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The Econometrics of Financial Markets

John Y. CamPgeU

A. Craig MacKinJay

Princeton University Press

Princeton, New Jersey

C"I'yri\l,ht 1',)97 hy I'rillc elOll

Ulliw "ily I'n'"
('fI''' . 41 Willi ,,," SII ,'('1.

Publisht" hy Princeton Univt"rsily

Plince\()II. New Jersey \lilr)~\l

In the linite tl Kingdonl; prinCt.'tlln

Unil' t'"ity



libra ry of Cong ress Catal oging in.Pu


1'1'''. Cltid,,,t<,.

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(:"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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List of Figures
List of Tables



Organization of the Book
Useful Background. . . .
1.2.1 Mathematics Background
1.2.2 Probability and Statistics Background
1.2.3 Finance Theory Background
Prices, Returns, and Compollnding .
1.1.1 Defmitions and Conventions.
1.4.2 The Marginal, Conditional, anclJoint Distribution
of Returns. . . . . . . . . . . . . . . . . . . . . . .. 13
Market Efliciency . . . . . . . . . . . . . . . . . . . . . ..
1.5.1 Efficient MarkrL~ and the l.aw of Iterated
. . . . . . 22
Expectations .. . . . . . . .
Is Market EffIciency Testable?
TIle Predictability of Asset Returns
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



Test s of Ran doll l Wal k 2: Inde pcn

den t Incr eme nts
2.3.1 Filte r Rule s . . . . . . . . .
........ .
2.3.2 Tech nica l Analysi~ . . . . .

..... .
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 g-Il oriz on Rell lrBs . . . .
. . .
2::>.1 Prob lem s with LOllg-1 [oriz
on Infc renn :s
Test s For Lon g-Ra nge Dep end
encc . . . . . . .
2.ti.l Exal llple s of I.on g-Ra ngc lkpc
/lclc ncc .
2.6.2 The Hur sl-M 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 s-Au toco rrch lliol lS '\Il(\
Lead -Lag Rc::IatiollS
2.8,4 Test s Usin g Lon g-H oriz on
RCll IflIS
Co nc lu sio n.. ... ...
... ... ...






Mar ket Mic rost ruct ure

3.1 {

3.2 I





'} r,

Non sync hron olls Trad ing . .

....... .
3.1.1 A Mod el of NOl lSyn c!tro
llous Trad ing
3.1.2 Exte nsio ns and Gen eral izat
The Bid-Ask Spr e'ld . . . . . .
. . . . . . .
3.2.1 Rid-Ask Bou ncr . . . .
...... .
3.2.2 CompOnel\L~ of the \)id-A~k
Spre ad
Mod elin g Tran sact ions Data .
... .
3.3.1 Mot ivati on . . . . . . . . .
. .
3.3.2 Rou ndin g <inc ll\ar rier Mod
3.3.3 The Onl trcd Prob it Mod el
Rec ent Emp irica l FilH lings . .
... .
3.4.1 Non sync itrol lolls Trad ing
3.4.2 Esti mati ng the Effe ctive BidAsk Sprc ad .
3.4.3 Tran sact ions Data
( ',onc I '
IISIO I1 . . . .

4 Eve JStu dy Analysis

4.\ ; Out line of an Evel lt Stud y
......... .
All Exa mpl e of an Evcn t Stud y .
...... .
Mo<iels for Mea s\lri llg Nor

mal I'crfOnll'<lIlCC
Con stan t-M can- Retu rn Moc kl
Mar kct Mod el . . . . . . . . .
... .







CCJllifll 1.1


4 .~l


'1.:~.3 Other Statistical Mlldds

,1.::1.'1 Ecollomic Modds . . . .
Me;\sul'illg and AnalYl.illg Abl\ormal Retlll"lls .
4.4.1 Estimation of the Market Model . . . .
'1.4.2 Statistical Properties of Ahllonnal Rellll'lls
4.4.:~ Aggregation of AIlllormal Returns . . . . .
4.4.4 Sensitivity to Nor11lal Rl'llll'l\ Modd . . . .
4.4.5 CARs for the Eamiligs-Allllolllll'l'ment Example
4A.G Inferences with Cilisterillg
Moclifying the NullllYl'othesis
Allalysis of Power . . .
Nonparametric Tests .
Cross-Sectional Models
Further Issues . . . . .
4.9.1 Role of the Sampling lntel'val
4.9.2 Inferences with Evelll-Date Uncertainty
4.9.3 Possible Biases.

5 The Capital Asset Pricing Model

:1. I




Review or the CAI'M .. .

Results from Efficient-Set Mathematics . . . . . .
Statistical Framework for Estimatioll and Testing.
5.3.1 Sharpe-Lintner Version
:l.:t2 nlack Versioll
Size of Tests . . . . . . . . . .
Power of Tests . . . . . . . . .
Nonnormal and Non-lID Returns
Implementation of Tests . . . . .
:>.7.1 Summary of Empirical Evidence
5.7.2 Illustrative Implementation
Unobservability of the Market Portfolio
Cross-Sectional Regressions
Conclusion . . . . .

Multifactor Pricing Models

Theoretical Background . . . . . . . . . . . . .
Estimation and Testing . . . . . . . . . . . . . .
1;.2.1 Portfolios as Factors with a Riskfrcc A.sset
li.2.2 Portfolios as FaClors without a Riskf'ree Asset
Macroeconomic Variables as Factors . . . . .
(i.!!A Factor i'ortfillios Spallllilll-\" the l\kall-V;triance
Frolllicr .. ' . . . . . .



















Estimation of Risk PrellIia and Expcelcd Returns

Sdcelion of FaclOrs . . . . . .
li.'1.1 Statistical Approaches ..
NlImher of FaCiors . . .
{i.'l.:\ TllI'oretical Approach('s
Empirical R('sults . . . . . . . .
Interpreting Deviations from Exact Factor Pricing
{i.{i.1 Exael Factor Pricing Models, Mean-Variance Analysis, and the Optimal Orthogonal Portfillio
li.li.2 Squared Sharpc' Ratios . . . . . . . . . . . . . .
Implications fi)J' Sc'parating Altcrnativc Th('mil's
.................... .

Present-Value Relations




The Relation I)('twec'n Prices, Dividends, and Returns

7.1.1 'I'lli'I .inear Pn'sc'nt-Value- Relation with Constant

Expected Relllnls . . . . . . . . . . . . . . . . . . . ~:);)

Rational Blibbles . . . . . . . . . . . . . . . . ..
7.1.:1 All Approxilllalc'l'n'sc'nl-Vahlc Relation wilh TillleVarying Exp('cled R('lurns . . . . . . . . . . . . . . . <'(ill
7.1.4 Prices and Retul'lls in a Simple Example
Present-ValliI' Relations and US Stock Pricc Ikhavior
I.ollg-iioriwil Regressions . . .
7.~.'2 Volatility 'Ii'sts . . . . . . . . . .
7,'23 Vector AlilOregn'ssive Mc,tllOds


Intertemporal Equilibrium Models



The- Stochastic Discounl FaCIOI' . . . . . . . . . . . .

H.I.I Volatility BOllncls . . . . . . . . . . . . . . . .
Consumptioll-Basl'd Asset Pricing with Pown Utility.
H.:!. I Powc'r Utility ill a I.ogllol'lnal Model. . . .
H.'2.'2 Power lItility and (;('ll\'rali'.cll Method of
MOlllents . . . . . . . . . . . . . . . . . . . . . . . .
Market Friel ions
H.:I.l Market FriClion~ and Il;ulsclI:)agalinathan
Boullds . . . . . . . . . . . . . . . . . . . . .
H3.'2 Markc,t Frictions and Aggre-gatc Consllmption
Data . . . . . . . . . . . . . . . . . . . . . . .
More (;('nnall 1tility FunC'lions . . . . . . .
H..t.1 Iiallit Forillation . . . . . . . . . . .
H.I.'2 Psychological Mockls or Pr('fucnc('s
( :ondllsion



:q 4

:1 I Ii

Derivative Pricing Models

Brownian Motion .
341 I
9.1.1 Constructinr; Brownian Motion .
9.1.2 Stochastic Differential Equations
346 [
349 .
A Brief Review of Derivative Pricinr; Methods.
9.2.1 The Black-Scholes and Merton Approach .
9.2.2 The Martingale Approach . . . . . . . . .
Implementing Parametric Option Pricing Models
9.3.1 Parameter Estimation of Asset Price Dynamics
9.3.2 Estimating (j in the Black-Scholes Model . . .
9.3.3 Quantifying the Precision of Option Price
Estimators . . . . . . . . . . . . . . . . . . . . . . . . 367
9.3.4 The Effects of Asset Return Predictability.
9.3.5 Implied Volatility Estimators . . . . . . . . . . ..
9.3.G Stochastic Volatility Models. . . . . . . . . . . ..
Pricing Path-Dependent Derivatives Via Monte Carlo Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
9.1.1 Discrete Versus Continuous Time . . . . .
9.1.2 How Many Simulations to Perform . . . .
9.4.3 Comparisons with a Closed-Form Solution
9.4.4 Computational Efficiency .
9.1.5 Extensions and Limitations.
Conclusion '"

10 Fixed-Income Securities
10.1 Basic Concepts .
10.1.1 Discount Bonds
10.1.2 Coupon Bonds
10.1.3 Estimating the Zero-Coupon 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 . . . . . . . . . . . . . . . . . . . .


11 Term-Structure Models
11.1 Affine-Yield Models .
11.1.1 A Homoskedastic Single-Factor Model
11.1.2 A Square-Root Single-Factor Model
11.1.3 A Two-Factor Model . . . . . . . . .
11.1.4 Beyond Affine-Yield Models . . . .
11.2 Fitting Term-Structure Models to the Data
11.2.1 Real Bonds, Nominal Bonds, and Innation
11.2.2 Empirical Evidence on Affine-Yield Models





(.'U/I 11'11 1.1



Pricing Fixed-Incomc Dcrivativc Sccuritics ..

11.3.1 Filling the Currcnt Terlll Structure Exactly
11.3.2 Forwards and Futures . . . . . . . . . . . .
11.3.3 Optioll Pricing in a Tcrlll-Structure Modc1
Conclusion . . . . . . . . . . . . . . . . . . . . .

12 Nonlinearities in Financial Data

Nonlinear Structure in Univari<lte Timc Scric~ .
12.1.1 Some Paramctric Models . . . . . . . . .
12.1.2 Univariatc Tcsts for Nonlincar Structure
12.2 Modc\s of Challgill~ Volatility
12.2.1 Univariatc Models . . . . . . . . . . . . .
12.2.2 Multivariatc Models. . . . . . . . . . . .
12.2.3 Links between First and Second Moments
Nonparametric Estilllation . . . . . .
12.3.1 Kernel Regression. . . . . . .
12.3.2 Optimal Bandwidth Selcction
12.3.3 Average Derivative Estimators
12.3.4 Application: Estimating State-Price Densities
12.4 Artificial Neural Nctworks . .
12.4.1 Multilayer PerccptfOns . . . .
12.4.2 Radial Basis Functions . . . .
12.4.3 Projcction Pursuit Regression
12.4.4 Limitations of Learning Networks
12.4.5 Application: l.earning thc Bbck-Scholes FOflllllla
1~.5 Overfllting and Data-Snooping
12 G Conclusion . . . . . . . . . . .





:) I Ii



Linear Instrumelllal Variablcs . . . . . . . . . .
Generalized Mcthod of MOlllcnts . . . . . . . .
A.3 Serially Correlated and f Icteroskeoastic Errors.
GMM and MaximulII Likelihood . . . . . . . .



Author Index


Subject Index


List of Figures










Dividend Payment Timing Convention . . . . . . . .

Comparison 0(' Stable and Normal Density Functions


Nontrading-Induced AutocolTelations . . . . . . . .
Histogram of Daily Price Fractions and Price Changes for
Five NYSE Stocks from January 2, I~)~)O to December 31.
1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..
2-Histories of Daily Stock Returns luI' Five NYSE Stocks from
.Ianuary2, 1990 to Deccmber:ll, 1992 .. . . . . . . . . . .
TIll: Ordered Probit Model .


Tinlt.' l.ine for an Event Study

(a) Plot of Cumulative Market-Model Abnormal Return for
Earning Announcements; (Il) Plot of Cumulative Conslant-Mean-Return-Modcl Abnormal Return for Earning
Announcements . . . . . . . . . . . . . . . . . . . . . . ..
Power of Event-Study Test Statistic Jl to Reject the Null Hypothesis that the Abnormal Retllrn Is Zero. When the Square
Root of the Average Variance of the Abnormal Return Across
Firms is (a) 2% and (b) 4% . . . . . . . . . . . . . . . . . ,
Power of Evelll-Study Test Statistic Jl to Reject the Null Hypothesis that thc Abnormal Return is Zero. for Differelll
Sampling Intervals, When the Square Root of the Average
Variance of the Abnormal Return Across Finns Is 1% for the
Daily Interval . . . . . . . . . . . . . . . . . . . . . .
MinimulIl-Variance POrll'olios Without RisHree Asset
Minimulll-Variance Portfolios With Riskfree Asset . .







for the CAPM Zero-I II tercept Tesl Statistic fur

FOIII' Ilv\lollH'~(,s






!I. I

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 Dividend-Pric(, Ratio and ESlimaled Dividend COlllPO1I('nl, Annual US d;lIa, IH7G 10 Iq!H . . . . . . . . . . . . .
(a) Mean-Standard Deviation Diagram for Asset Returns;
(h) Implied Sla"c\arc\ Deviatio,,-Mean Diagram for Stochaslic Discount Factors . . . . . . . . . . . . . . . . . . . . . .
(a) Mean-Standard Dcviatio" Diagram for a Single Excess A~
set Return; (h) Implied Standard Deviation-Mean 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 . . . . . . . . . . . . . . . . . . . . . . ..







Zero-Collpon Yidd a"d Forwanl-Rate Cllrves in Jallllal),

I !IH7 . . . . . . . . . . . . . . . . . . . . . . . .
Cash Flows in a Forward Trallsactioll . . . .
Calculatioll of llmation (1I' a Coupon Hond . . .
The Prire-Yil'ld Relationship. . . . . . . . . . . .
Short- alld I.ong-Terrn I n(erest Rates 1952 to 19!11


Change ill Short Rate I )ivided hy Short Rate to the Power y

Sample and Theoretical Average Forward-Rate Curves


The Tent Map. . . . . . . . . . . . . . . . . . . . . .

Monthly Ex('('ss I.og liS Siock Returns, 1926 to 1!J!J4
Shifled ,\lHI Tilll'd Ahsoillte-Valll(, FIIllctioll
12.4 Simulation of}', = Sin(X,) + O,:'f, . . . . . . . . . . .
12.;. K('(IIeI Estimalor . . . . . . . . . . . . . . . . . . . .
12./i Bullish Venicil Spl'l';ld 1':lyolf Fllnclioll and Silloothed
Vnsion .. . . . . . . . . . . . . . . . . . . . . . . . .
12.7 Biliary Thr('shold t-.I"dcl . . . . . . . . . . . . . . . . .
I :!.H COlliparisoll of I kavisidc and I.ogistic Activation FIIIICliolls
12.!) MIIJtila)'('I' I'CI'Cl'I"l'On wilh a Single IIidden l.ayer .
12.10 MI.!'( \.:.) Model of l', = Sin( X,) -+ O':'E, .......
12.11 Typir:1l Silllillated Trainill)!; !'ath . . . . . . . . . . . .
12.12 Typicallkha\'ior or FOIII'-Nonlill<'ar-Tl'I'lIl RBF Model





41 Ii

o. \ ()
:; 1:1
:d 1


List of Tables


Stock market returns, 1962 to 1994 . . . . . . . . . . . . . .


Classification of random walk and martingale hypotheses.

Expected runs for a random walk with drift J.I..
Autocorrelation function for fractionally dilTerenced process.
Autocorrelation in daily, weekly, and monthly stock index
returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . "
Variance ratios for weekly stock index returns . . . . . . '.
Variance ratios for weekly size-sorted portfolio returns. . . ..
Variance ratios for weekly individual security returns. . . . . ,
Cross-autocorrelation matrices for size-sorted portfolio returns.
Asymmetry of cross-autocorrelation matrices.


Summary statistics for daily returns of five NYSE stocks.

Relative frequencies of price changes for tick dara of five
stocks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..
:t::la Expected upper bounds for discreteness bias: daily returns.
::I.::Ih Expect.ed upper hounds for discreteness bias: monthly returns.
'\.::1(' Expected upper bounds for discreteness bias: annual returns.
Autocorrelation matrices for size-sorted portfolio returns.
:t:J Estimates of daily nontrading probabilities.
NOlltrading-implied weekly index autocorrelations. .
SUJllmary statistics for transactions data of six stocks.
Estimates of ordered probit partition boundaries.
:tHh Estimates of ordered probit "slope" coefficients. . . .




Abnormal returns for an event study of the information contelll of earnings <lnIlOllllcemeIllS . . . . . . . . . . . . . . "
POW('f of evellt-study test statistic JI to reject the null hypothesis that the abnormal return is zero. . . . . . . . . . . . "





I.isl oj '['abil's


Fini te-sa mpl e size of tests of tile Sha

rpe- l.int ner C'AI'M !Ising
large-salllple test statistics . . . .
............... .
Pow er of f'-test of Sha rpe- Lint ner
CAPM usin g statistic Jl ..
Emp irica l results for tcsts of thc
Sha rpe- I.ill tncr versio/l of
theC APM . . . . . . . . . . . . .
.............. .





1SUJIlmary of results lilr tests of exaCl

blCIO !' pric ing lIsing

'zcro -illl erce pt F-tes!. . . . . .
. . . . . . . . . .
: Lon g-ho rizo n regr essio lls of' log
stoc\:. retu rns on the log
,div iden d-pr ice ratio . . . . . . .
. . .. . . . . . . .
II.on g-ho rizo n regr cssi ons oflo g
stoc k relll rns on the stoc has\tically detr end ed shor t-ter lll inte
rest rate. . . . . . . .



\Molllents of cons ulIll lliol l grow th

and asset retu rns'. . . . .
\1~lstrumental variables rq~rcssiollS for retll
ms and COIlSlllllP,tlOlI grow th . . . . . . . . . . . .
............... .

~lIltiplic~tion rulcs for slOchast~c diffe rent

{\symptol1c stan dard erro rs for a
. ...... .
Asymptotic stan dard erro rs for 0 2

~uto{rva!lIes for colllparativc statics of VI'
.;\sYlllptotic variances of' Black-Sc
holes call pric c sensitivity
estim ator s. . . . . . . . . . . .
............ .
Opt ion prices on asseL~ with nega
tively aillo corr elat eu
retu rns. . . . . . . . . . . . . .
. . . . . . . . . . .
Mon tc Carl o estim atio ll of look back
opti on pric e. . . .
Macaulay's and mod ificd dura tion
for sele cted hon ds.
Mea ns and stan dard devi atio ns of
terll l-str uctu re vari able s.
R.egression coef licie nls fill and YII'
... ... ... ... . .



Pr efa ce

Thc secd s of lhis hoo k wcr e plan

led 01'('1 ' fifteell year s ag-o. al lhc
very slar l
of 0111' prok ssio ll;t1 care ers. Whi
le sllidyillg- fillallcial ('con ollli cs,
and as
wc 1)('g-;1I1 to lcac h iI, we disc over
cd seve ral exce llcn l ICXlbooks
(ina nc;:tl Iheo ry-D uffi e (1 U92 ), I'lua
llg alld l.ilzcnbcrg-l'I' (19HH), and
( 1~)K7), for cxa lllp lc-b ul no equi
vale llt ICXlbook for elllp irira lmc
lhod s.
Dur ing lhe sam e pcri od, we parl
icip aled in resc arch con fcrc nces
Fill;lllcial M:lrkels and MOllelary
Eco noll lics. held und er lhe allsp
ices of lhe
Nati ollal BlIr eau orEc onu lIlic Resc
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allel liiol l al lhcs c Illceling-s invo
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cs. We
felli hat this was SOIl l(' of the Illos
l exci lillg rese arch hein g don e
in !ina nce
lIlC! lhal sllld cIIls shou
ld be exp osed 10 lhis Illal crial al
an earl y slag e.
III 1!)H!) we bega n to disc uss lhe idea
OrWriling- a hoo k lhal wou ld cove
ecol lolll elric IlIClhoc!s as app lied
10 filla llce. alol lg wilh som e of
lhe mor e
prOlllill('Il1 elllp irica l resu lts ill
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earn esl in
I ~)91, com plel ing lhis ardu ous
pr<~jccI five ycar s and almO
hUl ldre d
page s latcr. This boo k is consi<ler
.lbly long cr lhal l we had orig illal
ly plal lned ,
bill wc havc finally over
com e lhe lcm ptal ioll 10 incl ude
jusl one lIlor e ncw
lopi c . lIld hal'c pUI our pcn s to
res!. or cour se. lhc acad emi c liter
alur e has
evolved rapi dly whil e wc have bcen
wril ing, and il con linu cs to do
so cven
;1,\ litis boo k goes
to pres s. We have alleJ
llplC d 10 prov idc hroa d cove rage
IlIlI ('1'(,11 ,\0. Iher e are JlIan
y su!~j('C1S lhal IVt' do 1101 louc h
Ilpo n, and mallY
o111ns lit;ll wc can ollly JlIclllion
ill p;lssing.
y\'e OI,'t' 1I1;lllY Illor c dcb ls-p crso
llal alld illle llec lual -tlia n IV(, (,'In
pos,\ihll' ;ICkllowlcdgc. Thr oug hou l
our pl'oks~j()lIal cal'ccl's our coll
1II('Illors h;II'c o/ln ed us advic(',
d('h ale. imp irali oll, alld fricl ldsh
ip; IYC wish
to lh;lllk ill parl inrl ar And y Al>c
l, lkll lknt allk e. Sln' (' CC('ChClli
../oh ll Cox .
AlIgll~ Dea loll. (;cll e Faill
a. Ihllc e (;rlll lcl),. Jerr y llauSIlI<l
Il, Chi-I'u IllIallg-.
~1,'n')'11 Killg. Noh ll Kiyo
laki. \'el( ' Kyit-. C.cg Mallki\\', Bob
Mnl oll. WhillH'Y
\/,,\, '('\',1 \,," Sllill ('I'. lilll 'Ii,"
i" ",,,1 \, ",,1,1 '/,11 .....

Man)' individuals ha\'(' also I'rovid('d us with invaluahle COIIIIIH'nts alld

discussions nganling the COIIIl'nis and I'XPOSilioll of this hook. WI' thauk
David Backus. Nil-k Barhnis. D,wid Barr. David Hates. KI'I\ Ikdllllallil. Dilllitris I\l'rtsilllas. Tilll IlolIl'lsll'\'. Peter ChriSloffl'rsl'lI. Susall KelT Christo/~
krsl'n. (;I'orgl' Conslantinidl's . .John Cox. Xavier Gahaix. Lorenzo (:iorgianlli .Il'rl'lny (;0111. I.ars I Iotusl'n. Camphdlllarvl'Y.Iohn JIeaton. I.udgl'r
Ilenlsdll'l, Rogl'r 111I_lIlg. R_\\'i.lagannathan. Shmllel Kandel. (:aulam K.III!.
.Iung-Wook Killl. 'I')dcl f\lillon. Dan Ndson. Amlan Roy. Boh Shiller. Marc
Shivers. Rohert SI;lIllhaugh. Tom Stoker .Iean-Lllc Vila .Iiallg Wang. and
Ihl' ph.n. SllIdl'nls at IIaITard. MI'I: I'rincetoll. alld Wharton Oil wholll Ihis
lIIaterial was "test-marketed" alld rdinl'd.
\"'1' have rdied heavily on Ihe ahle research assislance o/'Pl'lr Adalllek.
Sangjoon Kim. f\brtill 1.(l\all. Terenn' Lim. Conslanlin Pelrov. Chllllshellg
Zhou. and parlicllbrly Mall Van Vlack and Luis Vinira. who undertook the
diffinllt lasks 01' prool'n'ading Ihe llI;l\lllsnipt and prq>aring the ilHlex.
WI' an' grall'ful 10 Sll'phani(' Ilogu\' fill' h<'l' greal skill and carl' ill
prl'parillg Ihl' l'Il'Clmllic version of this llIalluscripl. alldlhe Iypcselll'rs ,It
Archl'l)'pe fill' producing Ihl' final \,I'rsion oflhc hook.
WI' Ihank 1'('ln \)oughl'rly. 0\11' ('(Iilo)' al Princelon UniversilY Press. fur
his pati('IHT, ('II .. "urag(IlH'nl, alld support throughout this project.
Se\,l'ral orgalli/atiolls provid('d IlS wilh generous suppon during \',11ious S\;lges of Ihis hook's geslalion; in paniclllar, we thank Ballcryman h
Financial Managellll'nl, the National I\lIreall of E.conomic Rl'search. till'
Nalional Science Foundalion, Ihe John M. Olin Foundation, Ihe Alfred 1',
Sloan FOllndalion, alld research cl'nlers at I larvaI'd, MIT, Prin('('toll. and
i\lltllillal\y, we OWl' 11101'1' thall WI' ('all say 10 the SlIpport alld lo\'l' 1lJ' "Ill'
/;lIl1ilics .



The Econometrics of Financial Markets


is a highly empirical discipline, perhaps the most

cmpirical among the branches of economics and even alllong the social
sciences in general. This should come as no surprise, for financial markets
arc not mere figments of theoretical abstraction; they thrive in practice
:llId playa crucial role in the stability and growth of the global economy.
Therefore, although some aspects of the academic finance literature may
seenl abstract at first, there is a practical relevance delllanded of financial
lllodeis that is often waived for the ll10dels of other comparable disciplines. l
Despite the empirical nature of financial economics, like the other soci:.il sciences it is almost entirely noncxperilllentai. Therefore, the primary
method of inference for the financial economist is model-based statistical
inference-financial cconolJleuics. While ecollometrics is also essential in
other branches of economics, what distinguishes financial economics is the
central role that uncertainty plays in both linanrial theory amI its empirical
implementation. The starting point for every financialmodcl is the uncertainty facing investors, and the substance of every financial model involves
the impact of uncertainty on the behavior of investors and, ultimately, on
market prices. Indeed, in the absence of ullcertainty, the problems of financial ecollomics reduce to exert"ises in basic microeconomics. The very
cxistence of financial economics as a discipline is predicated on uncertainty.
This has important cOllsequences fi)!" finaJlcial ecollometrics. The randOIH fluctuatiolls that require the use of statistical theory to estimate and test
tiluncial models are intimately related to the ullcertainty on which those
Ill()(lcls <Ire based. For example, the maningale Illodel for asset prices has
V('I)' specific implications for the behavior of test statistics such as the autoc()rrelatioll coellicient of price innelllcnts (see Chapter 2). This close
cOllllection between theory and empirical analysis is unparalleled ill the


B<", ml .. in (I ~J~:l) provides a highly, c.ulab,," '''"("'H'''I "I Ih .. inl<rpl y h.lween theory and

pr;l("tiu~ ill tilt" dt."c!OpJIIClll of Illodt'nl fiualu"iai econolllics.

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 graduate-len'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
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 well-known 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('ss-no self-respectillg fillallce text
could olllit llIarket efficiellcy altogethn-Senion 1,5 bridly discusses tIl!'



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-


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 short-run behavior
of returns. Similarly, in Chapter 4 we discuss simplc statistical models of the
cross-section 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 longer-run
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 timc-variation in expcctcd returns. We use
the samc principle to divide a basic treatmcnt of fixed-income securitics
in Chapter 10 from a discussion of equilibrium term-structure 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 onc-semcster coursc. For cxamplc onc teachcr
might start by discllssing short-run time-serics bchavior of stock priccs using
Chaptcrs 2 and 3, then covcr cross-scctional 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 long-run 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 flxcd-incomc 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 exchange-ratc bchavior or the homc-bias 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 frequency-domain methods of time-serics 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



' ,.' , .,:: "" ~ t;


cconometric issucs, somctilllcs at (hc expensc ofo(her equally ill('/'IHuch rcccHt work ill hchavioral !inan('t'-that
is ccbllollletrically more straightforwanl.

cstill~ l1Iatcrial-indudill~

1.2 Useful Background

The lIIany rewards of financial cconometrics come at a price. A solicll>ackground in m.athematics. prohahility and statistics, and finance theory is nc('essary for the practicing financial economctrician. for precisely the reasolls
that make financial cconometrics such an en~a~ing endeavor. To assist
readers in obtaining this background (since only the most focused and directed of st\l(ients will have it already), we outline in this scction the IOpics
in mathematics, probability, statistics, and finance theory that havc becollle
indispensahle to financial ecollomctrics. We hope that this outline call scrve
as a self-study guidc for the lIIore enterprising rcaders and that it will bc a
partial substitute for includin~ backgruund material ill this houk.
1.2.1 Atllt/wlllltirs B(!ckg'HlUUd

The mathcmatics background most useful for !inaneial ecollonletri('s is not

unlike the background necessary for econollletrics in general: lIlultiv'\Iiate
calculus, linear algebra, and matrix analysis. References for each or these
topics arc Lang (1973), Strang (197!i), and Magnus and Neudecker (I ~IHH),
respectively. Key concepts include

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


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 coill-Ilippin~ l:alcuhltions to measure-theoretic
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 IIlGlslllc-theoretic level. Key COIIc('pts incillde

ddillilioll of a ralldom variable

di,trii>ulioll and density fUllctiolls
c()nditional prob~lbility
modes of cOllvcrgenct:
laws of large numbers
centrallilllit theorems.

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 well-delined subdisciplines such as lIIultivariate analysis, nonparalIlelrics, tillie-series 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) three-volullle 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,"e-series analysis. Hamilton (\ !l94) is an excellenl comprehensive text.
Key concepts include
Neyman-Pearson hypothesis testin~
lint'ar n:gression
IIl<lximlllll likelihood
hasic lillie-series analysis (stationarit)" alltoregn.'ssi\e and ARMA pro,"('sses. vc("(or alltoregrcssiollS, unil rools, etc.)
('I"III('lIlar), Bayesian illferellcl'.

F()r ("(JlIi ill1lOm-lilIlc 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).

J.2.3 Filllll/u' 'filml)' HllrkgmHlld

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

or this material: Duffie (I!l!l~), /-luang and Litzenberger (19HH), Ingersoll

.14'- L"~~I.~ t,1 .... ; ,"
.'~I:~:)L" iIJCJudt"

,hI. ,.I<ISIIIJI .tlllI ''''IWI 11'11-,<111111' IIJ('ory

s!<llic lIIean-varian((' portfolio II1('0ry
the Capilal Ass!'1 Pricillg Model (CAI'M) and the Arhitrav;e Pricing Theory (AI'T)
dynalllic ass('t pricing models
optioJl pricing th('on'.

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 replc-h' 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 Ic-lI('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'
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 variance-covariance matrices, we use n for the variancecovariance matrix of asset returns, L for the variance-covariance matrix
of residuals from a time-serics or cross-sectional model, and V for the
variance-covariance 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.

The professional literature uses Illany specialized terms. Inevitably we

also use these frequently, and we italicize them when they first appear in the

1.4 Prices, Returns, and Compounding

Virtually every aspect of financial economics involves returns, and there are at
leasltwo rcasops for focusing our attcntion all returns rather than on pri~es.
Firsl, for the average investor. financial markeL~ may be considered c1os<lto
pnft"l:tly competitive, so thatthc sizc of the investment does not alTect prke
changcs. Therefore, since the investment "tcchnology" is constant-retu~ns
to-scale, the return is a complctc and scale-free summary of the investment
Second, for theoretical and empirical reasons that will become apparent
below, returns have more attractive statistical properties than prices. such
as stationarity and ergodicity. In particular. dynamic general-equilibrium
models often yield nonstationary priccs, but stationary returns (see, for
example, Chapter 8 and Lucas [1978]).

1.4.1 Definitions and Conventions

Denote by 1', the price of an assct at date I and assume for now that this asset
pays no dividends. The Jim/lie nfl rl'lum,
on the asset between dates I - 1
and I is defined as




(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

cC]ualto thc product of the k single-period returns frolll 1- k + I to I, i.('.,

1+ R,(k)

+ I?d . (I + /{,-I)'"

+ I?,-k+d








I',-H I







( I.U!)

and its net rcturn over the 1I1osl recent k periods, written /{,(k), is simply
cCjualto iLS k-pcriod gross return minus olle. These llluitiperiod returns are
callcd com/Jound rcturns.
Although returns arc scale-free, 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 +







rcturns are gencrally slllall in magnitudc, the following a~proxilllation bascd on a first-ordcr Taylor expansion is often used to
annu~lize multiyear returns:
Anllualizl'd[U,(k)] ~


k L Ilt-r



Whether such an approximation is ade<)l1ale depends on the particlliar

application at hand; it may suffice for a <)ui<"k and coarse comparisoll or
invcstmcnt pcrformance across many assets, bllt for finer calculations in
which thc volatility of returns plays all important role, i.e., whell the higher.. order terllls in thc Taylor expansion arc not negligiblc, the approxill1ation
t (1.4.4) lIlay hreak down. The only advantage orslich an approximation is
. (OIlVcnience-it is easicr to calculate all arithmetic rather than a geolllet ric avcrage-howevcr, this advantage has diminished considerably with the
.. advclll of cheap and convenienl computing power.



}'ril'f.\', 1II'lUnt.l, !luti



(:oll/ill Will.\' (:olll/mulldilll{

'! '", diflicully or manipulating g\~ol\wtrir ,Iverages surh as (1.4.:~) motivates

,t .. .. <'1' approach to compound returns, (In(' which is not approximate and

,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



+ R,(h)) ==


+ H,) + logO + H,_I) + ... + logO + RH+I)



+ T,_I + ... + r,-ktt,

+ HI)' (1 + RI _ I ) (1 + U'-H1)
( 1.4.ti)

and hence the continuously compounded llIultiperiod retum is simply the

sum of continuously compounded single-period returns. Compounding,
a multiplicative operation, is converted to an additive operation by taking
logarithms. However, the simplification is not merely in reducing multiplicatioll to additioll (since we argued above that with modern calculators
and computers, this is trivial), but 1II0re in the modeling of the statistical
behavior of asset returns over time-it is far easier to derive the lime-series
properties of additive processes thall of multiplicative processes, as we shall
~('e in Chapter 2.
Continuously compounded returns do have one disadvantage. The siJnpie relU!'ll Oil a portfolio ofassels is a weighted average of the simple rellIrns
011 the assets thelllselves, where the weight 011 each assel is the share of the
portrolio'~ value invested in that asset. ]j' portfolio /) places weight W,p in asSel i, thell lhe return 011 the portfolio at litlle /, HI'" is related to the returns
Oil individual assets, Rjlo i == I ... N, hy R/" = L:':'d W,/,Hil . UnforlUnatrly
conlinllously compounded returlls do lIot share this conveniellt property.
Since Ihe log or a SUIII i~ 1I0t the sallie as the stun or logs, 'i" docs not equal

L...,=1 1l'I/ lrli'

In empirical applicalions this problem is IIsllally minor. When returns

,Ire lIwasured over short intervals of lime, alld are therefore dose to zero,
Ill(' cOJltinllously (,OIllPOIIlHlcd /'(>Iurll Oil ,I port!,.!io is close to Ihl' weightl'd



1+ I
I Jil'idl'lld I'mll/PIII "'ill/il/~ CIIIIl'rIIlill/!

