day.n This ;Iv('l";Ige
is COllllllllt'd OV('I" alllra<lilll!; days rrolllJllly :~. I!Hi2 to Ikn'lllhn :1(), 1!191
(HI7!) !lhS{"("\'<Iliolls). COIIIIl<\I'illg tIlt' (,lIlries ill lhis COIIlIllIl Wilh thost' in
11H' othns sholl'S lht' lilllil;lIiolis of lIolitrading as an t'xplallation for the
alllo("orrcl;lIioll~ ill III(' <1;11;\. Nonlr;lding llIay he responsihl(' lill' SOllle of
11H' lillH's('rits propt"ti.s .. f stock n'tllrllS hilt (;1111101 ht' til<' !lilly SOllrn~ of
<111 .correia! iOIl.
nTh" iulium.Hlon" IBU\'"l,'" HI '\11' (J{Sl' ",Illy hh!\tn ",hit'll "11' (luo;,tng pdcT nl;, ,('nully
i, "'pol1t'C' 1o ht' Ih,' ,Hg.II"".,l IIII' .I\C'J ;Igc' ot Ih,' hill alltl ask prin'!'i (lJI (I.ly~ wht'll th,11 .'C'C IIril)'
Ilid 1101 II.U"', SLuul.lld "1101 ... 1111 proh.lhilil\' ,',lim.lit'S .tlt' h,l."i('(\ olllht d.lily lilll{'
Iht' iI~lnitlll
nlll,hlC'lIl.
ni
11011;111(,.
1"1,,'
,nul
'(Til"
01
;1Il10fOIT('Lllillll
J.4. Ilfcmt
Table 1.6.
Estimator of If i
Nq~ative
133
I~",piri((ll Findillg.~
N(Jl/lmt1il/~illll,lif(/
1.4
I.H
4.H
5.9
Share Price
Daily AUlOcorrelatio"
(Ill
= 1.5.13111 = ()5)
si/t"'rt~"
M!l!5ynfitron()1L5
(3.4.\1)
3. Markel MimH/l"Ilrlurr
f.
BidA~" .'>/))"('(1/[
In implementing thc model of Scction 3.2.1, Roll (1981) argucs that thc
percentage bidask spread s, may bc more easily intcrpreted than thc al)solute hidask spread s, and he shows that thc Ilrsturdcr 'lIl1ocovari'lllcc of
simple returns is relatcd to .I, in the following way:
Cov[ R  l
'
s,
.\~1
.\;
4
Hi
H, I
JJ>1I 1',.
s,~
(:H.'2)
(:H.:\)
'
Notc that (3.4.4) and (3.'2.9) arc only wclldeflllcd whcn thc returtl al1tocovariance is negalive, sincc by conslruction the hidask bOllllce elll only
inducc negative !irslorder serial correlation. Ilowever, in praclice, po~i
tive scrial correlation in returns is lIot IInCOllllllon, and in thcse cases, Roll
simply defines thc spread to he (sc(' footnotcs (l ,lIld b of his Tallk I):
Hnuudollkh, Richa,.dsoll, alld Whit,law 1199:, M"('h (I!I!I:I) alld Sias alld Sta,b (I!I!I!)
prt~ClIl
1,
10 a \':lIil'll' (II d:llaS('ls 10 ~allgl' tlte I'xplallalOry pow('r alit! st:lhilit\, 01 ('ach
lIIodd.
J.".
/It'ct'lll
Empirical Filldings
137
138
3. Markel Mirm.IITllrlllTf'
TableJ.7.
Variable
\Low Price
,lIigh Price
'Markel Value (SBmiolls)
\
IBM
CUE
FWC
IINII
NAV
104.250
129':'()0
('9.HI"
6:,':'()()
IOH.2:,O
2.1t17
11.500
17.250
0.479
14.2:,0
HI.500
0.219
~.12:'
24.12:,
7.H7:,
H.9!J1\
:\0.:\7:,
211.\I\lO
4:1.81
12.ijij
43.5:\
4~.19
:'17.13
2~.',8
22.:,3
26.2K
51.20
40.110
11\.11
41.0!l
:12.:\7
18.67
:lK.14
0.0010
0.7530
O.OOJ('
1.23:>3
().0017
O.l'~!JO
0.0021l
O.74!l2
O.1l002
0.644"
(1.000 I
1l.!i:,40
27.21
20:1.,.2
:l1l2.lij
2\1(,.:.4
416.49
1129.37
1497.44
:1~L\(;
:11.00
:14.I~
7(i5:1
:\1.:\\1
1.9470
1.462:,
3.2909
\.(,203
2.01'30
1.1682
2.4707
0.8994
l.46lti
0.(,713
l.Ii,.1;4
0.79%
0.0000 (LOOO4
0.0716
l1.l3!l7
0.0017
0.147,.
0.0064
0.1903
1).0001
O.103K
(WOOl
0'<171;:.
0.00211
0.9:146
O.I)02H
0.9(Wl
0.0\1:1:1
O.K:1:'(;
O.IO',!)
6.1474
0.:\:,74 1l.O:,23
6.27911
".6643
1.%43
6.0I:l!lO
57,37,.
40.900
(;,1:,0
",:\(;3
.% Trades at Prices:
Mid'luote
;>
= Mid'luole
< Mid'l"ole
39.29
2:J.~)2
41.71
Price Change. }.
Mean:
SId. Dey.:
Time Belweell liade
"It
Mean:
Std. Dey.:
0.0332 0.42,.(;
6.\)70:,
75H4!i
3,O()O
7.\1,.0
Summary statistics for lr~ll.\a(tiOl) priet . . alul )rn'sIHlIHii1Jg '>rdercd probj( ('xpl'lIldlc)I y \'~II i
able. oflnlernationaillusinc.., Marhincs Corporation (IUM. 20(;,794 trades). Qllantutll <:l>t'lIIkal C.orpor~\ion (CUE, 26,n7 lraclesl. Foster Whet'ler Corporation (FWC, IH.I\''I tradt's).
Handy and Harman Company (IINII, ~.174 t,adt'sl, Nayi<lar International Corpmatinn (NA\'.
trddesl, and Am~rican TcI .. phone and 'Icle)(raph Cotlll'.my (T. HIO,721i lracles)./o,. rhe
peri
from January 4, 1988 to Dccemht'r :10. I \lllll.
!/f),11'
I
I
MacKin lay (1992) set m =: 9 for the larger stocks, implying extreme Slates
of ~4 ticks or less and +4 ticks or more, and set m = 5 for the two smaller
slocfs, FWC and HNII, implying extreme stales of 2 ticks or lcss and +2
lick1 or more.
1fhe explanatory variables Xk arc selected to capture several aspccls of
traJlrction price (hanges: docktime cfTeCls (such as the arithmetic IkoIV
nian mol ion model). the cfleCls or hidask houn("(' (silln' many
transact iolls
are mCl'el)' II10VenH.'lIls rromthc hid price 10 III(' ask pritT or vice
versa).l he
si/.e or Ihc Irallsacl ion (so prin' illll'al'l (";111 lit' delcl"llIill('(1 as a function
or
Ihe fjllalllilY Iraded). alld Ihe illll'acl or "SYSlclllalic" or Illarkelw
ide 1II0vemenL~ olllhc cOllditio nal dislrihll iion of an individll;1
1 slock's pritT challges .
These aspens call for the followin g expiallalOlY val iahlcs:
61k: The lillie clapsed betweell transaCl iolls IiI alld It.
in seconds .
An k _ l : The hidask spread prevailin g al lillie Ik __ I. in licks.
Yk ,: Three lags [l = I. 2. :~J orthc dqH:lld ellt v;uiahk r J{ccalith
atl(lIh
III = !l. price changes less than 4 licks
arc sel eqllal 10 1 licks (slalc
.\1). and price changes greater thall +., licks are scI elIal
to +4 ticks
(Slate ~l). and similarly for 111 = [,.
V k _,: Thrce lags [I = 1. 2. :q of Ihe dollar volllllle or Ihe (ItI)th
transanion. ddinc:d as Ihe price of the (il/)Ih Iransact ion (in dollars.
nol
tic ks) lillles the nlllllber of shares Iraded (dellom illated in hundred
s of
shares); hcnce dollar volume is ckllollli naled in hundred s of
llollars.
To reduce the influenc e of oUlliers. if the share volume or a trade
exceeds the (19.5 percenti le of the empirica l dislrihu lioll or share
volume
for that stock. it is set equllllo Ihc !I(l':' perccilli le.
SP500 k __ ,: Three lags [I = I. 2, :1 I of fivclIlinule continu
ously COIIIpounde d rctllrllS of the Siandar d alld Poor's (S&l') [,00 index
futures
price, for Ihe conlrac t maturin g in the c10scsll llonlh beyolld the
lIIonlh
in which transact ion It  I occurre d. where Ihc: [('Iurn is compul
ed with
Ihe: flllures price recorde d OIl(' minule hC'fore IIle nearcsl roulld
millule
firiur 10 Ik' alld the price recorde d five millules hcf()Jc this.
mS k _ / : Three lags [I = I. 2. :Ij of all illdicato r variahle:
that takes Ihe
vaillc + I if the (It  /Jth transact ion price is grcaler Ihan the average
or
Ihe qlloted bid and ask prices al tilll!' Ik _,. Ihe vallie I if the
(ItI)th
transact ion price is less th,1I\ the average of Ihe bid and ask prices
at
lime I.I. and zero otherwis e. i.e.,
IBS h _ 1
II
I
if
+ I'~'_I)
if
1'._1
~ U'h'_1
+ 1':'_1)
if
10
allow
fill
clocklilll!' df(cls
Oil
Ihe
J. All11kl'l
x" I'
a;
I
~
141
Table}.Ba.
l~.'limfllf.\
IBM
CUE
FWC
HNH
NAV
4.670
(145.65)
6.213
(IIl.92)
O71l
(25.24)
4.456
(5.91l)
7.263
(39.23)
(56.~5)
4.157
(157.75)
5.447
(11l.99)
 1.712
(25.96)
1.801
(5.92)
7.010
(36.53)
7.270
(62.40)
3.109
( 171.59)
2.795
(19.14)
1.679
(26.32)
1.923
(5.97)
6.251
(37.22)
a.
1.344
(155.47)
1.764
(11l.95)
4.334
(25.26)
4.477
(5.1l5)
1.972
(34.59)
a~
1.326
(154.91)
1.605
(11l.1l1)
1.938
(34.66)
1.977
(62.1l2)
ali
3.126
(l67.IlI)
2.774
(19.1 I)
6.301
(36.36)
5.371l
(62.43)
a7
4.205
(152.17)
5.502
(19.10)
7.742
(31.63)
7.294
(57.63)
aH
4.732
(131l.75)
6.150
(11l.!14)
1l.631l
(30.26)
8.156
(50.23)
Paramcter
al
O':!
u:\
TI
IUJ73
5.472
(63.~)
I. .0
(61.4H
Maximulll likelihood estimates of the partition boundaries of the ordered probit model for
transaction price changes of International Business Machines Corporation (IBM, 206.794
trades). Quantum Chemical Corporation (CUE, 26,927 trades). Foster Wheeler Corporation
(~WC. IH,I99 trades), Handy and Hannan Company (HNH. 3.174 tr..des). Navi'Ulr International Corporation (NAV. 96.127 trades). and American Telephone and Telegraph Company
(1'. I HO,7'.!ti tr.. des). for the period from January 4. 1988 to December 30.1988.
the coefficients of the explanatory variables fl . _... fl.3, and "the BoxCox
parameter v. The 5state specification requires the estimation of only 20
parameters.
'J'hf Maximum Likelihood Rslimales
Tables 3.Ha and 3.1 Ob report the maximum likelihood estimates of the ordered prohit model for the six stocks. Table 3.8a contains the estimates of the
houndary partitions a, and Table 3.8b contains the estimates of the slope"
coelTIcients /3. Entries in each of the columns labeled with ticker symbols
are the parameter estimates for that stock; zstatistics, which are asymptotically standard normal under the null hypothesis that the corresponding
cocfficient is zero, are cOn\ained in parentheses below each estimate.
Tahlc 3.Ra shows that the partition boundaries are estimated with high
prl'cision for all stocks ancl, as expected, the %Statistics are much larger for
thost slOr.:ks with many more observations. Note that the partition bound
."
Table3.8b.
mM
CUE
~wc
HNII
NAV
YI : AI/100
0.3\19
( 1:>.:>7)
0.'199
( 1l.G2)
o:n!i
( 11.2(i)
O.Il37
(1.07)
O.42H
(HUll )
O.:IH7
(H.H!I)
Yt :AIL 1
0.:>15
(71.0H)
I.\IU
(l5.3!1)
0.72:1
(145'1)
\.109
(4.4H)
O.HW
(\\1.\1:1)
(l.HliH
elH. IIi)
0.11[,
( 11.12)
0.014
(2.H)
(l.OI:\ IU)IO
(:1.:,0) ( Vi!))
O.O:I~
( :tH2)
0.127
(!151)
Paramclcr
III : A/flOO
111
: Y.. 1
1.012
0.:1:13
l.:tl:, 0.740
2.liO\I
(13!i57) (13.41i) (24.49) ([>.I H) (:\(i.:{2)
fl:, : >'t
0.:,:12
(HS.OO)
fll : 1'.:.
0.211
(17.1:,)
fl:. : 51'500_ 1
{Iii : S1'500 .. t
fJ7
: S1'500_ 3
fJK : illS_I
fJ'
:
l
mS~2
fll :
ms_~
fJlj
't~(V _I )IBS_ I
i
tJl~
t;, (V 2)[85_ 2
"'T
(l.OOO
O.G:{H 0.40G
1521
1..112
(tI.03) (IGAr,) (4.O(i) (31.1:1) (:,(;.:,21
(l.III;
OSH;
0.:.01
0.0211
O.~~:I
(!I.~:{) (U14) ( 31.1;3) ( I7.!1I )
( 1.42)
~.2!1~
1.120
(54.22)
(1:1.:.4)
0.:2:,7
(12.!Hi)
1.:173
0.302
(!l.(iI )
(~.!13)
1I.(i77
(5.1:.)
( 1.!J7)
O.OO!;
(l.~(i)
2.:Illi
(ti~.7'1)
1.359
(I :~.49)
O.~04
0.472
( I.:~{j)
(li.Wl)
tUi2 c,
(17.12)
O.14H
( I.~O)
0.1:.0
(2.H7)
0.177
(I.!/(i)
O.:lHH
( 1.13)
0.1 r.!J
(/.1.1\
(:\.(l~)
n.!/:\)
0.41!1
l.I:n UH:>
(('3.1i4) ( " . 31i)
O.:l1i!/
0.~79
(~I.:,:,) (:1.:\7)
0.71\)
0501
0.7!JI O.HO:l
(7.HI) (2.H!J) (17.:{H) (2:1.01)
0.174
(1O.2!J)
tU)79
(1I.!lH)
0.122
(47.37)
(12.97)
().~!l!l
0.177 0.022
0.3111
( :l.Ii'l) (0.17) (I :,.:17) (I!/.7HI
(l.W,()
O.03H
tUII.1
0.0:12
( I.HO)
(U.5:,)
(~5ti)
(I.rll I
U.!H7
(IH57)
(l.O:lt;
(2.H:'
O.III!/
(7.70)
(l,007
(0.5!1)
0.~17
0.:\70
0.:110
O.IH1 O.IH4
(:\.fiG) (0.75) (I:>.:\H) (IH.II)
(1.03(i
(O.!iS)
tUlI " o.()(/(;
(15Ii) (0.34)
0.01:,
(1.:,4 )
0.011
0,1/11
(~,:,'I)
('U!1)
11.000,
(\1.()9)
n.m!)
II.OW,
MOlX;IHll1U likdBu)(){l l~timat('!\of the ":.Iopc,''' ("odJiril'Ht!O.ol thl' oH.h.'ICd I)lohit moth'llu .. lIall!'o~
pO". II "~'" ':' """'~"h'...~, ~'.""'~'~ M.,,,,, ...., 0"',, .... ,,," II "". "",."" ....,
"e '.
QII" Hum
111.1 19
Irade~).
arie, arc not cvl'nly spaced, e.g., ja:\ a.a! = 1.7(i:/. whereas ja'la,.j = ~.(i7()
(it can hc shown that these two values arc statistically <lifkrent). One implication is that the eighthsharrier model 01' dislTete prices, e.g., that 01'
Marsh and Rosenfeld (I DHG), is not t'llIlsistent with thcsc tr<lnsanions data.
Another implication is that the estim,lIed ((JI/I/ili(JI/!I/ prohahilities of price
changes need not look normal, hut may (and do) di"play a clustering phenomenon similar to the clustering of the 1l1l{,(lIl1lili(Jl/u/ distrihution of price
changes on even eighths.
'!:lble 3.Hh shows that the conditional means ul'the rk' 's li/l' all six stocks
arc only marginally affected hy t.1k. Moreover, the zstatistics are minuscule,
especially in light of the large sample sizes. Ilowevel', t.l does enter into
the a,~ expression significantlyin bct, since all the parameters for
are
significant, hOllloskedasticity may he I'~iectedand hence clocktime is important for the conditional variances, hut not fi/l' the conditional JIleans of
Note that this does not necessarily imply the same I'or the conditional
distribution or the Yk's, which is II(JI//ill('{lr/y related to the (,(lIulitional distrilJutiOlI or the r; 'so For example, the l'<lIlditional nl(";ln or tile Yk's may well
depcnd on the conditional variance or the
's, so that clocktime can still
affcct the conditional mean of ohsCI'ved pricc changes eVt'n though it docs
not aflect the conditional JIlean of
a;
Y;.
Y;
r;.
illlparlIIII' dkn 01 a Iralk Oil IIII' lIIark('1 prirefall hI' 'Illantilied wilh
rdalivdy high prl'ci~ioll. il dol's illITl'ase wilh tralll' sizl' althollgh lIot linI'ady, and it dilfns 1'111111 slock to ~tork. The ll10re liquid stocks sUfh as IBM
t('ntlto 11;1\'" rd,lIi\'t"l\" 11,11 prin'illlpan fllnctions, whereas less liquid ~torks
sllch as IINII .111' Ilion' s('nsitivl' to tradl' sizl' (SCI', in particu!ar. I {allsmall,
1.0, alld IIla(Kill!a\" II!I!I~, Fi!\lIn' ,11).
Also, disnt''IIt'Ss dOl's lIIaUl'r, ill Ihl' SCIlSI' that Ih,' cOllditiollal di~lIihll
lioll orpricl' challgl"s illlpli('d by IIH' ol"ll('n~d prohil SllI'cilicalioll call caplure
("('I"laill 1I01lIillcaliliesprin't"!lIsl('I"illg Oll,~vell eighlhs Vl'I"SIIS odd eighlhs,
fill' ,'xampll'Ihal oill<'r 1I'("lIl1iqll(,s Sllt'h as ordillary least sflllares call not.
While il is slill 100 t'arlv 10 say whelher Ihl' ordered pmhit mOlk! will
hOI\'!' hroadl'r applicatiolls ill llIarkl't microstructllre sltlliil's, it is cllrn'lItl),
th,' ollly II10dd Ih'lI call capilli"!' t1isnett'ness, irrcglll<lf trad(' illtervals, alld
lIlt' df('('\s of \'COlllllllic variahks 011 transactioll prin's in a rdatiVl'ly parsimoniolls Etshillll,
:\.5 Conclusion
Then' an' III.UI\" oUlslandillg c("ollolllic aud l'COIIOIlIt'trit" issues Ihat call now
hI' n'sol\'l'cI ill III .. "1"1",'1 lIIi.rosl IIII'I 1111" lilt'rallll"l' thallks 10 Iht' plelhora or
I),'wly a\'ail,IIII<' Ir'1I1sa ... ioIlS ,LII"hasl's. III Ihis chapter WI' have 10IH'h('(1 Oil
ollly Ihn'" of th,' issul's Ihat an' pari of the hurg"(lIIing markt,t microstructure Iiter.Hure: 1I01lS),llt'itrollOtlS Irading, the hidask spread, alld modeling
transactiolls dala. IlolI't'ver, lIlt' t'olllhillalion of transactions dalal>ast's and
everincreasing t'OIlIPUtillg )lower is surc to Cfeate many new direCliolls of
research, For ,'xalllple. th,' nlt'asllrt'menl anti cOlltrol of trading costs has
hel'lI of prilllar)' COIII','rn 10 largt institlltional inveslOrs, hili thefe has 1,"1'11
rdalil'dy !illle acad,'lIli(' rest'arch dl'votl'd to Ihis importalll topi,' b"elus,'
Ihe lH't't'SS'II'1' dala wt'n' 1I11.1\"ilahlc IIlIlil rccelllly, Similarly, meastlres of
markel trallspan'IH'Y, liqllidit\', alld t'oIllJl('titiveness all liguI"I' promillelltl),
ill 1'1'(,('111 IIH'on'lit'al lIIodds of senility prices, hilI it has het'll \'irtllally impossihlt' 10 illlpll'III1'1I1 allY of Ihl'sC Ilworks IInlil rl'cemly I){'causl' of a lack
of dala. Tilt' t'x!lt'rilllt'llIal markt'ls lilerature has also cOlllrii>lIll'd mallY
illsights illiO lIIad,el IlIitToSlrllctlln' issllt's hilI ils ('1I0r1llOIlS P(lIt'lIlial is ollly
I){'~illllillg 10 Ill' Itali,,d. (;il't'li tiH' growillg illltTl'st ill mar"t't IlIin()~lntC
Illn' hy aCldt'lllics, iIlV"SIIIH'1I1 pl'oit'ssiollals alld, 1I10st n'tTully, policYIIl;lkt'I'S ill\'olved ill n'\\'/ ilill),!; secllrilics lIIalkcls regulalions, Ihl' lIext I'cw n',lrs
art' surt' 10 I){' ,til t'xllellH'lv t'x!'ilillg and fertile period for Ihis art'a.
/lmMI'IIISC!lUpter J
\
\
\
I
:~.l
" luvi"CIIU
145
3.2 Under the nontrading process defined by (3.1.2)(3.1.3), and assuming that virtual returns have a linear onefactor structure (3.1.1), show how
nontrading affects the estimated beta ofa typical security. Recall that a security's beta is defined as the slope coefficient of a regression of [he security's
n'lurns on the return of the market portfolio.
.
3.3 Suppose that the trading process {8 il l defined in (3.1.2) were not 110,
but followed a twostate Markov chain instead, with transition probabil\ties
8il
!
given by
o
!
(3.~.1 )
I
3.3.1 Derive the unconditional mean, variance, first<>rder autocovari'lIlce, and s~eadystate distribution of Oil as functions of 1rj and 1r;.
i
3.3.3
3.4 Extend the Roll (1984) model to allow for a serially correlated ordertype indicator variable. In particular, let I, be a twostate Markov with 1
and I as the two states, and derive expressions for the moments of 6P, in
terms of s and the transition probabilities of I" How do these results differ
from the llD case? How would you reinterpret Roll's (1984) findings in
light of this more general model of bidask bounce?
3.5 How docs price discreteness affect the sampling properties of the mean,
standard deviation, and firstQrder autocorrelation estimators, ifat all? Hint:
Simulate continuousstate prices with various starting price levels, round
to the nearest eighth, calculate the statistics of imerest, and tabulate the
("('Ievant sampling distributions.
146
J. Markel Miomtrurtllrp
1
3:7
7.2 Are there any discernible rclatioll$ between revisiollS ill the bidask
uotes and transactions? That is. do revisions in hidask quotes "cause"
rades to occur, or do trades motivate revisiolls in the quotes? Propose
estimate a modclto answer this question.
tnd
*.7.3 How are changes in the hid alld ask prices related to vulume, ir at
all? For example, do quote revisiolls c.:allse trades to occur, or do trades
IllOtivate revisiuns in the quu(es? Propose alld estimate a modclto answ('\'
this Cjucstion.
3.7.4 Consider an asset allocation rule ill which an investor invests fully
ill stocks until experiencing a scquence of three consecutive dedilles, .tfter
"'The NYSE deline> a block trade a, any tr;lde (O",;,tillK of 10,000 ~har("' or mor,,
147
which hc will switch complet ely into honds lin til cxpcricncin~ a
scquenc e
of six rlJlI.ll'(ul iw advance s, Implelll ent this rille for .111 inilial investm
ent
of SI 00,000 wilh the transacl ions data, hill do il two ways: (I)
lise the
avera~e of the bidask spread fi,, pllrchas es or
saks; (:!) lise the ask prilT
for pllrchas es ancl the bid price (('I" sales. Ilow IIlllch do YOIl have
left at
the end of two days of trading? YOII may a"I1I1I<' a I.ero riskfrcc
rate ((, ..
this exercise ,
EventStudy Analysis
IW.. will rurther discuss Ih,' firsllhr~. "xamples laler in Ihe chapler. McQueen anrl,Rolry
( I ~I~):~) provide an ilIusfration using macrocconomic new.IIi annnuncement5.
~S~~Schwnl (19HI).
"See Milchell .1Ilt! Neller (1994).
149
15U
frolll 1921 to 1931, hc found th<ltthe price increased ill [)7 uflhe cast's and
thc pricc dcclincd in only 2(\ instances. Then~ was no effecl in thc other 12
cascs. Over thc decades from Iht' early 19:10s ullliithc late I!1I\()s the lcvl'1 of
sophistiration of evellt studies incrcased. Myers alld Bakay (I!HH), Bar\;("I"
(I!l!ili, 1957, 195H), and Ashley (1%2) are examples of sl\ldil's during this
time period. The illlprovclllenL~ inclnde rellloving general sl\)("k lIIar\;et
pricc movelllents and separating out confounding evenl~. In (he late I!l(;Os
seminal studies hy Ball and Brown (I !}(iH) and Failla, Fisher, .I(nsen, ,Iud
Roll (1969) introduced the IIICtllOrioloh'Y lhat is essenlially still in use (oday.
all and Brown considered the information content of earnings, and Failla,
I' isher,Jensen, and Roll studied the C!fecL~ of stock splils aftcr rCllloving Ihe'
dfccts of simultancous dividend incrcases.
\ 111 the years since these piolleeriug studies, severallllodiiiratiolls of til\"
hllsic lIIelhodoloh'Y have Iwcn snggested. These modifications h,l\\(lIe COIIIplications arising from violations of the statistical assumptions used ill the
e,r1y work, and they call accollllllodate l1Iore specilic hypotlwS("s. Browll
al~d Warncr (19HO, l!IH:.) arc useful papns that discllss til{' practical illlpl~rlancl.' or lIIany of thcsl.' nloditications. Thc I VHO paper considers illlpleIIIpntation issues ror dala sampled al a monthly intcrval and the I!lH:) paper
dials wilh issues for daily data.
I This chaptcr explains the ecollolllclric IIIcl/todoioh'Y of evellt stndies.
~e\liOIl 4. [ hriclly outlines the procedmc for conducting an event stndy.
Se tion 4.2 selS up an illustrative ex'llllple of an cvcnt study. Celltral to
an evenl study is the mcasuremcllt (;r the abnormal returII. Section 4.:1
de ails thc first stepmeasuring the normal performanceand Senioll 4.4
fol\ows with thc necessary 100ls for calcnlating the abnormal retllrn, \\laking! stalistical inferences about lhese returns, and aggregating over lIIany
evehl observations. In Sections 4.:1 and 4.1 the discussion maintains the
nul', hyp~thcsis thalthe cvent has no impact on the distribution or ret.urt1s.
Section 4.5 discusses modifying the null hypothesis to focus only on the
mean of the return distribution. Section 4.6 analyzes of the power of an
event study. Section 4.7 prcscnL~ a nonparametrk approach to event sl\l(lies which eliminates the need for parametric structure. In SOIllC Glses thcory
provides hypotheses concerning the reI.llion between the lIIagnitllde of the
event abnormal return and linll characteristics. I n Section 4.H we consider
crosssectional regression models which are lise fill to investigate slI('h hypotheses. Section 1.9 considers SOll\l~ fnrther issues in eventstudy design
and Section 4. I () concludes.
l!il
<,
<,,
= il"  E[lI"
I X,].
('1.U)
whl're
I!", and E(il,,) arc the abnorm al, anllal, and normal returns,
rcsplTti vdy, for tillle period t. X, is the l'IlIlditionin!{ inl()J'Itla
tion for
the norlllal perform ance lIIodel. There al'l' two COlllnlOU choices
for
lIlodeliu g the nonn;d rt'llIl'11 the rOl/.lt{/I//III1'III/I('/lIrJ1 lIIodl'! whnl'
X,
j, a constan t, and the lIl(l1krl lIwdl'l where X, is the
IIlarket return, The
COl1stanlIIII';tnreturn model, as the n,lIne inlplil's, as,ulII('s
that the
IIlcan return 01'.1 given secllrity is constan t through tillll'. Th('
mark('t
nlodel assumes a stahle linear relation betwcl'n t h!' IIlarkcl return
and
till' secllrit)' rl'turn.
4, /:1'1'111.'11111/,1' :\//(//)'1;1
'I. /':,1;111111;"/1
/W/(/'dllli', (JIIl'1' a lIonnal pI'I'lill'lllallCl' lIlodl'l has hl'l'lI SI'"'I"II'd, Ihl' p;ILlnll'lns ol'lhl' nllHlcllllllSI Ill' \'Slilllatt'd \lsillg a suhSl'1
01'1111' I\;(LI \..11011'11 ;IS IIII' 1'.\1;lIIl1lill// W;IIt!Ol/l, Tht' mosl CtlllllllOlI r\wict',
WII<'III",I,iblt, is lOllS,' IIII' 1'1'1 iod prior 10 IIII' 1"'l'III willdow I'ollhl' I'sliIlialiollll'illdOl", For I'X;lIl1plt, ill all 1"'1'111 SIllIly IIsilig Ilaily lIala alld Ihl'
lIIarkl'l IIH1,kl, iiII' 11I;II'kl'lllilHII'I param{'ll'ls cOllld 1)(' ('slimall'd oVl'r
IIII' I:!() davs prior 10 Ihl' ""1'111. Cl'lIl'rall: Ihl' l'I'I'1I1 pl'l'iod ilsdf is 1101
illdlllll'li illdll' I'slilllalioll plTiod 10 prl'VCllllhl' l'V1'1i1 I'rolll illflllelicillg
iiII' 1101'111;11 111'1'101'111;1111'1' 1I11.d'" l'arallll'll'l' l'slilllall'S,
:1, '/i'llillg/",/(,'dllli', \\'ilh Ihl' P;II;IIIII'II'I' l'slilllall's IiII' Ihl' lIonll;a! pnli)l'IIlalln' IHodel, IIII' ;lilllormal rl'lurllS I'all hI' calculall'd, NexI, \I'{' IIlTd
10 dl'sigll Ihl' (l"lillg I'rallll'\\'oll. lill' Ihe alllloflllal rl'llIl'IIs, ilnporlalll
l'ollsidnaliollS an' ddillillg 11ll' 111111 hYjlotlll'sis alld dl'll'rlllillillg Ihl'
1('dllliqlll'S lill' aggl'l'galing IIII' allllol'lIIal relllrns Orilldividllallinlls,
Ii, /':I11/Jiriml li'IIIII" Thl' PI'I'S"III:!lioll of Ihl' t'mpil'ical I'{,SlIlts rolloll's Ih{'
formilialioll 01'1111' ('COIIOIIII'll'ic dl'sigll, III addilioll 10 PI't'St'lIlillg IIII'
basir I'mpil it"al n'sillts, III<' Pl'l'Sl'lIlalioll of diaglloslics call hI' I'I'Uilflll.
(kclsiollalh. ,'sl)('('iallv ill sludil's wilh a limill'd III IIII her 01"'1'1'111 obsl'l'";lIiollS, IIII' ('llIpirie:!1 I'('SlIlts call be hl'oll'ily illlhll'lHTd by OIH' or Iwo
linns, Kll1lldl'dg" or Ihi' is illlportalil fi.1' J!;auJ!;illJ!; Ihl' illlport;III<T of
Ih,' rl'sil It s,
7, (1II"I/m'lali'"1 (lilt! "lIldllli"",, Idl'ally Ih,' "mpirical n'slilts will lead 10
illsighls aholll IIII' IlIl'l'hallisll\S hy which Iht' t'V"1l1 "fl'l'cls sl.'l'IlrilY pi in's,
Addiliollal allah'sis 111,1\' Ill' illriudl'd 10 dislillguish \)1'111'1'1'11 COU'lwlillg
I'Xplallali('IIS,
.154
4. EventStudy Allfllysi.l
(All
fot flll t.
El slI ] = ()
Var[s,tl
where Il;" the ith clement ofR" is the periodt retun! on security i, ~" is the
disturba/lce term, and a~~ is Ihe (i. i) clement of n.
Although the constantmeallreturn model is perhaps the simplest
model, Brown and Warner (I9HO, 1985) lind it often yields resu1L~ similar to those of more sophisticated models. This lack of sensitivity to the
model c1lOice can he attributed to the faCl that the variance of the abnormal
rel\lrn is frequently not reduced much by choosing a more sophisticated
model. When using daily data the model is typically applied to nominal
returns. With monthly data the model can be applied to rca! returns or
excess returns (the return in excess of the nominal riskfree return generally
measured using the US Treasury bill) as well as nominal returns.
l!i!i
The market model is a statistical modd which rdatcs the retlll'll or allY
givell security to the return of the lIIarket portfolio. Thl' lIIodel's linear
Sl)('cificatioll f()lluws from the assllmed joillt Ilormality of asset rcturns:1
For any security j we have
H"
(X,
+ {l,U"" + E "
where Ji alld N"" are the periodt rc!lIl'11S Oil scclII'ity i alld the market
"
portrolio, respectively. and f;, is the zero meall disllIrhallcc term. (X" fi;.
alld (1f~ are the parameters or the market model. III applirations a broadhased stork illdex is used ror the market ponf()lio, with the S&P!iOO index,
the CRSP valllcweighted index, alld the CRSI' eqll;liweiglitcd index heilll:
popular choices.
The market model represellts a potclltial illlJ)rovemellt over the CUIlstantmeanreturn mudel. By remuvinl: the portiun uf the return thal is
related to variatiull ill the market's returll, the variance of the abnormal
rCllIl'Il is reduced. This can lead to increased ahility to dcteCl evellt effects.
The h(,lIdit from using the market model will depelld IIpOIl the Ji2 of thc
lIlarketlllo(kl regressioll. The higher the Ji~, the greater is thl' variallce reduction of' the abnormal returll, and Ihe la, gcr is the gain. Sel' Sel'lion 4.'!A
for nlore discllssion of this poillt.
Oil
('lllpirical work.
Tillie Line:
,
\
est~malion ]
wmdow
event ]
( window
po~t~venl ]
( Window
o
r
Figure 4.1.
. dAi ri .'
J..~~;f. ..
,,':~~.;t'
.;;~~.
r;~'
.~:.
4. HlIflllSIIll!y illI(/!y.\i~
158
the event is endogenous. For these cases, Ihe usual inlerprelalion will be
incorrect.
It is typical/or the estimation window and the event window lIotlo overap. This design provides estimators for the parameters of the normal return
odd which are not inlluenced by the eventrelated returns. Including the
vent window in the estimation of the normal model parameters cOllld lead
o the event returns having a large influence 011 the norlllal return Ille<lure. In this situation both the normal returns and the abnormal rei urns
ould reflect the impact of the event. This would be problemalic since the
I~lethodology is built around the assumption that the event impact is (';'1)Lured by the abnormal returns. In Section 4.:' we consider expandin!( the
null hypothesis to accollllllodale changes in the risk of a linn around Ihe
event. In this case an estimation framework which uses the event window
returns will he reqllin~<I.
'1.4. J blilllfllillll
Recall that the market model for security i ami observalion r in event time
is
(4..1,1)
U" = u, + Ii,RIIIT + (",
The estimationwindow ohservalions call he expressed as a regn'ssioll system,
R, = X;O, + {"
where Ri ::::: [R;7i,+ I ... Ri'li l' is an (1'1 xl) vector of estimationwindow returns, Xi::::: [L R.,] is an (1'1 x2) matrix with a vector of ones in the lirst colulHn and the vector of market return observations R,.
[U,.7i,+I' ,Il"'/i J'
in thesecondcolulllll, allll (), =:: [u,fi,l' isthe (2x 1) parameterveclOr. Xhas
a subscript because the estimation window lIlay have timing that is specific
to firm i. Under general conditions urdinary least squan:s (01.5) is a collsistent estimation procedure for the marketIlludel parameters. Funher, /(ivelJ
the assumptions uf Section 4.3, 01.5 is efficient. The 01.5 estimalors of Ihe
lIlarketmodel parameters usill/( all estimatioll window or LI oilserv<ltiollS
arc
0,
II
ti.
11 ~ , '
R, 
Vade,]
X,B,
I
\V~ next show how to use these OI.S estimators
I
(1.4.4)
(4.4,ti)
to l1leasur(' Ihe slatistical
/{('/l/m.1
1!i!1
==
wh('l'('
R;
R'I X'O
I
/.
(4.4.7)
I U,r,+1
X; == It R;"I
E[R; 
X;O,
X; 1
o.
X;
(4.4.8)
fill' allthc dCIIH'IIIS olthe ahllonllalrctllrn vector, wililcad to s('rial correlalion of Ihe ahllonll.d reI urns dcspile lhe bet lhal lhe lrue dislurbances
arc indqlCndellt Ihrollgll lillie. As Ihl' length of the cstilllatioll willdo\\' 1,1
Iwcolllcs large, IiiI' second lerlll will approach zero as till' salllpling clTor of
lhl' paralllell'l's vallishes, alld Ihe abllorlllal relurns arross lime periods will
hecolllc illliq)(,lIdclIl ;tSl'lIIplOlicalll'.