Fi}.,"In' 1,1,

average of the continllollsl\' COlJlpoIIIHled returns

'i,' ""

L:t lfIll"i"~


lhe individual


We lise this approxiliialioll in Chapter :1, Nonl,thelc,s

it is conllnon to USI' ~illlpk returlls when a (Toss-section of assets is heillg

stlldied, as in ChaplCls I-(i, ;IIId cOlllilluously cOIlIpounded relUnls whl'1I
Ihe lelllporal behavior of relllnlS is the lilcus of interesl, as in Chapll'!s '2
and 7,
I )ir/it/nlll I'ayllll'll/.\

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 ciale-I 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 elld-ol~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

1'1 + /),


Multipl'riod and cOlllillllollsly COIIIIHHllldcti relllrns 1\Iay hc oi>uilll'ci

ill Ihe sallie way as in Ihe lIo-dividellds case. Nute that the cOlltillllOllSI~'
compollllckd rellll'll Oil a di\'idl'lld-payillg assel, r, = log(/'I + /),) -log(l',_1 ),
is a nonlincar rllll('(ioll or log priccs alld log divicknds. Whell thc ratio
or prices to tlidclcnds is nol ICHI \'ariahle, however, tbis rlllll'liOll elll hc
approxilllaled hy a lilH'ar rllllClioll or log prices alld di\'idelld~. as discllssed
in detail in Chaptci 7,



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 shorl-l<T!ll Tn';lSlIrl' hill n'lmll, Workillg with silllplc retllntS, thl'

:.',,, \1", hmt1 \d"'"'1i''H'l'''


1I"i.t'd 10 Id,lIf' ,ilJll'k




,1\ S('( titlll ~I. t .'1(11 (:h.l\ltt"1 I,.

'''lIliIIlIOIl,h (PlIIl'0lltultclICIUI n~"

silllple excess return on asset i is

where I~Jt is the reference return. Alternatively one can define a log excess
return as
( 1.4.9)
The excess return can also be thought of as the payoff on an amitmgt
/Jllrtjo/io that goes long in asset i and short in the reference asset, with no
net investment at the initial date. Since the initial net investment is zero,
the return on the arbitrage portfolio is undefined bllt its dollar payoff is
proportional to the excess return as dc!inecl above.

1.4.2 The Marginal, Conditional, and joint Distribution of Rrtums

I"laving defined asset returns carefully, we can now begin to study their
behavior across assets and over time. Perhaps the most important characteristic of asset returns is their randomness. The return of IBM stock over
the next month is unknown today, and it is largely the explicit modeling
of the sourres and nature of this uncertainty that distinguishes financial
economics from other social sciences. Although other branches of economies and sociology do have models of stochastic phenomena, in none
of them does uncertainty play so central a role as in the pricing of finanrial assets-without uncertainty, much of the financial economics literature,
both theoretical and empirical, would be superfluous. Therefore, we must
articulatl' at the very start the types of uncertainty that asset returns mi~ht

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:
( 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
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


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 cross-section 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 trade-off 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
croSs-sectional 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:

FUlil' ... ,Rrr)

/';1 (R.d . /';~Ul,t I n,d /'i:l(fl,:1

... /';'r\R,'f

lilT-I .


R,2. R,d


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 plac-ing 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 random-walk 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-

1.". Prias, Returns, and Compoundillfi


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 "two-period" 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 single-period 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 single-period returns arc indeed
normal, hut the slim of single-period silllple rellll'IIS does not have any economically meaningful interpretation. However, as we saw in Section 1.4.1,
the slim of single-period continuously COlllpOlllHlcd rclllrns docs have a
meaningful interpretation as a llIultiperiod continuously compounded return.

'Jile 1.og71oTlIlal Distribution

A sensible alternative is to assume that cOlllinllollsly compounded singleperiod returns Til are lID norlllal, which implies that single-period
gl'Oss silllpll~ returns arc distributed as liD lO!-,'1wnllal variates, since Til ==
log( I + RII ). We lIIay express the lognormal model then as

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

(1.4.14 )

AIII'matin-h', 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



(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)



or lIortn;tii/.l'd ',l\lItll I\lOllll'lll, of is defined hy

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
.!',I-Iaifl'/{ 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. I (I)

I .. /.


l'nuI, I!I'LrII7l.I, 1I1It! COII//IIJlllldillJ;

Ill(' sample variance


a~ - TI '\'((
L-'-'" ,

Ihe salllple skewnf'Ss




.Ii -- 'fo-:I L-(f, - Ii) ,



alld the sample kurtosis


l\." == -I-4


(E, - Ii) 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 fat-tailed 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"('lo-l.(\,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).


1. Introductioll









Figure 1.2.



CompariiOll o/Slab'" (wd Nomlfll Dl'Ilsily FIUlcliolU

these distributions will not converge as the sample size increases. but will
tend to increase indefinitely.
Closed-form 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) =


+ (x -


In Figure 1.2, (1.4.23) is graphed with parameters <5 == 0 and y

\, and il
is apparent from the comparison with the normal density fUllction (dashed
lines) .that the Cauchy has faller tails than the normal.
Although sc.able distributions were popular in the 1960's and early 1970's,
they are less commonly used today, They have fallen out of favor partly because they make theorelicallllodelling so difficult; standard finance theory
4I!uwever;I..e"'! (1925) deriveilihe \ol\owillK ~xplicil exp ....,sioll for Ih" 10Ka";III", of Ihl'
ch'lra<ll"rislic fUllelion \0(1) of allY slahlt' laudolll v;triahle X; 10K \0(/) == lOll EI ,"'\) = i.lrlll"11 - i,8'gll(l)lan(aJl'l2). where (a.fI,., y) are Ihe lour paramelers lhal chara('('rilt'
each .!able clisuibution, 6 e (-00,00) is said 10 he Ih" loraliUlI "arameter, fI e (-00,00) is Ihe
inrinr, r e (0,00) is the '(flU "a""la'tl'l. and" e (O,:l\ is the fxpVllml. Whellll = :l.
Ih .. ~table di~lribulion reduce~ tn ,I nOl'lIIal. A" a. dCO't,IM'~ hlllll 'l 10 0, Ihc lail area. or lIlt'
51allle dislribution become incrl"asinf;ly "(aner" Ih,,,, Ihe nor",al. When a e (I. 2), the .Iahl,'
distribution has a finite mean Kivell hy &. hut when a (0, I\, "vcn Ihe mean is illlillite. TIlt'
parameler fJ meamres the symmelry of Ih,' slahle dislribution; when {j = () the distrihution b
'ynlmelric, and when fJ > 0 (or fI < 0) Ihe distribution is skewed to the riKht (or lefl). Wh"11
fI = () ")'d a = I we have the Cauchy di,lIihulion. ,lIId when" 1/:l, fl I, & ll, allli r I
we han! Ihe Bernoulli diMriblltion,


1.4. Pl'ires, Uellmls, IHld CornpoullliillK


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 long-horizon returns will he just as non-normal as short-horizon
returns (s'nce long-horizon returns are SUIllS of shon-horizon returns, and
these distributions arc stable undcr addition). III practice the evidence
for non-normality is much weaker for long-horizon 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 fat-tailed unconditional
distribution with a flllite variance and finite higher moments. Since all
momcnls are (initc, the Central Limit Theorem applies and long-horizon
rcturns will tend to bc closer to the norlllal distributioll than short-horizon
rcturns. It is natural to model the conditional variance as a time-series
process, and we discuss this in detail in Chapter 12.


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 equal-weighted 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 market-capitalization deciles using 1979 end-ofyear 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



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 rcturns-the vallle- and eqllal-weighled
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 hll-Iailcd distrihlllillns with linile higher moments, f()r
which Ihe Centrall.illlil Theorelll applics and drivcs longn-horil.oll rt'lmIlS
lowards normality.

1.5 Market Efficiency



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 llIarket-lIot to b('
confused with all alloraliollally or I'areto-eflicielll markel-pricc 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




httOLHUI to.




1abk 1.1.

S/ork marl,,/ "/lIm.<, 196210 J 994.





Valllt'-Wt'i!(htt'd Index































Interiak .. Corp.





R"ylrrh Corp.
AlIlpco-l'ill,bllrgh Corp.








Kllrtosis Minimum


Pond A: Daily Rrlurru


Intefnati(Hlal Bw;inc5..o;

Crr1l"r,,1 Si!(n,,1 Corp;

Encrgt"n Corp.

Ceneral 11"'1 Corp.

Caran Inc.

COlitint"nt,,1 Materials Corp. 0.143



Pan.' B: Monthly Returm


Eqllal-Weighted Index
Intt"rnational Business
(;"n"lal Si~n;\1 Corp.
Wrigley Co.
Intc-ridke Corp.
R;lylech Corp.






























ETlt"Jgell Corp.



Cent'ral Ilost Corp.




Gar-all Inc.







CmHinelllal Maleriah Corp. 1.64








I." I



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) .

. . . implies that it is impossible to make economic profits by trading on

the basis of [tbat information setl.
Malkil'l's first sentence repeats Failla's definition. His second and third sentellCl'S expand the deflJlition in two alternative ways. The second sentence
SltJ!:J.!;('.~ts that Illilrket efficiency can he tested hy revealing information to


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

Weak-Corm Efficiency: The information set includcs only the history of

prices or returns themselves.

Semistrong-Form Efficiency: The information set includcs all informatioJl
known to all market participaJlts (publicly available information).
Strong-Form Efficiency: The information set includes all inforlllatioll
known to any market participant (private information).
The next step is to specify a 1II0dei of "no rill a I" returns. Here the dassil'
assllmption is that the normal returns on a security arc constant over time,
hut in recenl ycars there has hecn increased intt'l'est in equilibriulIl models
Wilh time-varying normal security returns.
Finally, abnormal security returns are computed as the dill'erclllT betwecllrthe return on a security and iL~ normal return, and forecasts of the
ahllor/,Ial returns are constructed lIsing the chosen infilfluution set. If till'
abnormal security return is unforec<1stahlc, and in this sense "randolll," th('n
the h)~pothesis of market effici('ncy is not rc.:iected.

1.5.1 Ffficif'll/


(/Ilil/hr i.alll o/lIrlil/l'd EX/ll'r/a/ioll.\

The idea that efficient security returns should be random has oftcn caused
confll~ion. Many people scem to think that ;lnefficicllt security price shollid

J.5. Mil/lid J~jli(il'l/ly'

he SlllOOlh ralhn thall randOln. Black (I !)71) h;ls ;Illa('k(~d this idea rather

:\ 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 present-valuc model of a sccurity price is entirely
consistent with randomness ill security returns. The key to understanding
lhis is the so-called 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


1':[ V' I I,] = I':, V'.


The s;lIne equation holds one period ahead, so

1',+ I = E( V' I I"

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+1-1',1 = E,IE,tIIV'j-F./[V'))


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/.

1.5.2 !., lI/(///U'I/':llifil'llry '/r.\lab!r?

Althollgh the l'mpirirallllt,thodoloh'Y slIllImari7.ed here is wdl-('SI;lhlishcd,

Ihere arc sOllie seriolls C\if'firultics ill inllTpreting ils resllJrs, Firsl, allY lest of
efficiency nnlst asslln\(' an eqllilibrilllll model thai c\ermes nOflllal secoritv
relurns. If dIicicncy is rejeclec\, Ihis could be because the markel is Iruh
incl'lkienl or bccallse all illcorrcci cqllilibrium model has hcen asslIl\lcd,
This joillllr:v/ltlllrl'.li,1 pl'OlIl('\1I \\leans 11\;11 lIIarkel crrlciency as slIch em newr
he n:je('\I'c\,
Second. perli'('\ I'fficiency is an lin realistic benl'hlllark th;1I is uillikely
10 hold in pranicl'. Evell in thcory. as Grossman alld Sliglitz (I !lHO) h;l\c
shown. allllonnal \'('tllI'llS will exist iftherl' are costs of ).(.lIherillg and pmcessill)!; ill(III'lIIalioll. Thcse rellirns are necessary 10 compensate illv('siors
fill' their infonnalion-gathnill).!; alld informatioll-processing eX)lenses, and
are 110 lon).!;er ahllol'mal whell Ihese expellSes arc properly accollnlcd (i,l'.
III a large and liqllid mark('I. inlilrlllalion cosls are likely tojllstify (111)' snd}
allllOrmall'l'llInlS, hili il is dimcllit 10 say hnw small. evell if sllch costs could
he measllred precisc\}',
The nolioll or rrialil'f efficicncy-Ihe efficiency of one marketmc;lSlll('d
agaillst allothcr. e,g,. tlie N('w York Stock Exchange vs, Ihe Paris BOllrsc. 1',,lures markets vs, SpOl markets, or all('\ion vs, dealer markels-llIay he a mort'
IIscrlll rOllccpl Ihall Ihc all-Ol'-llothill).( view lakcn by milch or Ihe tradilional
lIIarkel-eflicit'IKY lilnatllre, The adv;llIla).!;es of rclaliw elliciellcy over absolule efliciellcy arc easy 10 SC(' hy way of all ;lIIal0!n'. Physical syslelIIs arc
ofIe II ).!;iv(,11 all ('nici('III"}, rat ill).!; has('d Oil the rclalivc propol'.tioll of cllergy
or flld ('ollwr!ed to IIsd'lIl work. Therdc)J'(\ a pis Ion ellgille lIIay he rated
al n()'){, eflici('lIcy, 1I\('allillg Ihal Oil avcra).!;c 1;0% of tilt" ellnh,)' cOlllailled ill
the ell).!;illc'S fllel is IIseli 10 tllm lhe nallkshafr, wilh the remaillill).!; 40'7" lost
\0 olhel' forms of work slich as hcal.lighl. or noise.
Few ell).!;illeers wOllld e\'eI' t'ollsilln pCfrOrtllill).!; a stalislicaltesllo (11:1('1'lIIille whclhn or 1101 a givclI ('lIgillC i.~ perfcnly d'lirienl-sllch all cllgill!'
exists ollly ill 11\l' idt',11 i/.ed frid iOllll'ss world of Ihe imaginatioll, I\lIlnwasll rill).!; I'elalivc eflkiclI('\'-rclalivc 10 Ihe friniolliess idcal-is conHllonplan',
hHh-I'I\. wc ha\'\' fllllH' \1) ,"xpcn SlIl'h IIH'aSlln'lI\ellts (i)\' lIIallY hOllsl'!lold
prodll('I~: ail' fOlldilioll('JS, hoi wal('J healers. rcfri).(('raIOl's, ('tf. Similarly,

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
market-dflciency debate-tests of variance bounds, Euler equations, th
('APM and the APT-we 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.



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 interest-after all, investors are constantly bombarded
with vast quantities of diverse information-nevertheless, 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 4-9, 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 2.2-2.4.
l.ong-horil.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 \ong-ilori/oll retllrns leads naturally to

the notion of IOIlv;-rallgl' dCpCII(/CI\(T, and a test ()r this phenolllenon is

prest'lIt('(1 ill SCrlion ~.(i. For complewlll'ss, we provil\e a hricr discussion or
tests for IInit roots, which an' son\('lin\('s confused wilh lesls of 11((' randolll
walk, III S('CliOIl ~.H WI' prescnt s('\'l'I'al cmpirical illustratiolls that docull1ellt
illlportantdepartur('s from thc random walk hypothesis for r(,Cl'nl US stork
markel dala.

2.1 TIle Random Walk Hypotheses

A uscfnl way 10 organizl" Ihl' various versions or Ihe ralldolll walk alld mar
lillv;ale IIwdds Ihal 11'(' shall ]In'st'llt 1)('1011' is 10 consider the varions killd,
or depl'llIl('ncl' Ihal can exisl helwl'I'1I an asset's returns T, and T'H all\\'11
dales t alld (+ k. To do Ihis. dl'lIlIl' Ihe random variahles !(r,) alld ~(7i+d
where I(') and g-(.) are Iwo arhilrary functions, and consider thl' situatioll'
in which

(:01'1 I( r, l. g( r, \ ~)I


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(it-l
}'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,+.)


Cuusificalion of random


and martingalR hypo/hPsrs.


g(r, ),

Yg(.) Linear

'V g(.)

Uncorrelated Increments.
Random Walk 3:

f( r,). VfO Linear

Proj[r,+.lr,) = J.L

Martingale/Fair Game:

fer,). Vf()

Independent Increments, Random

Walks I and 2:

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


2. 77le Predictubili/.v oj A.U



Lud o Ak ae (Th e Boo

k oJ GmllfS 0JC hal lrf)
, in wh ich he wro te: 1

Th c JIlost fun dam ent al

pri nci ple of all in gal llb
lin g is silllply eql lal ('111
dit ion s, e.g., ofo pp on
cn ts, ofh yst and ers , of
mo ney , ofs itll atio ll. >1
dic c box , an d of the die
itself. To the ext ell l to
wh ich YOI l dep;1I1 1111111
tha t cqu alit y, if it is in
yo ur op po ne nt' s favollr
I arc a fool, all d if ill
yo ur ow n, you arc IIn
Th is pas sag e clc arl y con
tai ns the no tio n ofa Jai
rgt lllle , a gam e wh ich
in yo ur favor no r you
is ne ith er
r op po nen t's, and thi
s is the ess enc c of a lIla
sto cha stic pro ces s {I',}
rtil/ jial l', a
wh ich satisfies the fol
low ing con dit ion :
E[ /"I I I I'/, ["- I, ... J
=:= 1'/,
(2. 1.2 )
or, equivalently,

E[ I', tl- I'/ 11 ',,1 '/-1 ,

... 1 = o.
If P, rep rcs cnt s on e's
rtll llli lati ve win nin gs
or we alth at dat e I fro
sOllie galliC of cha nce
lll playiflg
eac h pcr iod , the ll a fai
r gal lic is oll e (l>l' wh
exr }'c ted wc alth nex t
irh the
per iod is sim ply eql lal
to thi s pcr iod 's
(2.1\.2)), con dit ion ed
we alth (se e
011 the his tor y of
the gam e. Alt ern ativ ely
if tli,c exp ect cd inc rcm
, a gal lic is (~Iir
ent al win nin gs at any
sta ge is zer o wh en con
on the his tor y of the gam
dit ion ed
e (sc c ('2 .1. 3.
If 1', is tak cn to be an ass
et's pri ce at dat e I, the
n the ma rtin gal e hyp oth
esis sta tes tha t tom orr
ow 's pri ce is exp ect ed
to be equ al to tod ay'
givch thc ass et's ent ire
s pri tT,
pri ce history. Alternativ
ely, the ass et's exp ect
cha lig c is zer o wh en con
ed pri ce
dit ion ed on the ass et's
pri ce his tor y; hen ce iL~
is ju~t as likely to rise
pl'i re
as it is to fall. Fro m
a illr cca stin g per spe cti
mar~ingale hyp oth
ve, the
esi s im pli cs tha t the "be
st" for eca st of tom orr
sim~y tod ay' s pri
ow 's pri ce is
cc, wh ere "bc st" me ans
nim all llc an- sql lar ed
Ch al> ter 7).
err or (se e
An oth er asp cct of the
ma rtin gal e hyp oth esi
s is tha t no no ver iap
pri ed cha ng cs arc un cor
pin g
rcl ate d at all lea ds and
lags, wh ich im pli es the
efTccliveness of all line
inar for eca stin g rul es
for fut ure pri ce cha ng
on hIstorical pri ces alo
es bas cd
ne. Th e hlct tha t so sw
eep ing an im pli cat ion
cOlin! fro m as sim ple a
cou ld
mo del as (2.1.2) for esh
ado ws the im po rta nt
the nla rtin gal e hyp oth
rol e Iha l
esi s will play in the lIIo
del ing of ass et pri ce dyn
(se c thc dis cus sio n bel
alll ics
ow and Ch apt er 7).
In fact, the ma rtin gal e
was lon g con sid ere d to
be a nec ess ary con dit
for an 1firienl assct ma
rke t, on e in wh ich the
in( llfI lla tio n con tai ned
pri ces is instantly, fully,
an d per pet ual ly ref l(,c
ted ill the ass et's cll rre
If the ma rke t is eff icie
nt pric(':~
nt, th( 'n il slio lll< lno t be
pos sib le to pro llt by tra
dil lg Oil
'Se e \laI d (1990, Cha pte
r 4) III' \",.,

ll<'r ,\('t;,i\"
1Se~ Sam llet ."" (I
!Iii,>, I !In , \'IT \) , R"h
trt, (1\)1,7)
market effIciency.


.,lso ,\d' lu's an


,;oil, Iht martjll~;ol .. hyp


malKet to he .\,mi.um

Il'I'fl h'

.HH t "IOU!["{mm

2. I. The R(l//(~{)1Il Walk Hypolhe.lf


the illfo rma tioll cont aille d ill the

asse t's pric (' histo ry; hCl ln'lh e cond
ition al
expc n;lIi oll offl ltllr e pric e chan
ges, cond itiol lal olltl ae pric e histo
ry, cann ot
ill' eith er p"'l ii,,' or nega live
(ifsh or\s alcs arc I.... asih le) and ther
efor e nllls t
he 1.('1"0. Thi~ lIoti on of enic iellc
y has a won derf ully cOll lller intll
itive and
secm ingl y cOll trad icto ry flavo r to
it: The llIor e dlk icnt the mar ket,
the lIIor e
r;tlHlolll is thc sC'l uell ce of pric e
chan ges gell erat ed hy Ih(' mar ket,
alld the
IllOSt eflic ielll mar ket of all is olle
ill whic h pric e chan ges arc com
plet ely
r.lndOIll anel ullp redi ctah le.
How cver , one of the cell irall enei
s ofln odc m fina llcia l econ omi cs
is Ihe
ncce ssity of sOlnc trad c-of fbet wee
ll risk and exp ecte d retll rn, and
the lIlar ting ale hypo thes is plac es
a restr ictio n on exp ecte d retu rns,
it doc s
Ilot ,\CCOUllt for risk in any way.
In part icul ar, if an asse t's exp ecte
d pric e
chal lge is posi tive, it may be the
rewa rd nece ssar y 10 attra ct inve
stor s to
hold the assel and bear its asso ciate
d risks. The refo re, d('sp ite the
intu itive
iq)j> calth at the fair-galliC inte rpre
tatio ll lIIight have , it has been show
n that
th" Illar ting ale prop erty is neit her
a ncce ssal )' nor a suff icien t cOll
ditio n fOI
riltionally dete rilli ned assc l pric
es (sec , for exal ilple . I.em y [197
3]. Luc as
[ : ~)7H]. and Cha pter 8).
Nev crth eles s, the mar ting ale has
beco me a pow erfu l 1001 in prob
abil ity
anel .,tatistics and also has illlp orta
nt appl icat ions ill mod em theo
ries of assct pric es. For cxal llplc . onc e
<lsset ITtUI"IlS arc prop erly ;J(!i"~lcd
fill risk,
tl1e mar ting ale prop erty does hold
(see Luc as [197 8], Cox and Ross
[197 6],
I brri son <lnd Krep s [197 9)). In
part icul ar. wc shal l sec ill Cha pter
8 that
Illarg-inal-utility-weighted pric es
do follow JIlar ting ales und er ljuit
e gen eral
COllditiom. This risk- a(lju sted mal
lillg aie prop erty has led to a vCI
itable rev()III lion ill thc- pric ing of com plex
fina ncia l instr ullle nts such as opti
ons. swaps,
alld othe r deri vativ e secu ritie s (see
Cha pter s 9. 12. and Mer ton [199
0], for
exam pie) . Mor eove r. the mar ting
ale Icd to the dev elop men l of a
clos ely related JIlo dclt hat has now beco me
an illle gral part of virtu ally ever y
scie ntifi c
di~ci plin c con cern ed with
dyna mics : the rand olll walk hypo
thes is.

2.1.1 The RandulIl Wal/( I: /lj) !1l0f

llle/l1 5
Perh aps the simp lesl vers ion of
the rand olll walk hyp othe sis is
the inde pend entl y and iden tical ly dist ribu
ted (liD ) incr ellle nis case in whic
h the
d!'na lllic s of {I'd arc give n by the
follo wing equa tion :

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.

indt'pcnd(,IHT orlht' in('Jt'III('nls {f,} implics Ihatthc randolll walk is also a

/;Iirgamt', hUI in a IIl1l<"h sll"OlIgt'rst'lIsc thalllhc martingale: Indq)('ncll'll("('
illlplit's Ilot ollly Ih;11 illn('IIH'nls an' IlIlcolTclaled, hilt Ihal allY Ilolllilll'ar
fUllclions of Ihl' ill<TI'IIH'IIIS ;11(' abo IUlcolTl'ialcd. WI' shall call Ihis Ihl'
NII/llillm I\(tih I model or RW I.
'Iil dl'l'ciop SIIIlII' inluilioll 1m RWI, consider ils coudiliollallllcall ;11111
\'ariallcc al dall' I, cOIHlilioll;ti Oil SOIll(' inilial valu('
al dall' 0:


(: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', ==


+ /It_I +f"


This itllplies Illal conlilluously COIllPOIlIH\c(IITlllrtlS arc liD normal \,~lrialc,

wilh 1I11'<l1I /1 <111(1 "<lri<lIHT (l ~, which yields 11ll' \ogllo\'IIl<l\I'llo(ld of l\achl'lin (I ~l()O) alld Einstl'in (I ~lO:)). \1\'(' sh.lIl rcillfll 10 this ill Serlioll ~1.I 0('
(:hapltT ~).



II'II/Ii 2: ftlth'l"'lIt/pl/lln(/'PIIII'I//I'

Ill'spile 1IIl' degalHT alld silllplilil)' of RWI, Ihe assumplion of'id('nlil'all\'

dislrihlllni illlTl'lIll'lIls is 1101 plallsihle iiII' financial assel priCl'S OWl' IOllg
Ii IIIl' spa liS. For l'xalll pie, ovcr Illc Iwo-IIIII HII'l~d-ycar h iSlory of Ih c New York
SllIck Exdl;lIIgc, Ilwre 11;1\'(' b('('11 counlless changes ill Ihe (,CIlIlOlllic, soci;d. Ic.-iliiological. ill'lillllillll;d. alld rcglllaloryellvironllH'll1 ill wllicll siock
prin's arc dClnlllilll'd, 'I'll(' assl'l'lioll 111;\1 IlIl' proh;,hililv!oJ", of' daily ""Hk


relllrns has rem-ained the same over this two-hundred-year period is

implausible. Therefore, we relax the assumptions of RWI to include processes with independent but not identically distributed (INID) increments.,
and we shall call this the Random Walk 2 model or RW2. RW2 clearly contains
RWI as a special case, but also contains considerably more general price pr;
('('sses. For example, RW2 allows for unconditional heteroskedasticity in the
(/'s, a particularly useful feature given the time-variation in volatility of man)'
financial asset return series (see Section 12.2 in Chapter 12).

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 hypothesis-the one most
often tested in the recent empirical literature-may 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 Et-kl = 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).

2.2 Tests of Random Walk 1: lID Increments

Despite the fact that RWI is implausible from a priori theoretical considerations, nevertheless tests of RWI provide a great deal of intuition about the
behavior of the random walk. For example, we shall see in Section 2.2.2 that
tbe drift of a random walk can sometimes be misinterpreted as predictability if not properly accounted for. Before turning to tbose issues, we begin
with a brief review of traditional statistical tests for tbe llD assumptions in
Section 2.2.1.
2.2.1 Traditional Statistical Tests

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 \


2. 'f'lte Predictability oJ A55el Uelu71/.1

impossible to catalog all tests of 110 in any systematic fashion. and we shall
mention only a few of the most well-known 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 R-statistics (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 data-gcncrating' 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
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.

2.2.2 SI'f{III'1/(fJ IInti Unwr.\(/Is, (/1/(1 Hu7ts

Thc early tests of the randolll walk hypothesis were largely tesL~ of I{W I and
RW2. Although they arc now primarily of historical interest, nevcrtheless
we can learn a great deal about the propcrtics of thc random walk from slIch
tests. Moreover, several recelllly developcd econometric tools rely heavily
on RWI (sec. for example, Sections 2.5 and 2.(i), hence a discIISsion oftl\('se



of R(/lldom Walk ): 11)

lests also provides us with an opportunity

we shall 1't'<I'lire later.






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:





/1, -

/'t-I > 0


1'1 -

/'t -





~'!Il('h like the classical Bernoulli coin-lOss, I, indicates whether the <iate-I
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 coin-tossing 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


1'1 -

II I(j-j

+ (I

- / / )(1 - IIt-d



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 coin-toss
with probability one-half 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 _





I, -





I - Jr,


== 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 drift-cil her positive or negative-c1carly 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 coin-toss hut is hiased ill
Ihe direclion orlhe dril't. i.c ..


with prohahility


wilh prohahility I -




I'r(r, >


l (;;').


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

2Jr (I _ Jr)

::: 1.


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 "fair-game" 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 f-l'Cn tllry. This yieJ!ls the folJowill~
estimate of'rr:


O,OH) == O.fi1R4






:\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


ollr \';11 iuu, ;1II.1Jy~C.' h;l\"(' (li~( )u,,,d ~I Ictldc'll(

ill Ilei (a"iC' i~

y loward."

p(rsi."i.I('lIct' ill stork 1)1 in'


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?
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


y = {I

with probability IT, = rr2

with probability 1 -

+ (I

- rr)2;


hcnce we may approximate the distribution or N, ror large n by a normal

distribution wi~h mean E[N,] == nJf, and variance VarIN,). I\ecause each
pair ofa<Uacent Y/'s will he dependent,1 the variance of N, is not nJf,d -rr,)the usual expression ror the variance or a binomial random variable-but is


+ 2nCov[Yf, YHd
rr,) + 2 (rr 3 + (1 - rr)~ - Jf;).

mr,(1 - rr,)
nrr,(1 -


Applying a first-order 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


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 -

'III bn. 1', is a tw(~stat~ Markov chain with prohahilities Pr( Y,

/,1"1/1', ,md Pr( Y, == 0 I Y,_I = 0) = 1/2.



= I) = <p" +

2. TIll' I'mli(/abilil)' 1I/A.I.II'IIMum.\

Iwo-slate Markov chain:


I (I .-



\\"11('1:(' (j denutes thc fU1II/ili(J1I1I1 prolJ'lhililY Ih,lI 1",+ I is negalivl', condilioll.1I

a \msilivc Ii. and fl elCIlOIt'S Ih(' mJldili(JllIli proh"hility 11I.1I1111 is POSiliv<',
n"l(~itiol\al on a IIcgative I;. If a = 1- fJ.this rcd\lces 10 thc rasc exanlinl'd
aho\'(' (setl! = I - a): lhc Ill) r,llldol\l walk wilh drift. As IOllg as a t- I - fl.
I, (hl'nce ,.,) will he serially corrdatl'd. \'iolating RWI. In this cas('. th('
thl'ol\etiral \'aille of lhe ratio (:J is givl'1l hy


(.). ==

(I -

whidi ran take



O'}fl + (I

,lilY nOlIlIl'g.llin' I ('al












'2.:n 1.:)0
'2.'21 1.:iH
'2.1 :1 1.'29
'2'()(; 1.'2'2
'2.00 1.17

as illlistratcd hy Ill!' ")lIowiJlg


n.1O o.:m n.:lO


(:!,~.l 0)



Il.I 0

- fJ)a
















O':\:I 0.'21







2.1 :~


Il.I '2


A~ 0: and fJ hoth approach Oill'. tile lik('lihood of revn~als increases alld

hencc q approaches O. A~ either Ci or fJ approadlt's I.no. th(' likelihood
of sequl'nces increases and q ill('l'l'as('s wilhout bOllnd. In such CISl'S. ( ]
i~ d('arly a rcasonablc illclicator of deparlurt's from RW I. [Iowt'\'('r. lIot('
that there exisl combillatious of (a. {I) for which at-l-{i alld q= I. ('.g.,
(o:.fi)=(~. ~); hence the (;1 statistic canllot distinguish illt'sl' ca.~(.~ froJlI
RWI (s('t' I'robl('1I1 2.:~ for hlrtlH'r discussioJJ).

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'



o/fill/lli(J/Il'Walk I: /If)



of Os (oflcnl-\th~, I, and 2, respectively), thus six runs intota!' III contrast,

the seqll('Jl(T 0000011111 l'OlllaillS thl' S<tllll' 1Illillber Os alld Is, hut olily
~ I'Iln,. I\y COlli paring the lIulllher of nUlS ill lhe dala wilh Ihe expected
11Ilill ber of rum under RW I, a lest of the 11 () randolll wal k hypothcsis \IIay
be cOllstruct('(!. To pel'fonH thc test, we reqllire Ihe samplillg- distribution
of the totalllllllli>er ofnllls N,,,m in a saillplc of Ii. Mood (1940) was the (irst
to provide a cOlllpn:hellsivc allalysis of rllllS, .111<\ we shall provide a brkf
slllllillary of his \IIost general resulL~ here.
Suppose that each of 11 liD observations takes 011 olle of q possiblc
v;t1ues with probability Jr" i = I, ... , I{ (hence Li Jri = I). In Ihe case or
the indicator variable I, defined in (2.2.2), q is equal to ~; wc shall return
to this special case below. Dellote by Nrun,(i) the total Ilumber or runs
of type i (of allY lellgth), i
I, ... , q; hence the tOlal IIl1mber of nllls
N,,,.,, ;;:: N,,",,(i). Using combinatorial argulIlenls and Ihe properlies of
the Illullinolllial distribution, Mood (1940) derives the discrete distribution
or N,,,,,,(i) frolll which he calculates the f()lIowing 1Il01lle11lS:




Val' [N""" (i) ]

1IJr,( I - Jr,)
IIlf,(l -


+ If/

(2.2.11 )

+ (;If,~

- :~lf;l)

+ If,~ C~ -- Hlf,l- !)Jf /)

Cov(N,,,m(i), Nru",(j)]

-Illfi If,( 1 - ~lf, - 2lf,

- lfi If,(2Jri

+ 2lf,


+ 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,) -


If /


lfi(l - If,) - :'If/( I '- If,)l)


N,,,,,, - 11(1- L,lf,~)



where .. ~ .. indicates that the eCJllalil), holds aWlllplolicallr. Tests of RWI

b(' pl'I'j'ol'llll'd using- IIze aSYlllptOlic appl'O~ill1~tli()lls C!.~.14) or

1lI;1)' (itcll

Tahle 2.2.