1I11dl'l' tlie lIull hl'polhesis. 11 11 , Ihat the givcn ewnl has 110 impaci Oil
IIH' nlt'an or variancc of 1I'lurns, wc call lise (4.4.H) and (4.4.9) and Ihcjoilll
normalily of Ihe ahunrmal rei urns 10 draw inferl'lIces. Ullder Ilu, for the
\'cflol' of e\'l'lllwindow salllpll' ahllol'lllal rt"lIlnlS Wl' 'have
('1.4.10)
F(luation (,1..1.10) gil'es us IIJ(' dislrihution for any singk ahnormal rl'tul'll
ohsl'I'l'alioll. We ncxl hllild on Ihis resul! and cOllsider Ihe aggregalion of
ahnOrlllall'l'turlls.
,.
('1.4.11 )
1"/
V"r\(:A\{'(TI.
= ,'ViI'
(4.4.12)
VI'., (';111 cousln, .. 1 a It'sl (.1' II" 1'01 se .. ulily i from (4.'1.1 :') lIsing th., SI,lIld,ll'di/l'd nl'lnillali\'(' alHlol'llial 1<'111111.
SO\R,(rl. r~)
CAR,(rl'
T~)
(T/(r\, r~)
(.1. .!.l.! )
",herea/(rl, re) iSl'OlkuLlled wilh o,~ frolll (4.4.4) SlIhSlilUll'd li)r(1,~. L'nder
lhl' nlll1 hVl'ollll'si'; IIII' dislrihulioll ofS{:AR;(rl' r:!) is Sludelil I wilh 1.\  2
161
i;
(4.4.15)
\
!
(4.4.16)
I
(4.4.20)
162
4.
J~III'11I.SllUly
'\I/(/IY.I;'I
In (4.4.16), (4.4.18), and (4.4.~O) we use the assumption that the event
windows of the N securities do not overlap to set the covariallce terllIs t<)
zero. Inferences about the cumulative abnormal returns can be dra\"llllsill~
(4.4.~
1)
since under the null hypothesis the expectation of the ahnormal returns
_2
is zerD. In practice, since a 2(TI, T2) is unknowll, we can lise a (TI, r~) =
;& L::I u;(rl, r2) as a consistent estimator and proceed to test II" using
CAR(rl r2)
11 ==
[J
N(O,I).
(rl' r2)p
This distributional resuit is for large samples of events and is lIot exact
because an estimator of the variance appears in the denominator.
A second method of aggregation is to ~ive equal weighting 10 the indio
vidual SCAR;'s. Defining SCAR( rl. r2) as the average over N secnrities frol\l
event time II to T2, we have
SCAR(Tt. T2)
I)fu,(TIo r2)'
(4.4.~3)
,=1
12
= (
NU., 1.1 
4); __
I
l
I
\
I\we have developed reslllL~ using the market model as the Ilormal retLlnt
model. As previollsly noted, Ilsing the market Illodrl as oppmcd to the
IIi:!
,I
constantmeanreturn model will Ie,HI to redlldioll in Ihe ahnormal ret\lrn variance. This point call he shown hy C()nlp'lrin~ the ahnormal rclul"\l
variances. For this illustr,ltion we take the llormal returll model parameters
,IS gIven.
The variance 0(' the alJllortnal rellirn l(lI' the market model is
a,~
(x, 
fl, Um ,\
(I  U;lYar[UIIJ.
(4.4.25 )
U;
where
is the /{2 of the markellIIodel regressioll for security i.
For the cOllstantmeanrellirn model, the variance of the abnormal retUI'll ~" is the variance of the uncolHlitional retul'll, Yar[ U" J. that is,
o~~
:=
YarlU" II,!
:=
Yar[Uill.
(4.4.26)
(4.4.27)
H;
Since
!;es betwccn zero and one, tbe variance or the abnormal return
using the market model will be less than or eqllal to the abnormal retllrn
variance using the constantmeanreturn model. This lower variance for
the market model will Gln'Y OVCI' into all the av;v;nv;atc abnormal retlll'll
lIleaSllres. As a result, usinv; the ",arkel ",,,dd .all lead 10 llIore precise
infl~rellres. The v;ains will he v;reatl'st for" '''ll\plc of "'<:Ilriti,'s with hiV;h
lIlarketmodel U2 statistics.
III principle further illcreases in U 2 cOllld h(' achieved by using a Illultiractor model. In practice, howevCJ', the g.lins in /{2 fwm adding additional
ractors are usually small.
Table 4.1.
..lhI/lJUI/I/III'IIIu/'
/111" (/1/
(1'1'111 ,111111'
"lIlit' ili/iJUI//lliulI
11011111""""'11/\,
\1;1It...'1
:.. \I(
i'
C'\I{
i'
C'\I{
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':!O ttl 'ht' ... "t'c. iht'd el.l\'. F\('ut lime i .. mc."'lIll't\ in dO\y!<i rt'l.uin' hi the ;HlIHllllU'(,l1It'Ht d,\h',
,
165
0.03
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NnNC'WI Fir"1I
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0.01
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~.03~~~~ww~~WW~~WW~LUWW~WU~~
20
10
10
20
Event Time
Figure 4.20.
111m I.'
0.03
0.02
CouciNt.,W!\o
.,.
(j
~
()
"
Firm~
\.
0.01
NoNcws Firml
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0.01
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0.02
20
10
Firms
10
20
Event Time
I
I
166
4.
EllelltSlud.~
A 1I1/(~sis
using the market model is 0.965%. Sincethe standard error Ilf the oneday
goodnews average abnormal return is O. I 04%, the value of 11 is !1.~H and
the null hypothesis that the evellt has 110 impact is strongly n:iecled. The
story is thc same for the hadnews finns. The event day sample ahnorJnal
return is 0.679%, with a standard error of 0.098%, leading to 11 eqllal to
6.93 and again strong evidence against the null hypothesis. /\s wOllld he
expected, the abnormal re\Urn of the nonews firms is slllall at o.ml1 %
and, with a standard error of 0.098%. is less than one st'UHlanl error frolll
zero. There is also some evidence of the announcement e1lect on day OlW.
The average abnormal returns arc 0.25 I % and 0.204% for the goodnews
and the badnews firms respectively. Both these values are more than two
standard errors from zero. The source of these dayone effects is likely 10 be
that some of the carnings announccmcnts arc made on cvent day zero after
thc c10sc of thc stock markct. In thesc cases the cffects will he caplured in
the return on day onc.
Thc conclusions IIsing the abnormal returns from the constantIllcanrcturn model arc consistent with those from the market modcl. Ilowever.
there is some loss of precision Ilsing the constantIlleanreturn lIlodel, as Ihc
variancc'of the avcragc abnormal rcturn increascs for a)) thrcc categorics.
When measuring abnormal rcturns with the constantmeanrelllrll model
the standard crrors increasc from 0.104% to 0.1300/0 for goodnews finns,
from 0.098% to O. I ~4% for noncws firms, and from 0.098% to O.I:H %
for~)adnews finns. Thesc increascs arc 10 bc cxpcctcd whcn consideril1g
a s~mplc of large IInns sllch as those ill the Dow Index since Ihese slOl'ks
ten~1 to have an important markct compunenl whosc variability is elimillated
using the market modcl.
!The CAR plots show that to SOIllC cxtent thc markct gradually Icams
abo~1\ the forthcoming announcemcnt. The avcrage CAR of thc goodnews
fil"Ofls gradually drifts up in days 20 to I, and the avcragc CAR of thc
bad ncws firms gradllally drifts down over this period. In thc days after the
am unccmcnt the CAR is relatively stahlc, as would be expcctcd, although
the c docs tcnd to hc a slight (hut statistically insignificant) increase for the
bad news firms ill days two through eight.
4.4.61I1jl'll'II(f.\ with
Clll~/l'rillg
l\i7
OIlTtip, the covarianccs betwc('n th(' abnorlllal r('lurns lIlay dilfer 1'1'0111
Z(TU, and th(' distributional results preselll('d Ii) .. Ih(' a~~rq~al('d almormal
r('lums art' uot applicable. lkmanl (1~IK7) dis(lIss('s SDIll(' "I' tl\(' prohlems
relaled 10 c1ustcrin!{.
\"'hen thcre is onc evcllt date in calendar tillll', dusterinv; call he accom1ll()(\atl'd ill two dilkrcnt wa),s. First, thl' abnormal returns Gill he
aggr('g;llcd into a portfulio dated using (,\'(,lIt tillll', and thc sccurity ieI'd
analysis ofScnion 4.4 can be applied to the porth)lio. This ;Ipproach allows
for cross correlation of thc abllormal retllrns.
A sccond way to handle clustering is to analyzc th(' almurmal relllrns
wilhout <Igv;regation. Qne can test the null hypothesis that the evellt has ilL'
impact Ilsin!{ lIna!{wegated seclIrit),hysecllrit)' (\at,\. TIll" basi, appro,lCh is
an application of a lIIultivariate rc!{r('ssioll lIlodel wilh dUlllnl)' variables fur
the cvent date; it is c1usely related to the lIIultivariate Ftest of the CAPM prescnted in Chapter ;}. The approach is developed ill the papers of Schipper
and Thompson (I !IH3, 19H!i), Malatesta and Thompson (I !IH:)), and Cullins
aII'I Dent (I !lH4). It has some advantav;es relativc to Ihe portfuliu approach.
First, it can arculllmutlate an alternative hypothesis where sOllie of the linns
h,l\'c positive ahnormal returns and some of the firms have nev;ativc al)llorm,d returns. Second, it can handle cases when' thne is partial dustcrin~,
Ihat is, where thc CVCllt datc is not Ihc same across linlls bllt tlane is overlap
in the evcnl windows. This approach also has SOllie drawbacks, however. In
t1\;II\Y CIS('S till' tl'sl statistic h,ls poor tinitesample propnties, and oftl'lI it
h;I' liuh power against economiclily rcasonahk altl'rnatiws.
(1,:1,1 )
'

'"
~I
I
I
t
\
I
I)
I
1'1'1'111 silldy, 11'1' 1I1"l'd III kllow whal is our ahililY 10 ([('ItTI
Ihl' pn'sl'lIn' of a noulero ahIlOI'lIl;\I relurll, III Ihis seuioll WI' ask ",hal is
IIII' likdihood Ih"l ;llll'VI'IlISllId)' It's I rcjcl'ts the 111111 hypolh('~is for a gin'lI
level or aillloflllal 1'('1111'11 associaled Ivilll all 1'1'1'111, thaI is, "'I' ('vaillal(' i11t'
POIl't'!' or Ihl' It'S!.
'\'1' cOllsidl'r a twosided lesl "('Ihl' 111111 hypothesis \Ising Ihl' l'\Il\1ulalil'l''1IlIIOl'lllaln'lllrllh"~I'd slalistil./I ('rolll ('1.'1.~2), WI' aSS\lIlll' Ihalthc ;Ihll!)rlHall'l't\lrns arl' \lllrlllTdall'c! a<TOSS s('cllrilies; thlls Ihe variallct' of C:"\R is
 " rl, r~ l, wlll'l'l' ,7'(
 " rl, r~) == 1/ N" \L;~
~ v"
,
(1(
1(1;( rl, r~) aliI IN'IS Ihl' s'\llIplt: Slfl',
Ulltier Ihl' 111111 hypolhl'sis Ihl' dislrihlltioll 0(' JI is stalldard norlllai. For a
IIVOsilil'tilt'SI ofsiJ('11 WI' rl'jl'rl Ihl' 111111 hypollwsis if.!1 < I(a/~l or if
,It > I\} I ( I  u /~) 11'111'1'1' 'I) (,) is I he st;lIllianl IIormal l'IlIlllllal ivl' tiisl rihlll ion
IIIIII'Iioll (CI>F),
169
4.6. AllalY.fiso/Power
we
Gill
Pea, H A)
H A)
I HA).
(4.6.1 )
With this framework in place. we need to posit specific alternative hypotheses. Alternatives are constructed to be consistent with event studies
using data sampled at a daily interval. We build eight alternative hypotheses
using four levels of abnormal returns. 0.5%. 1.0%. 1.5%. and 2.0%. and two
lcvels for the average variance of the cumulative abnormal return o~ a given
sccurity over the sampling interval. 0.0004 and 0.0016. These varia~ces correspond to standard deviations of2% and 4%. respectively. The sample size,
that is the number of securities for which the event occurs, is varied from
I to 200. We document the power for a test with a size of 5% (a
0.05)
giving values of 1.96 and 1.96 for <1>1 (a/2) and <1>I(Ia/2), respectively.
In applications. of course, the power of the test should be considered when
selecting the size.
The power resultsare presented in Table 4.2 and are plotted in Figures
4.3a and 4.3b. The results in the left panel of Table 4.2 and in Figure 4.3a
are for the case where the average variance is 0.0004, corresponding to a
standard deviation of 2%. This is an appropriate value for an event which
does not lead to increased variance and can be examined using a oneday
event window. Such a case is likely to give the eventstudy methodology its
highest power. The results illustrate that when the abnormal relUrn is only
0.5% the power can be low. For example. with a sample size of20 the power
of a !l% test is only 0.20. One needs a sample of over 60 firms before the
power reaches 0.50. However, for a given sample size, increases in power
arc suhstantial when the abnormal return is larger. For example, when the
abnormal return is 2.0% the power of a 5% test with 20 firms is almost 1.00
with a value of 0.99. The general results for a variance of 0.0004 is that
whcn the ahnormal return is larger than 1% the power is quite high even
for slllall sample sizes. When the abnormal return is small a larger sample
size is necessary to achieve high power.
In the right panel of Table 4.2 and in Figure 4.3b the power results
are presented for the case where the average variance of the cumulative
abnormal return is 0.0016, corresponding to a standard deviation of 4%.
This casc corresponds roughly to either a multiday event window or to a
oneday event window with the event leading to increased variance which
is ;ICcol\1l1loc!ated as part of the nllll hypothesis. Here we see a dramatic
decline in the power of a 5% test. When the CAR is 0.5% the power is only
0.09 with 20 firms and only 0.42 with a sample of200 firms. This magnit\ude
II
4. EventStut/.v All11~VJiJ
Tat1e 4.2.
"film is
10 rrjr<1I11,
ZLm.
Sample
ISize
1.0%
0.06
0.06
0.07
0.08
0.09
0.09
0.10
0.11
0.12
0.12
0.13
0.14
0.15
0.15
0.16
0.17
lUll
0.19
0.19
0.20
0.24
0.211
0.32
0.35
0.39
0.42
0.49
0.55
0.61
0.66
0.71
0.78
0.84
0.S9
n.92
0.94
0.08
0.11
0.14
0.17
0.20
0.23
0.26
0.29
0.32
U.35
0.311
0.41
0.44
0.46
0.49
0.52
0.54
0.56
0.59
O.fil
0.71
O.7B
H.1I4
O.II!!
0.92
0.94
0.97
0.99
0.99
1.00
1.00
1.00
1.00
1.00
1.00
1.01l
(I
2
3
4
5
6
7
8
9
IU
II
12
13
14
15
16
17
III
19
20
25
30
:lr.
40
45
50
60
70
80
90
100
120
140
100
1110
200
Abnormal Return
Abnormal Return
0.5%
15%
2.0%
05%
1.0%
0.17
0.2!1
0.41
0.52
0.61
0.69
0.75
OJ\!
IU\;,
0.119
Il.!ll
0.93
0.95
0.96
0.97
0.98
0.98
0.99
n.99
0.99
LOO
LOO
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.110
1.00
1.00
1.00
1.01l
1.00
0.05
0.05
0.06
0.06
O.Ofi
0.n6
n.06
0.06
0.07
0.07
0.06
0.06
0.07
O.OS
O.ll9
0.09
0.10
0.11
0.12
0.12
0.13
0.14
0.15
0.15
0.16
0.17
=2%
0.12
0.19
0.25
0.32
0.39
0.4!>
0.51
0.:)1)
O.f,1
O.fil;
D.70
0.74
0.77
O.!!O
0.83
ON,
0.117
0.119
0.90
0.92
O.9\i
O.!!II
O.!l!l
1.HO
1.0H
1.00
I.on
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
(I
o.m
0.07
0.07
0.08
0.08
0.08
(I.OH
(1.011
(l.OIl
O.O!)
(1.1 0
0.1 I
0.11
0.12
0.13
0.14
O. ](;
0.18
0.20
0.22
0.24
0.211
0.32
0.35
1l.:19
042
15%
2.0''',
= 4%
(l.~H
0.19
0.19
0.20
0.24
n.211
0.:12
0.3:.
0.39
0.42
0.4!)
0.:):)
0.61
0.6ti
0.71
0.711
0.84
O.S!I
0.92
0.94
0.07
0.011
O. ((l
0.12
0.1:1
0.1!>
0.17
O.I!!
0.20
D.22
1l.24
n.2:,
0.27
0.29
0.31
0.32
0.:14
n.:\(;
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0.47
0.:,4
n.w
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0.71
1I.7h
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1I.!)2
O.!)4
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1.00
LOt)
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0.011
0.11
0.14
0.17
0.20
0.2:1
O.2ti
O.2!1
IU2
0.3:,
0.38
nAI
0.44
0.41;
0.49
0,!',2
0.;"1
0.:,1;
()59
IUil
lUI
0.711
CUIl
CUI!1
H.92
II.!H
0.!)7
n.!'!)
II.!)!)
LOll
1.00
1.00
1.00
I.I~I
1.00
1.0\1
pow~r
is reportc(1 for a tcst with a !'lilt" of' 5%. Th(' sample sil.c is the IHlIl1h('1 of t'\'('rH
included in the study. Olnd rr is the sqllal't' root of the average \'~tri"I\('(' of the
abnormal return ",cro~'" f\nu~.
The
uh~crv"tions
of abno~mal relurn is difficult to delect with the larger variance of 0.00 IIi.
In conlraSl, when the CAR is as lar~e as 15% or 2.0% the 5% lCst slill has
reasonable power. For example. when the abnormal return is 1.!'J'Yo and
171
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0
<D
<; 0
" .,.
0
c..
0
0'1
'~'....L.'~'''''~''L.L.1_'.l.''
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I0
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100
Sallll'i,' Sill'
(h)
Figure 4.3. 1'0"''''' "l ElII'II/S/wly '/i'.11 SllIliM;"./1 (II Ufjrrl tllf' NlIlI IIY/I(II/t,.li.\ l/tal tiff
AbllOnluzlllPillfll i.I /.I'IlJ. ~\?lfl! Iii, S'/IUII' illlllt "J rI,,' '~!"''''r;r \'II;f/I/,r IIf Illr Abllormal
liflum Arml.' i'ima i.\ la) 2% f/Tlff IIJ) 4%
there is a sample sizc of :'0. thc power is 0.:>'1, Generally ir lhe abnormal
return is large one will havc little dif'/iculty n~ectillg th(' lIull hypothesis of
IlO abnormal return,
We have calculated power analytically using distributional assumptions,
If these distributional assumptions are inappropriatc thcII ollr power calculations IIIay be inaccuratc_ llowcver. Brown and Wamcr (1 9H:)) cxplore this
./.