1:\lJnIPfIIllIH!"r" /(/Ildom walk with fiJl!/11.


I ,DOll




J.I O.71H
IIi 0.777
20 O.H:\O



:~ I :>.:,

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/ =
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


ErN,I/,,,] == 211JT(1 _rr)+n 2 +(I_n)2.


()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('ro-ilrirl 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.

To perform a test for the random walk in the Bernoulli case, we may
calculate the following statistic:

z ==

Nun, - 2n7r(1 - rr)

~ N(O, 1)
2Jmr(l - rr)[ 1- 3rr(l - rr)

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 z-statistic is eval
uated <It the midpoint of the interval (sec Wallis and Roberts [1956j); thus

z ==


+~ -

2nrr(l - rr)


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 non-lID 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;t-passagr 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).

2.3 Tests of Random Walk 2: Independent Increments

The restriction of identical distributions is clearly implausible. especially
when applied to financial data that span several decades. However. testing
for independence without assuming identical distributions is quite difficult; .
particularly for time series data. If we place no restrictions on how the.
marginal distributiolls of the data can vary through time. it becom~s virtually
illlpossible to conduct statistical inference since the sampling distribution,
of l"VCll the most elementary statistics cannot be derived.

2. Tht' Prt'diclabilil.y of Awl


: SOllie oflhe lIonparamclric lIIethods melltioned in Section ~.~.I such ;IS

correia lions do lesl for independencc wilhoUI also rC!Juiring identical
dislhhlliio/ls. bUI the number of distinrl marginal distriblitions is typically
a lillite and slIIall lIullIber. For tx~!lllpk. ~I tcst of independt'\lIT ('l'tWl'l'lI
IQ tcores and academic performance involves two distinct margin;ll distrii>lllions: one for IQ scores and the other f()(" academic perf()J"JIl'IIHT.
Mul~iple observations are drawn frOIll ealh lIIarginal dislributioll alld variOilS \Ilonparametric tesls can he designed to check whether the prodllrt of
Ihe ~Ilarginal distribulions equals Ihe joint distribution of the paired ohserv\ltions, Such an approach ubviously GlIIllot slJcceed if we hypothesi!.('
a l1Jiifllle marginal dislri1>ltIion f<II' each observation of IQ and academic
Nevertheless. Ihere are IWo lines of elllpirical research Ihat CIII 1)('
viewed as a kind of "e("(lII0 III ic" lest or RW2: jil/a ntln. and leelwintl wlltly.I;I.
Although neither of these approaches makes much usc of forlllal statistical
inferenle. hoth have captured the interesl of Ihe linalllial COllllllllllily 1(11"
pranicOII reasolls. This is lIot 10 say that statistical inference (/III/lOt bl' "1>plied to thcse modes of analysis, hut rather that the standards of ('vidence ill
this literature have evolved along very different paths. Therefore, we shall
present only a cursory review of thl'se techniques.

2.3.1 Fillt'r Rules

To test RW2, Alexander (1961, 19(1) applied a filter rule ill which all asset
is purchased when its price increases by x%, and (short)sold when its price
drops by x%. Such a rule is said to be an x% filter. and was proposed by
Alexander (1961) for lhe following reasons:
Suppose we tentatively assume the existence of trends in stock market
pdccs but believe them to he masked by the jiggling of the market. We
might filter out allmovelllellls smaller than a specified sile and examine
the remaining movements.
The total return of this dynafllil portfolio strateb'Y is then taken to be a
mcasllre of the predktability in assel returns. A comparison of the tOlal
retllrn to the retllrn from a huy-and-hold stratq..'Y for thc Dow Jones and
Standard ,lIld Poor's industrial averages led Alexander to conclude that
" ... Ihere liTe trends in siock lIl<lrkl"t prites. , . ,"
Failla (191l;J) and Fama and Blume (I!JGli) present a morc detailed empiric; I analysis of filter mil'S, fOIT('((ing for dividends ,\l1d trading ("Osts,
and tbnrlude that such rules du not perform as well as the buy-and-hold
stratt~'Y' 11\ the absence of transanions costs, very slllall filters (1 % ill
Alexander [ 1~Hi41 and belWet'n OSlo and 15% in Fama and Blume { 191i!i 1)
do "itl)cl superior returns, hili hec!lIs(' slIlall filters generate considerably

2. J. TI'Jls (if /{1/111101ll Walk 2: hllll'{'I'III/1'II1



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;lllce-it 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 reguiarities-often (but 1I0t always) in the form of geometric
p;lllerns such as double bolloms, head-lIlu[-:,lwuldeIJ, alld Jul'porl and resistance
levels-that 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 economists-for example, earnings, dividends,
and other balance-sheet and income-stalement items-it 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 gox-Pierce Q-slatistic slIgl-\cst the
prescnce of a high-frequcncy 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



~ ' . . . IfHII



J"',Uf'/ J{t'/lIrll.\

COlltrast this with the statclII('lIt:

The pn'S('IHT or dearl}' id(,11 tifled,~lIpp()rt and resistallcc levels, couplc:d
\vith a olH,-thinl retra("('IIH'lIt parametcr whclI prices li(, betwcen thelll,
slIggests the pn'selH"(, of strong buying alld scllillg opportullities in the
l\oth statclllellts ha\'e !Ill' sallie IIIcaning: Using historical priccs, one Gill
predict rlltllre prices to sOllie extent in the short ntn. Hilt becausc the tW<l
statemcnts arc so laden withjargon, the type or response they elicit depends
vcr)' milch 011 the individllal reading them.
Despitc the differences in jargon, recent empirical evidence sugg('sts
that lechnical analysis al\(I more traditionalllnancial analysis ilia), have IIlllch
in common (see, in particnlar, Section2.H), Recentstlldies by mllllle, Easley,
and O'Hara (19!14), Brock, I.akonishok, and LeBaron (1992), Brown and
Jennings (19H9), l.eBaron (HI96), Neftci (1991), Pall (1991), Tilylor and
Allen (1992), alld Trcynor and Fcrguson (19R5) signal a growing interesl in
technical analysis ,\ilIOn)!; financial academics, and so it may becorne a lIlore
artiv{' rcsearch area ill the Ileal' flltllre.

2,4 Tcsts of Random Walk 3: Uncorrclated Increments


()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
flrst-difrerences 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 lirst-dilTerenccs 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 lIatllraltime-scri('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

(2.4.1 )

, 45

2.4. Tfjls oj ilandom Walk 3: UI/(orre!ated Increments

Given a covariance-stationary time series {T,}, the hth order autocovariance

and autocorrelation coefficients, y(k) and p(k), respectively, are definedtts6










r,. r'Hl

Var[ rtl




where the second equality in (2.4.3) follows from the covariance-stationarity

of {T,I. For a given sample {T,I;"'I' aULOcovariance and autocorrelation coefficients may be estimated in the natural way by replacing population moments
with sample counterparts:
1 T-A


T 2:)r, - fr)(Tt+A -



0 ::; k < T







(2.4.5 )

1 T



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,

== LakE,-b

where {E,) is an independent sequence with mean 0, variance 0'2, fourth

moment 1')(14, and finite sixth moment, then Fuller (1976, Theorem 6.3.5)
shows that the vector of aULOcovariance coefficient estimators is asymptotically multivariate normal:

JT[ y(O)-y(O)

y(l)-y(l) ... y(m)-y(m)]' :.- N(O, V).



v ==



(1] - ?y(i) y(j) +





+ y (l+ j)

y (l- i) ] .


IIThr- rrC]uirement of (~uvarian(e-stationariry i:o. pr)Jn;nHy for notational conv~nien[e

(llht'",i, .. y(k) and p(k) may be functions of I a, well as k. and may nOI even ~ well-defined i
s(,fond moments are not finite.

2. The Predictability oj A.\sft Hfturn.!

Under the same assumptions, Fuller (1976, Corollary shows Ihal
the asymptotic distribution of the vector of autocorrelation coerlicient estimators is also multivariate normal:

v'T[ p(O)-p(O)

p(m)-p(m)], ~ N(O, G).







[p(e) p(l'-i+ j)

+ p(l'+ j) p(l'-i)

- 2p(j) p(f) p(f-i)



- 2p(i) p(l') p(/'- j)

+ 2p(i) p(j) p2(e) ].


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 finite-sample means and
varia~ces. In particular, if hI satisfies RWI and has variance o~ and sixth
mo~ent proporlionalto 0 6 , then
(2.4.1 I)
E[p(k) 1
O('r- 2 )

Cov[p(k), p(m

I;;J. + O( r2)
{ O(T-2)

if k



i: 0


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
cross-p,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 cross-produc\.~ 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 bias-corrected estimator p(k):7




+ --,'{-It
--" ( I
( f-I)<


- p (I,) .


7 NIlI Ihal pIA) i~ nllt IInbia",,": 11ll' I<'nll "hias<olT.. ctcu" rcfers lU Ihe fan Ih.1I

2. 1. I;'.I/s 0/ Url/II/O/ll IVlIlI, J:



Wilh IIllililr!lIf)' houtlded sixth 1II01lletltS, he shows Ihat the s.\llIl'le autororrelatioll coefficicnts arc asymploticall), independcnt and normally distribilled wilh distribution:





N(O, I).

These r('stllls yidel a variel), or atllocorrdalioll-lJasnl lesls or the ralldolll

""Ilk hypothesis RWI.
1.0 and M.ICKillhty (1~18H), Richarclsoll and SllIith (1!1~14), all(l Romano
and Thombs (f9!l(i) derive asymptotic approxilllatioll~ for salllple aUlOcorrelatioll codliciellis under evell weaker cOliditioIiS-lIl1corrdatcc\ weakly
dq>ellc\ellt observatiollS-and Ihesl' results lllay he used 10 COllstruct tests
or RW~ and RW:~ (sec Sectioll 2.4.3 helow).

2.4.2 Portmall/Pal! .'i/a/istirs

Sillce RW I implies that all aUlOcorrclatiolis arc zero, a simple test statistic
of RWI that has power against mallY alternative hypothescs is Ihe Q-statislic
due to ~ox and Pierce (1970):






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 finite-sample correctiotl whirh yidds a helll'r
(it lO the X~, for slIlall sample sizes:



== '1'('1'+2) "" -p-



By summing the squared autocorrclations, the Box-Pierce Q-statistic 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 care-if too /CW arc used, the prcsencc of
highcr-orcler autocorrelation lIlay hc IIIbsccl; if too lllallY arc IIsed, the test
Illa), lIol have lllllCh power due to insignificant higher-order 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.


2, -I, }


1111' 1'll'Il/dli/II/I/,\' "/ 11.1.11'/ UI'/IIII1,\


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,

l'o/l11/a/ioll I'm/lI'l/il'l 0/ \ II/iiII/O' NII/illl

Ikillfl' (Icriving slich s;lIliplilig dislrihlltiolls, we develop sOllie intuitioll for
the pOjlllhllioll valll('s of t!rl' varianrl' ratio statistic Ilnlln variolls scenarios, COl1Sic\l'I' again IIIl' ralio or Ihl' variancc or a two-period (onlilluol"ly
compoundcd ITlurn I,I:!) == 'I + '1,,1 (0 Iwirl' the variance or a olle-period
H'tllnl 1',. and 1111' the 11101111'111 kt liS aSSIIIII(, lIothing "hollt the time scri('S
of n'turlls othn th;\1l st;lIionarity, Thcn this varianre r;ltio, whirh WI' Wrill'
as \'R(~), I'('cluccs 10:

VOId I, + Ii I I
~ V;ld 1',1

\'011'1 It 1+ 2 Cov! Tt Ii-II





Wlll'IT p( I) is thc Iit-st-onln alltocorn'lation ('od'llcil'l1t of \'('turns {I,\, For

any slationary lillie series, Ihl' populatioll value or thc variallcc ralio stali~lic
VR(2) is simply OUI' plus Ihl' first-md('!' aUlocorrelation co('fficiellt. III particular, IIlIdl'r RW I a!lthl' ,lIlIOCOlTl'btiollS an' 7.1'1'0, helll'(' VR(2)= I in tltis
rase, as ('''periI'd,
IlIth(' pn'sl'IH,(, ofposilil'l' lirsl-orcln autocorrelatioll, VRe!) will ('xl'l'l'd
Ollt', If rl'tllrllS arl' positi\'d\' ;lll\o('olTclal('d, Ihl' variallce of 11t(' SIIIII of 111'0
"Thi\ Iilu-arilr

propPllV j, iliOn'

difli, lilt

rase.' of R\\'~ and R\\,:\ hl'r;IIIS(' du'

11ow("\'(" 1", (,\'("11 in Iht-,(, ('''''I'S .li(' \'ar-jallfT
and Ihis b Ihc.' lilU'aril), IJlopc'ny \dlirh lilt'

10 ,';IIt' ill Iht"

\';uiann's 01 iIlIT('IIU'III."; ilia\" ";11\' 1IIIIIIIgla lilllt'.

oltlu' .";11111 11111,1 ffjll.tllhe '11111 (If lh(' \';lIi;lIl(('S,

\;11 i'lllt t' lalio ,,"~I (xploih. \\'f' .. h.tli ('Oll"nll I h ... b of;,lIllIn'c' hypfllh(,~f''; helo\\,.
')~I;III\ .. llIdic', 1t,1\"t' ("1'10111'" liIi .. I" CIlu', IV 01 lilt' lalUlo11l walk hypolh,"" ill dc" j .. illg ,'IIII,i, ic.II 1("",' 1)1 ('flu fahilil\,: I ('f CIII ",.11111 ,Ie' ill( Illcle (~HHplU'11 ;lIIcI ~Ltlll..i,\' ( I ~IH7), ( :( If 1lr.1l1t'
(I!IHH), F.III,1 (lqlJ'.!l. 1.41 ,IIICI i\1.h

(I!I!I:\). .11111

Ri( h.tld",1t ;11111 SIOf I..





;\1111 SUIIHIIC'I' (1~'HN),



2.4. "I'r.I!'1 of Ralldolll H'tilk J: Ullron'f'llIlrrllllnrlllflllJ


one-period returns will he larger dian the sum of the one-period return's
variances; bel.ICe variances \ViII grow faster than linearly. Alternatively, in
lhl" presence of negative first-order autocorrelation, the variance of the slim
01 two one-period returns will he smaller than the sum of the one-period
r('IIII'Il's variances; hence variances will grow slower lhan linearly.
For comparisons beyond one- and lw(}-period returns, higher-order autocorrclatio!lS come into play. In p,lrticuiar, a similar calculation shows that
the gener;'!1 q-period variance ratio statistic VR(q) satisfies the relation:




q. Varlr,l

== 1 + 2


'II (


I - - p(k).


+... + r'-H I ,md p(k) is the kth order autocorreiatiQ,n

coefficient of (rrl. This shows that VR(q) is a particular lineaT combination
of the first k-\ autocorrelation coefficients of I Ttl, with linearly declinil1g
Under RWI, (2.4.19) shows that for all q, VR(q)=I since in this Ca.'le
p(k)==() for all k~ 1. Moreover, even lInder RW2 and RW3, VR(q) must still
eqllal one <IS long as the variances of r, arc finite and the "average variance"
L/~I Var[ r, 1/ T converges to a finite positive number. But (2.4.19) is eve~1
lIIore inforlllative for alternatives to the random walk because it relates the
t)('h,lVior of VR(q) to the autocorrelation cocflkients of I Til under such
allcrnatives. For example, \Inder an AR(I) alternative, TI = tPT,-1 + f"
(2.4.1 !) implies that

",lIn(' r,(k) '"' r,+ r'_1


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).


2. The PTedirtability of A.I.II'I

/(1'1/1 m.1

The n the ilUli hypo thes is we cons

ider ill this sect ion is II

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~:




L (I'. - 1'.-1 )

"i""II (/'2"


- 1~1l



L (I'. - I'H - II)




(2.4.21 )

L" ({'!. -

{'l.- ~ - 2/~) 2 .



Eqll ation s (2.4 .20) alf(l (2.'1.~ I)

Me the IIslIal sam ple mea
n and vari ancc
estil llato rs. The y are also the maxi
mum-likeWwod estim ator s of f.1 and
a ~ (sct"
Sect ion 9.3.2 in Cha pter 9). Thc
seco nd estim ator
of a ~ mak es usc of tIlt
rand om walk natu re of PI: Und er
RWI the mea n and vari ance of incr
cme nts
arc line ar in the incr eme nt inter
val. henc e the a ~ can be estim ated
hy onchalf the sam ple vari ance of the incr
cmc ills of even -num bere d obse rv;lI
I/~)./). 1'4 ... pln)'
Lind er stan dard asym ptot ic thco ry.
all thre e estim ator s are stro ngly
COIlsisten~: Hol ding all othe r para met
ers cons tallt . as the tota lnul llbe
r of ohse rvatioris 2n incr ease s with out hou
nd the estim ator s conv erge almo
st slIrely to
thei r j>opulation values. In addi tion
. it is well know n that cr'/.' and a,7
the following norm al limi ting distr
ibut ions (see , for exam ple. Stua
rt and
Ord [~987:





:.:.- NJ ,4a 1 ).


lIow erer . we seek the limi tillg

dislI 'ihut ioll of the ratio of the
vari ancc s.
Alth ol/g h itllIa y read ily be show n
that the ratio is also asym ptot icall
y Ilorm al
with IIlrit mea n und er RW I. the
vari ance of the limi ting dist ribu
tion is not
appar~nt siricc the two v;lriallce
cstil llato rs arc dear ly /lot asym
ptot icall y
IInc orfe lated .
Bilt sinc e the estim ator
is asym ptot icall y crtic ient und er
the nllll
hypo tlles is RW I. we may \lse llall
sma n's (1~7H) insig ht that the asym
ptot ic


II \\'t' a\.lIjume nonn ality only tor

txpo . . itioll.lI ("onn 'lIicn rt'-th l' resl1l
t~ in this s('nio ll "pply
1I111ch 1II0re gelle rally to log price
I'lOces,,"s with liD illrn"II1<"lIt'
th;\l posse ss fillite I(lIIllh
Iltnm eilis.

2, 1, 'li',I/.1 4UflllI/OII/ Walk J: l/lIomdfllnllllrll'll/l'/Il.l

",Iriallce of tite differenct" of a consistent estilllator and an asymptotically

dlicil'llt estilllator is simply the C\iI"i"el"clln' of II\{' aSYIll(>lOtic varian(es,l~
II IV(' ddill(' tlw vari'lllce di(fc.'ITIIlT estimator as VI)('2) ==
C!"I.~:-\), (~.'I.~.j). and I'!ausman's result implies:

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
The as),lllptotic distrihutioll of the t,,'o-lwriod v;lriaIK(' ratio statistic
\"71\(2) == a,~
now follows directl), fmlll (:2A,2!i) usillg a (irst-onierlil),lor
applOxilllatioJl or the delta Illethod (se(' SeClion/\..J of the Appendix):I:1


'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 Jlormal-if it lies
()llIside the illtnval 1-1.~l(i. I.~HiJ. RWI Ilia), 1)(' rl'jnwd at thl' :)'}{, kvd of

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 scalc-fret", 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 ofVR-I=O (l!' lhe ratio SiIlCl':


ff,i(a,; - 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



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,



"111(' I ("'1111 1t)lIo\\'~

dirt'nly. thcll. sinn';

,'\',III,i,,1 '"



Iii, + Ii" -,i,1

,'\',11 I Ii,

,I\'a'IO" -

,'\';111';" I


",hefe ;I\',IIIJ d('IIIJI('~ thl' a~>'llIptolic \',uian("('

,'\',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".


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:




(Ilk -

11. - I )

(I'k -

/1.-1 -








11,/ k,-I




(/'"k -


/1"*_,, -

(:~. 1.:2!I)


qll) ~



0/; (1/)





(2.4.:\1 )


llsillJ.( silllilar arglllll('lIlS, Ihc aSYlIlplolic distributiolls of VOl'll alld \/R(,/)

IItHlcr till' RW I 111111 h)'JJotlwsis are

JiIii (1)( 'I)

N(O,'2(q-I)IT' I )

JIif/(Vlt(q) - I)



Two illlportalli ll'iin('nH'nts of these statistics can improve their finitesample propntics slIhstantially. Th(' first is to lISC OlIIT/aNlinK q-peric,d rcIlIrns ill estimaling Ih(' variances h)' dellning Ihe following alternative l'slimalor for IT ~:
.. "


IT,-Utl = -'7

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'




- - L (II. -/1.-1
'''/ - 1 k~ I


' ~

. ,

..... UV




and define the statistics:


This yields an unbiased vari;lIlce difference estimator, however, the variance

ratio estimator is still biased (due to jensen's Ine<]uality). Nevertheless,
simulation experiments reported in Lo and MacKinlay (1989) show that
the fi~te-samplc properties of VR(q) arc closer to their asymptotic limits
thall VR(q).
Ullcler the null hypothesis II, the asymptotic distributions of the varialice difference and variance ratio arc given by


J1lii (VR(q) - I)

( 2(2q-l)(q-l)
N 0,



2(2 q-l)(q-l)).




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)(q-I))-1/2

J'ilfjVf5(q) (2(2 Q-1)('1- I





N(O. 1).


Sam/}/ing Distribution of VR(q) under RW3

Since there is a growing consensus among financial economists that volatilities change over time (sec Section 12.2 in Chapter 12), a rejection of the
random walk hypothesis because of heteroskedasticity would not be of much
interest. Therdore. we seek a test for RW3. A5 long as returns are lIncorrelated, even in the presence of heteroskedasticity the variance ratio must sti.1I
approach unity as the lIumber of observations increases without bound, ft'
the variance of the SUIll of un correlated increments must still equal the sum
of the variances. Howeyer, the asymptotic variance of the variance ratios will
clearly depend on the type and degree of heteroskedasticity present.
One approach is to model the heteroskedasticity explicitly as in Section
12.2 of Chapter 12, and thell calculate the asymptotic variance ofVR(q) uncler this specific Ilull hypothesis. However, to allow for more general forms


2. The Predictability oj A.I.Ip ( HI'll/m.1

of hete rosk edas ticil y, we follo w

Ihe app roac h take n by 1.0 and
Mac Kin lay
(198 8) \'{hidJ relie s on the hete
rosk edas ticit y-{: onsi sten l met hod
of Whi te
(198 0) and Whi te and ))om owit
l. (1 ~184). This app roac h appl
a IIlttc h
broa der class of log pric e proc
esse s !tIll than the liD 1I0r mai
incr ellll 'nls
proc ess of the prev ious seCl ioll,
.\ part icul arly rele vant cOll cern
for US stoc k
retu rns as Tab le 1.1 illus trate s. I 1
Spec ifica lly, let r
alld defi ne
the follo wing com pou nd nlill
hypo thes is H~:

(Ill) For ailt, E[ir l

== O,ll luIE [i l il_ r ) = OJura71yr '" O.

(112) Ii rl is CP-lIiixillg wilh curfJicieu

ts cP (lit) vJ siu r/ (2r- l) vr is a-mixillg
(oifficimts a(m ) oj size r/(r -I), wher
e r > I, such that Jor all t (lwl Jur
r ~ 0, iI!l're exists s07l/eli > 0Jor
whi rhE lklil _rl'l (,H) ) < D.
< 00.
I nq
lim E[i; J = a- < 00.
"'1_ 00



j'llr rlllt, E{il il_; fl (,-.1 = 0 jor


/Wl/Z. I'I'O j and k will'l l'

j l' k.
Con ditio n (Il I) is the unco rrcla
ted incr eme nts prop erly of the
rand om
walk Jhat we wish to test. Con ditio
ns (112) and (H3 ) are restr iClio
ns on the
max illlu m degr ee of dep end ence
and hete roge ncit y allow able
whil e still
perll~illing sO/lle form of the Law of Larg
e Num bers and thc Cen trall .illli
TheO rellJ to obta in (sec Whi te
[I mH) for the defi nitio ns of cp- and
rand+1IJ sequ ence s). Con ditio
n (1!4 ) imp lies that the sam ple
aUlO corr elation spf' l are asym ptot icall y IIJlc
orrel ate< i; this cond ition may be
w('a kene c\
cons iller ably at the expe nse of
cOll lput ation al silllp licit y (see
'I~Jis com pou nd null hypo thes
is assu mes that jJ, poss esse s lInc
one lalc d
incr etne nlS but allow s for 'Illit
e gene ral form s of hetc rosk edas
ticit y, incll ldillg dtte rmin istic chan ges in
the vari allce (due . for exam ple,
to seas onal
factor~) and Eng le's (1~)H
2) ARC II proc esse s (ill whic
h the cond ition al variance (~epe~~ on past info nnat
ioll) .
Sihc e VR( q) still appr oach es one
IInd er lit" we need only com pute
asym p'tot ic vari ance [call it U(Ij)
J to perf orm the stan dard
infe renc es. 1.0
and Mac Kin lay (198 8) do this
ill two step s. First , reca ll that
the follo wing
equa lity hold s asym ptot icall y und
er 'Illit e gene ral rond ition s:

j) ==


(I - ;k) p(h).

(VI Al)

rOIlI~(". second 11I0ll lt'ub an'

",1111 .t....!'IIIIBe d 10 hc' fillite
; other\\,ls(', Iht" \'ari~lIln'
lougt"r \\'e11 defin ed. This rull'.,
out (1i:"'l Iibulio lls with IIIlilll tc
\"lri~lIlre. such as thoM '
Ihe st.thlt' P,lrt" lo.. Le\y f.uuil), (with
flt.n,1 ( It'n:"l. lif eXpO llt'Ill.
\ th.1l are Ic~s tll.tn 2) prop
~1.11l(1tlhr(}t (19tj3 ) al1d
o\('d In
Failla (I~)I;:)). J1{)WC H'r, 1l1;IIIY
olll('r fC)lIII!'o ofl('p tokur
t()\is ~,rt .111(Jwc'd.
"I< h 'I' Illal ~enerdled
hy ElIgl e', (1 \IH~) ""tol q~ .. ""in
(olldi lioll,l lIv 1t~lel ",~,'d'''li( (AI{(
11IOf~" \'ee ScClill1l 12.2
ill CIt"PI"\' 1'2)

j, 110


2, 5,


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 heleroskedastirity-n)Jlsistenl eSlimator of Il.:

:t The followillg is a heleroskedastit:ily-rollsisll'nl estimator of O(q):

1- 1

8(q) -


4L (I - ~). 8.


Despite the presence of general heteroskl'dasticity, the standardized test

st:11 i,)tic if' (if)
if;' (q)

CIII 1)(' used




J1zij(VR('/) - I)




ill lile usual way.

2.5 Long-Horizon Returns

St'\'nal recent sludies have focused on the properties of long-horizon returns to test the random walk hypotheses, in some cases using 5- to 10yt'ar ITtUJ'IlS OWl' a 65-ycar salllple. There are fewer nonovcrlapping longhori/ol1 rcturns for a given tillle span, so samplillg errors are generally
l\lthollgb Ihl., 1("~lriClion 011 the fOllrth ('r()!\!\'lIlOlIIl'l1l~ 01 f;, III .. }' ~t'l"Jll sOIllt'whdt lIlIiJlIIl~
it i", :-.ati:-.f"ll'd tor .~ny process with itHkpelHlent illcrelllelits (legaJ(lIess of heterogeneity)
.IIHI ~Ibt) luI' Ijllt'~lr (;all:-.~iaJl ARCII processes. This a . . sumptioll !Hay he relaxt'd entirely, req\lir~
IlIg tilt' l"lilll~llioll of the asymptotic rov.uiuHTS of tht' ~IHI()n)IT(l.ttioll (,!'ttiIllClIOr:'i in order In


\",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 long-horizon returns. Hut for some a\lertlati\'es
to the randolll walk. long-horil.on returns can he 1II0re informative than
their shorter-horizon ('Ollllterparts (sec Scction 7.2.1 in Chapter 7 and 1.0
ami MacKinlay I 1~IH9j),
One motivation flu' using long-horizoll 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.




+ 11',_.1 + f,.

any l.{'ro-l11ean stationary proccss.

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 ZCfO-l11ean ~ta
tiouary COI11POllCIH Ihal rdkrls a short-Ierm or transitory (\eviatioll from
the e('fi('ienl-lnark('ls price II'" il11pl)'ing the prescnce or "fads" or othef market inefficiencies. Sin('c )', is slationary. it is mcan-rcvcrting 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:tllrt-ncvcrthdess. 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



= II+f,+.v,-,~'-1

1',( II)



t -,


L f,-k +

,y, - .V'-'I




Val'l 1',(1/) I


'P~ 1- ::!)'I(O) - '2y\(q),

(:!,: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](',~


l/a 1

+ 2y\.(O) -

If (a~

+ '2y,(O)


- '2y\( I)




+ 2y\(O) -



q -+ 00


2y\(O) - ~y,(I)


+ 2y,(O)

- 2y,(I)

Var[ l'.y]
I - ----'----Var[l'.y] + Var[l'.w]





whl'l'e (2.:l.6) requires the additional assumption that y,(q)-+O as q-+oo,

,11\ asymptotic independence condition that is a plausible assumption for
most economic time series. II; This shows that for a sufficiently long horizon q. the permanent/transitory components model must yield a variance
ratio less than one. Moreover, the magnitude of the difference between the
long-horizon variance ratio and one is the ratio of the variance of l'.YI to
the variance of l'.PIo a kind of "signal/ (signal+noise)" ratio, where the "signal" is the transitory component and the "noise" is the permanent markets
cOlllponent. In fact, one might consider extracting the "signal/noise" ratio
frolll VR(q) in the obvious way:




2.5. J Problems with Long-/lorizon Inferences

There are, however, several difficulties with long-horizon returns that stem
frolll the f;\ct that when the horizon q is large relative to the total time span
'J'= "'1. the asymptotic approx:mations that are typically lIsed to perform
infercnces break down.
For exalllple, consic\er the test statistic VR(q)-l which is asymptotically
nOrlnal with mean 0 and variance:
2('2q- 1)( q-I)


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


HI'I his j... ilnpliecl hy ergociirit}'. {lJld ('\'('11 Iht'

Strtinn '2.t; sati . . ty this nmditioll.

1()lIg~r..tTl~e . .depencit"lIt time ~rie~ di~{lI~\('d!in


2. The Predictability oj A.w'l J{d/lrm

hound for VR(q)-1 is -I. Buttilcn the smallest algebraic vallie thaI the test
statistic (VR(q)-l)/.fV can tak(' on is:


VR(I/) - I





== -,,'211 =



'11"'11 11,


suprlOSC that If is set at two-thirds 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 II-such 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







!J(r) - H(r-o) - SU(!).

(2.:>.11 )

where no is standard Brownian motion ddillcd on the unit interval (see

Section 9.1 in Chapter 9). Unlike the standard ufixed-q" asymptotics, ill this
case VR(q) does not converge in probability to one. Instead, it converges in
distribution to a random variable that is a runctional or Brownian llIotioll.
The ex'pecled value of this limiting distribution ill (2.5.10) is

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 long-horizon returns-withont 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..


2,0, 'If.!t,\ N,r /,ollg-U(Wgl' DI'/JI'lu/l'Il(f

.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 dividend-price ratio COIlIC illto play-sc(' Scctioll 7.2.1 III
CllaptlT 7 for further discussiofl,

2.6 Tests For Long-Range Dependence

There is olle departurc f.-om thc r.Illt!OI11 walk hypothesis that is ullL~ide the
slalistical framework we have developed so I;tr, and that is the phenomenon
of long-rangf de/Jelllimce. LO\lg-rall~{'-dcpelHlcllt limc series exhibit an unu~Llally high (lcgree ofpersistellce-ill a seme to be made precise beluw-su
that observatiom in thc rcmute past arc llulltrivially correlated with uhservatioIlS in the distant future, even as the time span between the two observatiuns increases. Nature's predilection towards lon~-range dependcnce
hJS becn well-documented in the natural sciences such as hydrology, meteorolu6,)" and geophysics, and some have argued that cconomic time series
are also long-range dependent. In the frequency domain, such time serics cxhibit power at thc lowest frequencies, and this was thought to he so
cOIlllllonplace a phenumenon that (;rallger (J ~(ili) dubbed it the "typical
spectral shape of an economic variable." MandcIbrot and Wallis (1968) used
the more colorful term "Joseph Effect," a rdl'\'cnce to the passagc in the
Book of' Genesis (Chapter 41) ill which Juseph rOl'elold the sevcn years 0('
plenty followed by the seven ycars of lamine that Egypt was to experience. 1H


examples oj Long-Range De/Wilder/a

A typical example of long-range 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/),


I"here I, is the lag operator, i.e., I./'t = /It-l. Cl-angcr 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' IOl1g-l~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 IOJlg-lcnn sloraKt' cap.H:ity of n.,~t~l"'\'o~rs. hull-eel. 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,\.




well-defined lillie seri('s that is said to he frartionally dif/fTl'1lm/ of order Ii

(or, r()llival('Jllly, fi'flrliolllll~y illlrgrlltn/
ordcr -Ii), Briefly, this involvcs
expanding th(' ('xpn'ssion (I-I,)" via the hinomial thcorelll fi)r nOllilltq~er


(I - /.)"

d(d-l)(d-2)---(d-k+ I)


and Ihell applying Ihe expansioll




LAk/ll-k ==




wh('J'(' t\le autoregressive C()('flicicnts Ak arc often re-expressed in t('l"IlIS or

the gamma funt'lion:

Ak =



\'(11 -


/11 may also he viewed as an infinite-order MA process since


nli + d}
J'(d} ['(Ii

+ I)

It is not ohviou's that such a definitioll orfractional dirrcrcllcing might ):cld

a tlscrul stochastic process, bllt Granger (1980), Granger andJoyeux (I !IHO),
and I-Iosking ( 19H I) show that the characteristics or fractionally clirrerenccd
time series arc interesting indeed_ For example, they show thaI/II is statiollary and invertihle fill' dE (- ~, ~) (scc Ilosking (19H I) and exhihits a unique
kind of c1qwnd('Il('(' that is positive or negative depending on whether d is
positive or ncgat iv(', i,c" t he autocorrelation coefficients of /Jr arc oft\tc sallle
sign as d, So slowly c\o the alltocoJ'lclatiollS decay that when dis posili\'e
thdr slim <iiv('rges to inlinit)', anc\ collapses to zero when dis negative, I"
To el('v('lop a Sl'nsl' li)r long-r,lllg(' depen<ienn" (Olllpart' the allt()(orrelations of a f,'action,lily diITl'I'('lIcec\ II, with those of a stationary AR( I) ill
'J;,h\c 2,:t Although hoth the AR( I) and the rractionally diITen:llcec! (d= \)
P'MandcliH o( awl Cllhl'l~ havt' (allt'd tht' d<O Cil."'l' anli/JrniMfna, 1 ('serving du' 1(',111 {otlKm"J.:' "",,,,,,d"IIO' fOI III" If.,.O (";1"', IlowC'\"c'I, ."inl"(' hoth ca.'''''s iuvolvt' ;111101 orrt'latioTl' 1Ii,It
tl,t:ay In\uh mon' :\lu\\'I\' th.u} tho"",' of IlUB,' to1\"l'll1i'Hl~,l \imt' st'lit,S, ,,'t' raU hoth long-rallge



Table 2.3.