J:lII'lI/S/III/y .. II/(//pil
issu(' ;lIl1llilld Ih'll III(' ;III,III'li(al (OIIlIlIlI,lIiO\lS a\ld Ih(' "lllpil'icII }l()\\'(T ,\I'l'
do,,'.
\'('1'1'
/1
] N'/~
Vf
'  0.:.   ~
[ N
0.:1
N(o.
I) ,
173
event day zero. The framework can he easily altered for events occurring
over lIlultiple days.
Drawing on notation previollsly introduced, consider a sample of LJ
abnormal returns for each of N securities. To implement the rank test it
is necessary for each security to rank the abnormal returns from I to loIJ.
Ddine KIT as the rank of the abnormal return of security j for evenl time
period r. Recall that r ranges from Tl + 1 to T:z and T = 0 is the event day.
The rank test uses the fact that the expected rank under the null hypothesis
is
The test statistic for the null hypothesis of no abnonnal return on
event day zefo is:
14 =
s(lJl)
I~
IJl
I)
K~l  ~ /s(ld
Ll r='1i+1
(~t (K
N
;=1
_ loIJ
IT
(4.7.1)
+
2
I)Y
(4~ 7.2)
:
Tests of the null hypothesis can be implemented using the result that the
asymptotic null distribution of J~ is standard normal. Corrado (1989) gives
further details.
.
I
Typically, these nonparametric tests are not used in isolation bllt in
conjunction with their parametric counterparts. The non parametric tests
enable one to check the robustness of conclusions based on parametric
tests. Such a check can be worthwhile as illustrated by the work of Campbell
ami Wasley (1993). They find that for daily returns on NASDAQ stocks
the non parametric rank test provides more reliable inferences than do: the
standard parametric tests.
I
(4.8.1 )
when' 0 is the (Kxi) coefficient vector and fl is the (Nxl) disturbance
E[X'fll = 0, we can consistently estimate (1 using OUi.
wC\or. A~suming
174
4. El/t'1llSllli(V 1I11f11.\',li,1
Assuming thc c\clllcnlS of 1/ arc crosssectionally uncorrclatetl allli hOllloskcdastic, infcrcnccs can be derived using the usual OLS standard errors.
Dcfining (J~ as thc variancc of thc clcmcnts of 1/ we have
(4.H.3)
.~
a 1/ 
I.,.
(N  K)
(4.HA)
1/1/ ,
wherc r, == y  xiJ, wc call construct Istatistics to asscss the statistical si!{lIiliGIlIce or the clelllel\l~ or 0. Alternatively, without assuming hOl\loskcdastkity, wc can construct hctcroskcdasticitycolISisten t 2statistics usin!{
\
\
Var[9]
= .!. (X'X)I
N
[t XIX;r,;]
(X'X)I,
i=1
wherc x; is thc ith row of X and i'i is th<; ith element of r,. This cxpression
for \he standard errors can be dcrivcd using thc Gencralizcd Method of Mome~lS framework in Scction A.2 of the p.ppem\ix and also follows rrOIll the
rcs Its or Whitc (1980). The usc of heteroskedasticityconsistent standard
err rs is adviscd since therc is no rcason to expcct thc residuals or (4.H.I)
to b homoskcdastic.
quith and Mullins (19HG) provide an examplc of this approach. The
tw lay cumulative abnormal rctufll for thc announcemcnt of ,III equity
offe ing is regrcsscd on thc sizc of the offering as a perccntagc of the value
of tl e lotal cquity of thc firm and Oil the cUlllulative abnormal relul'II ill
thc leven months prior to the annollnccmcnt month. They lind that the
mag itudc ofthc (ncgative) abnormal rcturn associatcd with the allllOllllcemcn~ or cquity offcrings is relaled to both thest' variables. Llrger pre'Cvcllt
cuml.lalivc abnormal rcturns arc associatcd with less negative abnormal
rendns, and largcr offcrings arc associated Wilh lIIorc ncgativ(' ahnormal
retll~ns. Thcse findings are consistent with theoretical prcdiclioJ1S which
thcy discuss.
Onc lIIust be carel'ul ill interpreting the results of the Cfosssenional rcgression approach. In many situations, the eventwindow abnormal r('llIm
will he relatcd to firm characteristics not only through the valuatioll effects
of thc cvcnt but also through a relation between thc linn characteristics
and thc cxtcnt to which the cvent is anticipated. This call hapJl('1l wht'll
4.9.
FIII"//I/'I" lUIIt'.!"
I.
1:IJrI/ISll/fly Al/aly.I;.!
'~.
c:.
~
OJl('MlIlllh Inh'l\,11
(I
:!II
.(0
fill

HO
1110
1:!O
110
1fill
1HO
:!OO
S;lIIII'''" Sill'
Figllre 4.4.
1',,/1 1,"1
"/
1."1'1'II1SllIIly 'li'll Slal;I/;I".h III Jlpjrd Ihp NIIII "Y{i(llhl'.lil Ihal Ihp
:lhllllnllal JlpllIlIl il
lit IIII'
Thlls br Wl' kll'l' ;\SSII\\l('(llklllhl' ('\,(,111 d'lIl' call he idl'lIliliec! wilh n'naillil'.
Ilowever, ill sonll' sllllli,'s il Ill;\\, he difficult to idelllify Ihl' exan dale. 1\
l'OIllIllOIlI'X;lIl1pll' is when ('olkclinJ,!; "I'l'nl dates fromlinanrial puhlicaliolls
sHch as Ihl' Ilidl SIIi'I'I.!m//'IIal. When IIJ(' I'Vl'llt anllOlllll'l'lllent appears ill
Ihe III'WSpa!H'!' onl' ,all 1101 !)(' l'l'l'laill if the markl'l was inlilrllled Iwji)l'"
IIII' dose 01 III(' 1II;lIk"1 IIII' priol Irading day. If this is Ihl' ('ase Ihell Ihe
prior d;w is II\(' ('WIlt ,\;tv; if lilli, Ihl'lI Ihl' (,UITl'nl day is Ihl' eVl'nl day. The
uSllal nll'lhod of handling 111i\ 1'1'0111"11\ is 10 expa\\d Ih .. 1'\Tnl wi Ild 0\\" 10
111'0 daysdal' 0 and ,b)' + I. Whil .. Ihel'l' is a ('osl 10 ('xp;llldillJ,!; th .. ('\'('111
windo\\', IIll' Inll!" ill S'Tlion 'I.ti illdicall' Ihallhe pOlI'I'r propl'rties or 111'0day ('Will willdows ;11,' still gOlld, ~lIgg,'slillg Ihal il i~lI'orlll h('aring 1111' ('oSI
10 ;lvoiclllll' risk Ilr Illissillg Ihl' 1'1'1'111.
flail and Torous (1988) investigate this issue. They develop a maximumlikelihood estimation procedure which accommodates eventdate uncertainty and examine resull5 of their explicit procedure versus the informal
procedure of expanding the event window. The resull5 indicate that the
informal procedure works well and there is little to gain from the more
elahorate estimation framework.
4. EuenlSllu(V tll/f/ly.\is
There can also be all upward bias ill cumulative ahnormal returns wh('11
these are calculated in the llslIal way. The bias arisdi frolll the ohservalionbyobselVation rebalancing to equal wcighL~ implicit in the calculation or
the aggregate cumulative abnormal retum combined with the lise or transaction prices which can represent hoth the birl alld the ask side or the
market.. Blume and Stambaugh (1983) analyze this bias and show that it
can be important for studies using lowmarketcapitalization finns which
have, ill percentage terms, wide bidask spre;lds. III these cases the bias Gill
be cjminated by considering cUllIulative ahnormal returns that represent
bUYindhold strategies.
4.10 Conclusion
In c1jsin g, we briefly discuss examples of evelllstudy successes and limitations. Perhaps the most successful applications have been in the are,1 of
corp rate finance. Event studies dominate the empirical research ill this
area. lmportant examples include the wealth effects of mergers and acquisition! and the price elTects of financing decisions by firms. Studies of these
evellllltYPiCall Y [ocus on the ahllonnal return around the date of the lirst
anllOl ncelllent.
II the 1960s there was a paucity of e!npirical evidence 011 the wealth
elTecL<;! of mergers and acquisitions. For example, Manne (196:,) discllsses
the vaJious arguments for and againstlllergers. Al that time lhe d(,hate ("('11tered ~n the eXlenllO which mergers should be regulated in order to foster
comP9lilion in the product markets. Manne argiles that mergers represent
a natural oUlcome in an efficiently operating market for corporale control
and consequently provide protection for shareholders. He downphlys the
importance of the argumenl thal mergers reduce compelition. At the conclusion of his article Manne suggests that the two competing hypotheses
for mergers cOllld be separated by studying the price eflects of the involved
corporalions. He hypothesizes thal if mergers created markel power one
would obselVe price increases for both the target and acqnirer. In contrast
if the merger represented the acquiring corporation paying for control of
the target, one would obsen'e a price increase for the target only and 1I0t
for the acquirer. However, at thal time Manlle cOllcludes ill refen'I\C<~ to
the price effects of lIlergers that " ... no data are presently availahle on this
subjecl."
Since thaI time an enormous hodyofempirical evidence on mergers and
acquisitions has developed which is dominated hy the usc of evelll studi(s.
The gellera! result is that, given a successful takeover. the abn,onnal retllrns
ufthe targets are large and positive aud thc ahnormal returns of the aClJllircr
ue close to zero. Jarrell and Poulsen (19H~) lind that the average ahnorlll;ll
179
retul'll li>r larf\el shareho lders excenls ~()(X, li>r a s'"l1pk of titi3
successf ul
takeover s frolll I~Hi() 10 19H5. III cOlllras llhc "lmOl"III,1I relum
(ill' acquirer s
is close to zero OIl 1.14%, and evell nef\,lliv(' al 1.10% in Ihe
19HOs.
Eckbo (I ~IH:1) explicitl y addresse s Ihe role of increase d markel
power
ill explaini ng nlergcr related ahnorm al r('lurIlS. I Ie separate
s nH~lw~rs of
competi nf\ lirms rrolll other merf\ers and linds no evid"n'T that
thc wealth
circus for cOlllpeti nf\ lirms arc differen t. Furtllt'r. he linds no cvidenc
c that
l'iV,lls of' linns IIIt~rf\in!{ horizont ally "xperit'I HT lIegativc abnorlll
al I ctllms.
FrOIll this hc concllld cs that redllced cOlllpct itioll ill the prodllrt
markct
is not an importa nt explana tion ror III'T!{Cr gains. Thi.~ leaves
(t)lnpcti tion
for corpora lc control a more likely cxplana tion. Much addition
al empiric al
work in thc arca or mergers anti acqllisit ions has Iwen conduct
cd . .Jensen
alld Ruback (I !lH3) and.larr ell, Brickley. alld Netter (I ~IHH) provide
detailed
survcys or this work.
A number of robust results havc bcclI dcvelop cd from cvent
studies
or financil lg dccisioll s by corpora tiolls. Whcn a corpora tion
announ ces
tI.'lt it will raise capital in external lIIarkcts there is on average
a negative
abnorm al retul'll. The magnitu de of the abnorm al rcturn depends
on the
sourcc or cxtcrnal financin g. Asquith and Mullins (l~lH()) study
a sample of
2GG firms ,1I11l011llCillg an equity issue in the pniod I~)W to 19HI and
filld
that tile twoday average ahnorm al rt'l1ll'1I is ~.7%, wllil,' on
a sam pIc of
80 finns for the period 197~ to 19H~ Mikkels on and Pal tch (I!lHfj)
find that
the twoday avcra!{c ahnorm al relurn is :{,;>!i'X,. In contrast
. when lirms
decide to usc straight dcbt linancin! {. Ihe averag'~ ahllorlll al rcturn
is doser
to I.ero. Mikkels oll alld Partch (1!IH(i) lilld tht'
;IWLlg" ;\I>11orlllal return
for debt issues to be O.~3% for a sample of 171 issues. Finding
s such OIS
tllesc provide thc fud for the dcvelop ment of new theories . For
example .
these external financin g results Illotivatc thc pecking order theory
of capital
Siructur e develop ed by Myers and Majluf (1~IH'I).
A major success related to thosc in the corpora le fillancc area
is the
implicil accepta nce of eventst udy methodo logy hy Ihe lJ .S. Suprem
e Court
for dctCl'm ining material ity in imider trading cases and li>r
determi ning
appropr iate disgorge lllent amollnt s in cases of fralld. This implicit
aCtTptance in lhc I ~IHH Basic, Incorpo rated v. J .cvinsoll case alld its
importa nce
for sccuritic s law is discusse d in Mitchell and Neller (1~194).
TIH'rc havc also been less slltTt'ssful applicat iolls of cventst udy
IIlcthod oIOh'Y' An importa nt characte ristic of a slIcccssful e\'t'nt stud),
is the ability
to idellliry precisely Ihc date of the cvelli. In cascs \\'hne the date
is difficult
to idelllify or the evcnt is partially antirip'i lcd. eVCIII studics have
been less
useful. For cxample . thc wealth dferls of n'!{uIator), changes j(>r
alkned entilics can hc diHicult to dClect usillg t'\'t'ntst udy IIlelhodolol.'Y The
problem
is that regulato ry challgc.~ arc often dcbated in Iht' polilic" ,IITlla
ovt'J' time
alld any aC(,(>lllpanying wealth cf(('((S will he ineol porated graduall
y inlO
4,2
\
I
YOII are giv(,11 Ihe li,lIowillg illlimnalioll for an eW1I1. AhllorJllal I'l'IIlI'llS an' salllpkd al all illl("l"val of 0111' day. Th(' (,vcnlwindow Ienglh is
Ihn'(' days, Th(' IIll'all ahnol'ln,tI relllrn owr Ihe f'V{'nl window is (I.;\'}{, pn
da)'. '1'011 ha\'(' a salll)llc oi" :,0 ('VI' II I ohservations. Tht' ahnorJllal r('lllrns an'
int!('p(,lld('11l across thl' ('\'('nl observalions as well as across ('Vl'llI days for a
giv(,1l CVI'III ohs('I"valion. For :?:, o/Ihe ('\'('nl ohservalions IIII' daily slandalCl
d('vialion of Ihl' alllHlllllal 1'('1111'11 is :~'y,) and lilr llle rl'mainillg 2:, OhSI'IT;Iliolls Iht' flail), siandard dl'vi;lIioll is li%. Civclllhis infilrmatioll, whal would
1)(' 111(' pow('\" of Ihe leSI for ;111 ('v('nl sllldy IIsing Ille clIlIllllaliVl' ahllormal
rl'tllrn test statistic ill (''1l1alioll (1.1.2~)? What would hI' Ihl' pOWl'l' IIsillg lhl'
stalldanii/('d C1mlllialiv(' ahllol'lllal n'llIrII lest slalislic in eqllation (4.4. ~I))
For Ihl' pow('r (,;licubliollS, aSSIlIl\(' lilt' st;IIHbrd dl'viation Ilf II,ll' abnol'lllal
rt'llIrllS is knolVlI.
4.3 Whal wOllldl)!' Ih(' answl'I's III qlll'Slioll '1.2 il'lhe IIll'an ahnllrmal r('llIrn
is O.li'Y., pl'r dav f(,r Ihe ~:, linll.s willi Ihe larger siandard dcvi;llion?
182
E[R;]
=:
Ilj
+ fiilll(E[R",]
{Jim
=:
Covlll" Nm ]
,
Var[Ntn ]
 IV)
(:;.1.1)
(:).I.~)
wi erC Il m is thc relltrn on the market portfolio, and Ilj is the return 011 the
ris free asset. The SharpeLintner version can be most compactly expressed
in ~erms of returns in excess of this riskfree rate or ill terllls of ,xrru nlum.l.
Le\ lj represent the reUlrn 011 the ilh asset in excess of the riskfree r,lle,
Z;
H.  Hj . Then for the SharpeLintner CAPM we have
:=
E[l,]
Plln
iJimml",]
([d.:1)
Covl1.j , 1.111 J
Var(l,n)
(:>.1.4 )
where l,. is the excess return 011 the market portfolio of assets. Because the
riskfree rate is treated as being nonstochastic, equations (5.1.2) alld (!d.4)
are equivalent. In empirical implementations, proxies for the riskfree rate
arc stochastic and thus the betas can differ. Most empirical work rebting to
the SharpeLintner version employs excess returns and thus uses (5.1.4).
Empirical tests of the SharpeLintner CAPM have focused on three implications of (5.1.3); (1) The intercept is zero; (2) Beta completely captures
the crosssectional variation of expected excess returns; and (3) The market
risk premium, E[z..J is positive. In much of this chapter we will foclls on
the first implication; the last two implications will be considered later, in
Section S.B.
In the absence of a riskfree asset, mack (I ~172) derived a more general
version of the CArM. In this version, known as the Black version, tht' expected return of asset i in excess of the l.erahet'l return is linearly related
to ito; beta. Specifically, for the expected return of asset i, E[ R,l. wt' havc
E[N,)
=:
Elll"",]
+ fl,,,,(Elll,,,1
 E[ll. .. ).
ll,. is the return on the market portfolio, and It .. is the return on thl' um
portfolio associated with III. This portfolio is defined to he the portfolio
that has the minimullI variance of all portfolios nncorrelated with 1/1. (Ally
brla
5.1.
1I1'l/jl'w
oflhl' CAI'M
18;\
other 11l1('olTdatcd ponfolio wOllld have till: same expcctl'd retlll'll, hilt a
highl'l'variancl'.) Sincc it is wealth in n~.d tnms th"t is relevant, lill' the
Black Illodcl, retllrns arc gener.lily stated on ,III inll.lliOll"djusted hasis and
fI"" is ddilll'(t in tt'nns of real retllrllS,
fi,m =
Econoilletric analysis of the Black version or the CAI'M treats the I.('IOh('ta
ponfolio rellll'll as an u1Iobserved qu.,ntit)', making the 'lll'll),sis more con.plicatcd than that of the SharpeLilll1l('" vl'l'sioll. The Black vlTsion Gill he
tested as a restrictioll on the re;!Iretul'll market III(HIl'I. For the realretltrn
m'lrkct model we have
E[N;] = u""+/i""E[N,,,I,
ex"" = E[N"",]
(I 
fI",,)
Vi.
Ud.Hl
III \I'ol'ds, the Black model restricts thl' ;I~setspt'cilit illtlTt't'j>l of the realretul'll market modcl to be equal to the ('xlH't'tt'd l('loIll'ta portli,lio retul'll
tilll('s olle minlls the asset's beta.
The CAI'M is a singleperiod Iliodd; hence (:',.1.:\) and (:,.1.:1) do lIot
h'll'c .1 tilllc di mellsion. For ecollometric analysis of till' Illot kl, it is nefessary
to add an asslllnption concernin!{ the timeseries heh<lvior of returns and t'stim,lte the model over time. We assume that retllrllS arl' independe1ltly ;md
idcntically distributed (110) throltf.(h tinle and jointly lI11dtivariate 1Iormal.
This assllmption applies to excess retllrns for the SharpeLintller version
and to real retllf'llS for the lllack version. While the "SSlllllption is strong,
it has the bendit of being theoretically consistent with the CAl'M holding
period by period; it is also a good empirical approximation for a Illolllhly
ohservation interval. We will discllss rclaxinf.( this assllmption in Section !'l.G.
The C..AI'M can be useflll for applications requirinf.( a measure of exp('cted ,tock returns. Somc applit"atiolls illdude cost of capital estimatiOll,
portfolio performance cvaluation, and eventstudy 'lIIalysis. A~ all eX<llllpll',
we hriclly discuss its lise jill' estilllatill!{ the cost of npital. The cost of equity
G1pilal is required for use in corporate capital hlldgetillf.( decisions and in
tile dl't('l'lIlill<ltion of a fair rate of rctllJ'll for 1'('f.(ul;lIl'llutilities. IlIIpl('lIIcut;lIion of the lIlodd rcqllires three inpltts: tite stock\ heLl, thl' market risk
premiulll, and the riskfrl'e return. The uSII;1I estilllator oflll'ta of the equit),
is the OI.S eMimalO1' of the slope codlicit'llt ill tite ('X('('SSrt'llIf'11 market
model, that is, the heta ill thl' n'f.(rt'ssioll ('qllatioll
(.rI.I.!)
\\'11('1"(' i d"lIoles llie ;!sSC'1 and I d,'lIo'S Ihe lilllC period, I = I, ... , 'f. /."
alld /."" are II,,' rl';,li/l'd ex\'css n'IIII'IlS ill lilll!' period I for asst'l i alld lile
lIlarkel portt(,li", /l'I)('clil'dy. 'I)'pically Ihe Sialldard alld Poor's !iOO Illd,'x
s('rves as a prox\' 1(.1 11f(' Illalkel portlellio, alld tlie US Tr('asury hill r;lIe
proxi,'s li.1' III(' riskIn'" n'llIl"/I. 'I'll,' eqllalioll is lIlosl cOlllIIIOllly ,'stilllOltl'd
IIsillg :. ye;lrs "rlllotllltl" dala (.,. ::::: (iD). (;iwll all eSlilllale of Ihe beta, the
cost of capital is caielllalt'd IIsillg a liistoric;.1 average lell' til(' excess I'l'l Ill'll
011 the S&'P :.00 0\,('1' 'licaslll"Y hills. This sort ofapplicatioll is olllyjllstilied
if Ihe (:AI'1\1 II/m'id,'s a good desniplioll of tlic dala.
(1,; =
'11,'11t!
/1'11/1'11 /11' il ill /J(I"I/iJ/ill 1I 11'ij;ltl Tl('f/or i.1 Ihl' .m/ll/ioll 10 Iltl' f()lIl1lllillj; {Ol/.I/milll'li
Il/i/illliwlilll/:
lIlillw'nw
...,
(!. ~.I
.whil'l"ll()
w',.
1.
Ii. sol\'(' thi~ 1'1"11111,'111, WI' ".nullll' I.agl'all(!;iall functioll I., dil"!irelliiale with
rl'spl'ct 10 w, Sl'1 IIIl' r(,~\Ilti/l).( Cq\l;It'IO/lS 10 zero, a/lCilhl'1I solve for w. For
Ihe I.ap;rall),(iall fllllClioll \\,t h;\I't'
185
whnt' L is a conforming vector of ones and 0I and lit are l.agrange m\lltipliers. Differentiating L with respeC! to wand selling the result equal 10 zero,
we have
(5.2.5)
2nw  Oill.  02L = O.
COlllbining (:).2.5) with (:).2.2) ane! (5.23) we find the solution
(5.2.6)
whnt' g and hare (N xl) vectors.
(5.2.7)
,
. h
(~.2.R)
!
anel.A == L'nIJL, n == /l.'nI/l., C == L'n1L, anel D::::: Be  A2,
Next we summari7.e a. number of resU!IS from efficientsel malhen1atics
for minimumvariance portfolios. These results follow from the form of the
sohllion for thc ~ininHimvariance portfolio weights in (5.2.6).
.
C ( /J.p  C
A') (/J.r  CA) + C'1
= D
(5.2.9)
f..l x
2
Ox
InI L
(5.2.10)
A
C
(5.2.11 )
C
(5.2.) 2)
Result 4: For e,tch minill1l1l1lvari,\llce portfolio /1, except the global minililt I Illvariance portfolio g. lhere exists a unique minimumvariance porllil!io that has zero covariance with /1. This portfolio is called the zero1I("la portfolio wilh respe<.:t 10/1.
B6
t
C.
coefliciellt.~
Ih
{JI
we have
{Ja/,
Op
(:).2.17)
I  {J"p
Oof
fin
(!>.2.1H)
== 0
'1wc J1~xt
Ii" = (I  fia/,)Il,,/,
+ /3,,/,/J./,.
I).
(!).2.1!1)
introduce a riskf"ree asset into the analysis alld consider portfi>lios Fomposed of a combinatioll of the N risky assets and the riskfree assel.
Witl, a riskfrce asset the ponlolio weights of the dsky assets are not COIIslraj~led 10 slim to I, since (I  'w' L) Gill be invested in the riskfree asst't.
I
187
I'
If}
(J
Figure 5.1.
sul~iect to
(5.2.21)
==
w'Dw
+ 8 (PI' 
<
W'IL  (I  w'L)IIJ ).
(5.2.22)
IVL),n1 (IL
Il/ i)
... 11/,.).
NOh' that WI' elll I'xprl'ss Wt, as ;) scalar whirh depends on Ihe lllt'all of
lillH'S a portfolio w('ighl v('nor which does nol depend on Ii,
/1
where
(:I,2,~t;)
alld
Thlls wilh;) riskfnT aSse'1 alllllilliIlHIIIlI'ariall('e ponli,lios an' a COlllhillalioll
ofa J..:il'l'll risk" assel pOll ",Iio wil h weighls propOrlionallo W ;lIlcllhe riskrr('c
assel. This pOI'lf()lio of risky assels is callecllhc tanJ..:t'llCY pOI'lI()lio anel has
wl'iJ..:hl 1'1'('(01'
I
w'l =
I
rrl(/t  HIt},
d!
(/1 
Uti)
WI' IIS(' Ihe sllhsnil'l 1[10 id('lllil~' till' lallJ..:I')I('Y portfolio, Eqllalioll (!" .. ~,2K)
divides Ihe d('llH'IlIS or W hI' tllI'ir slim 10 gel a veclor whose elelllellls SIIIll
III 0))(', Ih;11 is, a pO 1'1 fill ill wl'iglll I'(,(,(OJ'. FiJ..:llre :),2 illllstrales 1111' sel of
lIlillillllllllvariann' pOllllllim ill IIII' presellce or ;1 riskl'n'(' assel. Wilh;\
riskrn'(' assel all dlil'i('111 pOrlfi,lios lit' alollJ..: tlw lille frolll Ihe riskfre!' assel
thrtlllJ..:h portti,lio I"
The I'XIIl'C\('d l'Xcess )'('1111'11 pn IIllil risk is IIsl'lirllO prol'id(' a hasi~ ror
ecollomic inlerprelalioll of lesls or 11ll' CAPM. The Shmj'P m/in ml'aSI')'('S
Ihis qllalllilY. For ally assel or pOrlli,lio II, Ihe Sharpe ralio is IIdilled as Ihe
1111'0111 exn'ss 1'1'1111'11 dil'ided hy til!' slalldard (\t:viatioll of relllrn,
\ : :;:
'~j
I'"  lit
(:I,2,2~l)
III Figure :I,:! Ihe Sh;ll"!lC r;\lio is Ihl'slopl' orlh(' lillt: frollllh(' riskfrt,(, rl'lurll
(Ill' 0) 10 IIII' portfolio !II,,. n,,), Tlw lallgelJcy portfolio q can he characterized as Ihl' portfolio lI'ilh Ihe Illaxi 11111 III Sharp!' ralio orallportfolios or risk\,
assels, '11'sl illg Ihe Illt'arrI';lrialll'c cfficicllcy of a J..:ivl'I1 pori folio is eqlliva\err I
10 ICSlillJ..: II'lwlI\('r Ih(' Sharpl' ralio of Ihal portfolio is IIH' IIIaxinllllll of Iltc
sci of Sharpl' ralios of all possihk pOll fol ios,
. 5.3.
189
and Jesting
"
'
"
"
"
"
" ,,'"
R /",
I
o
Figure 5.2.
z,
0:
+ (3 lm, + f/
(5.3.1)
(5.3.2)
E[ftl = 0
(5.3.3)
E[f/f/l =:E
E[l.. ,]
Jl .. ,
E[(l,.,  Jlm)2]
Cov[l.. "
f,l
= O.
..
0'2
(5.3.4)
(5.3.5)
{3 is the (Nx 1) vector of betas, lin' is the time period t market portfolip
excess return, and 0: and "', are (N x I) vectors of asset return intercepts and
90
Ct
r
==
tJ(Z,
I 7.,.,)
,=1
T
== n(27T)~I~I~
1=1
r(Ct.f3. E)
==
NT
f3%ml)'
(!i.:t !l)
HII
The maxilllulll likelihoud estimators are the values of the parameters which
maximize L To find lhese estimators. wc differcntiate L with respeClto 0:.
(3. alld :E. and set the resulting equatiolls to I.ero. The pallial derivalives
arc
ilL.
iJo:
ilL
iJ{3
t(Z, 
1;1 [
0:
/;z",,)]
U,.:t 10)
,=1
ta, 
:E 1 [
0: 
r:11.",,)Zm,]
([/.3.11 )
'=1
ilL
iJ:E
(5.3.12)
Selling (5.:t 10). (5.3.11). alld (!i.:t 12)
IIIUIll likelihood estimators. These arc
ii.  ihi. m
'L;=I(Z, 
l.crO, we
(',Ill
(5.:~.13)
,,1' (.
L...,,=I
to
M)(Z""  {i m )
A) .
Z",I 
Jim ....
(5.3.15)
where
T
JL =
A
TI "L..,Z,
alld
/Ill/
,=1
As already Iloted. the~e are just the /()\'JIlUlas fill' OLS estimaturs of the
parameters.
The distrihutiuns of the maxillllllnlikdihood estimators conditional on
the excess return of the market. 1.",1, I",~, ... , Im/.lilllow from the assumed
joint normality or excess n:ltIrns and the II D assumptiun. The variances and
covariances uf the estimaturs can he derived using the illverse of the Fishrr
infonnatioTl lIlatrix. As discussed in the Appendix, the Fisher information
matrix is minus the expectation of the secolld old('l' derivative of the 101{likelihood fUllction with respect to the wetOI or the paramcters.
.1.
/1//1111'/
.tV
(0'r~ [I + Ii;',]
I:)
G,;,
(:l.:t Hi)
(:d.IH)
" .
TI 'L.."(Z",,

_ ,.
/1",).
,~I
r
I:.
'I'll(' ctl\'ari;lIICl'
tI(
c"\ alld ii is
_~ [ii.III]~.
'f
II
a~
/i;,,]I (\'",,I n,
'J' [I I 
n:!II.
L,.,
WIl('ITW(' kl\'('slIhslillllnl (rolll (r.. :I.I(i) forVar!c\!. Ulltler Ihe lIuli hypolhesis./" will have ;1 chis'l";"(' dislrihlliion wilh N degrecs of frcedolll. Sillce
~ is ullknowlI, 10 lise ), II" leslill),.; II". W(' SUhslilule a ("oll\islelll eSlilllalor
Ill!" ~ ill (:l,:\.~~) alld tllI'lI asvlllpiolically Ih(' lIull dislrihulioll will 1)(' chisquare wilh N elegn'('s of Ircceloll\. Till' llIaXillllllll likelihood eslilllator of
fall S.TV., as a fonsis\('111 ,'slilllalor.
I:
Ilowever, in this case we need 1I0t resort (0 largesample distribution theto draw inferences using a Waldtype test. The finitesample distribution.
which i~ developed in MacKinlay (I9R7) and Gibbons, Ross, and Shanken
(19WI), can be determined hy applying the ()Uowing theorem presented in
'
Muirhead (19R3):
01)'
Theorem. 1.1'1
"If
mlIl'clor
di.\IJivu/ni W",(n, 0) with
(nm+l)
_I
'xA x
'
111
/1/
J1
(TNl)
Jl.'2m
+'2
am
J
"i I
QL.JQ.
(5.3.23)
I
I
Under the null hypothesis, JI is unconditionally distributed central F with
N degrees of freedom in the numerator and (T  N  I) degrees of freedom
in the denominator.
We fan construct the Wahl test Jo and the finitesample Ftest JI usi:ng
only the estimators from the unconstrained model, that is, the excessretlln
market Jllodel: To consider a third test, the likelihood ratio test, we need
Ihe estimators of the constrained model. For the constrained model, the
SharpeI .intner CAPM, the estimators follow from solving for (J and E from
(:).:'\.11) and (5.3.12) with Q constrained to be zero. The constrained estim;ttors arc
13'
,
(5.3.24)
::
::
..
.
TI "
~(Z/  f3 Zm/)(Z,  f3 Z.. /)'.
(5.3.25)
'~I
N({3'+['21111l+I GJE)
2
(5.3.26)
III
T'E'
(5.3.27)
(:in'lI bOlh the unconstrained and constrained maximum likelihood esti1\l,llors, we can test the restrictions implied by the SharpeLintner version
...
; :
~~!~
,.~.tl'"
194
using the likelihood ratio test. This test is based 011 the lo'garithm of the likelihood ratio, which is the value of the collstrained loglikelihood function
minus the ullconstrained loglikelihood fUllction evaluated at the maximum
likelihood eSlimators. Denoting CR as the loglikelihood ratio. we have
c
CR
T
.
~(logIE IIogIEI].
(5.:t~H)
})Z/ 
0:  j3z,.,)'t
(Z, 
/37./n')
0: 
(5.3.2~)
1=1
= L trace[t I (Z, 
6  j3ZIII')(Z,  it 
137... ,)']
(:. 3.30)
1=1
\
I;
1""
L,.(Z, 
trace E
[
'
Q  (3Zm')(Z,  Q  (3Z",,)' ]
(5.3.31)
,=1
1
tracc[E
'
The step from (5.3.29) to (5.3.30) uses the rcsultthat trace All == trace EA.
a~d the step to (5.3.31) uses the result that the trace of a SUIIl is equal to the
sl\m of a trace. In (5.3.32) we lise the result that the trace of the iC\clltity
mttrix is equal to its dimension.
The test is based 011 the asymptotic result that, under the null hypothesis,
times the logarithm of the likelihood ratio is distributed chisquare with
d grees of freedom equal to lh(' IIlllJlher of restrictions untler II". That is,
w call test 110 using
r
J~
ZR
I. Interestingly. here we need not reson to largesample theory to conduct a likelihood ratio test. JI in (5.3.~3) is .iL~e1f a likelihood ralio test
statistic. This result, which we nexi develop. follows from the fact that JI is
a monotonic transformation of J'1' The constrained maximum likelihood
tlllt!
I!I5
Tr.l/iIlK
;1'
...
It",
...
!J + ~.~ n.
J.l",
.
~
+ 111
'""'
.
.
TI L(ZI
/~ ",,)(Z, ('1 ",,)'
1=1'
I
~
I ,=t
X
Notin~
.
[ (ZI
0: 
Ii '"
",1 )
:~':!
u. ]
ILm
+(1",
fi '" Z"'I ) .] I
~'i a
lim
t (fm
(5.3.35)
that
1
T
'""'(Z
 0:. fJ' Z..1 )' (
1 '
1 ", 1.ml ~ )
L
1
_~
'=1
0,
0:
(5.3.36)
111/1+0,.
we have
. = ~ + ( _~ a;' . ~ ),_'
au.
J1. m
(5.3.37)
+ am
where to go rrom (5.3.37) to (:).3.313) we factorize "E and lise the result that
II + xx'I = (I + x'x) for the identity matrix I and a vector x. Substituting
(5.3.38) into (:).3.28) ~ives
T log [( ~i
17 /;' ) n...1:,1.0
CR = :2
11,.+01/1
+ I]
(5.3.39)
[t]i  I )
(5.:UO)
JI
(T  N  I) (
exp
which is a mOllotonic transformation of J~. This shows that JI can be interpreted as a likelihood ratio test.
Since the finitesample distribntion of./I is known, equation (5.3.40)
can also be used to derive the finitesample distriblltion of./l. A~ we shall
/.
"It'
see, ulldl'r IIII' lIull hvpollll'sis IIII' fillill'sample dislrihulion of)~ rail diffl'r
frolll ils laq~I'salllpl(' dislrilHllioll, JohsoJl alld Korkic (I !IH:!) suggesl all
,UljllSlllH'JlI 10 .h whirll has ht'lIl'1" fillilesample properties, Dl'iilling JI as
Ihe llIodified slalislic, \\'1' 11;1\'1'
(J' _. ~  ~)
.h
.,..h
(r;~)llogrt'Ilogltl]:' X~,
\Vt' will visil IIII' isslI!' of Ihl' fillilcsample propcrtics of .h alld JI III SI'CliOIl rIA.
A II st' I'll I !'rolloillic illlnprl'lalioll can he made of Ihl' II'SI stalistic Jt
IISing results fronl I'flid('nlsc( ma(h('malics, Gihbons, Ross, and Shankl'n
(1!1H!) show IhOlI
_ CJ' N 
,i;
;;: 
I)
/1     
'.~)
n!
,."
I+~
n;;,
Wh('H' Ihl' portfolio dl'lI1111'd II\' If rl'prl'S('lltS Ihl' t'x /10.11 l;\ngl'lll"y portfolio
cOllslnrrll'l1 as ill (!I.~.~H) rrOlIl IiiI' tV illrlllded assets /1/111 tlie markel portfillio. RI'r;11l frolll Sl'l"Iioll :I.~ (hal IIII' pllr(fillio wilh (Iw maxillllllll sqllared
Sharpe ralio of all pOrl/lllios is thl' \;Illgency portfolio, TilliS whell 1'.': /lu11
(he llIarkl'( (lort/illill is Ihe langl'nry ponfillio JI williII' l'qllallo 1.('ro, and
as Ihl' sqllOlrl'd SharpI' ralio of Ih(' lIIarkl'l dccreases, .It will increas!', illdicating slrongl'l l"\id('lllT "gainsl Ihl' I'fficiellcy of the lIIark!'1 jloll/illio. III
S('l"liOIl !i.7.~ W(' pn's('lIt ;111 I'lIlpirical l'XOlJllpic using ./1 afll'r cOllsidl'ring
IIIl' Black versioll or IIII' CAPM ill IIII' IIl'xl sl'ction,
'i.