A utororrriatioll Jlmrtioll Jor Jrartionally diJJtrrnud pmass.




[d==~ ]

[<1== - ;]

[ARO)'.p == .5]








-3.21 x 10- 4
-1.0~ x 10- 4

2.98 x 10-"
R.RR X 10- 1
7.89 x 10;-31





Comparison ofautocorrelatioll functions of fractionally differenced time series (1- L)d p, = (,

fo, d
~. -~, with that of an AR(l) p,
to yield" unit V'anance for p, in all Ihree ca..... ,.

+ f"


= .5. The variance of (, wa. chosen


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 long-range dependent processes has been taken by many to be this slow
decay of the autocovariance function.
More generally, long-range dependent processes (1',1 may be definc:d to
be those processes with a~l\ocovariance functions Yp(k) such that



kV JI (k)


E (-1.0)

{ _kv Ji (k)


E (-2, -I)






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



where h(k) is a slowly varying function. For example, the autocovariance

~"t\ function

I fl.


Il> be slowly varyin); 'II 00 if lim._ oo f(lx)l/(x) = 1 for a\\ I E

x is an rxample ofa slowly varying function at infinity.

fix) is sait!

The (unction


2. The Predictability 11 AI.lrl


function and spectr,t1 density near frequency zero of the fractionally dillerenced process (2.6.1) is

r(d) r(l-d) r(1I

I - ell




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.

2.6.2 The JIllnl-AlllIHlrlbmllll'.I((Ilrd



The importance of long-range ,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 long-rangt'
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
rescaled-range statistic, which w(~ shall call ~" is given by

s" is the usual (maximullJ likelihood) stanclard deviatioll estilllator,


'-;-(1) - _r,,) ~]l(t

I "



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

Q,. m~\y hl' 1>l'I1("1" tIlUit"f!<o.t(Jod hy (llHsi<ic:ring its urixin~ in hychnl(l~'(.d

of It''t'n'oir <It.siX1\. To .\fr()lIIl11l1d~\t(. ~,:~\:-,oH~\hti("s ill rlnrtlow.;.\ n!\tl\oll~ ( ap.t( U\'

11The- hehavior or



III sncral sCJllillal papers Mandcl lm)(, Taqqll, alld Wallis demons
lite sllJ>criorily of R/S analysis to lIIore nJllvclll iollal JIlelhod s
of detenni llillg IOllg-rallge 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 IOllg-range depelld ence ill highly Iloll-Gaussiall lillie series
with large
s!--ewlless alld/or kllrtosis . III f~ICl, Malldd brot (I!)7:!, 1!175)
reports the
allllOSI-SlIre 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 well-def 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,
("yclt-s 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 g-range depelld ence ell I indel"d he detecte
d by the
"cLlssical" R/S statistic. Howeve r, perhaps the lIIost illlporta nt shortco
01 tile rescaled range is its sensitivi ty to short-ra
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
long-ra nge
depeIld cIIce, but Illay merely he a symptol ll or short-te 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 long-term
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

!'olwll.," ill E1-.'Ypt Ihott sparkt"d J IlIrst's lifelong Lis<"ill.llioll

wilh Iht' Nilt', Ic',ulillg t"v("IHllall y to
III . . 11I['lt .... 1 III dl(' It'.'i(';ilt'd ra I1gt' ,



" / ,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 short-rallgl' 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 10llg-rangl' dq)(,lIeil'lICI' ill ltS stock retllrns Illay well he Ihl' 1'1"1111 of
quickly decal'illg sholl-r;lIIge dq)('ndl'nce inste;lIl.

2.7 Unit Root Test..

t\ IIIOl'e I'C(,('lIt alld nHm' spcciali/l'd class or lesls thaI art' orten conruscd
wilh lests or lhl' random walk hypotheses is Ihe colleclion or Iwit rolll lests
in which Ihl' lIuli hl'pollit'sis is




+ f"

('27.1 )

often with til<' followillg ,tlt('JII,tti\'(' h"l'0thesis:

X, -/il = <p(X,


I -. /1(/-1))




E (-1.1),

is all)' Il'n)-IlH'an st;\lioll;t1T process, stich Ihat

() <


lim E

I ., '-





I klll'istil'alil', condition (:2.7.:\) r(,quirl's thaI variance of the partial stlln

2:.:=1 f, inneasl' at approxim;ttl'ly thl' sanlt' rate as T, so Ihal each ne\\' f,
added to thl' palli;Ii sum has a nontrivial contrihulion 10 the partial SIIIlI's
\'ariancl'.~~ This condition enSllrl'S th;\I Ihe usual limit Iheorl'ms are applicahle to the f,'S, alld it is satisfied hy virtllally all of the stational')' pron"sl's
th;\I wc sh;tli han' " .... asion to sttldl' (l'xCCpl for those in Set'lion '2'(i).

0, IIH'



\\'e'I!' In glll\.. ,10\\,('" Ih;1I1

';'0 that tilt, lilllil ill ('l. 7.:\ I \\('1('
the' ,,cJlU'lIe (. 01 ( I \ \\'lIl1ld he "clIICt'l1il1g 011'" o\'(,r lilll(, ;11,,1 \\'ollid 1101

p;lIli,tI ,11111 \ \".11 i.111I t'

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


I,", /

The unit root test is designed to reveal whether X, is diff"mc~stationary

(the null hypothesis) or trend-stationary (the alternative hypothesis); this
distinction reSL~ on whether rp is unity, hence the term unit root hypothesis.
The test iL~elf is formed by comparing the ordinary least squares estimator to unity via its (nonstandard) sampling distribution under the null
hypothesis (2.7.1), which was first derived hy Dickey and Fuller (1979).2'
Under the null hypothesis, any shock to X, is said to be permanmt since
E[ XI+k I XI) = /-lk + XI for all k>O, and a shock to X, will appear in the
conditional expectation of all future XII... In this case X, is often called a
slochfl.ltic trend since iL~ conditional expectation depends explicitly on the
stochastic variable X" In contrast, under the alternative (2.7.2). a shock to
XI is said to he tem!lOrary, since E[X'+k I X,J = /l(t+k) + rpl(X,-/lt), and
the influence of X, on the conditional expectation offuture X,+k diminishes
as k increases.
Because the (,'S are allowed to be an arbitrary zero-mean stationary
process under both the unit root null (2.7.1) and alternative hypothesis
(2.7.2), the focus of the unit root test is not Oil the predictability of X" as
it is under the random walk hypotheses. Even under the null hypothesis
(2.7.1), the incremenl~ of XI may be predictable. Despite the fact that the
r,lIldOIll walk hypotheses arc contained in the unit root null hypothesis,
it is the permanent/temporary nature of shocks to X, that concerns such
tesL~. Indeed, since there are also nonrandom walk alternatives in the unit
root llull hypothesis, tests of unit roots are clearly not designed to detect
predictability, but are ;,\ fact insensitive to it by construction.

2.8 Recent Empirical Evidence

pre(~ictability in asset returns is a very broad and active research topic, and jt

is illlpossiple to provide a complete survey of this vast literature;n just a fe~

pages. Therefore, in this section we focus exclusively on the recent empiric,\1
literature. 24 We hope to give readers a sense for the empirical relevance ~f
predictability in recen t equity markets by applying the tests developed in the
earlier sections to stock indexes and individual stock returns using daily and
weekly data from 1962 to 1994 and monthly data from 1926 to 1994. Despite
~'Since then, advance, in econometric method, have yielded many extensions and generaiintio", to thi, 'imple framework: te,ts for multiple unit roots in multivariate ARIMA systems,
tt'st, for rointrgration, consistent estimation of mode" with unit roots cointegration, etc. (~e
Cal~lphell and Perron [19911 for a thorough survey of this literature).
H Ilowrver, we would be remiss if we did not cite the rich rmpiricaltradition on which th(
reft'nt literature i, built, which includes: Alexander (1961. 1964), Cootner (1964), CowIe,'
(19W), Cowles and Jone' (19~7), Fama (1965), Fama and Blume (1966) Kt,ndall (1953),
C;r"n~('f and Morgenstern (1963), Mandelbrot (1963), Osborne (1959, 1962), Roberts (1959),
;llld Workill~ (191;0).

2. '/'lIe Predictability of Auet ReinDl,\


of these examples, the empirical resullS illustrate many of the
issufs that have arisen in the broader search for predictability alllOIlf.: assel

2.8. I 111l/ocorrela/iulO

Table 2.4 reporlS the means, standard deviations, alltocorrelations, and Hox
Pierce Q-statistics 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 equal-weighted CRSP index has a first-ordcr
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 Q-statistic 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 99.5-percclltik
is 16.7).
Similar calculations for the value-weighted indexes in panel A show
that both CRSP daily indexes exhibit statistical\y significant positive serial
correlation at the first lag, although the equal-weighted index has hight'r
autocorrelation which decays more slowly than the value-weighted 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
first-Qrder autocorrelation. Therefore, an autocorrelation of 3:>.0% implies
thaI 12.3% of the variation ill the daily CRSP equal-weighted index return
is predictable using the preceding day's index return.



'l')UIl?t'~ stated othenYist'. we rakt' returns [0 he rOlllillllollsly compounded.


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 sile-SOrled 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.

,,' 2.4.


A ullJrurrelatiml ill dllily, wrri<iy, IWrlllwlIlltly '/01 k illtifx "tunt.l.

Sample M



A. [hill' RCllll'llS

CRSI' V'lllIt'-Wci~hl('d Index

ti:!:07:tn-94:12::lO H,I79 0.041 O.H24 17.6 -0.7
li~:07:0:~-7H: 10:27 4,090 0.02H O.nH 27.H
71-1: 1O::{O-~)1: 12:30 1,OH9 O.!)!)4 0.901 IO.H -2.2

0.1 -O.H
-2.\l -:\5







CRSI' Eqllal-Weighted Index

1i:!:07:0:{-94: 12::\() H,179 0.070 0.761 :~;,.()
ii:!:07:0:\-7H: 10:27 4,090 0.Ofi3 0.771 4:1.1
7t'.: 1O::\O-\J4: 12::\0 'I,OK\! 0.07H 0.75ti ~(j.~




9.9 1,301.'J 1,36'J5

1:>.2 1,062.2 1,110.2
:HH.'J 379.5

1\. W('(')"I), Retllrns




h:!:07: 10-\)1: I '2:'27 I,W:> 0.1% VI\l3

15 -2.:)
H4H 0.141 1.9~)4
:>.Ii -:n
H47 0.248 2.IHH -2.0 -1.5


:-15 -0.7
I.t; -:>.:\






4.:\ -5.:1 -I.:{ -0.4

ti.4 -:\.8
U -6.3 -H.3 -7.7






ti:!:07: 10-\14: I '2:~n l,fi9.'i 0.339 ~D2I 20.3

h'2:07: 10-78: 10:0:\ H18 0.324 2.4liO '2I.H
7li:J 0: I O-'J4:12:27 H47 0.351 2.171 IHA



C. Monthly RcLUms

Valllc-W"i~hl .. d


ti:!:07::{1-94: 1:!::lO
li'2:07::{ 1-7H:m):29
7H: I (I::{ 1-\14: 12::\0

:-190 0.861 4.336

19!1 O.64ti 4.21\1
1% 1.076 4.4:,()

li~:07::\I-\H: I ~::{()

:1'J0 1.077 5.749 17.1 -3.-\ --:\.:\ -1.6

195 1.049 fi.I4H 18.4 -2.:)
1'J5 1.105 5.:\3li 1!i.0 -I.ti - 12.4 -7.4

CRSI' Eqllal-W .. iglllcc\ huh',.

(i~:1)7 ::\ 1-7H:0\):2\)

7!-l: I ()::\ 1-!I4: I :!::{{)


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 (,<)lIJI-w('ighl('cI 1('1\ II'll indexes I()r tire ,.11111'1,' period frolllJllly :{, IYI;~
10 ))"'II1IJ<'1' :1O. I!)!H and slIbperiods.


j hI' j'mlidllhility

oj AUft


The weekly alld lIlollthly retllrn aUlOcorrelations reponed ill pallels B

and C of Table ~.'1, respectively, exhibit pallerns similar to those of the daily
autocorrelatiolls: positiv(, alld statistically si~nificallt at the first lag over the
clltire samplc and Ii)!' all sllhsamplcs, with smaller and sometimes lIegative
higher-orcin an[('("(lIre\ati(IIIS,

2,8.2 \'rllil/llrl' /lotios

The fact that the auto(orreiations of daily, weekly, and mOllthly index retllrns in Tahle ~A an' positive and orten significantly different frolll 7,no has
illlplications for the hehavior or the variance ratios of Senioll 2.'1 alld we explore these illlplicatiolls ill this sectioll for the returns of ill de xes, portfolios,
and individllal sl'rllritit's.

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, hewroskedasticity-nl!1sistellt aSYlllptoticallv
standard normal test statistics 1/I'(If} defined in (2.4.44), for weekly CRSP
eljual-and va It Ie-wei gh ted market retllrn indexes. 2t\ Panel A (olltains results
lilr tl\(' ('qllal-weighted 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!i-week 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 equal-weight(,d index. Moreover, the rejections are not !III(" to
changing varianc(,s sinc(' til(' ",'('1)\ arc heteroskedasticity-collsistenf. 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(' lirst-or!ln autocorrelation coefficient estim,llor
of weekly retunts; hellc(', [he elltry ill the first row, ) .20, implies that th('
first-order 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'



olily rhc'

1/,' (1/)--( CllIlplllt'd under Ilu' 111111 hrpoliu'sis R\\':~--.II(

,h;tll rhe' \".tllle' ... of 1/1(//) (';dclllau'<I lIlIde', InVl, (1I101l'('I\('

till" \";1111(,~ III

sl~tli~li("lIy Ic~~ ,igllific.lIIl



\';ui\"c :"ot;lIi"lic~,


2.8. R.ecenl r:mpirical Evidence

Table 2.5.

Sample period

Vminnu rat ins Jor wakl) stock intkx Yl'turm.

Number q of base observations aggregated

10 form variance ratio
nq of base -,_._._II

A. CRSP Equal-Weighted Index

62:07: I 0-91: 12:27


<i2:07: I ()... 78: I 0:03


78: I 0: I 0-94: 12:27






I. 74
1.90 I
154 "

(1.11 )


(0.41 )

(0.14) 'i
1.19 :

n. CRSI' Value-Weighted Index

62:07: I 0-94:12:27


62:07: 1()... 78: I 0:03


78: I 0: I ()"'94: 12:27


VJri:lIlrlratio test of the random walk hypothesis for CR5P equal- and value-weighted 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: r-atios are Matistically dine-rent from one at the :,% It"vei of .5iRoificance.

returns: the degree of predictability seems to be declining through time.

To the extent that such predictability has been a source of "excess" profits,
iLS decline is consistent with the fact that financial markets have become
increasingly competitive over the sample period.
The variance ratios for the equal-weighted index generally increase with
q: the variance ratio climbs from 1.20 (for q=2) to 1.74 (for q
16), and
the subsample results show a similar pattern. To interpret this pallern,
observe that an analog of (2.4.18) can be derived for ratios of variance


- =

1+ fJq(l)

(2.8.1 )

where (lq( 1) is the first-order autocorrelation coefficient for q-period retums

rt + rt-i + ... +rt - q+ t. Therefore, the fart that the variance ratios in panel A
ofTahle 2.5 are increasing implies positive serial correlation in multiperiod


2. 'f'/u' I'II'ILir/abilily of 11.\\('1/(1'111111.1

retu rns. For cxam plc, VR( 4)/VR(!1

)== 1.42 / 1.20== I.IH , whic h illlp lies
thai 2wcck rctu rns havc a lirst -ord er aUlO
corr elati oll coeH icien t of approxiJ


Pane l B of Tab le 2.5 show s tllat

the valu e-we ight ed inde x beha v(',
c1iITerclllly. Ove r the ellli re sanl
plc peri od, the vari allce ratio s arc
,III gl ('.11" 1
thal l onc, but not by muc h. rang
ing from 1.02 for q=2 to 1.04
for q=H.
Mor eove r, the test stati stics "" (,,)
arc all stati stica lly insig llilic allt,
hen ce RW:-I
cann ot he reje cted for any ". The
subs amp le resulL~ show that duri
ng Ihe firSI
half ofth c sam ple peri od, the vari
allce ratio s for the valu e-we ight ed
illde x do
incr ease with q (imp lyin g posi tive
seria l corr elat ion for lIlul tipe riod
but duri ng thc scco nd half of
the sam ple, the vari ance ratio s
q (imp lyin g nega tive scria l corr elat ion
for Illlli tipcr iod retu rns) . The se
opp osin g patt erns are resp onsi
ble for Ihe relat ively stab le beha
vior of Ihe
vari ance ratio s over the ellli re sanl
ple peri od.
Alth ough the test stati stio ill
Tab le 2.:) arc base d Oil nom illal
stoc k
retu rns, it is appa rent Ihat vil'lu
ally Ihe saJlle rcsult.~ wou ld obla
ill wilh real
or exce ss retu rns. Sillc e the \'olat
ililY of weekly Ilom inal retu rns
is so Illuc h
larg er than that of the infla lioll
alld Trea sury -bill rates , the use
nOll linal ,
real, or exce ss retu rns in vola tility
-bas ed tesls will yield prac tical ly
idcn tical
infc rcnc cs.

Size-Sorled Pori/olio.!
Thc fact that RW3 is rcjc ctcd by
Ihe eCJual-weighled inde x but IlOI
by Ihe
valu e-we 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
porl foVo s. We com pute wcekly
retu rns for live size-SOrice! pOrl
s from
Ihe Cl~)P NYSE-AMEX 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 l-we 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
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
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',

hTlgh ltd!lI I.lI kt'l illdex .


I.,,').~( .. t \.lhH \\Tig hltd jllili

lilt' I~ quilt' ~illlil;lr 10


\'.1 II It'


Table 2.6.

Vllrillltf"P mlio.\ jor lII("'dy .liU-.lollnl flllrijo/io Idllm.l.

of has"



of has" ohser\';lIions aggrq;att'd



rOJ III \,~triallc(,



A. P()rtfolio of linns with markct vallics ill sJIlalkst CRSI' quintile

(i:!:07: 10-~H: I 2:27


(;:!:07: I 0-7H: 10:0:-1


7S: 10: I 0-94: I 2:27



I. 7~J
(f).\J 1)*

( 10.74)*
(Ul!I) *



B. Ponf(,lio of firms with market vallics ill central CRSI' qllintilc

(i~:07: I 0-~J4:

I 2:27


I 0-7H: 10:0:'1


7S: I 0: I 0-\14: I 2:27







C. 1'()J:folio of firms with markct valllt"s in largest CRSI' qllintile

(;:!:07: I 0-\/1: I '2:27


li:!:07: I 0-7H: I 0:0:1


70: 10: 10-\/': I '2:'27


(1.71 )

( 1.4ti)
('2.1 :,) *
(!.Of, )

VIII.III(l'-r;Hio Il . . ' of tlie ralldDIlI walk h}'P()lhl'~i:) for :o.i/l-~ortl'd

pl"riodlroIll.l"ly 10. lV!i2

~\ll H.'ported in tht"


Decelllher '27,1\1\14. <llld '""periods.



( 1.59)

tor tht" !'lam pIc:

TIo," variallce ralios VR('11

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" \',II-j;IIlCt' ratio is one and the.' le.'M st~ltiMin, h~\\-l' ~\ ~\~\1Hl"lI"tl lloJ'lllal ciiMrihutioll

a_'Ylllpl(Jlic;dly_ T(':\1 :\t"ti~ti("s lII.uked with ;.1Mt"rbks indicate tllat tilt, (orrt'spondinH varid.nre


st.lll;\tic;tlly diJkrt"llt from on~ at the :)IYcJ 1t"\'l'I oj :\igllilirall("c.

(h;lIl OIlC, illlplying a firsl-order autocorrelation of :1:J'X, lill weekly returns

tl;e elltirc s;ullplc pniod.
Fur lite purtfolios of Illcdilllll-sil.l' ("OIIlJ!~lllic~, lltt" of!' (If) statistics in
p~llid 1) shows thal there is also strong t'vic\eIlCl' agaillst RW::I, although
til<" variance ratios arc slllaller 110W, illlplying lower serial correlation. For
tit, port!i.lio or the largest flrllls, pallel C shows th;l( evidcllcc against RW:~
i, 'par,,, lilllil .. d !lilly III the first ~lalr or th .. salllpk period.


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!


Illditlit/llul SI'I'//lili",1
Ilavillg shown that Ihe rallc\olll walk hypothesis is in('onsistellt wilh th(' behavior of the equal-weighted index and portlillios of Sill. tll- .l1\d IlIcdiulll-si/,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'oss-se('\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 ,1i9:1-W(,l'k salllph'()('riod, a sample of 111 companies, Panel/\. contains Ihl'
cross-sl'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 ClOss-seClional
slanllaul deviations arc gi"I'n in parl'nlheses helow Ill(' lIIain rows, SinCl' IIil'
variancl' ralios an' ('1t-:11'ly 11IIt lTOss-sc('\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 cross-s('('\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
(')'oss-senional 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 Ilt-tl'('\ Ihl' Pl'l'SI'lllT (If
prcdicraJ.1c ('OIIlP"III'II", Sillcl' IIII' idiosyntTatic lIoise is largely alll'III1;II('1I

Table 2.7.

Variance ratios for weeki) individual security returns.

!\'umber q of base observations aggregated
to form variance ratio


nq of base


A. Averages of variance ratios m'er individual securities

All stocks
(411 stocks)




(0.11 )

(0. (4)

Small stocks
(100 stocks)
Medium stocks
(100 stoc ks)
Large stocks
(l00 stocks)












B. Variance ratios of equal- and '"<llue-weighted portfolios of all stocks

Equal-weighted portfolio
(411 stocks)





Value-weighted portfolio
(411 stocks)






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
value-weighted 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.




p,.n!i,t(/bility of AI.lft Uptllnn

by forming portfoli os, we wOlild expect to IIIICOVCl ' the predicta hle .IJltl'/lU/t
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 Cros5-A lltO(ondl ltiullJ

llltt! I.mtf-I.ll g ReilltiuH.1

Despite the fact that ill(\ividu;d security relUrm arc weakly

negative ly autocorrcl ated, portfoli o returns -which ',\re essclHia lly average
s of individual security returns -are strongly positivel y autocor rclated. This
sOlllewh at
paradoX ical result can lIlean only o/le thing: large positive
crOSS-<lutocorrelation s across individu al securitie s across lime.
To see this, conside r a c()llenio n of N ~ec\lritit's and denote
by R t tht'
(N x I) veC10r of their period-t simple returns I lilt ... liNt]'.
We switch to
simple returns here becallse the focus of our analysis is on the
interact ion
of returns within portfolio s. and cOlltinu ollsly compou nded returlls
do 1I0t
aggrega te across securitie s (sec Section 1.4.1 in Chapter 1 for further
discussion). For conveni ence, we maintai n the followin g assump tion
through oul
this stlion:'l 9
(AI) R t is a joinlly (Oualiana-statiolwl)' stochastic /)(oa5.1 with expl'(talit
Jll EIR t 1

[It I /12 .. , /1N]' rmti autocouarirwu lIlatrices E[(R _ - ,.,.)(R t k

,.,.)'] ,; r(k) wherl',withnoloHojgl'llerality. welakek?:.Osinc
er(k) ::: r'(-k) .
::: ,.,. 1=

If Lis (Icfincd to bc a vcctor of olles [1 .. , 1]'. we can express

the e<\II;IIweigh\c d markel index as
L'Rr/ N. The lirst-Qrd er alitocovari<lllCe
of Rmt1may then be dccomp osed illto the sum of the first-Qrd er
OWJl-autocovarianre s and cross-au tocovari ,lllces of the compon ent securitie

not ""

I Cov[ Hmt - I II mt J


= Cov

rL--;::;- 'tv
L'R t _ 1




alld th~rcforc the first-ord er ',lIllo('o rrcblioll of U"., call be express

ed ,IS

,Umt -



\, ar! fl,.,]




------- + -- .
L -



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



\ \ ')'IOr) lor 1111 Ihf,. <Iflaih.


2.8. Rnm/

Tablr 2.8.

(:w\.\-Ilu/c u ont'iulioll IIlft/rir t'\ for ';1.1'-'>01 it'd










11:11 -



/{1I . l

U: I/ . ,





H.\) 14
H.\lti I








0.111 ':.!







O.O!) I




o. \Hi I





0.97 1 )




















/IO,.(/oli(l rf'/unu.



11,,- \

















lUll :,


127 )

-0.006 )

II{., J' whe,.e Il" is Ihe wee".

'\IIl()[o,.n blioll 11I.llri('c. of lhe veclor X, '" I /(" /(~, H" nil
the I,iI '1Uilililc.'. i:;:: I .... 5 (quintile
I return Ull dw equal-wci ghted portfoliu of Sl()rk~ ill
tUJlIl.Ju1y 10. 1962 tu
the ~1I1~IIlt"st ~locks). fur the s~lIl1plt.: of ,P\;YSl-:AMEX stocks

I cOllt;lius
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



= O.O:!4.

anccs. If
crossau toco\,ar iances and the secolld term ollly the OIvll-au tocovari
the own-aut
er. the
is positive, thell the cr05s-au tocovari ances must bc positive
of the
cross'<lutocovariances must be large,

'Clhle ~,H reports autocor relatioll matrices T(k) of the vcctor

of weekly
rctunIs of/i\'(' sil.e-sor ted portfolio s, formed from the sample of
stocks u~inl{
wcekly reluI"IIs fromJ Illy 10, I!Hi2, 10 Dccemb er 27, I ~1~11 (1,(i~I:)
obsl'l"vatiollS), 1.('1 XI dello((' Ihe \'('((01' I UtI U~I /l:ll HII U',I J', ",h('l"e
U,I is Ihe
r('(lInt ollihe ('<Jllal-weil{hled porlfoli o of stocks inthc ith qllilllil('
, Thclllh c
klh order alliocor reialioll /lwflixo fX , is I{ivcll by I(k) == D-I/~EI
Jl)(X I -ltnD-I/~, wh('l"e D == dial{(rr(, '"
and It == EIX/J, By Ihis
cOllven lion, the i, jlh elclllcnt of I(k) is the correlat ion of
U,I - k wilh Il/"
The cstimato r T(k) is Ihe IIsual sample alltocor relation matrix,
An interesli lll{ pallel'll emerge s from Table 2,H: Thc enlrics helow
thc diagollals ofT(k) arc almosl always larl{er th;1II thosc ahove the dial{olla
ls, For
exampl e, the firsl-ord er alliocor relation helwecn Iasl week's rei
II I'll Oil 1;lrl{('
slorks (/l,.,_t ) wil h th is \\'eek 's ret til'll on small stocks (Ill I ) is 2(i5';;"
Ihe first-ord er aUlocor relalioll l)('t\\'e(,11 last week's retllrll Oil
small stocks
(Ili/-I) with this week's relurn Oil larl{c stocks (I?r./) is only
2.1%, Similar
pallenls mOl)' he se(,11 illihe hil{her- order autocor relation malrice
s, allhong h
the magllitl ldes a 1'(' sm;1I I1'1' sillce Ihe higher-o rder cross-au loforrcla
liollS dcray, '1'11<' as)'lIl11H'lrV of Ihe TUl) malrice s implies thai Ihe aUlo('ov
malrix eSlimato rs h/l) ;11'<' also as)'lnnH 'trir.
This intriguin l{ 11'fIr/,lfI,i!, pallel'll, whcrc largcr capitaliz alion slocks
alld small('l" rapilali/ ,alioll slOcks );Ig, is morc apparcn t ill 'Llble
2,9 which
reports Ihe diff('rell(,(' of the aUlocor relation malrices and II1<'ir
transpos es,
Ever)' lower-d iagonal entr)' is posilive (hencc cver), upper-d iagonal
eiliry is
lIegalive ), implyin g Ihal Ihe correlal ioll between Cllrrcllt reltlrns
of smaller
stocks alld pasl rctllrns of largcr stocks is always largcr than the
hetw('('11 currl'nl retllrllS of larger slocks and past retllrns of' smaller
Of COII/'Sl', the nOlltnH lillg llIodel of Chapter 3 also yields
all as:'IlllIIell'ic alltocor rdalio/l matrix, Iloweve r, we shall sec ill that
chapter that
IInr('alis lically high probabi lities of' nonlrad ing are reqllired
to g('ll('rat<'
Cl'Oss-a lllocorrd aliolls of 111(' magnill lde reported ill 'Elhlc ~,H,
The resulls ill'l;lhle s 2,H and ~,~I point to the cOlllplt' x palll'l'ns
of CI II~S
effi'cts alllollg sennilie s as significa lll sourfl'S of positive illdex
alllocOITl'lalion, luclcl'd, 1.0 alld MacKill lav (1~1!)(lc) show that OVlT half
of Ihe positivI' iudex ,llllocol Tclaliol l is atlrihut ahk to positive {'f'oss-{'fT('cts,
They also
ohsC'l'vl' Ihal positive noss-dJ' e('(s CUI explaiu the apparen t profitah
ilil\' of
f/ll/lmrif/ 1/ ill\'esllIl<'lIl slral('gic s, slralegi( 's Ihal are coulrary
10 III<' gellnal
lllarkel direnio ll, Thesc siralegic s, predica ted ou the Ilotioll
th,lI ill\'('.'lllrs
lelld 10 O\'('IH'OIn 10 illforlllOllillll, ('ollSisl of sellillg "wilIlH'r
s" alld IHll'ilig
"Ios('rs," Sellillg Ihe willll('rs ;1I1e1 bllyillg til(' losers will ('anI
posilive eXpC('ieel prolils ill Ihe pn's('II(,(' "fllegal il'(' scrial cOiTclal ioll h,'('alls('
losers an'likel \' 10 IH'(,OIlI<' 1'111111'1' willllcrs alld CIIITellt willllers
are likeh' 10
I)('colll(' hlllln'lo sers,


Table 2.9.

AIYIn1Wtl) of rmIHlIl/or()rrriation matrir,s.


Y(I) - Y'(I)




Y (2) - Y' (2)



YCI) - Y'(3)





Y(4) - Y'(4)






















-02<1 )








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"al-weighled 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) = O-1/ 2 EI(X,_. - jl)(X, - I,)')D- I/', where
D 0= di'I~la~, ... ,a~;J.

sorted portfolio returns

But the presence of positive cross-efTecl~ provides another channel

through which contrarian strategies can be profitable. If, for'example, a
high return for security A today implies that security B's return will probably
be high tomorrow, then a contrarian investment strategy will be profitable
even if each security's returns are unforecastable using past returns of th~t
security alone. To see how, suppose the market consists of only the two
stocks, A and B; if A's return is higher than the market today, a contrarian sells it and buys 13, But if A and 13 are positively cross-autocorrelated,
higher return for A today implies a higher return for n tomorrow on average, and thus the contrarian will ha\'e profitcd from his long position in I}
Oil average.

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.
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.
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
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' l-l/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
llley arc
age of ow n-c 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
gie s '~1I1 als o 1)(' alt l'ib
llle d 10 cro ss- cll ecb
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.