III Ihl' allS('lllT of a riskl"nT asset WI' cOllsicll'r Ihe Black version of Ihe CAI'1'\'1
ill (:1. I.!"! ). TIll' ('Xp('("\1'I1 1'1'1111"11 1111 Ihe I('nlill'''l porllillio EI /{,,'" I is In'ated
as all 1.1II0hsl'l \"ahl(' alld hl'lIn' h(,("(III1I'S an unknown lIIodd paralllcll'J".
Dl'Iilling IIII' InoIll'\;1 )lortlillio ('xI)('cll'd 1'1'1111'11 as y, Ihe I\brk vl'\"sioll
is
FIR,I
I.y
+ (~(El a,",l 
(Ifi)y
y)
+,I3EII("'II,
197
lIIodel. Deline R, as an (N x I) vector of real returns for N assets (or portf()li().~ of asseL~). For these N assets, the realreturn market model is
R,
=:
a:
+ {3R mt + ft
(5.3.44)
(5.3.45)
(5.3.46)
E[Rill' 1
(5.3.47)
/lin'
=:
Cov[Rmt> Ed
=:
(5.3.48)
O.
{3 is the (N x I) vector of asset betas, Rot is the time period t market portfolio relllrn, and a: and f, are (N x 1) vectors of asset return intetcepts a,nd
disturbances, respectively.
'
The testable implication of the Black version is apparent from comparing the unconditional expectation of (5.3.44) with (5.3.43). The implicatipn
IS
Q
(~ (3)y.
(5.3,49)
This implication is more complicated to test than the zerointercept restriction of the SharpeLintner version because the parameters {3 and y enter
ill a nonlinear fashion.
(;iven the lID assumption and the joint normality of returns. the Black
version of the CAPM can be estimated and tested using the maximum likelihood approach. The maximum likelihood estimators of the unresuicted
Illodel, that is, the realreturn market model in (5.3.44), are identical to the
estimators of the excessreturn market model except that real returns ar~
slIbstituted for excess returns. Thus jJ., for example. is now the vector of
sample mean real returns. For the maximum likelihood estimators of ttt
parameters we have
{l {3[J.m
'L.:I (R
t 
(5.3.50)
jJ.)(R ml  ft )
(5.3.51 )
'L.~I(Ulnl  ftm)2
L(Rt 
ex  j3R,.t)(R,  ex  {In,,.,)',
1=1
where
1 T
"R
T~
1=1
mI'
(5.3.52)
198
U",~,
where
T
am :::
T1 \.""""""'
L(I~.I 
JIm
~I
)2
jJ is
.,
It .. ]
.
Cov[a,i3J =  [ ~
E.
am
\ For the conslrained modd, that is, the Black version of the CAI'M, the
loglikelihood function is
C(y. i3. E)
NT
= T
"2
log(2JT) 
21 'L" (R , 
y(t 
log lEI
m  i3R
ml ) '
E ,
1=1
)( (R,  y(t 
m  i3R",I)'
(5.3.57)
:~
==
iJL
==  E 1 +  E 1
(}E
E
T
2
(R , 
I
2
Y{L 
m  i3U
"1'
'"
S (R, 
ml )
(Hm,
yU 
(R,  y (t
y)]
(J} (JJ{ml)
~ m i3Rmt)'] E 1 (5.3JiO)
19!1
Selling (5.:!.!)!)), (:).:1.59), alld (~).:\'(i()) to {<TO, we ralllio~'for lhc lII01ximUIll likelihood estilllOltors. TIJ('sc arc:
I
(~
i/
t'
+. t(R
1
.
(it 
y'
......
~.
 li)'1:
L:~I(RI
(j Ii.,,)
Y~L)(/?""
L,'~tU{,,,(
(r,.:Uil)
" ..
(I, ,
0 )

y')
y')~
e',.:t()3)
I;J
Equations (5.:I.GI), (:).3.()2), alld (!1.3.G:\) do 1I0t allow liS to solve explicitly
for the maximum likelihood estimators. The nl<lXimll1l\ likelihood estimators can be ohtained, given initi,,) cOllsistent cstilllalOrs of (3 and :E, by
iteratin):; over (5.:~.GI), (5.3.62), alld (!I.:!.h:1) 11lItii ('ollvcrgellce. Thc 1111cO:lstraincd estilll<lLOrS j3 and can serve as the initial Lllf1sistent estimators
of (:J and :E. respcctively.
(;ivcII both the constrained alld ullconstrained mOlxilllulIl likelihood
estilllators, we can construct an asymptotic likelihood ratio tcst of the null
hypothesis. I The Ilull alld ,lIternative hypotheses ,11<'
(~
 {j)y
(!).:H4)
(:1.:\.65)
A likelihood ratio lest can be cOllstructed ill a lIlallll\T analogolls to the test
constructed 1'01' the SharpeLintner versioll in (:).:1.:tl), Ddillillg Jl as the
test statistic, we have
(5.3.G6)
Notice that the degrees of freedoJll of tbe null distributioll is N  I. Relative
to Ihe Sh'lrpcl.illtller vcrsioll of the model, the Black versioll loscs OIlC dcgree of freedom hecausc the zCJ'(>heta expected return is a frcc paramctcr.
In addition to the N(N  I )/2 parameters in tile residual covarialH:e matrix,
the IIIH"Ollstrailled model has 2 N paramcters, N parameters comprising the
venor Q and N comprising the vector p. The constrained model has, in
additioll to the sallle lIulllber of covariance llIatrix par;uIlClcrs, N paralllcters cOlliprising the veri or f3 antlthc paranH'\n lor 11](' cxpeclnl/,crohct<l
portfolio retllnt y. Thus the IlIlCollstraincd model has (N  I) Illore free
paramcters thall the constraine<lmodd.
1111 lil(' ("(>IIleXI (If Ihl' HIOlrk \'t'rsion 01"111" (:APM, (;,1,1.011\ (I q~:!l fit \1
Sh'"IKl'1I (t\IKClh) pm,"ill," d"I,liI"1I '"I;(\y,i,.
).
.f;. as thl'
~\lli",t
;lIli"~tl'd
X.V.I
lillillite salllplts, till' 111111 dislrihlltiollor). willillore dosdv lIIalch the chisqllarl'distrihlltioll. (S('(' Senioll :.. , 1'01' a Clllllparisoll ill tl)(' COli text or tl)('
Sharpl'I.itllIH'I \'('rsioll.)
There are t\\'o drawhacks to tht' IIIt'tltods wt' Itavejllst discllssed. First,
the t'stilllatioll is sOIlH'\\,hattcdiollS sillcc olle mllst iterate ovcr the Iirstordn
fllllditions. St'cond, tht' t('st is hased 011 largt'sample theory and call haw
wry poor flllitesalltpk properties. We 1'.\11 \lse tite res\llts of Kandd (1~IH4)
alld Shallkell ( I!)Hli) 1(. O\'l'rCOllle Ihes(' drawharks, Thes(' alit hoI's show how
to ('akllialt' cxact tllaxilllllm likelihood estimators alld how to impl('lI\clt!
all approxilllate tcst with good lillitesalltple perli>rtnanCt',
For tht, \lllcollstrailled mode\. cOllsidt'r the market lIIodel cxpressl'd ill
tt'flllS of r,'lItrlls ill I'xct'ss of Ihl' \'Xlll'(t,'d 1.,'1'01)('1;\ relllrll y:
R, .
)'1.
""
It/
(J(ll"" 
y)
+ 10,.
(!i.:UiHl
ASSlIllle y is kIlOWIl. Theil Iht' IItaxilllllJII likelihood estimators fi.n the IlItcOllstraitll'(IIlIOdcl an'
(5.:t!i!l)
(:i.:DO)
il",)~
alld
./
E=
+:LIR,it/J(/(m,ilmlIIR,iL{3{1l""(I,,,)J'. (:).:DI)
'~I
Thc lIlIcomtrailled I'slilllators "I' {J alld E do 1I0t dept'lld 011 tht' vaillt' or y
hili, as indirated, tht' estilllator or n dot'S, The vallie or tht, IIncollstraillt'd
loglikelihood rllllctioll ('\,alll;lIl'<I at Iht' JIIaXi1ll1l1l1 likt'lihood t'stitllat"r' is
NT
0)
I"g(~rrl
'J'
~
NT
IOlfIEI h
5. J.
Slfllisli{(l[
Constraining
0:
201
'IrSlillg
~.
(5.3.73)
!
I
I
(5.~.74)
NT
T,.
==   log(2rr)  2
logl~
NT
(y)I.
(5.3.75)
Note that the constrained function does depend on y. Fonning the logarithm of the likelihood ratio we have
CR(y)
== C(y)  [.
:::
(5.3.76)
The value of y that minimizes the value of the logarithm of the likelihood ratio will be the value which maximizes the constrained loglikelihood
fUllction and thus is the maximum likelihood estimator of y.
Using the same development as for the SharpeLintner version, the
loglikelihood ratio can be simplified to
CR(y)
2'log
[(
a~
(tlmy)2+a~
)"o:(y):,  I o:(y)
,
+.I]
[jL 
y~ 
yL 
13 ([i...  y)]
(3 (il .. 
+ I] .
y)l' E
(5.3.77)
= (' _ a~2 +
J1...
1
2)
[jLYL13(tlmy)l'E [jLYL:"'(3(il ... y).
yo,.
(5.3.78)
Thus the value of y which maximizes G will be the maximum likeIihpod
estimator. There are two solutions of aClay = 0, and these are the real
rools of the quadratic equation
I
!I( y)
A y2
+ By + C,
(5.3j79)
202
where
I
;;z (t
','/.
m
1.:
_
ii~)
1+ .;
I
l
,I
(i",
am
(J HI
I
(tf3) .~
(tf3)':E
/1 ~
+ ii",.
a;;' (J1. 
{3"
(t 
1
(p.{3(;.",)':E (jt{J(J.",)
alii
Om
(1+ am..;' )
1.:
(t  j.3)':E
1(",)
I
, {,  I .
L.
(ji.  {3,i",)
'J 
(,l ("I",).
If is greater tilan zero, the lIIaximulll likelihood estimator y' is the largest
rot, anel if A is less than zero. the II y' is the smallest rool. A will he
gl ater than zero if ii", is greater than the mean return on the sample
glll!>,,1 minimulllvariance portfolio; thai is, lhe lIIarket portfolio is (lIl the
c1~\lcient part of the constrained meanvariance frontier. We can suhstitute
Y'I into (5.3.62) and (:1.3.63) to obtain (J' and t' without resorting to an
itclrativc procedure.
I We can COllStruct an approximate test of the lIlack version using relllrns
in \bx(ess of y as in ([1.3.GH). Ir y is known then the same methodol0h'Y us(d
to ~onstructlhe Sharpel.intnC!' version Ftest in (5.3.23) applies to testing
the null hypothesis that the zeroheta exn'ssrelllnl nl<lrketIllodcl intenTpt
is zero. The test st.llistic is
(TNI)[
(ji.",_y)~]I.
,1 . .
N
1+
.~
a(y):E a(y) ~ /'.'1./.'11.
am
(:I.:tKO)
Ikcause y is unknown, the test in (:,.:tHO) GUlnot he directly implementcd.
But an approximate test can he implelllented with ],,(y'). Because y = y'
minimizes the loglikelihood ratio, it minimi/.es ],,(y). lIellce ],,(y') 5:
],i(y,,), where Yo is the unknown true vallie of y. Therefore a test ll~ing
],;(9') will acccptlOO often. If the null hypothesis is rejected IIsing Y' it will
he rejected for any value of y", This testing approach can provide a \I~cflll
check be~ause the usual asymptotic likelihood ratio test in (5.3.77) has been
IiHlIlel to rc:ject too often.
Finally, we consider illferenres for th(' expected I.crobeta porlf(llio rctllrn. Givcn thc maximulIl likelihood estimator or y, we reqllire its asymptotic \'ariance to lIIake inferellces. Using the Fisher infurlllation lIIatrix, the
asrlllptotic vari,lllcc of tilc maximum likelihood of y is
],.(y)
./1
('I'  N . I)
= 
NT
./".
/1
UNIl
N
(exp[~]
t/,~I.
I).
(5.13)
Under the llltil hypothesis. }o. }~. alld ./1 arc all asymptotically distributed
chisquare with N degrees of frecdolll. The exact nuH distrihution of }I
is celltral F with N degrees of freedom in til(' numerator and T  N  I
degrees of freedom ill the denominator.
We caIeulate the exact si/.e ofa test hased on a giv(,11 largesample statistic
and its asymptotic 5% critical value. For example. cOllsider a test usillg }II
with 10 portfolios and liO months of dat,\. III this rase, under the lIull
hypothesis }II is asymptotically distrihllted as a chisquare randolJl variate
with 10 degrees of freedom, Given this distrihutioll. the cdtkal value for a
test with all asymptotic sil.C of 5% is I H.31. From (:>.'1.1) this value of 18.31
~1I'1
,A, COITl'SPOII/Is
111111
r.
205
Table 5.1 .
.llllli,llir,I,
j,
j"
}l
\0
60
0.170
0.096
0.051 :
120
0.099
0.070
0.050 \
180
0.080
0.062
240
0.072
0.059
0.050 I
0.050 '
360
0.064
0.056
0.050 i
60
0.462
0.211
0.057 ,
120
0.200
O.IO~}
0.051
180
0.136
0.082
0.051
240
0.109
0.073
0.050 :
360
0.086
0.064
0.050.
20
60
0.985
0.805
0.141
120
0.610
0.275
0.059
180
0.368
0.164
0.053
240
0.257
0.124
0.052
360
0.165
0.092
0.051
40
The exaCt finitesample size is presented for teslS with a size of 5% asymptotically, The finitesample sire uses Ihe dislribution of J\ and Ihe relation between JI and Ihe largesample 101
stalislies. jl. fl. and j,. N is Ihe number of dependent portfolio!. and Tis Ihe number of
tilllt"~("rit"s
observations.
2qli
Under thc null hypothesis a is zero, so in this case 8 is lero and we have
Ihe prcvious rcsuh thaI Ihc dislrihution is central F with Nand T  N  I
dcigrces offrccdom in the IHllller,ltor and denominator, respectively. Under
Ih~ allcrnalivc hypothcsis, 10 specify 8 we need to condition Oil a value of
t!~/cr; and spccify thc vaillc of a':Ela. For the value of [1.;''/;';" ~iven a
m1>nthly obscrvalion intcrval, wc choosc 0.013 which corresponds to an rx
/10.[' annualizcd mcan cxcess return 01'8% and a sample annualized siandard
dC[iation of20%.
For the quadratic term a':E 1a, rather than separately spedfyin~ a .lIIel
:E, we can usc thc following result of Gihbons, Ross, and Shanken (I !IH!l).1
Rc ailing thaI q is thc tangcncy portfolio and thaI 111 is the market portfolio,
wc\havc
\
I
'I
0
'I
am~
USing this relation, we need only specify the difference in the squared
Sharpe ratio for thc tangency portfolio and the market portfolio. The tangency portfolio is for the universe composcd of the N induded portfolios
and thc market portfolio. We consider fOllr sets of valucs lor the tangency
portfolio paramcters. For all cases Ihc annualil.ed sland,lnl deviatiol\ of the
langcney portfolio is set to lli%. Thc anllllalil.ed expectcd excess return
thcn takcs on four valucs, 8.5%, 10.2%. 11.6%, and 13.0%. Using an allnllalized expected excess return of 8% for the market and an allll\lali/.ed
standard deviation of 20% for the market's excess return. these four values
corrcspond to values of 0.0 1,0.02,0.03, and 0.04 for 8/ T.
We consider fIve values for N: I, 5, 10, 20, and 40. For T we consider
four values60, t20, 240, and 360which arc chosen to correspond to !i,
to, 20, and 30 years of monthly data. The power is tabulated for a test with
a size of 5%. The results arc presented in Table 5.2.
Substantial variation in the power of the test for different experimental
designs and alternatives is apparent in T,lble 5.2. For a fixed vallie of N,
considerable increases in power arc possible with larger values of r. For
.example, under alternative 2 for N equal to 10, the power increases frolll
0.082 to 0.380 as T increases from 60 to 31iO.
The power gaill is Slibstalllial when N is reduced for a fixed alternalive.
For example, under alternative 3, /01' T equal to 120, the power illtTC'ases
from 0.093l0 0.47f) as N decreases from 40 to I. llowcver. such gaillS would
not he fea~ible in practice. A~ N is reduced, the Sharpe ratio of the tangency
portfolio (and Ihe noncentralily parameler of Ihe F dislriblltion) will declille
unlcss Ihe portfolios are comhined in proportion to thcir weightings in th,ll
portfolio. The choice of N which maximizes the power will depend Oil the
5.5. /'/)I/I//"/I/"'/i.I/.1
Tab/I! 5.2.
207
'J"
0=
r ==
IiI)
'J" == 210
"f'= :11;0
Alternative 2:
Il'l
==
10.2%
(1'1
r = 1;0
O.IH!)
'J"
= 120
O.:t~!1
'f'
=:
2,10
05!17
11.770
r = :11;0
Alternative :~:
"f'
Il'l ""
== (iO
I:.!O
"f' = 240
'f'= :1(;0
Alternative 4:
'J" = IiI)
"f'= 120
'f' = 2,10
'f'= :\liO
11.li%
(1'1
(1.262
0.47:,
O.71l9
O.'lOH
'1'=
Il"
./J.
= I
IU17
0.1 !1I
O.:HI
OAHO
I~I)
== 1:1.0%
(1'1
0,:1:11
O.:,!I:1
O.H7:1
0.%:,
n.07~,
O.IOli
0.17H
0.2;,!)
1).0Ii',
O.OHh
0.1:\,1
0.1!1I1
Il.O:,~)
0.10:\
0.1:\!)