2.8.4 '1i-.llJ (hil l!!, f.U II/iIIU liw lI IIrlurn.1

sev el\t l rec cnt slll <ii es
hav e eli lpl oye d lon ger
-ho riz on ret urn s-l ilu
tUf llsi inl llo st ca ses -in
lti- yc ar reexa lili nin g the ran dol
ll walk hyp oth esi s, pre
ity, an'd the pro fita bil ity
dic tab ilof con tra ria n str ate gie
s, wit h SOIlll' sur pri sin
Dis tin gui shi ng bet we
en sho rt all d IOllg ret ul'l
I-h ori /.o ns can he illl
cau se it is now well kno
p0r lal ltlw wn Ih~lt we ekl y flu ctu
ati oll s ill sto ck ret urn
in ma ny ways fro m mo
s dil ll'l '
vem ent s ill thr ee- to
live -ye ar ret urn s. We
the eco no me tric tra deCOlIsid!'I'
off s bet we en sho rt- anc
llo ng -ho riz on rcl lirn
det ail in Ch apt er 7,
s inl llll lT
and pro vid e oil ly a bri
ef dis cus sio n her e of
hor izo n imp lica tio lls
the lon g[01 ' the ral ldo lll
walk hyp oth ese s.
III con tra st to the pos itiv
e ser ial con -ei ati on in
daily, weekly, and 1I101I
ind ex ret uri ls do cum
ent ed by 1.0 an d Ma
cK inl ay (19 88) an d oth
an d Fre nch (HJH8h)
ers , Fai lla
and l'ot eri Ja and Su nll
lle rs (1~)88) fin d llI'i!
cor rel ati on in mu lti,alilll' scri~t1
yea r ind ex ret urn s.
Fo r exa illp le, Po ter lla
lIIers (1988) rep ort
ancl SUIlla var ian ce r~tlio of O.:1
7S t(lr ~){i-lilollth ret urn
val uc- we igh ted CR SP
s of Ih!'
NYSE ind ex fro m 19:
!!i to 19H5, im ply ing
rial cor rel ati on at sOl
neg,lIiVl' selie rel lirn llOril.ons (re
cal l tha t the var ian ce
spe cif ic lin ear com bin
ral io is a
ati on oL lu( oco rrc lal
iOIl coe ffic ien ts) . Bo
Fre nch (19H8b) and
th Fam a and
Po ter ha and Su mm ers
(l!lHH) con clu de tha
I llin !' is

slIiJslalltiaIIlH'all-rev<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
arc based Oil long-ho 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 five-year 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 long-ho
rizon return
c;J!cula tions-th 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
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 long-hoI"izon return :lutocor relation s and variance
(~(T, f(>r exallipl e, Richard soll alld Stock (19WJ,
'Elhk! ), which are typically
so large dS to yield z-statistics 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
adjustin g 1'01' the Slllall salllple sizes, alld for otl)('~' statistic al issues
associat ed
Wilh 10ng-horiLol1 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
time series parallle ters tend to exhibit conside rable samplin g
variatio n for
long-ho 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 long-ho 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
Icbtion ill long-ho rizon returns is ('xtrelllc ly sensitivc to the saJllple
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

sig ll of the ser ial co

nd ali oll coe ffic iell t
hil lge s Oil clata (i'o m
prc ssi oll . Th is CO IIII
the (;r ea tlk IHl rlll l1- wh (th er to
om it dat a iIlIlIlCI1CC
cat acl ysm ic ('\'1'111. or
t\ Ill' a sill gle
10 illc ilid c it all d arg
ll(' tha I sllc h all 1'1'(,111
.~cllta Iil'c of II J(' C(O
is rcp reIlOIIl ic sVSI e m- III lt\l
'rsc ore s tl J(' fra gil il)'
sta tist ica l illf ('lc ll(T .
of sllIa II-sa III I'll '
{)l 'n,I II. lit nt' is litt
le cvi dcl lcc f(lI' II1Call
IOl lg- hot i/o ll rct llrn
rev ers iol l ill
s. Iho ug h I his lIIay be
lIIo re of ,I sym Jllo m
pie sil.es ral lw r Iha ll
SIII;III sall lCOllclllSivc C"icll-IUT
aga ills tlll cal l rel 'er sio
cal l1l ot lell .
ll-w (' sill lply
Th esc ' cOllsicic-ralioll
s poi lll 10 sito rl-i tor il.o
ll reI urn s ,IS the ilio
C\iale .~OIllTC rro lll wh
n' illl llle ich C'\"ic\CI1("(' of prc c\ic
tab ilit y mi ghl be clil
Ilo t to say IIial a can
led . TIi is is
fll l ill\ "('s liga liol l of
ret url ls ovc r IOllgc'r
bc Ull ill( )fJl lali \"( . lllc
tilll(' spa lls will
\cl' d. ilm ay hc oll ly att
hc sc low er freCjllellci
im pac l or ITO Il() mir
cs IIia llli c
LtctO)S sllc h as thc bus
illc ss cyclc- is dClcCI'liJ
01'(' 1", to the cxt
k. Mo rcell l Iha llra lls ani oll
cos ts arc grc ate r (1I'
slr alc gie s exp loi lill g
sllOrI-llOrilOlI prl 'cli
cl,l bili ty. IOl lg- hor iwl
I pre e!i nah ilil Y lIlay
uill (' for lll ofl lllc xpl oil
bc ;1 11101"1' gC'lICc \ (llOlil opp ort ull ity
. Nc vcr the les s, Ihe C'C
cha llC 'llg cs POSI'c\ b)'
IOl lg- hor i/o ll rC'llIrns
arc' ('ol lsic lna blc -. all
for acl (lit ioll al C'conO
d Ihe llC'cd
lllic slr un llr c is par tic
ula rly gre al ill sllCh
cas cs.

2.9 Co nc lus ion

Rc ('cl lt C'CollOlIll'tric
ac\ val lcc s ane! I'm pir
ica l evi dcl lcc sec III 10
fin anc ial ass ct rct url
sug gc" 1 Ill<It
ls arc prc t\in abl c to
sOllie deg rC' e. Th iny
wOllld hav c I)('cll tall
yca rs ,lgO thi s
lalilOllil1 10 ;111 ou trig
hl n:jc Cli oll of lIla rke
Ilo wc ver . lIlo c\c m lill
l cfli cie llcy .
,)ll cia l eco llo mi cs tea
che s \IS Iha t olh n.
tio llal , (~Ktors lIlay
fcc lly raacc oll llt ()r suc h pn
dic tab ilit y. Th e fillC
sC' cur itie s ma rke ts all
' ~truClllrc of
d fric tio lls in the Ira
dil lg procC'ss cal l gel
dic tah ilil )'. Til lle- var
;er ate pre yil lg ('xp c'(" lnl rctufll.
~ du e to cha llg illg
tio lls cal l gC lln ate ' prc
hus ille ss cOlldiclin abi lil) ,. A cer tai ll
deg ree of pre dic lab ilil
IH'("('ssary to rcw ard
Y ilia), be
iIlV(~SIOrS for bea
rin g cer tai ll dyn am ic
hy Ilte sl' cO llsi dcn llio lls.
risks. MO li\'a ted
We' slia ll dCI'!'Iojl ma
n)' mo del s and tcc hni
adc lre ss tlic sl' and oIl
qll cs to
ier rel alc d issl lcs in
Ihe com illg rha ptc rs.

Pr ob lem s-C ha pte r 2


If 11',1 is a IIlarliligaic-. sho

w tha t: (I) the llli nim
ull llll ('an -sc llia rnl nr
fill Tca st of I'H I. con
dit iol lcd oll thc en
tin ' his tor y 11',.1',_1
1',; (2) lIo ll(} \'l'r iap pil ig
... . 1. is sim pl) '
hlh ciif fer cnc cs arc ull
cor rci at( 'c\ at atl lea ds
lor all /; > O.
,lI1 dla gs
2.2 Ilo w all ' till ' RW
I. RW~, R\'\':l, .lIl Clm
art ing ak Iiy pot hes ('s
clu de' a \'(, lIn di;l gr;
rda ted (in Jm 10 illl lslr ;llc III<'
ons am on g lill ' fou r
Pro vid c spl 'cif ic c'x am
p!c s of I'ac lt.

2.3 Characterize the set of all two-state 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.
2.4 Derive (2.4. I 9) for processes with stationary increments. Why do the
weights decline linearly? Using this expression. construct examples;ofnonrandom-walk 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 value-weighted 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.


2.5.1 Compute the sample mean i<. standard deviation and first-orcier
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 subperiod-are they stable over time?


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
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


2. The Predictability oj AUft Uft /117/J

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
s(/rics, perform thc samc calculat ions using monthly data. What
do YOll
c911c1ude about thc normali ty of these rClllrn serics, alld why?

Market Microstructure

\\'1 III.E IT l~ AI.WAY~

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 bid-ask bounce (to he de filled in Section
:~.~) is responsiblc for the negative autocorrelation in the five-year returns
of US stock indcxes such as the Standard and Poor's ;)00, t even though
the existellce of a bid-ask spread c10es induce negative autocorrelation in
returns (see Section :{.2.1).
Ilowever, for other purposes-the measurement of execution costs and
Ilurket liquidity, thc comparison of allernative lIIarkelmaking mechanisms,
the impact of competition and thl' potelltial li'r collusioll among marketmakcrs-markct 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.~.

Ilillg- lIlall)' 11\;11 \..I'IS al\(I lIIallY lIIod

els,~ To lesl sOllie of Ihes e mod
els, alld
dele rllli llc IIII' illip onal lce of lIIar
ket lIlic roslr llctl ire effe cts for otlll
'r resear ch area s, WI' rcqu ire SOI\lI' clllp
irica lllle aslir es of lIlar kctl llirr ostr
llctl ire
effec ls, We shal l l'onslJ'llct sllch
lIlea sure s ill Ihis chap ler,
In Sl'l'I ion :\,1, Ive pres enl a silll
ple mod el of Ille Iradillg- proc ess
10 cap1111'1' IIII' cfkl 'ls of nons ),nc
llrol lous Iraclill~, III Scct ioll :~,~,
WI' cons ider tile
eff(ocis of the hid-ask spre ad on
IIII' tillie-series prop ertie s of pric
e dlan ges,
and in Sect ioll :1.:1 W(' (,xp lore scve
ral Icch lliqu l's for lIIo ddin g Iran
s<ln ions
dala wilich pose sl've ralu niqu ('
chal leng es incl udin g pric c disc
irreg ular salll plin g inl('l'vals,

3,1 NOn.';ynchronous Tra ding

Till' 1I00H )'II(li mllll/ /1 flll/li llK or lIollf
mdil lg effe ci arisc s whe n lillie
serie s, IISUally assel pric es, are lakc n 10 he
reco rded at time inler vals of olle
leng th
whc n in bl'l Illey an' rc('or<lcd
al time inter vals of otlle r, possihly
ular ,
Icng lhs, For ex alii pie , Ihc daily
pric es of secl lritie s qllo ted in the
fina ncia l
prcs s an' usua lly dll.liJlK pric es,
pric cs al whic h Iht' last IrallS<lcti
on in each
of Illosc sccu rilie s occu lTl'd on
Ilic pn'v ious hllsi ncss day, The
st' clos ing
pric es gCllcrally do nOI OITur al
Ilic sam e limt ' each day, bUI by
refe rrin g
10 IlIelll as "dai ly" pric
cs, wc have illlplicitly and inco
rrec lly assl lmed that
Ihl'), arc cl(u;llI)' spac cd al !!'I- hour
illlc rvals , A~ wc shal l sce helow,
sucl l all
assll lllpl ion can !Tea le a falSI' imp
ress ion of prcd ictab ililY ill pric
alld relu ms evell if Inle pric e I'hal
l~es or relli rns arc stali slica
lly inde pell dell t.
III pan klila r, IIII' nOlllrading- effe
ct indllCl's pOle nlial ly serio lls bias
in Ihe 1II00111'nis and CO-IIIOIIH'nls
of assel retu rns such as Ihei r mea
ns, variaIlC( 'S, ('O\'ariallces, hela
s, alld auto corr elal ion and cros s-ali
loco rrela tion coeffic ients , For ex;u llplI ', supp ose
Ihal Ihe retu rns 10 sloc ks A and
Il arc
lelll pora lly illdq )('nd enl hUI A
Iracles less freC]u('nlly than B, If
news affecting Ih(' aggr egal c sioc k mar kel
arriv es lIea r the clos e of the mar
ket on one
day, il is lIIore likely 111;11 II's 1'lId
-()/~day pric e will refle ct
Ihis info rma tion
Ihall A's, simp ly heca use A fIIay
nol Irac k afte r Ihe new s arriv es,
Of COllrse,
A will resp ond 10 Illis ill/iu'III;llioll
I'vel ltual ly hUI Ihe faci Ihal it resp
olld s
wilh a lag indUITS spur ious noss
-alll oco rrda lion helw el'll Ihe daily
of A alld B \\,11('1 1 (';II(,lIlall'lI wilh
dmil lK pric es, This lagg ed
resp onse will
~Th(' lill'I,l lllIe' j, 1.11 1110 \'~I'1
10 givl'. 1 (01111 '1('((' (iWli oll
Ii"" Jar 1"1', III ~Iclditi()n to tlit"
il;lIi tHl\ li:-.It'd in
h of die" :-.(t"licHl~ 1H'low, Ic';,dc 'rs
illlt'l" t'sl('d in all inlrod ll('fio
IlIieT o,,, tI( 1111('.11 C' ('III olll.I
ll to Illark "t
~,d 10 ('on\1 I1t III(' follow
ing t'xcc llt'ul lIIollograph~ and
\"oltll lit's 111.11, logt llwl.p IO\'id
ccUlh 'n'llft '
c;1 f.lidy nUllp lc,!t Il"cal lllc'llt
of III(' m;ljo r b.\\I(',o;, alld IIIcl(l
,hi, tile'I,I II1It': I :.. 111'10, ~l.li ... , ,~dl\\,
l'b in
;III1, ,111<1 \\'I,il"'IOIII> (J'IHI
i),Il., vi" allcliiolo (I~I~I:\). !'''"lk
(;,IIIi, ,11111 l:i"I',


( I II~I,I) ,

lIlIlil li 11


K.lf!d ,111<1 RII'Io (I ~1~'r)J. I...

(1~1~,r). (l'II .. r..

(I ~'~I:), a,,<1 SH:



also induce spurious own-autocorrelation in the daily returns of A: During

periods of nontrading, A's observed return is zero and when A does trade,
its observed return reverts to the cumulated mean return, apd this meanreversion creates negative serial correlation in A's returns. These effects
have obvious implications for tests of predictability and nonlinearity in asset
returns (see Chapters 2 and 12), as well as for quantifying the trade-offs
between risk and expected return (see Chapters 4-6).
Perhaps the first to recognize the importance of non synchronous prices
was Fisher (1966). More recently, explicit models of nontrading have been
developed by Atchison, Butler, and Simonds (1987), Cohen, Maier, Schwartz,
and Whitcomb (1978,1979), Cohen, Hawawini, Maier, Schwartz, and Whitcomb (1983b), Dimson (1979), Lo and MacKinlay (1988, 1990a, 1990c),
and Scholes and Williams (1977). Whereas earlier studies c~msidered the
effects of nontrading on empirical applications of the Capital Asset Pricing
Model and the Arbitrage Pricing Theory,3 more recent attention has been
focused on spurious autocorrelations induced by nonsynchronous trading.4
Although the various models of nontrading may differ in their specifics, they
all have the common theme of modeling the behavior of asset returns that
are mistakenly assumed lO be measured at evenly spaced time intervals when
in fact they are nolo

3.1.1 A Model of Nonsynchrvnous Trading

Since most e;npirical investigations of stock price behavior focus on ,returns
or price changes, we take as primitive the (unobservable) return-gerlerating
process of a collection of N securities. To capture the effects of nontrading, we shall follow the nonsynchronous trading model ofLo and MacKinlay
([990a) ~hich associates with each security i in each period tan uno?served
or virtual continuously compounded return ril. These virtual returns represent changes in the underlying value of the security in the absence of any
trading frictions or other institutional rigidities. They reflect both companyspecific information and economy-wide effects, and in a frictionless market
these returns would be identical to the observed relUrns of the security.
To model the nontrading phenomenon as a purely spurious statistical
artifact-not an economic phenomenon motivated by private information
and strategic considerations-suppose in each period t there is some probability Jri that security i does not trade and whether the security trades or not
is independent of the virtual returns {rjl J (and all other random variables

~S.... , for .. xample, ('.ohell, Haw'"wini, Maier, Schwaru, and Whitcomb (1983a, b), Dimson

Schol .. s and Williams (1977), and Shanken (19R7b).

S.." Atchison, Butler, and Simonds (1987), Cohen, Maier. Schwartz. and Whitcomb (1979.

19Hfi), and 1.0 and MacKinlay (I 98H, 19H!!b, 1990a, 1990c).

q'~:' .,


3. Markel Mirroslmrlu/'r



this nontrading process can be viewed as all
IlQ sequence of coin tosses," with different nontrading probabilities across
sec~rities. By allowing cross-sectional 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 one-factor linear model:


+ fJ,/t + E,t

I, .. ,' N


where f, is some lero-mean COllllllon factor and Ellis zcro-mean idiosyncratic

noise that is temporally and cross-sectionally independent at all leads and
lags, Sillce we wish to foclls on nontrading as the sole source of alltot'l>rrebtion, we also assume that the (01ll1110n factor It is lID and is independellt or
~JThr ca~e when' Irildil1~ is nllT('(at('d with viltHal IT\ltrIlS i:o. lIot without iIH('U'.,t, htll it j,

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.


3, I, No/t.\Yll rItlVllull s'fmrliug


(",., 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 rclurn-c 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 tillie-ser ies propcrt ies wc illtrodll lT two related randolll
variable s:


I (no trade)
{ o (trade)

with probahi lity n,

with probahi lity I -


.. 8,,_.,



I: > ()

with prohahi lity (I-lf/)lf ,'

with probabi lity I -- (I -If,)lf,

(:1. 1.3)

where X,,(O) == I - 8 i " {8,d is assllmed to be illdepcl ldent of

{8jt} for i 1= j
a:1d tempora lly lID for each i = I, ~, . " . N,
The indicato r'v;lriab le 8" lakes on the vallie (Jlle whell seclirity
i docs
not trade in period I and is zero olherwi se, X,,(ld is also all illdicato
r variahle
and takes on the value one when sccurity i tr"dcs ill period
f but has nol
traded ill any of the Ii previou s (,OIlSl'!'IltiVl' I)('riods, alld is
1,('10 otherwi se,
Si'ICC If, is withill the Ullil illlerval , for large II the variahle X,,(Ii)
will he zero
with high probabil ity, This is 1I0t slII'prisillf.( sillce it is highly
unlikely that
s(,curity i shollid lrade loday but lIever ill the past.
I Iavillg defilled lhe X,,(k) 's it is 1I0W a simple 111.11 t ('I to d(')'iv('
all explicil
expressi oll for observe d returns 1;';:

r/~ =

L X"Ud 'i,-.

I.,,,,N ,

(:U .4)


If security idol's 1101 trade ill period I. thCIIO,, = I which implies

lhal X,,(k)=O
liJr all Ii. alld lhus /';;=0, If i docs trade ill period I, thell its observe
d return
is equ.d to tlie sum ortoday 's virtual retllrll I',/ ;IIHI its past Ii,
virtual r('turns,
",Iinc titl' ralldolll variable h, is tlie IlIlml)('r or past ((I11,lfnll
ill!' periods that
i Ii<ls 1I0t tr;lcied, We ('all this tlie dllllllillll or 11(llllra<,lillg,
wliich 111<1)' he
ex pressed as


~ { ~J tI"_1 }


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"


t'XI'Il'lllltl l,d I fllI\"II"'II!


C' .lIlff III.I}'



I. .\I(/tllI'I.\li"' ...I/nIl1,m








I .... N.


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

wilh prohabililY Jr,


with prohabililY (\-Jr,)~




wilh probability (I-JrI)~Jr,

+ 1'", I

1",1_ I

+ r,,_~

wilh prohabililY (I-JrI)~Jr;



1- "", k

Exprl'sst'd in Ihis wa)" II IS appan'lIl Ihal 1I01llradill/{ Gill illdllcc spmiolls

st'ri;1l corrdalion in ohst'rvcd rctllnts hecause each r;; conlains withill il
Ihc SIIIlI of pasl Ii ('oIlS('('Uli\'(' virlllal rClllrns for t'very k wilh sOllie pusilive
prohahilil), ! I - Jr,)~Jr,k.
'Ie) st'c hoI\' Iht' nOlllrading prohahility Jr; is rdaled 10 Iht' duralioll of
nOlllrading. ('ollsidl'!' Ihe llwan and variance of h,:
Jr ,

1-:1 ",I


I - Jr ,

Varlk,l ==



(I - Jr,)~

If Jr,== ~ IhI'li S('(,II ri Iy i gOt'S wi Ih01l1 Iradin/{ lill' olle pniod al a Iilll(, on


ag(,; if Jr , == ~ Ih('11 Ih(' ;\\'('rag(' IlIlInhn of ('onst'flllivt' pniods of lIonlradillg

"Th,~ b

"mH.u \" ~p;r'\


,Ill' S, holt-, .\1U\ \\'miam~ ('~)77) :\uhmtlill.l1C" :\10('h;l~ti(' I"on'"

rq)l"('st'litalion 01 oh:\('I"\'('" 1I'llInl'. although \\'t' do 1101 rt':\trin tilt' trading lime's




lilill" illl('n,ll.


~tllf,lhlt, nonl1~lli/~"ioIlS il


Iilkc' \';dll("~

may Iw :\11O\v11 thai 0111' IHllllradillg

IIlCukl c'olln'lge''i wc;tI... h IOliae'("(llIliIIlIOlh'lillH' POi."-MIil pron':\s ofSdlOlt., ,uHI \Villi.IIII.' (1~177),
10'10111 (:\'1,,1) III(' OhM'1 nod 11'luI"II' III 01"('" molY abo 1)(' ("on~i,lc'r('d 'lIt illlilliu' ..ultl,r lIIonllg
~'n'lag" ell \"illllall('l1l1l1\ \\'h('n' du' \1:\ 111'11 It il'lll~ an" ~lorh"~liL This i~ in ("olllra.'1111 (:011('11,
~1.liC'l. S, h\\';tl"ll, .IIHI \\'hil( IlIlIh (1 qHli. (:h;'pll'r f.) ill whirlt oh~('n'('d n'lIl1l1'i an' a'i'lIl11cd Ie, hc'
;, lillih' ..uult'l ~L\ pIC II I'" with 1l01l .. llIch;I'lic nlC'lIil"i"lIh, /\!though 0111' nOlltl.uling Ilion .... i..
11101(' g(III'r,lI. Ihc'il 0),"'1 \'('d 1"1'111111' 1)lIIIT:\~ ill( IlHlt,:\ a hid-;Isk .. prt"ad ("01111)(1111'111; 0111" dot'S




is three. As expected, if the security trades every period so that1T;

the mean anel variance of kl are zero.

=0, both

1IIIIIliraiions Jar individual Securily Rrlums

To see how nontrading can afTect the time-series properties of the observed
returns or individual securities, consider the moments of r;~ which, in turn.
depend on the mOlJlents of X'I(k).11I For the nontrading process (3.1.2)(.~.l.:{), the observed returns processes {r,~1 (i = I, ... , N) are covariancestationary with the following first anel second moments:






I -




I ".",

= j,


for i =1= j,


for i

fJ fJ


' J Of 1Tj


n > 0,


where o,t == Var[r;ll and

== Var[/tl.
From (3.1.9) and !3.1.10) it is clear that nonrradingdoes notafTectthe
mean of ohserved returns bill docs increase their variance ifLhe security has a
nonzero expected return. Moreover, (3.1.12) shows that having a nonzero
expected return induces negative serial correlation in individual security
returns at all leads and lags which decays geometrically. The intuition for
this phenomenon follows frolll the faClthat during nontrading periods the
oliserved return is zero and during trading periods the observed return
reverts back to its cumulated mean return, and this mean reversion yields
negative serial correlation. When Il;=O, there is no mean reversion h<;nce
no llt'galive serial correlation in this case.

Mllximal S/mrious AuloforTelalion

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 first-order alllocorrelatioll and leave the higher-order cases to
the reader.
IIITo ("OIlM'I"\'(" span'. w(" sllllIl1Iaril.t'

( I !)!)O". I !)!)O("j I.... fllrtl ... r d.I;liI .

lht' rt'MIIt~ ht'rt and n:ft'T

rt"adt"n 10

l.u and MacKinlay


3. Market Miovslmrlurr

Under (3.1.2)-(3.1.3) the minimulII first-<Jrder autocorrelation of the

observed returns process Irj~l with respect to nontrading probahilities IT, is
given by

M In Corr l
where ~j



- (I~il)
I + v21~;1

== J1.;!ai. and the minimum is attained at

IT i = : : '

Over all values of 11"; E [0, I) and


+ ./21~,1

~i E (-00, +(0),

Inf Corr[r,~, r~+IJ


we have

= -;-.


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 nontrading-induced 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 longer-horizon 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 coarser-sampled
returns may be developed. We shall postponc further discussion of this and
olher isslles of time aggrcgation ulltillatcr ill this sectioll.

AS)'lIlmrlr1C CroH-A UIOfOlIar1anrrJ

Se\'eral olher important empirical illlplications of this nontrading lIlodd
are captured by (3.1.11). In particular. the sign of the cross-autoc()\'ariallct's

J. l.


NUIIS.yndlHJ/UIll.I 'J/1UliIlK

is deterJllined by the sign of /1,/1,. Also, the expression is nol symmctric

with respcct to i and j: If 7r;
0 and 7r} of 0, thcn there is spuriolls crossall tocovariance betwcen r;~ alld 1';; III but 110 lTOSS-;llItO("llVariance hetweell




for allY


0. 11 The intuitioll for this reslilt is simple: Whcn

j exhibils nOlllrading, the relurns to a constantly trading securilY i

call forecasl j due to Ihe common f;tctor it prcsent in hoth Ieturns. That
j exhibits nontrading implics that future obs('J"ved retllrns 1';;+11 will he a


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 cross-scClional 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) =


(I - lli)( I - ll,)




hy defillition

Ii, Ii (J~/ Jr"



Ir Ihe lion trading probabilities ll, differ across securities, 1'/1 is asymmetric.
From (3.1.17) il is cvidel1llhat


Therefore relalivc nontrading probabilities lIlay be eSlimatcd directly using

sam pic autocovariances n' To derive estimates uf lhe prohahililics 7ri thelllselves we Ileed only estimalc olle SIIl"h probability, say lli. <lnd the remaining
probabilities may he obtained fmln the ratios (:).1.18). A consistcnt estimalo\" of rr, is readily cunstructed with salllple IIIcans and ;llItol"ovarial\(:cs via

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


ret\lrns of allother ha~ lW('1I ))IOpo.... ((l ulldel'


diflt'n'nl glli.'\(' ill Sims


/1Il/,limlio/H jill' I'orlfolio Ul'llIT/I.I

Suppose securities are ~rouped hy their Ilontradillg prohahilities and eqllalweighted portll)lios are limlled hased on this grouping so that portfolio A
contai/ls N" set'llrities with idt'/lti("al /lolllrading prohahility TC", a/ld similarly
lill' pOrlli)lio Il. Iknott' hy ';~I and I~'I the ohserved time-t returns on these t\l"1
pOrl/illios rt'SIIt't'ti\'t'i)" whit'h art' approximately averages of the individll; I



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 volatile-plausihle ,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 cross-sectiollal 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:


I', -\- (I -IT,)fl.





I:!.\ PIC"

IIlh'llHt'l,lIioll 01 ':', j, tilt, 1('lIl1"n 10


pC)lllolio whOM' \,;,111(' is (".1)( 111;11('(\ .1'

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


IIlllii I~'HH.

(I ~IH:\;t), (:halllhc'rI.,ill ;uHIH.Olh.'1 hilcl (I~IH:\). alld \\';lIlg

III tht,,,, wC';&k('r (1IlIcliliolh j" ~jmply lu alltl\Y tI I..IW of I.argt (\;tllllh('", 10

i"SSt'l". lUI ('X,I1I1I'''', (:h,tlllhc',I.,ill

(I!II.I:\). Th('

ht, applic'd


'" 'ht, nn,~

('."C'II( t'


;1\'c'l;tgl' III




di'llIl 11.11 liT.", ~o lia;1I .. itlio."ylH ..."ir .. j,~" \',lIIbht,S


\111 (,1\'

for K = a. b. 'n.e first and second moments of the' poruqlio!s'feturns are

then given by

E[r:/ ]
Cov[r:1' r: lh 1
Corr[r:l r:l+ n)

Cov [r:1' r:l+ n)

= E[r./]





1 +]'(.



fJ.2 - - ]'(.n aI'


7r,," ,

2 n
fJafJbal ]'(b'
1- ]'(a]'(b

n ~ 0



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




Na lEI,
11. +

= l1a + {Jalt + N Lfit






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 nontrading-induced autocorrelation (3.1.25) declines geometrically. observed portfolio returns follow a first-order 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 first-order
own-autocorrelation coefficients for the portfolio returns.

Comparing (3.1.26) to (3.U1) shows that the cross-autocovariance 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 lead-lag relations
empirically documented by Lo and MacKinlay (1988) in size-sorted portfo-




M(lJ"krt M;n'U.IIl'llrlll/l'

lios. Ratios of the cross-autocovariances /IIay be forllled to estimate relativc

nontrading proba~ities for portfolios, since
rllft 'i,l.. + 11 I
C~ov I"
Cov[ ri:J't 1'::'+11)





~ddition, for purposes of testing the ovcrall spedfication of the

I~a{iing 1lI0del,


these ratios give rise to many over-idelllifying restricliollS.



Y ,(n) y., (lI) Y K,(II)" Y" ,.,(11) y.,1.(lI)

Y.,a( n) Y , (11) Y.,K, (II) ... YK,., __ , (II) Yb., (1/)





for 6ny arbitrary sequence of distinct indices KI. K2 . K,. !l -I b. r ::: N,,,
N" is the number or distinct )lOrti()lios and YK< I (11) == Cov[r"/. ,.u1<" ," n I.

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~discrete-tillle 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 coarser-sampled 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 T-time is equivalent to q units of I-lime. tlIlIS:


Then under the nontrading process (3.1.2)-(3.1.3), it can he shown Illal

the time-aggregated observed retllrns )ll'Occsses (r;;(q)} (i = I ..... N) arc
covariance-stationary with the following first and second lIloments (s('e I.\l
and MacKiIl!ay [1990a]):




'2 IT ;(\

IT ()


+ (\ _ rrY 11;


3. 1. NOIlJy"dmmuu.\. 'li"fUlillg

= -J1~ ITII/

Cord r;; ('I), r:; ll/(q) 1


(I I -

" > (I


~;( I - IT?)~lT,I/'i 'il I

I -



- ------------



i of




> 0,

I(;/Oi as hefore.

Altho\lf!;h expected relllrns tilll<'-af!;f!;regate linearly, (:1.1.:13) shows that

\';Iriances do nol. As a result of the negative snial correlatioll in r;;. the
\'<lri;IlICe of a slim i~ less than the Slllll of thl' v;UiaIH'l's. Tillie aggregation
docs not .\ffect the sign or the ;tutocorreLitiolls ill CI.I.:I:) although their
Illagnitll<les do decline wilh the af!;gregatioll val Ill' 1/. As ill (3.1.12), the autocorrelation or time-aggregated retllrns is a nonpositive continuous functiou
(l('lT, Oil {O, I) which is l,ero 'It IT, (I .111(1 appnl<lrJlcs 1.\'1'0 .IS ITi 'Ipproadws
unil),. and hClll'e it atuins a minilllulII.
To explorc the behavior of thc lirst-onlcr '1I1l0(,OITl'i;lIion, wc plot it as
;1 fllllCiioli of IT, in Figurc 3.1 \'UI' a variely o\' values 01''1 and ~: ,!takcs on lhl'
"allll's :), 22, (iG, alld 244 to correspolld to wcckly, lIIollthly, qllarterly, and
;\llIlII;J1 retllrns, respectively. since,! = I is takclI to he OIlC day, alld ~ takcs
on Ihl' val lies O.O~), O.lli, and O.211() rOlTcspond til <I.lily, wcekly, alH\lIlolllhly
I'Cllll'lIS, respeclively. H Figure :1.1 a plots tlte 111'st-0I dn autocorrelation Pt (f!)
J()l' the fOllr values of q with ~ == 0.09. The clirve lIIarked "q = !,, shows that
the \\'eekly Iirst-onlcr autocorrelatioll illduc('(\ hy 1IOIIIIatlillg II ever ('xn'ctls
-5(}I, alld ollly attains that vahl(' with a daily 1I0ntr;Hling prolJ<lhility ill CXtTS~


Although the alltocorrelatioll of coarser-sampled retllrns sllch as

IlJolllllly or quarterly have lIIore extrelllc minima, they ;\IT ;lltailled ollly
at highcr nOlltrading probabilities. Also, tillle-aggregalioll Ilced 1I0t always
yidd a lIlore lIegative autocorrc\atioll, as is apparclll frolll the portioll of
Ihe graphs to the left of, say, IT = .HI); in that I cgiolJ, all increase ill thc
aggr('g;ltiulI \'.lIl1e '/ leads to all alltllcorrcl;lIioll dosn to l(,I'O. IlIde(~d as If
ill(Tt';lSl'S without hOlilld the .1l11ocond;ttioll CI.I.:I;I) approaches I.cm for
fixcd IT,, alld thus Ilolltradillf!; has lill1c illlpatt Oil IOIlf!;('I'-hOlilOIl returns.
1"Vaill(" lor ~ well' ohl.!illl'li hy takillg lIlt' I'.,lio "lllIe ',lIl1pie IIl('alllo Ihe ,alllple .\[;)1111.11<1
d('\'ialioll for d"ily, w('l'kly, alld monlhly ('qnal-w('I~IIIl'd
I'eltll,,, i"dex .... lor Iltl' .ample
period h'lll" 1~1t;:L 10 1\IK7 '" rl'pOI'Il't\ in 1.11 a"d ~1."Kinl,,y (I\IKK, L,hl., L,-i). Allhongh


tIH',\(' \,;llll(,~ 111.1)' he ilion' l('pn'S('n,ali\'(' of .,Ior)..

w'n'\ tlwl{'~~ lor



illCltx('.\ I;lill("

of illu~trtuiul1 "u'Y ~honld :-oullic (',

11t.11I IIlfli\'idll.t1 .... l'("Ilfili(.~.

/'/ V.


~ "~





1IIIIp' ...... '"\




















I" <











t u-


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 short-horizon stock returns is negligible.


Time Aggregation For Porlfolios

Similar time-aggregated analytical results can be derived for observed portfolio returns. Denote by r;, (q) the observed return of portfolio A at time r
where one unit of I-time is equivalent to q units of I-time; thus

r:r(q) -





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 covariance-5tationary
with the following first and second moments as N. and Nb increase without

E[ r:, (q)]

Var[r:, (q)]

Cov[r:,(q), r:,+n(q)]



[ 2rrK I-rr!]
I_rr K 13 22
[I -rr!r

K al

nq-q+ 1 f32

Corr[ r:,(q), r:r+ .. (q)]


Cov[ T,:r(q),

(l - rr!)2 rr;q-q+1

q(l -

rr;) - 2rrK

(l - rr!) ,

T ,+II(q)]






n > 0

al ,




nq - q+1


f3 f3 a 2


n == 0


n > 0


Ii, q > 1, and arbitrary portfolios a, h, and time r.


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/lle-a!{~reg-ated 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 Fig-me :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 nontrading-induced serial dependence
ill portfolio relurns. This implies thaI we .Ire lIIostlikely to lind evidcllfc of
non trading in short-horizon returns. We exploit both these illlplicatiolls ill
Ihe empirical analysis of SeCiioli :1.4.1.
3.1. 2 l~xlensions and GPIleraliwlions

Despite the simplicity of the model of Ilonsynchronous lradill~ in Se(!ion

3.1.1. its implications luI' ohs('I"vcd tillle series arc surprisingly rkh. The
framework can bc cxtcnded and gencralized in many directions with lillie
It is a simple mailer to relax the assulllption lhat individual virllt.tI rclurn;lare lID by allowing Ihe COIllIltOIl faclOt 10 be attLOcolTclaled allel the
diSH! "bances to be cross-sectionally correlaled. For example, allowill~ ji
to he a stationary AR( 1) is conceptll,tlly strai~htr()rward. although the t'alclllatilOns become somcwhat lIIore involved. This specification will yield a
dcco61position of observcd <\utocorrclations into two componenls: one due
10 thJ COlllmon factor and anothcr dlle to 1I01l1ladill~.
Mlowing cross-section'll dependence in Ihe disturbanc'es also nllllplicates lthc momenl calculations hilt docs not crcate allY intrartahiliti('s.I~.
Indeed, generalizations 10 lIIuhiplc l;tctors. lime-series depcndence of the
diSIlIlI><I1lCCS. and correlatioll hetweeni;lctors and di.~LUrbances arc only lilllited h thc palicllce and perst'wranl'l' of the rt~adcr; the lIecessary lIlotnelll
(alcul t(iolls arc not intranablt" hilt lucrdy Itdious.
1> 'pelldcncc Gin he built into Ihe nontrading process itsclfhy asslllltin~
thattl e O,l'S arc Markov dlains, so II1<1ttl1(' conditional probability of Iradillg

tli.'nl~.,,(d (';U1it'l, ,OIlU" Itll III (II t rO~.'~l"t licltl.tl wc.".,}.;, dCptl1th-lIet 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 \\TH--i;\\\\\ ... 1tltl\ punt'oHo ....

3,2, '/'Ill' Hid-fbI! Sf/mid


tOll\orrow dqwllds 011 whellwl' 01' lIot ~I trad~' o<"nll'S tod"y, Ahl\()ugh this
specificatioll docs adlllit cOlllpact and cI('g~1I1i ('xpressions Ill!' the lIlonJents
of the obsel'ved r('tUI'IIS proccss, w(' shaillcave their derivalion to the rl'ael('1'
(Sl'(' Problelll :t:I), However, a bl'i('f slIlllm.II'Y of thc illlplications for the
lillle-snies properties or observed Idlll"\lS lIIay lit' worthwhile: (I) Individual SCCIII'ity retums lIIay he positively '1l1t()cond;ltcd and ponfolio IClllrns
ilia), be nq~alively aUlocol'l'c\alcd, hUl these possibilities arc unlikely given
empirically relevant paf'alllctcl' valucs; (2) It is possible, but IInlikely, 1(,1'
autocorrelation matrices to be sYlllllletric; alltl C\) 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'
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(orfllalioll-hased 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)'matioll-i>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,

3.2 The Bid-Ask Spread

011(' or Ihe mosl important charac\el istics th;1I ill\'('stors look for in all 0)'g;llli,,'(\ lill;\nri.d nlarket is li(plitiity. till' ;dJilitv to hili' \)\' ,ell significlIIt


good iltll~tr.Hi()m. of tl\t kind til

Il,Hhng hell.I\I(1I 111.lI (.111 .lIi\"

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 hid-ask spread I'" - Ph is
rardy larger thall (HIl' or two ticks-the N}'SI'; Fad /look: lCJIJ.I /)ala reports
Ihat the slHl'ad was $0.'2:) or Il'ss in 90.Kt;:, of the NYSE hid-ask qllott's frolll
I~)\H-o\'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' lillie-series 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!' hid-ask spre;ul arc inl'illckd, Blllme
alld Slalllhallgh (I!)l-tl) argll(' Ihal the hid-ask 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 so-called./fll/1/my
('frl'n-Ihe f;Il'1 Ihal slllalln-capil.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' hid-ask 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 lowcr-priced stocks for which Ihe /lI'rrPlllagl' hicjask
spreael is larg{'r. Sillce low-priced 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' hid-ask 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
hid-In-hid, as);-lo-hid, ('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}C-IU1.11 .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~~

J. Q..l Bid-Ask Bounce

To account for the impact of the bid-ask spread on the time-series prop~rties
of asset returns, Roll (1984) proposes the following simple model. Denote
the time-/ fundamental value of a security in a frictionless econ~my,
and denote by s the bid-ask spread (see Glosten and Milgrom [1985~, for
example). Theil the observed market price PI may be written as





+ 11-2

lID {+I

with probability ~ (buyer-initiated)

with probability ~ (seller-initiated)


where II is an order-type indicator variable, indicating whether the

tion at time t is at the ask (buyer-initiated) or at the bid (seller-initiated)
price. The assumption that
is the fundamental value of the security
implies that E(Itl == 0, hence Pr(/I=l) == Pr(/I== - 1)
~. Assume for
the lIIoment that there are no changes in the fundamentals oftl}e security;
hence P; = P' is fixed through time. Then the process for price changes'
t. PI is given hy



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 ,



Cov[ t.PI _ k


Corr[ t.PI _ 1

t.PI J ==




k > 1



Despite the fact that fundamental value P; is fixed, 6.PI exhibits volatility
and negative serial correlation as the result of bid-ask 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


J. Markd ,HirTU.s/rurturr

applies more generally to cases where the order-type 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 first-onkr autocorrelation remains constant at Observe from (3.2.0) that the bid-ask
spread docs not induce any higher-order 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 first-order 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


< O.

Although (3.25) shows that a given spread.l implies a first-order 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',] ,


hen(e s may he easily estilllated frolll the sample autocovariances of price

cha~ges (see the discussion in Section 3.4.2 regarding the empiric;!1 illlplemcn'lation of (3.2.9) for further details).
l:stimating the bid-ask spread lIIay seelll superfluous given the 1;l('t th;lt
bid-+k quotes are observable. Ilowever, Roll (1984) argucs that tile (I'loted
spre~d may often differ from the 1Jerliue spread, i.e., the spread between
the lual market prices of a sell order and a buy order, In many installces,
trans clions occur at prices wi/hin the bid-ask spread, perhaps hecause Illarketm kers do nol always update their quotes in a timely fashion, or hecause
they ish to rebalance their own inventory and are willing to "beller" their
quot s momentarily to achieve this goal, or because they <Ire willing to provide liscollnts to customers th,lt are trading for reasons other than private
inforlnation (see Eikeboolll [1993], Gloslen anc! Milgrom l19H:, 1, Goldstein
119931, and the discussion in the next section for further details), Roll's
(19R4) model is one measure ol'this cfkctiv(' spread, anel is also a means I(JI'
I~}'or example, scrial (orrdatioll ill I, (of ,ill\("1" ,i)(lI) do(" 1I0t chall)(" th,' Ian th,l! J,ida~k

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 ~hnn-hnril.()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.


3.2. Thl' fJ/d-A\k ,\/Jrl'a{/

accountillg fill' the

or asset returns.



of the hid-ask sprcad on the tillie-series properties


o!tlu/Jid-A,/i S/I/md

Although Roll's lIIodel of the bid-ask 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 hid-ask 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 adverse-selcction
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 bid-ask spread Illay bc vicwcd
as cOllJpensalion for taking the otller side of potcnti;il inforlllation-based
tr;\{!cs. Bccause this information COlllp'1I1enl can have very different stalistical properties from the order-processing ;\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'ic-ill ['onllatiol\ Illodel that captures the saliellt fe'lIllres or adverse sdertion fiJI' the COlllj)()nCllts or [he
bid-ask 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).




(;!t1l11'1I \ JIt'/mll/iII,1 1/1" "

Ikllott' Ill' /'" alld /'" 11)(" hid allc\ ask prices. respe('(ivdy. allc\ It,t /' Ill' the
"11'111''' or 1'/111/ 11/11/1111/0/,11//11 iOIl lll;lI"kl't price. t he price t hat all invest ors ,\'i t hout private intilllll;lIioll (1IIIill/(m/ll'l/ investors) ap;rel' "pOIl. Under risknl'lItrality. till' (,Olllllloll-int'lrlllatioll price is p;ivclI by J' == E[/"ISl] ",here
n c\I'noll's Ihl' ('0111111011 or pllhli(' illtill'lllatioll set alld I"~ tIl'lIot('S tlle price
thaI wOllld reslilt if l'VI'I)'Olle had access to all informalioll. TIll' hid ami ask
prices llIay thl'1I Ill' e"pressed ;IS the fol\owillp; sums:

[' - 1\" - Ct.

[' + ;1" -I-




/'" - ['" = (..I"

+ Ad + (COl + C,,),



",line A"+A,, is the ac\verse-selection component or thl' spreatl. til Ill' 11t-le!'lnilll'd !wlo\\', allli ('>1-(;" illtllllil's Ihe onlcr-procl'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'lllatioll-I\\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



1':[ I"~

Sl U I illveslor hllys ;It

r[ I"~

Q U {

xl ]

inwstor st'lls at )'}


'\11 alld ",. art' Ihl'lI ).\ivl'lI hy lilt' follolVillp; rt'laliolls:

il., '"

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('('



//( [',,) + (:"

I',. ==

['(/'J,) ...

:.''!S~'( ,\lIIilllui



[' + (,,(/',,)- I') + COl

= /'

+ '\" + (.~,

CI, -- /_([ .. f,(I'J,))-Ci. = /'-A"-C,,.

!\kllci('I,tlll ( P);-J.O); (:lIh(,lI. T\.LIit" r, Sdlh'.lrt/. ,11111 \\'1111('01111.

aucl Sloll (I!IHI); ,lfld ."iloll 'I~J7H) Itll lIuldl'" 01 these co .. I.\.


I Ii)

(I ~)H 11; 110


J.2. The Bid-Ask Spread

An immediate implication of (3.2.16) and (3.2.17) is that only a portion of

the total spread, Cn+Ch, covers the basic costs of marketmaking, so that
the quoted spread An+Ab+Ca+Cb can be larger than Stoll's (1985) Mef_
fective" spread-the spread between purchase and sale prices that ~cur
strictly within the quoted bid-ask spread-the dilTerence being the adverseselection component A,,+Ab. This accords well with the common practice
of marketmakers giving certain customers a beller price than the q\loted
bid or ask on certain occasions, presumably because these customers are
perceived to be trading for reasons other than private infoonation, e.g.,
liquidity needs, index-portfolio rebalancing, etc.

Im/liiwlio1l5 Jor Transaction Prices

To derive the impact of these two components on transaction prices, denote
the price at which the 11th transaction is consummated, and let i



= Pal" + Pbh.


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




E[I'Ir2 U All" + E[P"Ir2 U B1h + Cala - Cbh


1'.. + C.. Q,.


E[plr2 U AlIa + E[P"Ir2 U B1h

(3.2.21 )

ell -


if buyer-initiated trade


if seller-initiated trade


{ +1


if buyer-initiated trade


if seller-initiated 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



= E[AIPl


A:; {

if Q,.

== +1

if Q,.=-l.


That I'" ,\Ild Q,. mllst be correlated follows from the existence of adverse
selectioll. If Q,.= + I, the possibility that the buyer-initiated trade is informalioll-hased will cause an upward revision in P, and for the same reason,


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 adverse-selection 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 n-I and n. Then the nth transactioll price may be wrillell as

1'" == 1',,_1


+ t" + A"Q".

Taki/lg the first difference of (:~.~.~O) then yields





+ ((;"Q" -

(;,,_1 Q,,-I),

whiejl shows thattrallsaction price changes are comprised of a gross-profils

com mnent which, like Roll's (1984) model of the bid-ask spread, exhihilS
reverlsals, and an adverse-selection componelll that tends to be permanent.
The;fore, Glosten's allrii>utioll or the effective spread to the gross-profits
com onerit is not coincidental, hilt well-JIlotivated by the fact that it is
this omponent that induces negative serial correlation in returns, nol the
advc se-sclection component. Accordingly, Glosten (1987) provides alternativf relations between spreads and return covariances which incorporate
this d,stinction between the adverse-selection and gross-profiL~ compollents.
In pa~ticular, under certain simplifying assulJlptions Glostell shows thal~:l


= U(I + yfJ),

Cov( lit-I,


1 == -





y -

C+A '

fJ -

and where [4, Il, arc the per-period market and true returns, respectively,
and 7. is the continuously cOlllpoullded pcr-pcrio(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 bid-ask spread. Whether or not the adverse-selectioll
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~.

J. J. Mudrlill/i '1l"tlllSartiulls Data


("()lllpOllell! i~ ('collomically important is largely all t'mpirical issue that has

yet to be detCl"mined decisively/ I neverthelcss (;Iostcil 's (I !IH7) model shows
that advcrse seicrlion call have very dilli-n'llt ililplicatiolls lill' the statistical
properties of trallsauions data than other COmpOII('IJls of the hid-ask spread.

3,3 Modeling Transactions Datil

Olle of Ihe most exLiting recent developments ill clilpirical linance is tlw
avaibhility oj" low-cost tm/l.\tlctioll.l datab<lses: historical pi ices, quantities,
hid-a~k quoles and sizes, and associated markct cOllditions, transaction by
transaction and tillie-stamped to the 1\(",II"('st sccolld. For example, the
:--JYSE's Trades and Quotes (TAQ) dalahasc contaills all equity lI'allsactions
reported Oil the CUIlJulidated n/I,r from I !)!)2 to the presenl, which includes
alii rans<lnions on the NYSI':, AM EX, NASDAQ, and III(' regjollal exchange~.
Tht l\erkelcy Optiolls Database provides silllil<lr "al,1 f()r options transa("I:ons, <lnd tr<lns<lctions databases for lIIallY other securities alld markeL~ are
being developed as interest in market mirrostructure issucs continues to
The advent ofslIch transactions datahases has given linancial economists
Ille Illeans to ,uldrcss a variety of issucs SlliTOUIUlillg IiiI' linc stl"ll("\lII"(, oj"
the tradillg process or I'ricr di.ICOlJI'I)". For ('xampl(', what ,lie detnmillants
of the bid-ask spread, <lIld is adversc sclc('\ion a ilIOn' important bllor Ihan
invelltory costs in explaining lIIarketmaking hehavior?~" Does the vcry act
of Iradillg lIIove prices, alld if so, how I,ll gc is this II/-irl' ill//,ad d fen alld how
does it vary with the size of the trade?~o; Why do prices tClld 10 bll more
oftell or: whole-dollar multiples than on hall~dollar multiples, morc often
OIl h~Il[-dollar multiples than on quartcr-dollar multiples, etc.?~7 What arc
the benefits aIld cosL~ of other aspects o[ a market's microstructure, such as
margin requirements, the degree of competition faced hy (-alers, the freqllency tliat orders arc cleared, aIld intra(lay volatility?~H Although nOlle of
:!01 RccC1l1 iHt(,lI1pl~ to qualltlfy the .dativl" ("(Hili ihlltions ofordcr.pron~s~iIlK/iI1Y(~nt(}ry r():'iL~
and ad,~IS" ,cit'dion CU,L\ to the ui<.l-ask 'pre,,,1 in(iUlit-: Allkrk-Grav"., 11t-)(<.Ie, ami Miller
(l!J!J4), GI",t"n and lIarris (1!J!!!!),Georl(e, "'",I, and Nilllal<"lIdrdll (I\I!JI), IIl1allg and Stoll
(I !J\15a). alld Sloll (I \I!!\J). Set' Section ~.4.2 f()r fllnher disUl"ioll.
l';Sl"e Alllihlld and M<"lIddsoll (I!J!!O), lIa~<"hot (1!J71), (;01'<"1,11,,1 and (;alai (19H~), lkmsell (1!Jti!!), Easkyand O'llard (I!JH7), (;lost<"11 (1\IH7), (ao""11 alld lI,mi, (19HH), (;IOMt'lI
and Mil~roll1 (I\IH;.), 110 alld Stoll (I\IH I), SIOII (1\17H, 1\11\\1). alld Tilli\ (I \17:1).
"I;See 11<"1 L,illl;1S and 1.0 (1!J!JIi), Chan ,II1d Llkoni,hok (1'1\1:\1>. 1\19:, and K"im ali(I Madhd'<l1l (1\I\I:)a.i>.I!J\!t;).
27S<"e llolli. 'lillOIlS, and 'l,cho{'~1 (I\IW): ehri.,li<". Il.llri,. ,11111 Sdillitl (I!J\H); Chr;"i,'
alld Scltllitl (1!J\11); (;oodhan and Cllrdo (1\1\10); f ian i., (1\1\11); Nied{'lholkr (IV!;:), IV!;(;);

Nied('rholll'1" illld (hhonu.' ( I ~JlHi); and ()~hor rH' ( I ~Hi'l).

'!HS Cl' <:oluol1, M;li("r, Schwart/.. and Whilnuuh (1!IH{i), ILIII i.\. Sofiallo" .1IIe1 Slhlpilo (1!'c),O,

11,lSl>rolirk (I \)\)1,1. h). Madhavan alld Sillidl (I \1\)1). ,11111 SlolI .tIId II'h,lh'y (1'1\10).


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('. Bid-ask 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.


>. I


Trallsat'liollS dal;t POSI' a 11I1I1I1H'r of IIlIic]!l!' ('COIIOIlIt'lric challl'lIgl's thaI

do 1101 ('asil), Iii illio IIII' frolllH'work w(' have d('l'cloped so 1;11'. For 1')(:1111ph', t .. ans;tl'lioll' (lat<l <In' '<lmplt-,! at ilTl')::u!arly span'" rall,!olll illtl'rv;,hwhl'IIt'I't,,, tradl's e>l,\,lIr-alid Ihis pn'sl'lIls a nllml)('r of prohlems for stalld;tnl ('CllIlOltll'lric Iltockls: oilsl'rvations are IllIlikt'ly to 1)(' idl'lIlically disIrihllll'c\ (sillcl' SOItH' obs( 'rva Iiolts arc vcr)' doselyspaced i II Iillll' wh ilc 01 It crs
lIIay Ill' sql:uat('(1 hI' ltoUI SOl' davs), il is dil'flcIIlt to caplllH' scasollal !'Ifl'!'ls
(sllch as liItH'-ol:;I'I\ rl')!;lIlarili('s) wilh silllple indicator fllildiolts, all.! '/'('caslill)!; is 110 loltger a ~Irai)!;hll(.r\\'anl exercise Iwealls(' lite Iransaction t;il\l'S
an' ranclolll.
I\lso, Ir'lIIs:lI'lioll prin's are always qlloled in dis\Tell' units or lidonIITCn"" $0. I:!:. Ii,, I'qllilil's, $()'<)(;~:' fi,, eqllil)' oplions, $().W. for fllllll'CS
conlracts 011 Ihl' SI.lIId.llIl alldl'oor'.; :.00 index, $O.O:\I~:, fi.r liS Trea,nrv
hOllds alld I\OIt'S, al\tI sc> 1))1. \I\'hilt- t\wr" an' no II/Iliori 1\II'oJ'\,ticalIT:lsons
10 I'll'" 0111 COlllilllle,," pricl's, tIll' tralls;tclions coSIS associall'd wilh qllolillg and p\l)n'~sing slIl'h prin's 1Il<lk(' Ihl'lII highly illlpra(,li('al.~" ()f (OllrSI',
'.!"llt"pih' 11H' ilHli, i'lliilllil" 11i.1I


I"l( CO,"

1.11 ClIII\\'('igh 1111' IH1!I'IIII,aI

t' tli'in (I('IH"~!'o. Ih('rt, '('C'III' 10 lit' gellt'I.,)

.dil( dial tht dlie it'll( \' g.lill~ hU1I1

I Olllp.tll\ III it

.lgll'{'UWHI ,lIliCllIg c" 1111111111,1, .1I1t1 1'1.t( Iii II IlIc'1.'

n\h 01 illdid~ihlc.' Iradillg lOb.


IIOht\'C'r. ,Ill 1IIII"{',,,I\('(\

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' (h-l\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.




Transartioll.l /JII/a

Tabid. I.


SU71l71lmy j/lI/i~li(j Jor daily If/urns offive NY.'iE s/{)(/u.










I 29.()()()




























/JIIl tX



1'"", ('Yo)








a(l/) (%)


I.!i I



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:


C;lpi\al Citic...o;, Al\C; KAB = Kaneb St"rv1(es.

discreten('ss is less problematic for coarser-sampled data, which may be wellapproximated by a continuous-state 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 one-tick 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 three-year 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).




Mar/1ft Mi(/IJ.I/Illrllllf


(CCll), and Kaneb Services (KAll). The histogram for CBS is a paltiluljlrly good illustration of the classic price-clustering pallel'll: Prices lend
to'fall more frequently 011 whole-dollar multiples than on half-dollar IIlllltijlles, more frequently on half-dollars than on qllaner-dollars, and lIIore
fr quently on even eighths than on odd eighths. Price-cilistering 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 bid-ask 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 price-vari.lbility IIncler a ralldolll
walk model for prices), the discreteness of transaction returns will he less
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%).







:\1)11 . , - - - - - - - - -_ _- ' -_ _ _ _-,



r - r-



~ :!O!)






l ~l(1




















.~;,II .:\7;1 .!,IIH) .II:!;) .7!'IH ,M7;,

l'lll \. fl,\( ~I~II\ I\lr A1\<:







.J:!:. :!~,II .:\7;1 .;100



.7:,0 .M7!',






- 1
I',il" (.h,lIIgt tllt'k ... ) Itll ,\I'n

---.---- ..- - -_____


~ 1;10-



.1 'l.r, .:!!',,, .:i7!', . .r,Ot)

1'1111' 1-"1.\(111111





.7!,j) .K/.r,






iI'l <:BS

- - - . - - - _ _ __


:wo~ ~r,()

~ l~11I

~ 'LOO

;. :Wo


~ '~,Il











.:n;, .:,1111 .Ii:!!', .7;,1) .to!',

() -'Y-r-''r-.-''?-r9-r"Y-''''''''"T'9-,.-''i'-r"T'




FI.ltli'Iuiul <:(;1\



.'.!~ln .:n~,




.l '.!:,


.,;'.!~, .7~IH

1'111 (. h.lcU\)lIlol iV\B



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.


lidJ/(i""/"'I/'IJ'IIU,'" "/lll'il'( 1'/11,"/-:(.1 finlirk dlllll

"f/i"f . ,,,,in.










?: +4

,\,\( :













o.:\:! H.'II




I '1.~:1




( :IIS










(:( :1\








1.1i!} 05H






(1.1 Ii







O.t "


ltt-Luin' 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,.

"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( ks-K,\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'l-I',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;',
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 lower-pricl'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'\Toss-stllck 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' lown-pril'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" 2-hislOI 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'-



.rt /

i ./." , '
I ", - ",.. '\


! .: ",

.~ "'~

,;< 1;-'--




'.-- :~ t ~:.':"':';


; .~.-.-.---~~-----,~.~-~- , .......

_..... : '._--'.



. .

2-Hi.tory of AAC Remrn.,




....... --

P = $~B5!1


... .... -......





...... -- :

f> = $55,878

2-History of APD Return.,




. ....... - .....

f> = $17S.924

2-Hi.tory ofCSS Returns,

I; ,.::f5~~s~~;::>




...... -- :

2-Hi.tory of CCB Return.,







1 ~~-"'"-':.A"'~~.-;'-u.-



.. '-....



P= $467,844


Figure 3.3_
III J)frnllbrr



2-Hhtory of KAB Return.,





........ -- :

f> = $4.665

2-J/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 higher-priced 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 2-histories, see Crack
ancll.ecloit (1996).


3. Markrl Miov,llrul'lwl'

These empirical observations have motivated several explicit models or

rice discreteness, and we shall discnss the strengths ;md weaknesses of each
of these models in the followinl{ sections.
3.3.2 Uoundillg and /Jamer Models

ever;il models of price discreteness begin with a "truc" uut unobserved

cplltinuous-slatc price process PI' and obtain the observed price process 1';'
by discretizing 1'1 ill some fashion (sec, for example, Ball [1988), Cho and
Frees [1988J, and Gottlieb and Kalay [1985 J). Allhough this may be a convenient starling point, the usc ofthe term "true" price for the continuous-stale
price process in this literalllre is an unfortunate choice of terminology-it
implies that the discrete observed price is an approximation to the tme price
whell, in fact, the reverse is true: continllous-state models are approximations to actual market prices which arc discrete, When the approximation
errors inherent ill (,OlltillllOlIS-SI<llc Illodels arc neglected, this call yield misIcilding inferences, especially for transactiolls data. n
Rounding Errors
To formalize this notion of approximation error, denote by X, the gross
return of the continuous-state process PI between I-I and I, i.e., XI ==
I'd PI_I' Wc shall measure the impact of discreteness by comparing XI to
the gross returns process X," =- P," 11';_1 corresponding to a discretized price
process P,".
The most common mcthod of discretizing PI is to round it to a lIlultiple
of d, the minimum price variation increment. To formalize this, we shall
require the floor and ceiling functions


greatest integer < x


least integer

(!Ioor functioll)
(ceiling function),


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!' magnitude-hut 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),


3.3. ModrlinK '/ImllafliollJ iJatll

(3.3.4 )

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 continuouS-Slate 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 continuous-state 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

--- <


-- <




Subtracting x/y from (3.3.6) then yields

ly J



y(v --



which implies the inequality


-I Max

- - - , I ].


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:
where 0,_1 == til P,_I is defined to be the K'rid .Iizr at tillle t-I.
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 worst-rase 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' highn-priccd stocks, sillce
I, is all ill('J'l'asing fliJIlIiOIl or o( , aJld, thercforc, a dccrcasillg funclion


(If /', "

II is illlporl~11I1 10 "('('P ill nlind thaI (3.:t!l) is ollly an IIpp!'r hO\llld,
,\111\ while il dol'S I" oviel(' a II lI'aSIlrl' of Iht' Ill(Jn/-flI\e disl'l't'palll'y h('I\\'I'(,11
Il, alld U;', il is 1101 a IIwasur!' of lite discf('P<lIIl:y itsl'lf.:11 This dislillc(l()1I is
I)('sl IIl1der,IOl .. lllv grappling wilh l\1e Etn Ihat Ihl' I'XP!'CIt'd lIpper hO\llld
El/.I X" iii_I 118, I I is all increasillg rUIIl'lion ol'lhe lIlean alld varianc!' of X,the large)' lite eXpl'l'll'd n'llIl'J\ alld volatility, the large\' is the average value of
thc upper houlld, This SIT IllS paradoxical becallsc it is gcn(,rally presulIlcd
that dislTl,tl'lIl'SS is less prohlemalic Ii II' longer-horillln reI urns, bill these
havc highl'r Jlll'allS allc! variancl's hy cOllslruction. The paradox is readily
resolvt'll bv obsnvillg tllal although Ihe I'xpccted IIppl'r hound incrcascs
as thl' IIll'all ;lIId v;tri;tll(,(, ill\T!'asl', tht, probabilily lIlass of IH;' - Uti IIcar
thl' upper hound may al'lnally declinc. Therefore, althongh thl' expected
worsl-cast' disn!'f)alll'\' ill('l't'ascs \\'ilh Ihe lIlean allel variall<'t', IIll' prohahililY
that snrh dislTl'palll'il's arc rl'alill'd is smaller. Also, as wc shall sec hl'lo\\',
Ihe \'''(>I'I'l<'d ltpP('" boltlld S,"'IllS to Ilt' relatively illsl'lIs;I;\,(' 10 cIiallg(" ;11
Ill<' lIIeal\ ;1Ilt! vari'lIln' or x,. so lIial whl'lI measllred as a IH'rn'l\lage or till'
('XIIl'CIl'd 1'1'1111'111-:1 X,I. Ihl' n:pl'I'lt'd IIp(lt\' hOllnd dol'S declinl' for IOllge\,horizon retllrns.
I\y sp!'firyillg a pallicl1iar proCI'SS fi,r /'" \\Ie call ('valllate the expl'q~llillll
of /.(.) 10 dl'velop sonll' Sl'nSl' lill' the lIIagnitlldes of !'xpeflec\ diSlTl'l!'IICSS
hias E[ln;' - Udllhal an' possihk, For example, kt /', filllo\\l a gl'olw'lric
randol\l walk wilh drift /1 alld diffllsion fO!'Ili!'i!'''1 a so lhat log 1',/ /'(-1 arc
III> nonnal randoll\ variahles wilh IIl('all /1 ant! variance n~. III litis fas!', W!'

1':[ /.( rI, .\"



I /'(

_8_ {

I ]


'4 (I> (


log( 1-8) - /1

) 1,


wit!'r!' cfJ() is Ihl' 1I01illai CDF,'I"

lid ,Ii ....... ')'. hll\ il is '"1'1" isill~lv dimr"l, ,.. tin
','c'lIl(' cli,,'I1~!'\ioll heluw n.~."<li"~ 'Iw llH1Hding ,tlHI

:111''''011''', w, \..ollitt lik .. '0,11.11 ... I'" ill' III;' -,

~ow11h .\H~' ''''gu'''


gC'lIt'1 .ili1)',


',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". IWIn-tTI! rs.:~.II) ;11111 11i(' Hlack-Srholts ('all-uplioll pfidll~ 101"l1l1l1a.

h.1I1 in lIIo,ld'-IIIUI('I
01 fht tlisnc'h'IH'!'\'


3. J. Moddillg TransurtionJ Data

Tahles 3.3a-c report numerical values of (3.3.9) for price levels Pr-I =
$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

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 3.3a-c and the common intuition tliat
discreteness has less of an impact on higher-priced 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 return-horizon
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 rcturn-horizon.
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 continuous-State
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

(stimator of a, converging in probability to /E[(Iog ~+I

log P,')2] rather

than to jE((Iog PI +1 -log PI )2] Moreover, it can be shown that will be

an oVfTestimate of a in thc prcscnce of pricc-discreteness (see Ball [1988,
Tablc I] and Gottlieb and Kalay [1985, Table I] for approximate magnitudes
of this upward bias). nail (1988), eho and Frees (1988), Gottlieb and Kalay
Thi, is 110 acridc"l. sillce Max (X,. I-Ii) ",ay be rewrillen as Max( XI - (J -Ii), 01 + J -Ii; hence
Ih,' "pP"r houlld Illay h....... 'L'I as Ih,payolf of a call oJllion on XI wilh slrike price J.

Table J.Ja.




.. = ~O%

,= 40%



















O. 12{j~










= r,O'Yt,




F.xl'frifd 1I/11'fT bOlilUt. fllr tii.mrlf//(ss him: daily l'flllll"


._"_.. -._--








PI-I = $50

1"_1 = $100

I~_I = $200








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 w-dlk 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.

!',. I


I,'x/lfflnl 1I/'I1t',./1II1I1II1.,

= IWX,

.\ =



== $1






.1 ~.,



- .. __ .


I',. I ':"_$_:,____




__ ._ ..


.------ - -



ILld 17



h;m.' /I/lII,lhly,I'II1I71.I.

_." .. _-_.... -----

1I.I'!!1 !I


1m ";11.,,-11'//1'.11




_ - ..- - -

2.li:,O I














































O. I 2%







0.1 :m!i




















= $:.0

1',.1 = $100


1".1 = $~~12. ___






0.1 :{I:.


-------- _._--- -------




11.1 :~IIH
11.1 :\0<)
11.1 :111

II. Oi;r,(j


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

1"<: .... (.II('cI (0

d = O,I~:)"lI(

tI .... l'd

JIIatch mOl/lh~)d.If;t.


Il/I~. n/JI"":!. 1>1'.( I (II,,d IHi(c . . I};' == If'(/dJd.

loralrulalc r('tlInl\ U;':, (/';'/I',"' 1) - I

'Ii/MI' J. k


1~.\/.,.tll'd 11/1/11'1 Ilfl/lllt/Ijill t1iv/,rlr//I.1I

I'" :.'1l'Y"

1. == $1



.IO 'Y"

}".I .::'. $:.



2.'11 W.







o.:l:d H



I~'_I_==- S~ UU
I (}(){.






(1.1,12 I
0.1:,) 7


/' 1 = $21111





















.. ---




:1. I li1-!

- - - - -------O.I1Ii:l


- - - - - - - - ---H.I !l'l"l
O.lIi I 7
0.1 Ii?:!

_.- --

1I.07 r ,x



O.O!I:, 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';'.

Fxl'(" Ic'd



-------.--- .".-------"----lI.mlll



\ ==

= $:.11


== .1f)'Yc,


_____ - - - - -



== :10%

/11/1111111 Iflllrl/.I.


:.' 1.I:.'Hli

1:. 7:.'W.






I~UH'''''' \,.,l~

I' -


3.3. Modfiin~ TranJ(l(/iu7Is /)a/a

( 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 continuous-state
"true" price process 1', is also a continuous-time 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 first-passage 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

f/. (_1 ,I+d ) } .



Therefore, according to their model a stock which has just traded at time
Til_I at $10.000 a share will tracle next at time Tn when the unohserved
cOlltinuolls-state gross returns process Pt/$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

This process captures price-rliscreteness of a very diITerent nature since

the price increments defined by the stopping times arc not integer multiples of any fixed quantity (for example, the lower barrier 1/1.125 does not
correspond to a one-eighth price decline). However, such an unnatural definitiol\ of discreteness docs greatly simplify the characterization of SlOpping
limes and the estimation of the parameters of P" since the first-rliITerence
T" is lID.
Under thc more natural specificltioll of price discreteness, not COl\sidcred hy Cho and Frees (19HH). the stopping time hecomes


T,; = inf I > T,,_I: - - ' ,



d- )}
- - - ,I + - 1'(1,,-1)


which reduces to lhe Marsh and Rosenfeld (19Rfi) model in which the incrcments of stopping times are 110t lID.

:\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.

,,. ...


3. Market Microstructure

Although all of thc prcvious rounding and barricr lIlodcls do capturc pricc
discrctcncss and admit cOllsistent cstimators of thc paramctcrs of the IInol)scrvcd continuous-statc 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., bid-ask 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 continuOUS-lime prke process frpm discrele' 01>selved prices, never questioning the motivation of this arduous task. If lhe
continuous-time 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 mack-Scholes/Merton formulas depend on thc parameters of stich continuous-time 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 continuoUs-slate price processes to properly
~' motiVate the statistical models or discreteness in Section 3.3.2.
h~ the absencc of a wcll-articulated 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.