IU),,?>
0.O1l2
0.OH2
0.10:,
0.OH2
0.1:\0
(1.217
IUHO
0.(11;1<
II.O'lH
0.171
0.21;7
0.0:,7
0.077
11.12,1
IUKI
0,101
I).IHO
0,:171
(J,r,70
0,07H
0,12H
n.2lil
O,'I\(i
0.\)(,1
O.O9?>
0.17:,
0.2HO
D.121
o.:!:17
0.:,02
O,nl;
O.OHI)
O.IIi:1
o.:\!,,(j
0.:,(;:1
O.(Hi:,
0.1 III
0.2:\1
O.:IH!l
o.on
= II;')(,
0.111:1
0.17'1
(1.:1,10
n.r,OH
= lIi%
0.1:\,1
O.2~>i
O.!,01
0.711
= lIi%
O.lli7
0.:1:12
o.(iD
O.H,I:,
Th"
h)' lht'
and
Iht' \'alm' of 11i(' ~I.llld.lni <It.'vi.llioll of tilt" ,.lIIgt'll( r pOI Iloilo. The l:lngc'lu y pOIlfi,lio i.~ wilh
rl'spt'('t 10 til(' N illclllded portfolios and tht lIlal kct pOilloliC). 11.1/ i~ [i1(' c.'xP'( It'd ("xn'~'" rcWrn
of Ih(' t~m~(,'l\ry p~JI Ifolio, ;\nd Oil is til(" iU1UU"lil.l'd !>.t.uHLu({ d{'\i.,.ion oi tht.' l'x(T~S l"C.'t\lrn oi
the 1.tngnHy ptH ltolio. The lHarkcl portfolio is .\\.'';'UIIH'(} to h.nT .m l'Xpt't In} ("x( t's..11 return of
H.O'i; . .111<1 .1 .'it.\Il(LII(} dt'\i.uioJl or 2U%, UI1(i<'I" th(' 111111 h)'pOlh(,!'ii~ (}at' 11I.\rkt't pOI .folio is 1ht."
lallgt'II(\' portlolio, N i!'i the IItluli)('r of portfoli()~ infillti('d ill tile 1('.<.;1 ,Ind r i, lilt, IIIlmh("r 01
IJ}Oll1h., I)f d;\I" illrill<icd.
rate at which the Sharpe ratio of the tallgency portfolio dl'riillcs as assets
arc ~rourcd tOJ,\e!hcr.
While we do JlUl have gellcdl results ,Ibollt the optilllal design of a lIIultivariate test, we c<In draw somc insights ('romtllis pOWCI' all,dysis. Increasing
the lellgth ofthe time series can kad to a signilic<lnt payolfill terms of power.
Further, Ihl' power is very sellsitive to the vallie or N. The allalysis suggests
Ih;lI Ihe v<lIIll' of N shollid he kepI SIll<l11. I'l'l'h;l)s 110 largn than abollt ten.
"SI'I' F."".,
(I"III~I),
we have
1 T
= T L f (9).
gT(8)
1=1
jL 
j3j;.m
(5.6.4)
L...I=I (
Z
~
ml  11m)
(5.6.5)
a.
of and j3 will differ from the variances in the maximum likelihood approach. The covariance matrix of the GMM estimator iJ follows from equation (A.2.R) in the Appendix. It is
(5.6~6)
where
D
and
So
E[OgT(8)}
ao
+00
1=00
~
Dn
= [ )l",
I
(2fJ..m
2)J0IN'
u",+J1 m
(5,6.\0)
210
A consistent estimator OT can easily be constructed using the maximum liktlihood estimators of Ii", and a;;'. To compute a consistent estimator ors". ;UI
assumption is necessary to reduce the summation in (5.6.8) to a Ii nile 1111111'
her of terms. Section A.3 in the Appendix discusses possible assumptioll".
Defining Sr as a consistent estimator of So. (1/ '1') [O'1'S;,1 Or J 1 is a consisten t estimator of the covariance matrix of O. Noting that 0. = RO where
R = (I 0) IN. a robust estimator of VarIa) is (l/1)R[O'TS;,'Orl'R'.
Using this we can construct a chisquare test of the SharpeLintner modd
as in (5.3.22). The test statistic is
(5.1i.11)
Under the null hypothesis a
= O.
(:>.Ii.I~)
5.7.
ImIJ/i'IIII'lIla/ioll o/Tr.ll.l
:lll
III
J,
Jill'
,1/,,"'"
111/1",'"1/'1/1111;01/
WI' pn'St'II1 l('slS 01 II I<' Sh;1I1 11'1 ,i II L111'1' 1I1t)( 11'1 10 i II11s1 1';11 (' II
It' It'sl i IIg II 1<'1 I lOtIolog\', Wt' l'tlllsid n li,IIII('SI slalisLics: ,It frolll (:,.:I,~:I), ,h
1'1'0111 U',,:I,:!:!
)../I
. 213
from (53.41), and J7 from (5.6.11). The tests are conducted using a thirtyyear sample of monthly returns on ten portfolios. Stocks listed on theiNew
York Stock Exchange and on the American Stock Exchange are allocated to
the portf(}lios based on the market value of equity and are valuewei~ted
within the portfolios. The CRSP valueweighted index is used as a proxy
fi}r the market portfolio, and the onemonth US Treasury bill return is used
for the riskfree return. The sample extends from January 1965 through
December 1994.
T(:sts are conducted for Ihe overall period, three tenyear subperiods,
and six fiveyear subperiods. The subperiods are also used to form overall
aggregale test statistics by assuming that the subperiod statistics are independent. The aggregate statistics for J2, }l, and J7 are the sum of the individual
statistics. The distribution of the sum under the null hypothesis will be chisquare with degrees of freedom equal to the number of subperiods times
the degrees of freedom for each subperiod. The aggregate statistic for JI
is calculated by. scaling and summing the F statistics. The scale factor is
calculated by approximating the F distribution with a scaled chisquare distribution. The approximation matches the first two moments. The degrees
of freedom of the null distribution of the scaled sum of the subperiod JI'S
is Ihe l1umher of snbperiods limes the degrees of freedom of the chisquare
approximation.
The empirical results are reponed in Table 5.3. The results present
evidence against the SharpeLintner CAPM. Using JI' the jrvalue for the
overall thirtyyear period is 0.020, indicating that the null hypothesis is rejected at the 5% significance level. The five and tenyear subperiod results
suggest that the strongest evidence against the restrictions imposed by the
model is in the first ten years of the sample from January 1965 to December
1974.
C.omparisons of the resulL~ across test statistics reveal that in finite samples inferences can difTer. A comparison of the results for JI versus }l
illustrates the previously discussed fact that the asymptotic likelihood ratio
lest lends to reject too often. The finitesample adjustment to }l works well
as inferences with}l are almost identicalLO those with JI.
III Ihe preceding analysis, we have not addressed the problem that the rJturn
Ihe market portfolio is unobserved and a proxy is used in the tests. Most
(eSlS use a value or equalweighted basket of NYSE and AMEX stocks '' the
market proxy, whereas theoretically the market portfolio contains all assets.
Roll (1977) emphasizes that tesL~ of the CAPM really only reject the meanvariance efficiency of the proxy and that the model might not be'rejec\ed if
(he relurn on the true market portfolio were used. Several approaches rave
Oil
214
Table 5.3. I:m/liriml ".w/I.! for Iroflof of Ihr Shm/lr.l,ill/llrr ,,,,,,,iOIl 11/hr eM'/II.
.J.
Time
!~value
.h
!~valll("
./1
!~vahl('
.h
!>vahl('
Fiveyear subperiods
)/6~)12/fi!)
2.0~/l
0.019
20./lli7 0.022
1/l.1~2 O.O4/l
1/7012/74
2.1~1i
O.O:~9
1.914
O.O(j(i
19.179 OJnH
17.47ti 0.()(i4
2U~/7
1/7512/79
21.712 O.UI7
1!/.7H4 0.031
1/8012/84
1.224
0.:\00
13.:\78 0.20:1
1/8512/89
1.732
O.JOO
IH.164 OJ/52
I1.HI8 0.297
1(i.()15 0.098
1/9012/94
1.153
0.314
Overall
77.224
0.004
\,
12.1i1l0 0.212
1(){i58(i
**
11.200 0.:142
94.151 0.003
n.UIH
27.922 0.002
1:I.(Hi!; 0.22U
](UII :. 0.07(;
12.:\79 (1.2(iO
113.78~,
**
tenyear rubperiods
\ I/r"12174
2.400
0.013
23.883 O.OOH
22.190 O.oJ:1
24.1i19 O.O()!;
1/7512/84
2.248
0'<)20
22503 O.OI?>
2J.190 0.020
27.192 0.002
1/8512/94
1.900
0.0,,:1
\9.281 0.037
18.157 0.052
16.373 O.OH'.I
Overall
57.690
O.()(lI
1i[J.{ifi7
fiJ.8:!7 0.001
(iH.215
2.1:,9
0.020
2Uil2 0.017
21.192 0.020
n.17(; O.OJol
**
**
irtyyear period
1/6512/94
.5.8.
(:IO.I.I.\I'r/;III/I/[ U''J.,T'/I'.i.I;1I1I.\
t\ secolld approach 10 Ihl' prohll'1ll is 11I1'SI'11I<'11 hy KouHld 011111 SlOlIll(19H7) and Shanken (1!IH7a). Their papers ('slim,lIl' an npper hound
Oil lite correlalion hetween Ihe lIlarkel PlOxY 1'1'1111'11 and lite lrue lIlarkel
I'l'l Ill'll necessary 10 OVl'r!urtltlte rejeclion oflhe CAI'M. Tlte hasic finding is
Ihal if the correlation between the proxy and the tnl!' markclexcccds ahoul
0.70, thell Ihe njeClioll of Ihe CAI'M wilh a Illarkel proxy would also imply
Ihe rejenioll or Ihe CAI'M wilh lhl' lIue m,lrkel ponfolio, Thus, as long as
we belie\'e there is a high correlalioll bCIW(TII lite 11'11(' 1ll,lrk('1 rdurn allel
Ihe proxies used, Ihe rc.:jeclions remaill inlact.
ball~h
wltnl'
Y,
:Wi
allli
ll,illl: till' Y~I \ 1'1'0111 (r. H.:.), \\'" 1'0111 II'SI till' hypolhl'sis Ihal Sill' docs lI,ll
han' alii' I'xplall,lIol'l' 11<1\1'1'1' IW\'tllld hCla, Ihal is, Y~ = 0, hy sl'lIill~ j =' '2 ill
(:.,H,'2)(:dU ).
The F,III1,Ii\ladklh IIwilllldoloh,)', while IIseflll, do('s hal'" sCl'l'ral prohII'IIIS. Firsl, il CIIIIlOI hc direI'llI' applied hecallse Ihe lIIarkcl helas an,' 1101
knoll'lI. Thlls Ih,' rcgrcssiolls an' COlldllCled IIsin~ helas eSlilllalt',1 froll. the
dala, which illlro,liHTS all nrorsillvariahles complicalioll. Thc l'I"rorsi'lI'ariahlts prohlt'lIl elll hc addrl'sscd ill IWO ways, OIlC approach, adopted
hy Fama and Macl\elh, is (0 11lillillli/e Ihe errorsinvariahles prohklll hI'
),\rol1ping Ihe slocks illlo portli)lios allel illcr('asin~ Ihe precision or Ihe
hCla ('slilllal('s. A secolld approach, devl'iopcd by l.ilzellhcr),\cr alld RaIIlasw;III1Y (1!17!1) alld rdirH'd hy Shallkell (1!l!l2h), is 10 explicilly adjllsl
IIII' slalltianl ('1'rors 10 COIT('CI fill' Ihe hiases illlrodll('('d hy Ihe ('1'rorsillvariahles, Shallkl'lI sllgg('SIS lIIultiplyill),\ lr;, ill (!'UI.4) hy all a<\jusIJlleJlI
faClor (I + (ji",  f',,)'!/lr;;.). While Ihis approach elilllillales liIe errorsillvariahks hias ill IIII' 'slalistic ill (:. !t2), il does lIoll'lilllinall' IIIl' possihilily
thai olh('\' I'ariahles IIliv,ill ('l\ler spuriollsly ill (:1.115) as a result of lhe \ll!ohservahilily or Ihe lrue helas,
The IIl1ohs('l'l'ahilily of Ihe lIIarkel portfolio is also a pOlelllial prohlelll
1i1l'11H' ('I'ossseclioll,d legressioll approach, Roll and Ross (I !l~H) shill,' Ihal
if IhI' I nil' 1II;II'kel (1011 Ii .Iio is I'rticil'lI I, Ihe crosssel'liOllal rdal iOIl hel\\'(,(,11
l':<'p('(,I('(11 ('111111\ ,lIullwl;IS call hi' "1'1)' sl'lIsilivl' 10 1'1'1'11 small devi,lliolls of
IiiI' lIIal'k('1 pOrllolio prox)' frolll till' 11'111' lIIarkel portJ(,lio, Thus el'id('II(,('
of Ihe lack of a I'I'Lliioll IWIW('('II ('xl)('('le(1 relllrn all(1 hela could he Ihe
5.~.
217
CUllriu.lion
result of the fact that empirical work is forced (0 work with proxies for the
market portfolio. Kandel and Stambaugh (1995) show that this extreme
sensitivity can potentially be mitigated by using a gener.llizedleastsquares
(Gl.S) estimation approach in place of ordinary least squares. However their
result depends on knowing the true covariance matrix ofretums. The gains
frolll usin~ GL<'; with an estimated covariance matrix are as yet uncertain.
5.9 Conclusion
III this chapter we have concentrated on the classical approach to testing
the unconditional CAPM. Other lines of research are also of interesl. One
important topic is the extension of the framework to test conditional versions
of the CAPM, in which the model holds conditional on state variables that
descrihe the state of the economy. This is useful because the CAPM can hold
conditionally, period hy period, and yet not hold unconditionally. Chapter 8
discusses the circumstances under which the conditional CAPM !]light hold
in a dynamic equilibrium setting, and Chapter 12 discusses econometric
methods for testing the conditional CAPM.
I
Another important subject is Bayesian analysis of meanvariance einciency and the CAPM. Bayesian analysis allows the introduction of prior
illformation and addresses some of the shortcomings of the classical approach such as the stark dichotomy between acceptance and rejection of
lhe Illodel. Harvey and Zhou (1990), Kandel, McCulloch, and Stambaugh
(1995), and Shanken (1987c) arc examples of work with this perspective.
We have shown that there is some statistical evidence against the CAPM
in the past 30 years of US stockmarket data. Despite this evidence, the
CAPM remains 'a widely used tool in finance. There is controversy about
how the evidence against the model should be interpreted. Some authcls
argue that the CAPM should be replaced by multifaClor models with several
sources of risk; others argue that the evidence against the CAPM is overstated
because of mismeasurement of the market portfolio, improper neglect of
conditioning information, datasnooping, or sampleselection bias; and yet
others claim that no riskbased model can explain the anomalies of stockmarket behavior. In the next chapter we explore multifactor asset pricing
models and then return to this debate in Section 6.6.
ProblemsChapter 5
5.1 Result:l states that for a Illultiple regression of the return on any asset
or portfolio Un on the return of any minimumvariance portfolio Rp (except
ror the glohal minimumvariance portfolio) and the return of its associated
218
ar~~robCI.a=
/32
portfolio
/3np, /31
=I 
/l"i" and
0,
is I.ero
5! Using monthly returns from the \Dyear period January I!IW) to Dec \IIber 1994 for three individual stocks of your dlOice, a valul~weighted
III rket index, and a Treasury bill with one month to maturity, perform tlw
~ lowing tests of the SharpeLintner Capital Asset Pricing Model.
5.3.1 Using the entire toyear sample, regress excess retlll'llS or each
stock on the excess (valueweighted) market return, and perforlll t('sts
with a sizc of 5% that the illlercept is zero. Report the point estim.lll's,
Istatistics, and whether or not you r<:ject the CAPM. Perrorm regression
ragnostics to check yoIII' specification.
~.3.2
. For each stock, perform the saUll: test over each of the tlVO cuipartitioned SUbsalllples and report the point estimates, [statistics, and
~whether or not you reject the CAPM in each suhperiud. Also indudc the
same diagnostics as above.
5.3.3 Combine all three stocks into a single equalweighted portfi)lio
and redo the tests for the entire sample and fi)r each of the two snhsaIIIpies, and report the point estimates, Istatistics, and whether or lIot YOli
reject the CAPM for the whole sample and in each subsamplc. Include
diagnostics.
5.3.4 'Jointly test that the intercepts for all three stocks are zero using the
Ptest statistic JI in (5.3.23) for the whole sample and for each subsalllple.
5.4
6
Multifactor Pricing Models
lh(' APT provides all 1I/'/lIlIXi/ll(/11' n'lalion for cxpeCled asst'l relurns I\'illl
1I11kllOWll 11111111)('1" or IIl1idt'1I1ifit'd faclors. Al lhis It'I'cI I"ejcclioll oi" lhe
lhcory is impossihle (UlIless arhilragt' opportlllliti(~s cxist) ;Illd as ;1 (OIlSl'I(uell(,(' lcslabilil)' or III<' IlIodl'! depellds Oil lhe illlroduClioll of addiliollal
assulllptiolls. J
Thc AI hilral4t l'ritilt~ Theory ;ISSltll\l'S lhat tlIarktts an' COlllptt itivc ;\IId
i"rit'liOllltss alld 111;11 IIII' r('llIrJI I4t'IJ('l"alinJ!; prOfess i"or asst'l n'llIrJlS heill)!;
n ltIsidt't't'd is
:III
U,
Elf, I fl
(/, + h; f + E,
(i.L1 )
(;, I.~)
.,
(T
Elf;1
<
')
(T
<
00,
(!i,I.~)
when' H, is Iht nII .... 1 fill' assel i, (Ii is the illtercept of Ihe /:tetor model.
hi is a (Kx I) \'t'nor of bnor sellsitivities for asset i, f is a (Kx I) V('('\or of
COI,1I111011 /;tClor rt'ali/;llions, and f, is the distnrhance tenll. For the sysletll
of N aSS(,IS,
(IdA)
fl
Eiff' I fl
::
(G.I.:l)
E.
;. \.(i)
III the systcllt (''I"ation, R is alt (N x I) Vt'clor with R = [N I R'J ... 1'.\, J', a is
an (N x I) ,'('CIOI" I\'ilh a = II/I (/,! '" (l,v)'. B is an (N x K) Illatrix widl n :=
Ihl h~ ,., h,\' 1', ;\1\<1 f is;\I\ (Nx I) vt'ctor with = [fl E!? , .. E,'V \', We !'ttl Ihn
ass II II II' lhal IIH' i"a("\ol"s atTOIIIII fi'l" liIe COlllillon varialioll ill ;ISSI'I rl'IItI'lIS
so that tht disltllhalt("(' I('rlll lill' largt' wclldiversilicd portfolios vanishes,'!
This n'qllires Ihalllle dislurhaltce I('nlls be slIfficit'lIlly IIlu'olTcialed across
asst'ts,
C:il'en Ihis slrll("\llIt', Ross (11)7(;) shows that lhl' abst'ut'(' of arhitragc it!
tngc CCollolllies iltlpli('s Ih;11
/1. ~" d'l) I
n A",
;,\ ,7)
wll<'n' /t i, Ihl' (,\, xl) "'I",,"ll'd \1'1111"11 \','('tor, Au is lilt, 111011<'1 I.,'\'oI)('la par;lIlIt'I,'I" alld is ('qlla\ 10 11)(' riskln't' I"elllrn if slIch all assel ('xiSlS, alld Ai:
is 0\ (K x I) ,'(Tlor III b.lor risk preltlia. Ill'n', ;t11d Ihr()lI~h()lIl lilt, ('ilapl('\",
'Thl'''' \0,,, 111'1'11 ,11"","li . 1 .Ith,''I' Ill' IllI' 1I'.\I"hilil)' III II .. APT. ';I>;lIlkt1l (1~IH:!) "lid
Ihh\ig ,11111 H,,,, (I!U"r" 11I1I\ld(' ow' illlt'U"lillg C'xt hangl'. DhrYIIH'.\, Frielld, (;lIl!lkili. ,1I1l1
(;IIIIt'''ill (Ptx I) .at . . ., q"t,IHtli II", c'lIIl'il if ;11 IC"C'\,;lIIn' 01 tlu lIuulel.