J.J.J The OI1/rrl'd l'mbit Modrl

To ad1rcss the limitations of the rOllllding and barrier lIlodels. Hausmall,

Lo, anf'! MacKinlay (1992) propose ,11\ altern'ltive ill which price rlulIIgr.\ arc
1lI0dclkd directly using a statisticallllodel known as ordered !)Tobit. a technique
used niost frequently in empirical studies ofdepe\ldent variables that take on
only a finite mnllbcr of values possessing a \IaluL,1 ()nlering.~7 Heuristically,
'7For cxal1\pl~. Ih~ dqwml"111 \'ariahlt- lIlif(hl h,' Ih .. kwl Ill' ,-,Iucllion. as 111<"""1<'" h\'
,Int( ('t\l(goric.~: I(~.'\ Ihan hif.!,h !'(huot, hi~h ~fhool. aTIC) ("(llIq~t' (,duration, Tht ,It'IU'lUlt'Ut

3.3. Modeling '/hlllJ(l(liiJlls Dala


ordered prohil analysis is a gellerali /,alion or lile linc;lr regressi

on lIludei
10 cases where lhe dependc lll variable is discrelc
. As such, ,11110111{ lhc
exisling models or slock pricc dis('lTI( 'I\('SS-(' .g., lIall ( I !)HH), (:ho
and Frces
( 198H), COlllieb and Kalay (198:)), I Iarris ( I !)!)()), ;lIId Marsh and
Rosenld d
(19H(i) -orderc d prohil is Ihe only specifica lioll lh;11 elll easily
Capll\l"e Ihe
illlP;I('( of "explan alory" variahle s on pri(T eh;III),((" whik abo
accounl ing
f'II' pritt' dis(I'cl(: ness alld irregula r lransacl ion inll'n'als ,

/Jrl.\ir S/)f'('ijiwlion

Specific ally, conside r a scquenc e of Iransat'l ion pi ices 1'(1,,), 1'(11),

... ,1'(1 11 )
sampled al limcs 10, II, .,., III' and dellOI(' hy VI, }'~, ... , I'll Ill!'
corresp onding price changes , where Y. == 1'(1.) - 1'(lk .. l) is ;\S,ullled 10
be an inlcgn
llIulliple or SOllie divisor, e.g., a lick. I ,1'1 r ' d('1I01l' ;11\ ullOhsl'
lvabk conk
linnous random variable sllch Ihal


= X~rj

+ <k,



",h"n' lhe ('I x I) vector X. == [ X..

,'\'" J' is a veClor of explana lory
variable s lhal delermi nes Ihc condilio nal mcan of
and "INID" indicate s
thai thc E. 's arc indcpcn dclllly hUI nol identica lly dislrihu led,
an imJ>ortall! diffcren ce from standard econom clric models
whit'h we shall relurn 10
shortly. NOle Ihat subscrip ls arc used to dcnote Imll,\(/rli '!Il lillle,
time argullle nts I. dcnotc calenda r or r1urh tilile. a COnV('lllion we
shall follow
through ollt Sectioll :1.33.
The hearl of Ihe ordered prohil lllodel is the assllillpl ioll that
ohserve d
pricc changes Y. arc related to the cOlllillUOUS v;uiabks
ill Ihe 1()lIowing
llIanner :
if )" E ;11









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
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:

-k, +k.

variable is uisncw awl is 1I<11ur<llly onl,:,!'<1 ,ill("(' rolkg" ,,<I'I(;lIioll

"lw<lYs follows high ",-h'H,1
(,ee M.. ddal<l [ I \)11:\) for funher d"lails), Th" 01<1," "d !,,,,hilllll
,,ld IV,I.' "nd,,!,,'" by Ail(hi.,oll
and Silvey (1957)
A,ltf("d (I \):,\)). alld ge,",,;.li/, ,,I,o ", ""101111.11 "i.,1111 h,IIICt'" hy (;'"\;11111,
/."", and Dalllll (1\,11;0). For ilion' nT,'1I1 ,'x ... ",io",. "'" ~L"ltI"J.1
(I\IH:I). M,CIIII,,~1t (I!IHO).
""tlTlti,,, ,, (I!I!II),


-~. +~. and so OIl. For sinl(llicilY, Ihl' slale-span.' partilion ofS' is usually
ddil)('d to 1)(' illft'l va).;:

:1 I

(-00 ,



{!XI '

U~ I



(U,_I , 0', )


1\ '"


(0' 111-'


(: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 +4-tick
oUlcOllle anc! Ihe gl'ealer Ihan +4-li('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
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.


'fill' COl/di/iol/lIl ni'/libll/iol/ 0/1'1';11' (;},(/I/,I;I'.I

Ohsl'r\'l' that Ihl'
's ill (:\.:-1.11) arc asstlllll'd 10 be lIolli(\(,lIlicaIlv clisIrihlllt'll, I1l1Hli1i1l1l1'l1 ollthl' Xl's. The 111'('(1 for Ihis sllnll'WhalllOllslalllLlId
as~umplioll COIIII'~ Irolll IIIl' irrl')?;lIlar anc! r.ltldolll sp'King of Ir"t1~',\"lioIlS
(\;lIa. Ir. Ill!' 1',(;lIl1plt-, Irall'aniol! prin" wcn' (it-tcntlilll'd hy thl' Illodd ill
Marsh alld RO'l'llldd (](IHli) whl'n' 1111' l't\ an' illCn'lIH'1l1s of arilhllll'lic



J.J. Modtling 1ransactions Data

Figure 3.4.

'f7te Ordered ProW Malhi


BmwJlian motion with variance proportional to !'>.I. == I. - I.-I,

must he
a lineal' function of !'>.Ik which varies from one transaction lO the next.
More generally, to allow for more general forms of conditional heteroskedasticity, let us assume that
is a linear function of a vector of predetermined variables W. == [ WI ... Wu ]' so that




+ YI



+ ... + YL Wu,



where (3.3.20) replaces the corresponding hypothesis in (3.3.14) and the

conditional volatility coefficients IYJ} are squared in (3.3.21) to ensure t~at
the conditional volatility is nonnegative. In this more general framework.
the arithmetic Brownian motion model of Marsh and Rosenfeld (1986)
he easily accommodated by setting



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



J. Mmkf'/ AlilTo.l/rttrlw('

The dependence structure of the observed process Yk is clearly ilHluced

by that of Y; and the definitions of the A) 's, since

W k arc temporally independelll, the observed

process YA is also temporally independent. Of course, these are fairly ITstriclive assulllptions and are certainly not necessary for any of the statistical
inferences that follow. We I'equire only that the Ek'S be rOluJiliol/a'(v independent, so that all serial dependence is captured by the Xk'S and the W. 'so
Consequently, the independence of the <. 's docs not imply that the V;'s arc
independently distributed because no restrictions have been p\an'd Oil the
temporal dependence of the Xk'S or W. 's.
'~ The conditional distribution of observed price changes Y., clllI<litionl'l1
Ol~ X. and W., is determined hy the partition boundaries and the particular
distrihlllion of E . For normal fk'S, the (onditiollal distribution is
As a consequence, ifX. and



.I,/X., W.)

\ =


P( 0',_1




< X~f3
< X~f3

+ <k

Xk,W k
:::: 0',

if i

I X k , Wd

+ f A X k , W. )


if I < i <
if i =




I\~ :((:~:;))_(U"-X;f3) :::i~i<m

",(W , )




(u . ,-x;f3)




whe\e aA(W.) is written as all

ofWk to show how the conditioning
varilbles enter the' conditional distribution, and <I> (.) is the standard normal
cUlllulative distribution functioll.
To develop some inlllilion for the onlcn~d probit lIlodel, ohserve lhat
the probability of any particular observed prin~ change is d{'tCl'mined hy
where the condition<llmeanlie~ rdative to the partition boundaries. Therefore, for a given conditional mean X~{3, shiftill~ the boundaries will alter
the prohahilities of observing each state (see Fi~\lI'e :~.4).
In (;\CI, by shifting the boundaries appropriately, ordered prohit Gill (it
any arbitrary multinomial distrihutioll. This illlplies that the assumption of
normality underlying ordered probit plays no special role in determining the
prob'lhilities of states; a logistic distriblltion, for example, could have sCfved
equally wei\. llowe\'er. since it is (ollsiderabl!' more difficult to capt\lJ'c

J, J, /'v/{)(iPlillg TrllIBllrlivl/.l' DIIIII


condilional heteroskedasticilY ill the ordered logil lIlodel, we have chosell

the normal distribution,
Civell the partition bOllndaries, a higher condition.II 1I1ean X~r~ implies
a higher probahility of observing a InOIT extreme pmitiw st'lte, Of course,
the labeling of states is arbitrary, but the {)llirmi prohit model makes usc
0(' the natlll'al ordering of the states, The regressors allow us to separate
the dl'ccts of various economic bums that influl'llcl' the likclihoo<l of one
state versus another, For example, suppose that a large positive value of
XI usually implies a large IIcgative ohsCl'ved price ch;lnge alld vice versa,
Then the ordered probit coefficient til will he n('gatiV!' in sign alld large ill
magnitude (relative to ak, of course),
P>y a\lowing the data to oetet'minc the partitioll bOlllldaries 0, thc cocnicicnts (3
the conditional JIIl'an, and the cOllditiollal variall(,c ak~' the
oJ(kred probit Illodd captures the elllpirical rl'latioll Iwtwl'cn the unobservable continuous st;lle sp;lce S' ;uHllh(' observ('d di"'J'('Il' state space S
as a i'lIl1C1ioll of' the economil' variahles X k ;Illd W",


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 log-likelihood 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




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


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'-hy-rase 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'.


3.4 Recent Empirical Findings

Tlrc clllpirical 111.11\..('1 IlIicroSll'lll'llIrt' lilcratllre is an cXlI'nsivc Olll', slraddling hOlh ac"dl'mic "lid indllstr), p"hlications, and it is difficlllt if nOI impossihl(' 10 provide ('V('II " supl'rfici"l rcvil'W in a li~w pa),!;cs. IlIslead, we
shall p\'t'S1'1I1 Ihn'l' spl't'ilk III"rkl'l lIIicrosll'llctllre "pplicaliolls ill this seclion. cach in SOIlH' dqllh, 10 ),!;ivc rcadcrs a more COII('I'('IC illllstration of
empirical n's('"rdl ill Ihis l'XCilillg- "lid rapidly growill),!; lill'ratllre. S('ctioll
:1.'1,1 provid('s all ('lIlpirical '1I1OII),sis of lIonsYllrhronolls tradill),!; ill which
the lIIa)!;lIitudt, of lht' nOlllratiin),!; hias is mcasllreli llsin),!; daily, weeki)" md
nHlIllhly slock rl'tlll'l\s. SI'('\ioll :t4.~ reviews the empirical all;\lysi~ of d~
fl'Clivl' hid-ask sJl('('ads hased Oil Ihl' modd ill Roll (19H4). Alief St'uioll
:1.4.:1 prl'SelllS all applicllioll or Ihl' ordered prohil modd 10 IrallsaCliollS

1. ,I. I



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-


'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"

\, \.

3.4. UfI"fllt l~mJJirj((l1 Fiuding!


tional simplicity are unique to this framework. Under the assumptions of

Section ~.I.I, the presence of nonsynchronous trading

). 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 well-diversified and consist of securities with common nontrading
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 well-diversified and consist of securities with a common nontrading probability, yielding an AR( I) for
the observed returns process.
Ii. induces geometrically declining cross-autocorrelation between observed
returns of securities i and j which is of the same sign as fJ,flj' This
cross-autocorrelation 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 cross-autocorrelation between
observed returns of portfolios A and B when ponfolios are well-diversifted and consist of securities with common nontrading probabilities.
This cross-autocorrelation is also asymmetric and arises from the fact
that securities in different portfolios may have different nontrading
H. induces positive serial dependence in an equal-weighted 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 nontrading-induced 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 nontrading-induced autocorrela-l
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 size-sorted portfolios for daily,


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


Df.ily Nontrading Probabilitifs Implicit ill A u/ocorre/ations

3.4 reports first-ordcr autocorrelation matrices rl for thc vector of
fopr of the ten size-sorted portfolio returns using daily, weekly, and monthly
d*a taken from the Cemer for Research in Security Prices (CRSP) database,
P9rtfolio'l contains stocks with the smallest market values and portfolio 10
cO~llains those with the larges1. 41 From casual inspeClion it is apparent
thfl these autocorrelation matrices arc not symmetric. The second colUl1111
of\matrices is the autocorrelation matrices minus their transposes, and it
is ~videnlthat elements below the diagonal dominate those above it. This
cO\lfirms the lead-lag pattern reported in 1.0 and MacKinlay (l990c),
\ The fact thaI the returns of large stocks tend to lead those of sl11aller
stolks does suggest that Ilonsynchronous trading may be a source of corrcl4tion, However, the magnitudes of the autocorrelations for weekly ;\lId
monthly returns imply an implausible level of nontrading, This is lIIost evi(lcilt in Table 3.5, which reports estimates of daily nontrading probabilities
implicit in the weekly and monthly own-alllOcorrclatiolls of Table 3.4,
For example, using (3, lAO) the daily nontrading probability implied by
all estimated weekly autocorrelatioll or 37% for portfolio I is estilllated to
be 7I.7%,~2 Using (3.1.8) we estimate the average time between tracks to


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



NUI'IlI 1~'IIII)itiral Findings

7able 3.4.


A 1/11)(()n~I(lljl/1l 1II111";l'r.1 JilT .1;1.I'-.11/I"lr" f"'I"'folio

















. I ~)



























. I ~)





-.1 ~)



- 1'1

i'l - f'1

_II') , (""

, (""


1'1 -i"1



















lir~I~)nll'r;lIl1ororrcLlIi(lIlIJl.HJ"ix i",'ol"tlw (-I x I) slIln'('( lor I ,;' '.~'

,; 1;'111' of ohs('I"\'('"
fl'ltlfll:-' lD tell eqllOlI-weig-htcd sile-~orted pOrlfolios w
.. illg d~'il)'. week.ly. alld monthly NYSEAMEX (0111111011 stock returns data from th( CRSP lilts
for Iht' lime pt:riod .lilly :l. 1962 In
Den'mllei" :~(). I!)~H. Storks ;uc assiglled to portfolios
'lT1ll1lall>' lIsing th(~ IH01rket value.1t the
cnd urlhe prior }'(;If. If this market value is missil1K Ihl"
cud 01 year markt,t \'.dut' is used. IflxHh
mark('1 val lit's ,II"(' IlIis..... ill~ lil(' stork is 1I0t illt. Itlflt'd.
()lIly .\t'nll ilu':-, Wllit nllllpl('I(' daily 1('1(11 II
hi!'lloril':-' withiu a gi\'('IJ mOllth arc inrilHh-d ill Ihe d'lily U'WIIiS
f.lklll.tlio ll ..... ,;' i. . th(' U'tlil It 10
the portfolio containin g securities with tilt.' smelliest menkel
",,,III('s <uul,;'" is tilt return tn the

ponfolio ofs('curiti{'s wilh thc lar~csl. Th('I(~ ,lit' approxilll

<udy cqu,.1 Illlml)('ls of sCfuritics in
each portfolio, The t'ntry ill the ilh row and jIlt (011111111 is
Ihl' (01"1 elatioJ1lwtw('CIl ,;;
To gauge tlit, dt'glt'l' of

is abo r{'pontd.


.uHI';; .

in IlleSt' CllltocOIIl" latiulI mati i(t'.o;" the- dillt'n'lIfC (.... 1-


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,:,
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
duration s. hut the estimate d duratiol ls declille (111)' 'lI;lrgill;l
Ily for larger-



'1lIhle J.5.





(11.111:1 )

. :I!II








(0.11111 )



"/ tlllil\' lItH/lrmli,,/{ Im,l",bilili,.I.

f.:1 ii, I






= :!2)

LI h, J







:.. 12
(1.1i I )









.!") I:)
(ll.lti I )






of(.bily uoutLHhng pruh.dlilitit:o, impli('it in

Inliu n'unn ,\\lh.)( unt'I.H\tH\S-.

II/a/Ii,,/ MU'/m/m(/w"l'


wt'c:ldy ~'nd monthly \i/c.'\ortc:d port-

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

of 'bil\' IIOllll,ulill).,{ proh;thililit,."i, EIII ..it-S ill Ihe.' '"if" (,/


,It" ('~lilll,IIt-!\.


pUlllulio 1"1'111111 ,11110("01 Id.lIiOIi ('udlid"UIS,

~k('lioli :\,~


:1 101

= :,)" ;lIul "n,. (q


~~) ..

01 ,tlil\' lIolllr;uling I)luh.lhililit's ohtailU'\ Irolll li""I-ol(lt-r wn'kly ;IIHI

wc',,}"'1\' It'tunl' .IIHI

'I =


"!'Iillg Iht'


ag-gu'g'lIioli rd.llion'


for IllOlUhly n'IIII"II." ;o.i 1I."t' the.'f(' an':1 ~1I1(\:!~

fr.ulillg 1I;t\'s ill a \\'((k awl,lllIullth, n"IH'( li\'t'ly), Enlrit';o. ill (Ohllllll."i l;tlwlled

Mf:f k/l" alt' ('sri-

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 lahdlt-d 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





stalld.lnl ('nul's an' h(I(-ro!;,k(daSlkil~'





J.4. Ilfcmt

Table 1.6.

Estimator of If i


I~",piri((ll Findillg.~


wffkly i,ll/ex flulocomlnlions.

Implied Index PI ('Yo)

(Ill == 1. /ll" == 1)

Implied Indt;x PI ('Yo)





Share Price

Daily AUlOcorrelatio"


= 1.5.13111 = ()5)

IlIIpli .." firsH>rtier autocondation PI ofw"ekly relurns of an equal-weighted portfolio o(ten

portfolios (which approximales all equal-weighted portfolio of all ~curitie.). u~iJlg
two difkr~nt t'stilllators of daily lIontrading prohahilities for the portfolios: the aver.tge frdnion
of n~~ati\'(' sl"lrt' pric .. s reportt'd hy CRSI'. and daily nontr.tding prohahilities implied hy lirsiordl'r aUlororrdalion, of d;lily returns. Sinet' the index autocorrt'lation depends on the IX-tas
of till' tt'n portt(>lio,. it is colllputed tilr two set' of betas. one in which all beta.~ are set w I.U
;lIId anoth"r in which tht' hetas decline linearly fmm III = 1.5 to Pili = 0.5. The sample weekly
""t"r""r~hlti()n for an "'lual-weil\htecl portfolio of the I('n portfolios is 0.21. Results are ha",,"
on ,1"la frl)IlI.1nly :>. I\l\i:.! III nec.ember :>0. 1\1\14.



1rading and Index Autocorrelation

Dellote by r,~,( the ohserved return in period 110 an equal-weighted portfolio

of all N s(curities. Its autocovariance and autocorrelation are readily shown
to he
(' r(n) (


where r" is the contemporaneous covariance matrix of T," and ( is an (N xl)

vector of ones. If the betas ofthe securities are generally of the same sign and
if th(' Illean return of each secnrity is small, thell r~, is likely to be positively
alltocorrelated_ Alternatively, if the cross-al1l0Covariances are positive and
dOlllinate the negative own-au(Ocovariances, the equal-weighted index will
exhibit positive serial dependence. Can this explain Lo and MacKinlay's
( 19RRh) strong rejection of the random walk hypothesis for the CRSP weekly
(,qual-weighted index, which exhibits a first-{)rder autocorrelation over 20%?
Wilh little loss in generality we let N = 10 and consider the equalweighted portfolio of the ten size-sorted portfolios, which is an approximalely equal-weighted portfolio of all securities. Using (3.1.36) we may
calculate the weekly autocorrelation of r;;,( indnced by particular daily nontracling probabilities 7f; and beta coefficients {3;. To do this, we need 10
sel(,ct ('JlIpirically plausible values for IT; and 13;, i :::: 1.2 ... 10. This is
don(' in Table 3.6 \Ising two differ(,nt methods of estimating the 7T;'S and
IWo dill't'J'enl aSSlllllptioll5 for the 13,'5.
The first row corresponds 10 weekly autocorrelatiolls computed with
lhe nontrading prohabilities obtained from the fractions of negative share
prin's J'<'portet\ by CRSP (sec T~lbie 3.5). The first entry. 1.4%. is the first-

3. Markel MimH/l"Ilrlurr

qrdcr autocorrelation of thc wcckly cqual-weighted indcx aSSlIllling tklt all

twcnty portfolio bctas arc 1.0, and the second entry, 1.8%, is cOlllputed UII- .
dcr thc altcrnativc assumption thatthc bctas declinc linearly frorn III = 1.:>
f~)r thc portfolio of smallest stocks to IlIU = 0.5 for tl!c ponlc>lio of the
11rgcst. The sccond row rcports similar autocorrclatiolls implicd hy 11011l~ading probabilitics cstimated fmlll daily autocorrclations using n.IAI).
The largcst implicd !irst-order autocorrelation for the weekly equalw ightcd returns indcx reported in Table 3.6 is only 5.9%. Usillg direct
c. timatcsofnontrading via lIegativc sharc priccs yields an autocorrelation of
I~' s than 2%. Thcsc magnitudcs arc still considcrably smallcr than the '21 'Yv
s IIlplc autocorrelation of thc e<Jual-wcigllled indcx retUnI. In SIlIllIll,II")',
tl e rcccnt cmpirical cvidence provides lillie support for nOlllrad'lIlg as all
important source of spllrious correlation in the rcturns of common stock
o~er daily and longcr frcquencies. 41


3.4.2 1~,\tiIlUllil/li till' I:J/rrlivc

BidA~" .'>/))"('(1/[

In implementing thc model of Scction 3.2.1, Roll (1981) argucs that thc
percentage bid-ask spread s, may bc more easily intcrpreted than thc al)solute hid-ask spread s, and he shows that thc Ilrsturdcr 'lIl1ocovari'lllcc of
simple returns is relatcd to .I, in the following way:
Cov[ R - l





H, I

JJ>1I 1',.




where 5, is defincd as a pcrccntage of thc geometric average of the avcragc bid

and ask priccs Po and Ph' Using the approximation in (3.4.2), thc pcrcentage
spread may be recovercd as

Notc that (3.4.4) and (3.'2.9) arc only wcll-deflllcd whcn thc returtl al1tocovariance is negalive, sincc by conslruction the hid-ask bOllllce elll only
inducc negative !irsl-order 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-!)

additional empiricfll results on l1onlra<iillJ,{ as ;,\ soun:(" of iUltoccll"uhl1ioll. \\-'hilt- lilt,

hy nOll trading'. all 1111"('(' l),Ip('r~

p"pf'r~ do nut a~re(" on the I('\'l"i of auto("(lITf.'laliun indu('('d

rO"rltHl" thatllolllradilll: ,';,"lol rompl("I<"I), "e<'<>II1l1 Ii,, Ill(" 01>"'1'1'("<1 ;\lU()('o"rl"li"m.


3,4, Recmll:III/,irim/ Findings

This conv('ntion seems dirticuh to .iustilY 011 ('('onomic ~rolll\ds-ne~ative
spreads arc typically associated with lI1arkdll1;",i\l~ aClivity, i.e., the provision ol'liqui<lity, yet this seems to have lillie connection with the presence of
positive serial cOlTebtion in rClul'lls, I\. more plausible ahel'llative interpretation of cases where (:-1.4.4) iscollIplex-valllnl is Ihallhe Roll (I!)!H) model
is misspecilied and that additiollal structllre IIllisl be illlposed 10 an:ounl
for the positive serial correlation (sec, for example, (;eol~e l't a!. [1!191 J.
Glosten and l'brris [1988], l'luall~ and Stoll [I !)!):)a I, alld Stoll [I 9H9)),
RolIl'stilllatl's the c!1Cctive spreads of NYSl': and i\MEX stocks year by
year usin~ daily rclllfllS data from 19G3 to 198~, alld (inds the overall avera~l'
effective slHead \0 be O,'2!)8% for NYSE slocks ;\lHI 1.7,\')(, I'll' AM1':X storks
(recall that AMEX stocks tend to he lower-priced; hell(,(, they oll~ht to have
larger percentage spreads). However, these ligures II111St be interpreted with
caution since '2-1,3:)/l of the -17,414 eSlimated dknive spreads were negative,
s\lggestin~ the presence ofsubstalllial spccific<llionl'l'rors. Perhaps another
symplom of these specification errors is the bctlhal estimales oflhe effeclive
sFreaci hased on weekly data differ signilicanlly from Ihos(' based on daily
datJ. ~everthcless, the llIa~nitudes of these dkCls arc dearly important for
cmpirical ;'pplicatiollS of transactio\lS dat,\.
Glo~ten and Ilanis (1988) rcline ,lIId eSlinlatl' Clostcn's (1987) de(olllpositioll or Ihe hid-ask sprcad using trallsaniollS data ror '2:)() NYSE stocks
and conclude Ihat the perman('nt advers('-selection compollent is indeed
pn:sellt in the data. Stoll (19H!)) develops a similar decolllposition of the
~pread, and usin~ transactions data Ii)r Nalional Markct System s(,curities
011 the NASDAQsYSll'lII frolll Octohn to lkc('Inhl'l' or I!ItH, he concludes
that 43% of the quotcd spread is due to advlTse sel(,ction, 10% is due to
inventory-holding costs, and the relllainin~ 47'}(, is due to order-processing
costs, Georgc, 1<..;1\11, and NimalelHlran (1991) ;,lIow the expected retllfll of
the ullobservable "true" pricc (1',. in Ihe notation or Section :t~.l) to vary
through timc, and using daily and weekly data for J'I.'YSE and I\.MEX stocks
from 1963 to I ~)!:l5 and NASOI\.Qstocks alld frolll I!JH3 to I!)!:l7, they obtain a
much smaller estimate for the portion of the spread allrihutabk to adverse
sckction-8% to l:-I%-with the relllainder due to order-processing (,oSL~,
and 110 evidence of' inventory cosls. IllIang alld Sloli (I !I!I!'>a) propose a
[\\or(' gCllerallllodcl th,ll cOlltains these (lthlT specilications as special cases
and estimate the ('()lllpOllellts or tile spread to be \!l 'X, adverse-selection
costs, 14% iIlVl'lIlOry-holdin~ n)sls, alld (i:)'X) ()nln-plO('('ssi\l~ costs usin~
199:ltrall~<IClions data for I!) ofllH' '20 slorks ill till' t\L~jor Market Index,
'1'11(' raI'l Ihal Ihese ('slinlat('s v;lry so nlllrll ;llTOSS slueli('s makes it e1il'fiulit 10 regard any single stlldy as (,(lIIriusive. Th(' dilkn'lll'('s (,ollie /i'OIll
two SOllrcl's: dilkr('nl specifications I,ll' thl' e1ynalllio of the hid-ask spr('ad,
and the lise of dilkrent dalasets. Th('ll' is clearly a nl'l'd I,ll a 1II0rl' dl'laikd
amI (olllpn:hl'IISiv(' allaly~is ill whi('h all of Ihl'sC sp('('ilicaliollS arc appli('d

10 a \':lIil'll' (II d:llaS('ls 10 ~allgl' tlte I'xplallalOry pow('r alit! st:lhilit\, 01 ('ach

,. -1.1 nt/I/.lt/dill//.\' nolll

III I tlllSlll:lIl, 1.0, :11111 /'bcKin!;I\' (I~)q~), Ihrl'l' spl'cilic aspl'ns of Ir:lllsa('lions data arl' I'xaillilll'd \Isillg thl' ordl'rl'd prohil modd of Sl'niOll :\.:\.:\:
(I) Do('s thl' parliclIl:tr II',{III'IIO' ollratll's affl'cI till' cOlldiliollal dislriblliioll
of prin' changl's, I'.g., dOL's Ihl' Sl'ljlH'llCl' of three pricl' challgl's -I- I, - I, -I- I
ha\'l' II Ie S:\1 III' dIi'('( Oil the cOlltiitiollal distrihution ofthl' III'XI price change
as Ihl' S('qtll'IIII' -I, + I, + I? (~) DOL'S Iradl' sizl' alTecI priet, chall!-\cs, alld
if so, wh:11 is thl' pritT illlP:I('\ pn Ullil volullll' of Irade frolll Olle IrallSaclioll 10 Ihl' III'XI? e\) Dol'S pricl' disITell'Il1'SS l\Ialln? III particular, ell \
Ihl' cOlldiliollal di~lrihlllioll or pricl' chall!{l's he 1II0deled as a simple lillcar
rl')~rt'ssioll of pricl' r11:lIlgl'S onl'Xplallalory variables withotll accolllltillg for
dislTl'll'llI'SS al "II?
Til acldn'ss 1IlI'sl' Ihn'l' qllesliolls, Ilatlsmall, 1,0, alld MacKillLi), (I !)92)
('stimall' Ihl' o,dl'l;'t\ plllhil II10clt'I for 19HH IrallsaCliolls dala of o\'er a
hUlldrl'd slod.. s. 'Iii ('{IIISI'r\'I' span', wc rOnts (111)' Oil Iheir sllIalln ane!
IIlIIr(' d('I:lilnl s:lIl1pll' of six ~1()cb-lnll'rllali()llal IIl1silH'ss Machilu'" Corpmat i()n (\HI\!) , (.2"antllll (:lu'lllical (:orporation :U E), Foster Whcl'kr
Corporation (F\\'( :), llalle!v alit! Ilannan COlllpany (I INl \), N:l\'isl:lr 111Il'I'llaliollal Corporalioll (NAVj, aile! American TI'I('plloll(' and Tc'lcgraplt
IlIl'orpor:llt'd ('1'), For !iIl'SI' six slocks, Ihey foctls ollly Oil ililmtit/y Ir:lItsaclion prin' dlan~l's since illt:IS IWl'lI wdl-docIIIIII'llled Iltal overnight relurns
di/kr sllhslallliall), /'rolll illlrad:l), J'('llInts (SCI', for c'xalllpk, Alllihlld atlel
Ml'llclt'lson II!lH7I, Sloll and Whaky [19!1()], alld Wood, Mdllish, ancl Orel
[ I!)H!, I), Thl'v also impose sl'vl'ral oliter filters 10 l'IilJlin:ttl' "prohklll" lransanions and qllOlt'S, which ~'idclt-cl salllpll' sizes rangillg frolll :1,17,1 Iracles
II' IINlllo ''!Ot;,7~)'(lralks ror IBM,
Thl')' ;dSIlIISI' hid alld ask pric('s i II Iheir :llIalysis, alld since hid-:lsk qllOlcs
arl' I'I'Jlortl'd olll\' ",hl'lI IIII'\' an' r('vis('cl, SCllIIl' efrorl is J'I'qllirl'cl 10 Ilialch
qllOll'S 10 Ir:\lI~:ll'liolls, :\ natural algorilhm is 10 lIlall'h each Ir:lllsaniol\
pric(' 10 Ihe 1I10~1 1'1'1'1'11111' reported qllOI(' /willr 10 Ihl' Ir:lIIsauion; howevcr,
Brollfrllan (Ill!)!) :11111 1,('(' alld Rl'ad)' (l!l!ll) have shown llial prices or
Iradl's lIial prl'cipilalt, qlloll' r(,visiolls art' SOllll'lilll(,S report cd wilh a lag, so
Ihal Ihl' onlt-,' or qllOl1' r(,vision and IrallSauiol\ price is reversed in ol'licial
r('conls sllch as Ihl' (:ollsolid:lIl'd '1:11'('. To addl'('ss Ihis issll(" J lallsillall,
1.0, alld M:ld"illl:1\' (I'lc)~) 1I1:,td, trallsaclioll prices \0 qllotes Ihal arc set
til Imlt/i1,/' \/'/II/ld, {"i",. 10 IhI' Irallsacl iOIl-Ihe c'vidl'ncl' in 1.1'(' and Ready
(1!1'1I) sllggC'SIS Ihal Ihis will accolllII for 1II0s1 01'1\1(' Illissl'C(II('IICilll!;. This
is 01111' OIl<' \'x:lIl1pk of till' killd of IIl1ill'll' challengc's lIi:11 Iransaclions dala



Empirical Filldings


To provide some intuition for [his enormous dataset, we report a few

slIllllllary statistics in Tahle 3.7. Our sample contains considerable price
dispersion. with the low stock price ranging from $3.125 for NAVto $104.250
for \HM. and the high ranging from $7.875 for NAV to $129.500 for IBM.
1\[ $219 million, HNH has the smallest market capitalization in ollr sample.
and mM has the largest with a market value of $69.8 hillion.
The empirical analysis also requires some indicator of whether a transaction was buyer-initiated or seller-initiated, othenvise the notion of price
impact is ilI-defll1ecl-a 100.000-share block-purchase has quite a different
price impact from a 100.000-share block-sale. Obviously. this is a difficult
task because for every trade there is always a buyer and a seller. What we
hope [0 capture is which of the two parties is more anxious to consummate
the trade and is therefore willing to pay for it by being closer to the bid price
or the ask price. Perhaps the most obviolls indicator is whether the transaction occurs at the ask price or at the bid price; if it is the former then the
transaction is most likely a "buy" and if it is the latter then the transaction
is most likely a "sell." Unfortunately. a large number of transactions occur
at prices strictly withirl the bid-ask spread. so that this method for signing
trades will leave the majority of trades indeterminate.
Hausman. Lo, and MacKinlay (1992) use the well-known algorithm of
signing a transaction as a buy if the transaction price is higher than the mean
or the prevailing hid-ask quote (the most recent quote that is set atlea~t five
seconds prior to the trade); they classify it as a sell if the price is lower. If
the price equals the mean of the prevailing bid-ask quote, they classify the
trade as an indeterminate trade. This method yields far fewer indeterminate
trades than classifying according to transactions at the bid or at the; ask.
Unfortunately. little is known about the relative merits of this methOd of
c\;\ssific;ltion versus others such as the tick lesl (which classifies a transaction
as a buy, a sell, or indeterminate ifits price is greater than,less lhan, orequaJ
to the previous transaction's price. respectively). simply because it is virtually
impossible to obtain the data necessary to evaluate these alternatives.

Thf J~ml)iriral Specification

To estimate the parameters of the ordered probit model via maximum likelihood. three specification decisions must be made: (i) the number of stales
111, (ii) the explanatory variables Xk and (iii) the parametrization of the
vartance G k
In choosing In, we must balance price resolution against the practical
constraint that too large an In will yield no observations in the extreme states
\1 and .1 m For example. if we set m to 10 I and define the states SI and SIOI
syml\lctrically to be price changes of -50 ticks and +50 ticks, respectively,
WI' would find no Y. 's among ollr six stocks falling into these two states.
Usin~ the empirical distribution of the data as a guide, Hausman, Lo, and


3. Markel Mirm.IITllrlllTf'

Summary stnti.,tirJ fOT tmll.lflrtiollJ Ilntn cif.lix . /orh.,.

\Low Price
,lIigh Price
'Markel Value (SBmiolls)


























(1.000 I
















-0.0000 -(LOOO4






O.!I:,W, -0.(2)(; -0.2!llj7





0.:\:,74 -1l.O:,23






.% Trades at Prices:



= Mid'luole
< Mid'l"ole




Price Change. }.
SId. Dey.:
Time Belweell li-ade


Std. Dey.:

Bid-A.<k Spread, AB.