! {\ L""f\' \\dldi\"I', ... ili",1 p"nlulio i... ;, pu"tulluwith~, lal").~" n"'l\ht.'ruf~"" k~\\'''h \\'t'igh\i"~s
olouk. :y.
fl, J,
'J'IU'lII't'Iim/ JJarkg7Vllntl
.,
IL
= tAo + B>'K.
i
(p.1.8)
There is sOllie flexibility in the specification of the factors. Most empiri(';\1 illlpl('IlH'nt,ltions choos(' a proxy for the market portfolio as one factor.
Ilow(',,('\', different technic]lles are available for handling the additional facrors. We will consider several cases. In one case, the factors of the Apt anef
lhe state variables of the I(,APM need not he traded portfolios. In other
rases the factors arc returns on portfolios. These factor portfolios arc called
lllillli(kin~ po.rtfolios becallsejointly they are maximally correlated with tIlt'
factors. Exact factor pricing will hold with stich portfolios. Huberman,
K;llldcl, and Stambaugh (19f\7) and Breeden (1979) discuss this issue ill
the context of the APT and ICAPM, respectively.
2 2
(ti.2.1)
wlwre t and t" arc the lII<1xilllUllI likelihood estimators of the residual
cO\'jlriance matrix for the ullconstrained 1I10del and constrained model,
resnectivcly. T is the number of timeseries observations, N is the number
of ihclll<i('d portfolios, and K is the nnmber of factors. As discussed in
Ch.~pter 5, the statistic has heen scaled hy (T  ~  K  I) ralher than the
llSll~1 T to improve the cOllvCfgence of the flllitesample null distrihution
0,2, 1'.:~/i/ll(l/iuli
fllld
'Frs/inK
Ihl' lar).';l' ~;\lIIpll' distriIHltioll.: 1 The hlq.;e sample distrihutiull of} ulldl'\'
Ihl' lIull hypothesis will he chisqllare wilh Ihe dq.;n(s offrecdolll eCjllallo
Ihe 1I(11111)('r ofreslrictiolls im(lo!;('d hy Ihe 111111 h),pollH'sis.
10
6.2. I !'orljiJiiu,\
11,1
Iin/o/,I wilh
Il
lIi,I!;}II'I' AI,II'/
We Jirst cOllsider the case where the factors are Iraded (lortJ()lios ;lIld there
exists ;\ riskfrce assel. The unconstrained Illodcl will he a /\bclOr model
exprcssed in exccss retllrns. Define Z, as all (N x I) vcnor of excess retllrns
for N assets (01' portfolios of asscts). For excess relllrns, the /\l'al'lor linear
III orle I is:
Z, = a
+ HZ!;, + :,
Elf',!
(li.2.2)
(li.2.3)
()
(li.2A)
EI(Z,,,
It!;)
Cov[ZJ\,.
;J
(Z!;,
It!;)'j
= 0,
(li.2.!i)
B i~ the (N x 1\) Illatrix ofElCLOr sensilivities, Z!;, is the (/\ x I) vector onaclor
(lol'lfolio excess returns, and a ;l\ld (', are (Nx I) I'('ctors of asset return inlercepls alld dislurbances, respectively. 1:: is the variancccovariance matrix
of lile distllrbances, and n/\ is the variancecovarialHT malrix of the factor
pOI'l/"olio exccss rellll'llS, while 0 is a (/\ x N) matrix of zeroes. Exact 1,~ll'lor
pri( illg illlplics that the demcnts of the v('clor a ill (;.2,2) will he zero.
For lhe IInconstrained model in (li.2.2) lhe maximulll likelihood estimalors ar(' .iIlSt the OLS estimators:
(li.2.7)
(li.2.!/)
whcre
and
It/.,
I I
~Z.'
rL
'~I
n"
O.
10
he zero, Ihl'maximllm
(G. ~. \())
r
(Ii.:!. I I )
'~I
The !I II II hypothesis a eljllals I.no CIII he Il'slt'd IIsing the likdihood ratio
slatislic j ill (Ii.~. 1). L1l1cler the lIull hYJlothesis Ihe degrees offree<iolll 01' the
null distrihutioll will he N since the 111111 hypothesis imposes N restrictions.
III Ihis cas(' WI' (;111 also COllstfll('\ all exact lIIultivariale FIt'sl of Ihe Ilull
hY(lotlH'sis. Iklillill(.!;.h as Ihe II'SI stalistic we have
(G.:!.l:?)
(II
III tile ahs('llce of a liskfre(' aSSl't, there is a zerobeta JlIocil'l that is a IlIl1ltibnor ('l)lIi\';\\('llt 01'111(' 1~Ia('k \'('l'siOIl of the CAPM,IIl a II\lIltirauor COlllext,
the z('I'ohl'la port/t.lio i~ a port/i)lio with 110 sensitivity to any or the Eiuors,
and (,,,))('('\('<1 \'('tllI'l\S ill ('X('('SS of 1)1(' l('('obeta retllrn ~ll'e linearly rdatl'd
to 1)11' ('01 II III liS or Ihe lIIall'i" of faClor SC'lIsitivitil's, Thl' factors an' assullled
to hI' I'on/(.)io r('tunls ill ('''('I'SS 0(' III(' 'I.t'I'o))('la 1'('lul'Il.
I)l'Iill(, R, as all (N x I) v('clOI' or I('al returns for N ,ISS('\S (01' ol't)'olios
ofass('ls), For Ih(' 11I1('ollstraill(,d IlIodt'!, W(' h;lv(' a K/;J('\ol' lilll'ar lIIodd:
R, = a
+ n RI\, + 1':,
1':1 f,l
nf",'l
i.~.II)
;.~.)))
(i.:!.I(i)
6.2.
f:~timation
and 'Jesting
225
E(RKI  JLK) (RKI  JLK)']
COV[RKio ;]
= OK
= O.
(6.2.17)
(6.2.18)
"
a=
{LBP.K
(6.2.19)
1
Ii =
where
T I T
= T 2:= R,
P.
and
JLK
= T 2:= R K1 .
1=1
1=1
R,
=
=
Lyo
+ B(RKI 
tyo)
+ ,
(6.2.22)
(tBt)yo+BRK1+t.
(6.2.23)
to
T
T1 l)R
/
.'.
LYo 
B (R Kt  LYo)l
/=1
(6.2.24)
Yo
=
(6.2.2fi)
2261 .
(ti.2.2G)
(t  Bt)yu.
Var[y())
+
YUL)
x [(LBL)':Et(LBLW t .
(lJ
(j.2.27)
Factors
Factors need not be traded portfolios of assets; in some cases proposcd hlctors~:, leludc macroeconomic variahles such as innovations in GNP, changcs
in IJ nd yields, or unanticipated ill!lation. Wc now consider estimating and
tcstil g cxact facLOr pricing models with such factors.
Again define R/ as all (N xl) vector of real rcturns for N assets (or
portfolios ofasscts). For thc ullcollStrained model we have a Kf;IClor linear
\Ilo<\fl:
(G.2.2H)
I
I
I
!
E[f,]
Elf/E,'}
I Elf",) =
E[(f...:,
()
(i.2.2~)
== :E
Cov[f"/. f;1 = O.
(li.2.30)
(i.~.31)
(li.2.:m
227
f",
B is the
(ti.:!.33)
i.2.:H)
T
L..,(R , = T1 '\'
.',
a  Bf",)(R,  a  fif"l) ,
(G.:!.:l5)
1=1
wlwre
It =
T1 '\'
L.., R,
and
'~I
/L = a
where J.LI"
we havl'
+ B/L/".
(ti.2.:~(i)
LAu
+ 8(>'" 
J.L/,,).
(G.:!.37)
Delining y" as Ihe zeroheta paramctt'l' A/I and dclinillg II as (>'"  J.L/,,)
whcre >." is Ihe (Kx I) vcclor of faclor risk premia, for Ihc constrained
Illodel, we h,l\'c
(G.2.:lS)
Thl' constrained model estimators
<In:
(C).2.39)
(n. ~.40)
(li.~.11
to
1
(B"E,IU')IB"E\(Y.;'i{yu))
t'}:"
Iihil,,}:I B)I,
We \Villus(' Ihl'se I'ariallcc n'sulls li)r infercnccs cOllccrnillg Ihc lilnor risk
premia ill S('nioll (i.:1.
fl, 2,,' 1,(1t lot I''''I/o/im .'i/llllllli IIg Ihl' MfilIll'a/'illllC/' 1I1I1IIit,.
\,\'hclI 1~\('lOr pOI'I.lios span Ihe IlleanI'ariall(,(' fronlier, tIlt" inlerccpt 11'1'111
of thl' I'xact pricing rl'ialioll All is /('ro wilhonllhl' !ll'cd lill' a riskfree ass('\.
(6.2.4&)
a+BRJ\r+f.,
(6.2.47 )
(6.2.4~)
(6.2.49)
(6.2.50)
and
Bt
t.
(6.2.5\ )
= a+
(6.2.52)
where ROIl' and Ro, arc the return on the market portfolio and the associated
zcrobeta portfolio, respectively. The restrictions on the Black model are
a = 0 and f30m +f3rn = L asshown in Chapter 5. These restrictions correspond
to those in (6.2.5\).
For the unconstrained model in (6.2.46) the maximum likelihood estimators are
(6.2.53)
230
(li.2.:,1)
where
I '"
I.L. = TL.....RI
and
1=1
Substitllling a
jmodel,
I
1
== 0 and b l ==
L 
R,  ~RII = BI (R h ,!  ~RII)
+ E,.
(li.2.:,7)
(i.25H)
b;
:to
II
==
(G.2.IiO)
~rhe null hypothesis a euals I.em c<In he tesled lIsing rhe likelihood ralio
hatistic J in (6.2.1). Under the null hypothesis the degrees of freedolll of
the null distribution will be 2 N since a == 0 is N restrictions and B ~ == ~ is
N additional restrictions.
We can also construct an exact test of the null hypothesis given the linearity of the restrictions in (i.251) and the Illuitiv<lriatc normality asslIlllption. '
6.3.
231
(T  N  h')
[1i;;:;'1 I,]
((i.:2.(il)
I~I
(1~)H7)
prescnt a deriva
(i.:D)
IS
(li.:\.1)
().
ii."
I
I
.
\'arIAi:1
1.:rn,,+Varlrd,
(Ii. :l.Ii)
when' \;;;'[1'11 i~ lrolll (li.~.'I!i). I\l'callse ilfi: and 1'1 an' illdl'(lI'llIicllt Ihl'
lovarianfl' Il'nll ill ;.:U;) is 'l'fIl.
Thl' 1IIIIIIh casl', whert' Ihl' faclor portfolios span Ihl' nll'anvariancl'
fr(Jnlin, is IIll' sanll' as 1111: firsl casl' exn'pllhal rcal rl'llIJ'llS are SlIilSlilllll'd
\
\
lill' exn'ss n'llIrtls. 111'1'1' Ai: is 1111' I'l'l'Ior of !'aclor pOrlldio sampll' 1Ill',\lIS
;\lHI All is 1.1'1'0.
For any assel Ihl' t'X(lI't'lI'c\ reillm call bl' ('slimaled by suilsliluliJlg Ihe
('slilllall's 01 R, Au, alld Ai: illio (li.I.H). Sinn' (i.I.H) is nOJllillear ill Ihl' par;III1I'ttTS, calculating;\ stalldard ,.\ 1'01' \'<"Iuirl's \lsill)!; a lilll',lr approximatioll
alld ,'slinlaH's or Ihl' '1II',lriaIH'!'s of II\(' paraml'ler ('slilllall's.
II is also 01 illll'n'sl 10 ask ir Ihl' tll'lOrs ar(' joilllly prin'd. Cil'l'1I Ihl'
,'('\'lor of risk premia I'slilllall'S ;tllIl ils coval'i;IIICt' lIIalrix, II'SIS of Ihl' lIull
hl'polhl'sis Ihal II\(' bClors an' .ioillliv 1101 prin'd rail hI' cOII<lU('(C<\ usill)!;
II\{' filliowill)!; I,'SI stalislie:
./1 ""
cr  /\) .. _.
r
I'
Ai:.
(1;,:1,7)
Asymptolical"', IllId\'l the lIulI h\'(lollH'sis Ihal Ai: == 0,./1 hots ,Ill f dislribulioll wilh 1\ alld '/'/\ d"glTt,S or frlTtlolll. This dislribuliollal reslllt is all
applicalioll of lit!' Iloll'llillg 'r~ stalislic alld will he exaCI ill fillill' salllpil's
ror 111\' (';lSI'S whcrt Iltl' I'slilllalOr or Ai: is hased ollly 011 IIt I' sa III pll' IIwallS of
Ihl' Iit\'lors. \\'(' (;111 also II'SI Ihl' ,igllilicaIH'e or any indi"idllall;\{'lor IIsill)!;
A/A
(i.:I,H)
..[i';,
whl'll' ~'i: is Ill(' lilt 1'1('111('111 or>i: :tlld "II is Ihl' (j. jllh dl'lIH'llI 01'\Tt;'1>i: I
T('still~ irindi\,idll;tI Lln"rs ;\1'\' prin'd is sl'nsihll' lill' (,<IS,'S \\'hl'l'l' Ihl' bnors
halT hl'l'll IIlI'IIIt,til;tll\' spl'lili,'d, Wilh I'llIpiri(ally deril'l'd faClors, stlclt
\l'sls an' 11011,,1'1111111'(';111\,',;1\ WI' "'plaill ill Se(lioll li,'l.l, 1;IClor,~ al\' id .. l1lilil'd Oil'" lip 10 ;111 ()1111<1~OII;t1lr;IIISIiIl't1lalioll; II\'II\'!' illdi"idllall;lI'lor, do
1101 Ita,',' dl'al,nll '''''IIOlllit' illll'rpn'I;lIiolls,
6. I. Sdrcliull
UJ Faclors
Shanken (I 992b ) shows that factor risk premia can also be estimated
a twopass crosssectional regression approach. In the firsl pass ,he
f;ICtor sensitivities are estimated assetbyasset using OLS. These estimators
represent a measure of the factor loading matrix B which we denote B. This
estimator of B will be identical to the uIlconstrained maximum likelihood
estimators previously presented for jointly normal and lID residuals.
Using this estimator ofB and the (N xl) vector of asset returns for each
time period, the ex post factor risk premia can be estimated time periodbylimeperiod in the second pass. The secondpass regression is
usin~
(6.3.9)
The re~ression can be consistently estimated using OLS; however, GU) can
also he used. The output of the regression is a time series of ex pOSI risk
premi,l, )..KIo I = 1, ... , T, and an ex post measure of the zerobeta portfolio
return, XOIo / = I, ... , T.
Common practice is then to conduct inferences about the risk premia
using the means and standard deviations of these ex post series. While this
approach is a reasonable approximation, Shanken (1992~) shows that the
calculated standard (lrrors of the means will understate the trut standard
errors Iwcause they do not account for the estimation error in B. Shanken
derives an adjustment which gives consistent standard errors. No adjustment is needed when a maximum likelihood approach is used, because the
maximum likelihood estimators already incorporate the adjustment.
2;\4
+ B f, + (,
(Id.l)
where R, is the (Nx I) vector of asset rcHlms fill' time period I, f, is Ih('
(Kx I) veclor of faclor realizaliolls fiJI' lillie period t, and lO, is Ihe (Nx I)
\'l'ctor ofmodcl dist\lrhan(l~s lor time period t. The numher of assets, N, is
1I0W very hlrge alHlllsllally mill'll \arg,:r thall the IIIlIllber of till\\, pniods, '{'.
There arc two primary slalislic~11 approaches, f~IClor analysis and prilll'ipal
COlli pone illS.
'1,'(/(/01' AI/alysis
l
\
+ D,
(liA.:\)
there
J:'lf, r,l ==
~lIIkuown,
= GB'
+ D.
d.I)
With Ihe structure ill (i.4.4) alld the asslllllpliollihal asset I'l'l II I'IIs ;11 (',ioililly
IlOrlllal alld t('mporally III>, ('slimalors of B alld D call he fill'llllllated IIsill~
lIIaxillllllll likelihood factor aualysis. Becallse the firstorder cOllditiolls ({II'
lIIaxilllllllllikelihooc! ar(' highly nOlllincar ill the parameters, solvillg for lhl'
estimalors with the IIsual ilerativ(' proccdurl' ('all be slow ancl COnV('IW'IH'l'
diflicllIt. Alternative algorithms have hl'en developed by Jiiresko~ (19(i7)
and Rubin alld Thayer (I !'H~) which facililate Cluick ('ollvergl'lHT 10 Ihl'
l\IaXilll\lII1 likelihood estilllators.
(R, 
Il)
=:
B f, I <,.
Civell ({i.I 5), a candidale to prox), lor Ih(' 1;lclO(" re;ili/;llions lor lillie pniocl
I is Iltt.: crosss('c'liollal ~elll:rali/,ed leas I squares :I.S) re~rl'sSi(llleslilllal(lr.
Usillg lh(' 1l1'IXillllllll likl"lihllod ('slilllalms or B .\1\11 n we h,\\'(' ror eacll 1
(liA.{i)
I kre
\1'('
il) 01110
n.
izalioll scries, f" 1 == I, .. , , T, call hI' 1'Il1pl"yed 10 lesl IIIl" Illodl'l IIsillg II\('
app("oach ill Sl'('\ioll {i,~.:t
Sillce thl' fano(", are lilll'ar l"ol\lhill;ltioIlS or I'l'tlll'IlS WI' (";111 I"OIlSI\ 1\l"1
!)onf()lios whidl arc \lel'kl"lly t'I)\Tl'Iatl't! wilh lilt' 1;lrlo)"s, Denoling R h", as
lhe (I\. x I) Vl'rlor offartor ponfoliolTllIJ"Ils for lillie period I, w(' hav!'
((iA,7)
R h", = AWR"
11'1(('1"('
allel A is ddilll'd as a dia~ollalll\alrix Wilh 1/ II; ;\s till' JIll di;rgollal d<.'llIt'III,
wlll'l"<"
is till' .ith l'IClllt'lI1 OfWL
Thl' !;\\"Io\" portfolio weights oill;lill .. d !'" 1111' /111 1";,,1111 f.Olll this p.or .. dlln' .11"(' "'1l1ivaklll 10 Ihe weights Ihal \\'ollid '"S II I I I"I0lli