SId. Dey.:
S&P500 FU(llres Return
Std. Dey.:
Buy-Scllindicalor, IRS.
Std. Dey.:
Signed Transformed Volume
SId. Dey.:
Median li-ading Volume ($)

0.0332 -0.42,.(;


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
from January 4, 1988 to Dccemht'r :10. I \lllll.


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 HNI-I, 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: dock-time cfTeCls (such as the arithmetic IkoIV-

3.4. NI'("('nll~lIIfiiriflll FindinK-'

nian mol ion model). the cfleCls or hid-ask 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
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 Ii-I alld It.
in seconds .
An k _ l : The hid-ask 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
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 (It-I)th
transanion. ddinc:d as Ihe price of the (il-/)Ih Iransact ion (in dollars.
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
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
for that stock. it is set equllllo Ihc !I(l':' perccilli le.
SP500 k __ ,: Three lags [I = I. 2, :1 I of fivc-lIlinule continu
ously COIIIpounde d rctllrllS of the Siandar d alld Poor's (S&l') [,00 index
price, for Ihe conlrac t maturin g in the c10scsll llonlh beyolld the
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
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
Ihe qlloted bid and ask prices al tilll!' Ik _,. Ihe vallie -I if the
transact ion price is less th,1I\ the average of Ihe bid and ask prices
lime I.-I. and zero otherwis e. i.e.,

IBS h _ 1



I'. I > ~ (/'k'-,

+ I'~'_I)



~ U'h'_1

+ 1':'_1)


I'k I < W'k'-I -I- 1';_/)'

The spccific ation of X~fJ is then givell by the followillg expressi


+ fi~ Yh- I + fi:1 Yh--~ + fi1 Yk-:I + /I,.SI':,OO._I + fib SI'500.- 2

+ fi7SI'500h_:1 + fiXIlISk-1 + fi!,IIIS k- 2 + fiIOIBSh-~
+ filiI '/i..(Vk-!l IBS H I + fil~ 1I!.(\'k_~) .IIIS._ 2 )
+ fil:11 T), (Vk_:l) . IIIS k -:1 ) .
fil 61h

The v,lriablt- 61h is illcillde d in .\.




clock-lilll!' df(-cls



J. All11kl'l

MiOI lJ/III r/III l'

rOlu lilio llal lIIeall of I;. II plic

es an' slah le ill Irall saCl ioll lillie
ralh er
Ihall doc k lillII', Ihis (odf icin
ll shou ld 1)(' zel'O. l.a~~l'd prir
arc illcl ilded 10 aC("OIlIlI lor sni;t
1 dq)( ,lIc1 enci es, and la~~ed reI
lints 01 Ill('
SJ(-I':)"/) illd( 'x fllll lln prin ' an'
illci llded 10 acco unl for mark ('I-w
ide dkC ls
011 prir e challg-(s.
'Ii) m('asU((' Ihe prir e ililp acl or
a Irad e p('r unil \'olll llle, Iht'
'1;,(V~_tl is indl lded , whi
dl is doll al volll llle Irall sllll' l\l('d
ac("ordill~ 10 the
Box alld Cox (1!lfil) Ilalls ll'I"I lIatio
ll '1;,();
'1;.(\ )

x" I'

whe re I' E 10, II is also ;1 para

lll('l er 10 he eSlil llale d. The Box
-Cox IrallSf()l"Jllalion allow s doll ,lr voltlll\('
10 ('n(( 'r into Ihe cond ilion al lIIea
ll lIoll lin('arl y,;, parl intla rl), imp orta nt
inllo valio n sinc e cOll llllo n intll
ilion sugg esls
Ihal plic( ' illlp arl ilia), exhi hil ('CO
IIOllli('s of scal e with resp eC! to
doll ar \'0111111('; i.('., alth oug h IOla ll'ric e
imp arl is likely to incr ease with
volu me, the
lIlar~inal pric( ' illlp;'!'1 proh
ahly do('s no!. The Box -Cox trall
slim nati
capIlIn' s the lil)(' ar sp('c ifica lioll (I'
= I) and conc ave spec ifica tion s lipoll
to alld
illrludin~ till' lo~arilhlllic
rlillClioll (I' = 0). The eSli mate
d cllrv atur e or
Ihis IraIl Sf(.n llalio ll will pl;,y all
illlpol"lalll rolt- ill Ihe 1II('''SIl)"{'I
I)(,1I1 of pric e
illlp act.
The Irall sforl ll('d doll ar \'Ollllll(,
vari ahk is inle ract ed with IBS
k _ I , an
indi calo r of ",hel hl'l" Ih(' Irad ('
was hll)TI~illitiated (IBS = I), selle
tiat( ,d
IIBS~= - I \. or il)(I( 'I('fl llina
ll' (IBS k =/)) . A posi live fill wou
ld illlply thaI
hlly( 'r-in ilial ed Ilad( 's tl'lId 10 pllsh
pri('(~s up and selle r-ini tiate
d tlad es t(,lId
10 driv e prir es dow n. Such a rela
lion is pred icte d hy seve ral info
rm"l .ionhas( 'd lIIod eis of Iradill~, e.g-.,
Easl ey and O'H ara (I9R 7), Mor
eove r, Ihe
lIIag llilll de of /ill is II ... p('r-IIl1il
\'0111111(' illlp act Oil Ihe cOll ditio
llal lIIeall
of r~', whic h lila), he f(~adily Ir.lII
slale d into the imp act Oil the ('oll
dilio llal
proh ahil ilics of ohs( 'rv('d pric(
' chan~('s, The sig-n and lIIa~nit\l
<lt's of fll~
alld fll:! lIH'aSllr(' 1111' p('rs isl(, lIn'
of pric (' illlp act.
Finall)" 10 ("(11111'1('11' IIH' sp('c ifica
lion Ihe cOll ditio llal varia lllT
YI~ t- LY,~ "~k III11S1 III' par;lIl1(lIi/e(
1. 'Ii) allow for cloc k-lil ll(, !'ff('
illl"illd!'d, and sinc (' IIH')"{' is son
I!' ('\'il l('lIn ' lillk ing hid- ask spr(
'ads 10 IIt(' illfill"lllalioll C()III1'nl alld \'"Ia lilil\
' "II" ic(' chan~('s (SCI', for ('xam
pl(', Clos ten
II!IH71.1 b~llIolII"k II'IHH, I(I~II
;I,hl. alld l'el('rS(,1I alld
I!I~IOI). lite
lagg ('d spre ad All!. I i., al,,) i"cl
"ded , A"d sill!'(' Ih(' para llll'l I'r
\"I'nor,; 0,
(-J, and I arc unid !'lIli fi('d Wilh
olll addi lion al r('sl rinio ns, Y,~
is SCI 10 olle.
This )"idd s rlH' sp(c ifica lioll


III ""'"" ;Ir\" , Ih .. 'hl"I (" S;lI'l iIi,

,lIioll 11''I "ires rill' ('slil llali' "1 of:!
f l'"r;I I"I'tns: Ih(' p;lrl ili .. II """,, cla, il" UI
... , (rH, Ih(' vari ance
p;lra lllel crs YI alld


J.4. UI'I'l'nl Empirical Findin~


if ordn"fd !J/1Jbit partition boulIdarUs.
















- 1.712




( -171.59)


















(19.1 I)
















-I. .0


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 Box-Cox
parameter v. The 5-state specification requires the estimation of only 20
'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; z-statistics, 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-



H,lill/l//i., o/mdrmllJlobil .... ,01" .. mrijlt'iml.,.






YI : AI/100

( 1:>.:>7)

( 1l.G2)

( 11.2(i)


(HUll )


Yt :AIL 1






elH. IIi)

( -11.12)


-(l.OI:\ -IU)IO
(-:1.:,0) ( -Vi!))


( -:tH2)



III : A/flOO


: Y.. 1

-l.:tl:, -0.740
(-13!i57) (-13.41i) (-24.49) (-[>.I H) (-:\(i.:{2)

fl:, : >'-t


fll : 1'.:.


fl:. : 51'500_ 1
{Iii : S1'500 .. t


: S1'500_ 3

fJK : illS_I



fll :



't~(V _I )IBS_ I


t;, (V -2)[85_ 2

IIJ : t;,(V .. ,)IB5_ 1


-O.G:{H -0.40G
(-tI.03) (-IGAr,) (-4.O(i) (-31.1:1) (-:,(;.:,21
(-!I.~:{) (-U14) ( -31.1;3) (- -I7.!1I )
( -1.42)






(!l.(iI )



( 1.!J7)



(I :~.49)


( I.:~{j)


tUi2 c,

( I.~O)



( 1.13)

0.1 r.!J





-l.I:n -UH:>
(-('3.1i4) (- " . 31i)
(-~I.:,:,) (-:1.:\7)

-0.7!JI -O.HO:l
(-7.HI) (-2.H!J) (-17.:{H) (-2:1.01)





-0.177 -0.022
( -:l.Ii'l) (-0.17) (-I :,.:17) (-I!/.7HI
( I.HO)
(I.rll I






-O.IH1 -O.IH4
(-:\.fiG) (-0.75) (-I:>.:\H) (-IH.II)

tUlI " -o.()(/(;
(15Ii) (-0.34)

(1.:,4 )








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 '.

Ch<'IIIII',,1 (AlI'l'oralloll (CUI'., ~h,~1~7 lI;uk,), ~"'I"r Wh""\pr (.01'1'01;\1'0" (n\( ..

lIandy ""d II,Hl""" C""'P;\I,)' (I INII, :1,174 II'"des). N",;sl,,1' Inl<'I'II",i"II"\
Co,! oralion (NAV, 96,127 ,r;u\~,). a"d AlIIl'I'ir;", 'li'I"I,hOl\(' ;\lId TcI<')~""ph Co",I'''''\' (I'.
IIlO,7:lC, Ira~\e'), for 11\('I"'l'i",1 trolll.l;llllla ..\, 1, 19KK 10 llt-r'lIIb.. 1' :111, l!IKII.

QII" Hum

111.1 19


arie, arc not cvl'nly spaced, e.g., ja:\ -a.a! = 1.7(i:/. whereas ja'l-a,.j = ~.(i7()
(it can hc shown that these two values arc statistically <lifkrent). One implication is that the eighths-harrier 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 z-statistics are minuscule,
especially in light of the large sample sizes. Ilowevel', t.l does enter into
the a,~ expression significantly-in bct, since all the parameters for
significant, hOllloskedasticity may he I'~iected-and hence clock-time 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 clock-time can still
affcct the conditional mean of ohsCI'ved pricc changes eVt'n though it docs
not aflect the conditional JIlean of





On]/,/, Now, /)i;(I'plplIl'.B, awl I'ri((' /111/Hlfl

More striking is the significance and sign or the lagged price change coefficients fit, fi:\, and E'I, which arc negative f(lI' all stocks, implying a tendency
towards price reversals. For example, ir the past three pricc changes were
each one tick, the conditionallllean or r; change~ hy IJ~+~:d'~I' lIowevCl',
ir thc sequence of price changes was 1/-1/ I, thell the dli:l'l on the conditional mean is ~~-fiJ+fi" a quantity closer to I.!TO fill' cach orthl' security's
parameter estimates.
:-.Iote that these coefficients llleasure reversal tendencies bryolld that
induced by the presellce of a cOllstant hid-ask spread as in Roll (\9H4).
The effect of bid-ask bounce on the conditional mean should be captured
by the indicator variables mS A_ I , ms . ~, alld IBS .:\. III thc abscllce of
all other information (such as market 1Il0VCIlIellts or past pricc changcs),
these vari,lbles pick up any price dkcts that bu)'S alld sells might have Oil
the ronditioll,d mean. A~ expel'led, the l'stim,llc(l coe/lidents arc gener<llly
negative, indicating the presence of rev(')'s,tis due to lll(}\'l'lIlcnts from hid
to ask or ask to bid prices, Ilausinan, 1.0, ;lIul MacKilllay (1!/!/2) compare
their magnitlldes rorm<llly and cOllcludl' th,1l the cOllliitiollalmcan of price
changes is /l(llit.dl'/IPlu/rnl with respl'<"l to past price ch;lllges-the S('I/IIPI/{'I' of
price challges or nrdPl'jlrm' malleI'S.
Using these parameter estimates, llallsillan, 1.0, ;lIul Mad';'inlay (1!/!l2)
arc also able ;0 address the sccolld two <jllestiolis the)' pUI forward. Price

. ' " " . " . , , I U / t

illlparl-IIII' dkn 01 a Iralk Oil IIII' lIIark('1 prire-fall 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 1I01lIillcalilies-prin'-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 hid-ask spread, alld modeling
transactiolls dala. IlolI't'ver, lIlt' t'olllhillalion of transactions dalal>ast's and
ever-increasing 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'IIIS-C!lUpter J




l>tolin' lilt' 1IH'<lII, \ari:ult .... :l1I1'WOI'ariallct', alld ;lulocornlalioll 11I1It'

liollS ct 1.~I)-n.l. 1'2) .. I'I ht' "h"'rwd 1't'lllrtlS prm'('ss I r;; I for the 110111 radillg
lIlodd ofSt'(lioll :1./. Ililll: [',,Ih .. rqm's"lItalion CtIA).

" luvi"CIIU


3.2 Under the nontrading process defined by (3.1.2)-(3.1.3), and assuming that virtual returns have a linear one-factor 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 two-state Markov chain instead, with transition probabil\ties
given by

(3.~.1 )

3.3.1 Derive the unconditional mean, variance, first-<>rder autocovari'lIlce, and s~eady-state distribution of Oil as functions of 1rj and 1r;.

3.3.2 Calculate the mean, variance, and autocorrelation function of the

observed returns process Ti~ under (3.5.1). How does serial correlatio'1 in
8il affect the moments of observed returns?
Using daily returns ror any individual security, estimate the paJm(ters rri and rr; assuming that the virtual returns process is 110. Are the
estimates empirically plausible?


3.4 Extend the Roll (1984) model to allow for a serially correlated ordertype indicator variable. In particular, let I, be a two-state 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 bid-ask bounce?
3.5 How docs price discreteness affect the sampling properties of the mean,
standard deviation, and first-Qrder autocorrelation estimators, ifat all? Hint:
Simulate continuous-state prices with various starting price levels, round
to the nearest eighth, calculate the statistics of imerest, and tabulate the
("('Ievant sampling distributions.

3.6 The following questions refer to an extract of the NYSE's TAQDalabllJe

which consists of all transactions for IBM stock that occurred on January 4th
and 5th, 1988 (2,748 trades).
3.6.1 Construct a histogram for IBM's stock price. Do you see any evjc\t-nce of price clustering? Construct a histogram for IBM's stock price
rJUlIlj;I'J. Is there any price-change clustering? Construct the following
1\\1(, histograms and compare and contrast: the histogram of price changes
conditional on prices falling on an even eighth, and the histogram of price
changes conditional on prices falling on an odd eighth. Using these his-


J. Markel Miomtrurtllrp

tograms, comment on the importance or unimportance of discretl~ prices

for statistical inference.
3.6.2 What is the average lillie hetween trade$ for InM? Cunstruct a
95% conCidence intel"al about this average. Using these quantities and
the central limit theurem, what is the probability that IBM docs 1101 trade
in aflY given one-minute interval? Divide the trading day into olle-lIIinule
intervals, and estimate directly the unconditiunal and conditiol/al probabilities of nontrading, where the conditiunal probabilities arc conditioned
on whether a trade occurred during the previous minute (hilll: think
abollt Markov chains). Is the nontrading process independent?
3.6.3 Plot price and volullle on the same graph, with tillle-ofday as the
horizontal axis. Are there any discernible patterns? Propose and perlonn
statistical tests of stich patterns and other patterns that might not be vi$ihle
to the naked eye but are motivated by economic considerations; e.g., block
trades are followed by larger price changes than nonblock trades, etc-Y'
3.6.4 Devise and estimate a model that measures price impact, i.e., the
actual cost of trading n shares of IBM. Feci free to use any statistical
methods at your disposal-there is no single right answer On particular,
ordered prohit is not necessarily the best way to do this). Think carefully
: ahoutthe underlying economic motivation for measuring pric.:e impact.


The following questions refer to an extract of the NYS['s '//\Q /)1I/alm,11'

W\ich consists of bid-ask quote revisions and depths for IBM stock that were
d splayed duringJanuary 4th and 5th, 19HH (1,327 quote revisions),
3.7.1 Construct a histogram for IBM's bid-ask spread. Can you conclude
from this that the dynamics of the bid-ask spread are unimportant! Why
or why not? You may wish to constrnct various conditional histognllns to
roperly answer this Cjuestion .

7.2 Are there any discernible rclatioll$ between revisiollS ill the bid-ask
uotes and transactions? That is. do revisions in hid-ask quotes "cause"
rades to occur, or do trades motivate revisiolls in the quotes? Propose
estimate a modclto answer this question.


*.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,,

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
of SI 00,000 wilh the transacl ions data, hill do il two ways: (I)
lise the
avera~e of the bid-ask 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 ,

Event-Study Analysis

ECONOMISTS ARE FREQUENTLY ASKED to measure the effect of an economic

event on the value of a firm. On the surface this seems like a difficult
task, but a measure can be constructed easily using financial market data
ill an event study. The usefulness of such a study comes [rom the fact
that, given rationality in the marketplace, the effect of an event will be
reflected immediately in asset prices. Thus the event's economic impact
("all he measured using asset prices ohserved over a relatively short time
pcriod. In .contrast, direct measures may require many months or even
years or observation.
The general applicability of the event-study methodology has led to
its whle lise. In the academic accounting and finance field, event-5ludy
IIlcthodology has been applied to a variety of firm-specific and economywide events. Some examples include mergers and acquisitions, earnings announcemen!S, issues ornew debt or equity. and announcements of mac roe[onomic variables such as the trade deficit. I However. applications in other
fields are also abundant. For example. event studies are used in the field of
law and economics to measure the impact on the value ofa finn ofa change
in the regulatory environment,2 and in legal-liability cases event studies are
used to assess damages.~ In most applications, the focus is the effecqof an
event on the price of a particular class of securities of the firm, most often
common equity. In this chapter the methodology will be discussed in \erms
of common stock applications. However, the methodology can be applied
to debt securities with little modification.
Event studies have a long history. Perhaps the first published study is
Dolley (1933). Dolley examined the price effects of stock splits. studying
nominal price changes at the time of the split. Using a sample of 95 splits

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).



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 step--measuring the normal performance-and 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
cross-sectional regression models which are lise fill to investigate slI('h hypotheses. Section 1.9 considers SOll\l~ fnrther issues in event-study design
and Section 4. I () concludes.

4,1 Outline of an Event Study

AI Ihe outset it is nsefnl to gi\"(~ a brief ollllinc of the structure of an ('\"('111
study. While thcr!' is no uniqut' strtl('lun~, the ,lIIalysis ("an he \"inwd

4.1. O/ltlill~o/alll~vf1lt Stw/.V


as h,lvin!{ seven steps:

I. 1:'wllt t/llil/iti()l l. The initial task of cOllductill!{ an ('velll stlldy
is to define the l'vcnt orintere st and identify the period over whirh the
prices of the firms involved in this I'\'l~nt will hI' l'x,lInin l'd-the
willlimll. For example , if one is looking at the illf<)rJnation content
an earnill!{S announ cement with daily data, the event will he the
earnillgs announ cemelll and the l'Wlll window might he the onc day
or the
annOllll celllenl. In pr.lcticc , thl' event window is ofkn expand
ed to
two days, the day or the anllOlln Centent and the d,IY after the ,1IInOUIK
eIllt'nl. This is donc to captllre the price errects ofannou nlTml'n ts
occllr after the stock lIIarket closes on the announ cement day.
The period prior to or after the evcnt lIlay also he or interest and included
Sl'par'llely in the analysis, For example , in the l'arnin!{ s-annou neemen
case, the market may aCfJuire informa tion about the ('arnin!{s
prior to
Ihe actual announ cement and one call illv('stigatl' this possihili
ty hy
l'xaillinin!{ pre-even t returns.
~ . .)l'lrrliol1 rrilrria. After identify ing the evellt
or illtCn.:st, it is Ilcccssar y
to determi ne the selectio n criteria for thc inclusio n or a given
linn in
tltl' study. The criteria lIIay involve restriCliolls imposed by data
avail,lhility such as listing Oil the NYSE or AMEX or ma), involve restricti
such as llIembe rship in a spccific induslly At this stage it is Ilseflll
sllllllll'lrir.e some characte ristics of the data sample (e.!{., finn
capitaliz ation, industry represel ltation, distribu tion of events
time) ,Ind lIote allY potentia l biases which m'l}' hav!' 1)('('11 illtrodu
through the sample selectiol l.
:1. NOn/wi al/d almo17l1lli 7l~tllnlS. To appraise the I'\,('nt's impact we n'lltlire
a measure of the abnorm al relllrll. The abnorm al return is the
"X /lost return of the security over the event
window minus the normal
return orthe firm over the event window. The normal return is
as the return that would be expecte d if the e\'l'nt did not take place.
each firm i and event date r WI' hav('


= il" - E[lI"

I X,].


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
lIlodeliu g the nonn;d rt'llIl'11 -the rOl/.lt{/I//-III1'III/I('/lIrJ1 lIIodl'! whnl'
j, a constan t, and the lIl(l1krl lIwdl'l where X, is the
IIlarket return, The
COl1stanl-IIII';tn-return model, as the n,lIne inlplil's, as,ulII('s
that the
IIlcan return 01'.1 given secllrity is constan t through tillll'. Th('
nlodel assumes a stahle linear relation betwcl'n t h!' IIlarkcl return
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'l-llilHII'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

4.2 An Example of an Event Study

'1'111' Fill<lllci<ll ,\'TOlllllillg' SI;lIl1Ltnls l\o<ll'd (FASB) alld Iltl' Senllilil's Exchallgl' (:Ollllilissioll siril'l' 10 SI'I n'porlillg n'gulaliollsso Iltat JlIIOIllcial Sial\,II 11'11 Is alld r"'all'd illl'Ol'llialioli r"'l'asl's al'l' illli)rJnalil'(' ahollt Ihl' valliI' or
IIII' firlll, III Sl'lIillg sl<lII<I<lr<ls, Ihl' illl('l'lllalioll cOlIlI'lI1 or Ihl' lill<lllci;ai disdoslIl'l's is "I' illl('\'('S!. 1':\'('111 sllldi('s prol'ide all idl'alltlol Ii II' !'xamillillg Ihe
illlill'llIaliull ('01111'111 or Ihe disdoSlIl't'S,
III Ihis SI'!'Iioll "'I' dl'snilll' all I'xalllple S('lcCI('d 10 illllsll'al(' Ih!' ,'\'('111sllldv 1111'1 hodology, (lilt' pari iClllar II'PI' or disclosllre-qual'l!'r'" l'al'lI i IIgs
allllolltll','ml'lIls-is ('ollsill,'red, INc illl'l'sligale 1111" illlin'llIalioll ('01111'111 of
qllalll'd\' 1';llItings allllllll\lI'I'IIII'lIls I(n' Ih(' Ihirly {irllls ill lite Do\\' .I"IlI's
ItltIIlSlri;llllld", ovcr IIII' li\'I'-\'I'<lr pl'l'iod from.laullary \I)X() 10 Ikn'llIlll'l'
I~)~n, Tltl'sl' ;lIl1lollltn'lIll'lIls ('onrspolld 10 IiiI' qllarll'ri\' I'<lrllillgs 1'01 IiiI'
IaSI '111;11'11'1' "I I~IHH 1III0ligh till' Ihird qllarll'l' or l~)~J:\, Tltl' fi\'1' \'(';Irs or
dala lor Ihirl\' linlls l'rO\'idl' a 101<11 "lIlIpll' of (jO() allllOlllln'lIlt'lI", For

4.3. M()(/,lJ Jar Mrasunng Nanna/ Prrjonnanrr

each firm and quarter, three pieces of information are compiled: the pate
of the announcement, the actual announced earnings, and a measure of
the expected earnings. The source of the date of the announcement is
Datastream, and the source of the actual earnings is Compustat.
If earnings announcemenl~ convey information to investors, one wiuld
expect the announcement impact on the market's valuation of the firm's
eC]uity to depend on the magnitude of the unexpected component of the
announcement. Thus a measure of the deviation of the actual announced
earnings from the market's prior expectation is required. We use the mean
quarterly earnings forecast from the Institutional Brokers Estimate System
(I/R/E/5) to proxy for the market's expectation of earnings. I/8/E/S cO[llpiles forecas15 from analysts for a large number of companies and reports
sumlllary statistics each month. The mean forecast is taken from the last
month of the quarter. For example, the mean third-<Juarter forecast from
September 1990 is used as the measure of expected earnings for the third
C]uarter of 1990.
In order to examine the impact of the earnings announcement on the
value of the firm's equity, we assign each announcement to one of three
categories: good news, no news, or bad news. We categorize each announcement using the deviation of the actual earnings from the expected
earnings. If the actual exceeds expected by more than 2.5% the announcement is designated as good news, and if the actual is more than 2.5% less
than expected the announcement is designated as bad news. Those announcements where the actual earnings is in the 5% range centered about
the expected earnings are designated as no news. Of the 600 announcements, 189 are good news, 173 are no news, and the remaining 238 are bad
With the announcemen15 categorized, the next step is to specify the
sampling interval, event window, and estimation window that will be used
(0 analyze the behavior of firms' equity returns. For this example we set the
sampling inten'allo one day; thus daily stock returns are used. We choose a
4 I-day event window, comprised of 20 pre-event days, the event day, and 20
post-cvent days. For each announcement we use the 250-trading-day period
prior to the event window as the estimation window. After we present the
methodology of an event study, we use this example as an illustration.

4.3 Models for Measuring Normal Performance

A Illllnbcr of approaches are available to calculate the normal return of a
givcn security. The approaches can be loosely grouped into two categories-;statistical and economic. Models in the first category follow from statistic~1
assumptions c.oncerning the behavior of asset returns and do not depend on


4. Event-Study Allfllysi.l

any 1conomic arguments. In contrast, models in the second category rely

on a~sumptions concerning investors' behavior and are not based solely on
stati$tical assumptions. It should, however, be noted that to use economic
models in practice it is necessary 10 add statistical assumptions. Thus the
poteintial advantage of economic models is not the absence of statistical
aSsUiPtions, but the opportunity to calculate more precise measures of the
nor al return using economic restrictions.
or the statistical models, it is conventional to assume that asset return arejointly multivariate norlllal and independently and identically distrib ted through time. Formally, we have:


Let R, be an (N x I) vector of aJset relllrns fur calendar time Ileriuti t. R, i.l

inde endl'1ltly multivariate )!anllally distributed with mean /1. and COIJarianfe matlix

fot flll t.

This distributional assumption is sul'ficient for the con~tant-lIIean-relllrn

modrl and the market model to be correctly specified and permits the development of exact finite-sample distributional results for the estimators
and statistics. Inferences using the Ilormal return lIIodels are robust to
deviations from the assumption. Further, we can explicitly accol1lmodate
deviations using a generalized lIlethod oflllOlllenL~ framework.

4.3.1 CUll.llrmtMrnll-Ul'tunl Model

Let /1.;, the ith element of /1., be the mean return for asset i. Then the
constant-mean-return model is

El slI ] = ()


where Il;" the ith clement ofR" is the period-t retun! on security i, ~" is the
disturba/lce term, and a~~ is Ihe (i. i) clement of n.
Although the constant-meall-return 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.

".3. lVIIJ!lrLI.!;J/ MPtl.llllillg NIJnnall'njll/lI/f/I/i/'


4.3.2 Mil/hI'! MIJ"d

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



+ {l,U"" + E "

where Ji alld N"" are the period-t 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 valllc-weighted index, alld the CRSI' eqll;li-weiglitcd index heilll-:
popular choices.
The market model represellts a potclltial illlJ)rovemellt over the CUIlstantmean-return 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
lIlarket-lllo(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.

".3.3 ()thrr S/Illi.ltira/ Mo"dl

A number uf other statistical mudds have hc('n proposed Ii)r mudeling
the nurmal return. A general type of statistical model is the Jar/or model
Factor models putentially provide the henefit of reducing the variance ur
the abnormal return by explaining mure of the variation in the norl1lal
return. Typically the ractors are portfolios of traded securities. The market
model is an example of a onc-f;\ctor l\Iodel, but in a \\Iultifactur model one
mi~ht include industry indexes in addition to the market. Sharpe (1970)
and Sharpe. Alexander, and Bailey ( I \195) discuss index models with factors
based un industry classification. Anuther variant uf a bctor model is a
procedure which ca!culates the abno\'\\Ial retul'II hy taking the difference
between the a(\ual retul'll and a ponfolio of [inns of silllilar sit.e, where si/.c
is mcasllrcd hy market value of <,<)uity. III Ihis approach typically tell Sill'
groups arc cunsidered and the loadill~ Oil the sil.e portfolios is restricted
"The sptrilircttion OIctl1<tlly reqllin's the asset wc.'igills ill th" 111.\1 kt'l portfoliu to u'lIIain
constant. However, rhanxes over timt" ill tilt' markcr pOlIi"nlio weights 011(' small t'II01lXh th,U

they h"ve lillie dkct


('lllpirical work.

to Hllit)'. This pmcetllll'l' implicitl\' aSSllmes that expected r('tlll'lI is t1irl'nl\

rdaled 10 Ih(' III;uk!'1 \';1111(, of eqllity.
III praclic(' Ih(' gaills from cmployillg milltifactor models for ('I'CIII silldit'S arc limit!,(\. The n'ason t(lI'lhis is Ihal the llIar~illal explanalory power of
ad(litiollallil('\ors 11I'yolld Ihl' market factor is small, and hcnce there is littlt'
r('duClioll ill Ihl' 1':1Ii;IIHT of III<' ahllormal I'l'l Ill'll. The variallce r('dunioll
will Iypically h(' g;rl'alt'SI ill cases 1\'111'1'1' Ih(' sample linns hal'<' a COlllmOlI
charat'lnislic, for example Ihey aI'(' all 1I1('mhcrs of one indllslry or Ihey art'
all linns con('('lIlrall'(1 ill OJle market capitalization grollP, 111 Ihese casn
Ihc lise or a mllltif;\('lor mod .. 1 walTallls cOllsideralioll.
SOllll'lilll(,s lilllil('d dala al'ailahilily lIlay diclalc Ihc IIS(' of a reslricled
llIodd sllch as Ihl' I//m!w/-llIljIH/nl-rrllll'll IIIIIt/rl. For som(' ('vellts it is lIot f(:asihk to haw a pn'-('I'('nl ('stimatioll pniod for the normalmodd par:lllletns.
alld a market-adjllste(1 almorm:ll retlll'll is IIsed. The markehl<\jllslcd-rCI\II'1I
modd can hc I'iew('d as a reslricled lIIarkcl model with ex . cOllslraillt'd 10 he
() and fl, conslrained 10 hI' I. Since Ihe llIodel cocfficients arc prespedfied.
all cstimatioll pniod is lit)! required to oht,Iill parameter estimates. This
modd is oftcn IIsl'd 10 stllt!y Ihe IIlIderpricing of initial pllhli(' offerillgs.'
A g('lIt'1'al I'('comnH'IHlation is to tlS(' stich reslricled models only as a last
resort. alld to keep ill lIlilid that hiases lIlay arise if the restriclions arc false.

Economic Illodcls reslrict Ihe parameters of stalistical models \0 provide

\\lore conslrained norlllall't'tlll'li IIH)(lds. Two common cconomic models
which provide restrictions are the Capital A~scl Pridn~ Model (CAPM) and
exacl vcrsions of Ihe Arhitrage Pricing Theory (APT). The CAI'M, (hie to
Sharpe (191;1) alld I.illll\('r (I!}(i;lh), is all e(JllilihriulII thcory whne Ihe
expccled retlll'll of a gil'clI assel is a lillear functioll of its covariall('e wilh
Ihe 1'('1111'11 oftl\(' \\Iarkel port/illio. The AI'T. dill' to Ross (197G). is all asset
pricing' Iheory whl'I'(' in Iht' ahsellcl' of asymptotic arhitra~e the cxpl'ctl'd
r('tllrn oC'a gil'l'n assl'l is dltel'lnined hr its nll'ariances wilh multiple bClOrs,
Chapt<'l's !'i and Ii plOvidl' ('xll'nsiv(' treatnwlI\S of these IWO Iheories.
Tht' Capital Asst't I'riring Mot\1'l was ('()(Jllnonly used in evellt studies
durillg the I !170s. Durillg Ihe last 11'11 years, however, deviations from lhe
CAI'M have he('11 discOl'I'll'd. alld Ihis casts doubt on the validity or Ih('
restrit'liollS imposed hy lIlt' CAI'M 011 tht' markel mode\. Sillcc Ihest' ICstriniolls CIII 1)(' rdax('(1 at lillie ('osl hI' IIsillg Ihl' IIIarkel IIIodd, the liSt' or
the CAI'M ill e\'(,111 stlltlil's has allllOst c('ased.
SOIlI(' silldi('s haw IIsed IlIlIltirat'lor norlllal performallce 1II011cis 1110tivated hI' the Arhilrag(' I'l'it'illg Th 1'0 II', Thl' APT call he lIIade 10 fil lilt'

-1.-1. Mealunllg and Analyzing Abnonnal Returns

Tillie Line:


est~malion ]

event ]
( window

po~t~venl ]
( Window

Figure 4.1.

Ti= l.ine Ja,. an Eumt Study

cross-section of mean returns. as shown by Fama and French (1996a) and

others. so a properly chosen APT model does not impose false restrictions
on mean returns. On the other hand the use of the APT complicates the
implementation of an event study and has little practical advantage relative
to the llnrestricted market model. See, for example. Brown and Weinstein
( 19R!i). There seems to be no good reason to use an economic model rather
than a statistical model in an event study.

4."4 Measuring and Analyzing Abnormal Returns

In this section we consider the problem of measuring and analyzing abnormal returns. We use the market model as the normal perfonnance return
model. bllt the analysis is virtually identical for the constant-mean-return
We first define some notation. We index returns in event time using
r. Defining r := 0 as the event date. r = 1'1 + 1 to r = 1'2 represents
the event window. and r == To + 1 to r = 1'1 constitutes the estimation
window. Let LI = T t - To and l.Jl == 71. - 1'[ be the length of the estimation
window and the event window. respectively. If the event being considered
is an announcement on a given date then 1'2 == 1'1 + 1 and L;. = 1. If
applicable. the post-event window will be from r == 1'2 + 1 to r = 1', and its :
leni!;th is L:\ = 1~ - 71.. The timing sequence is illustrated on the time line .
ill Fi~\lrt 4.1.
We interpret the abnormal return over the event window as a measure
Oflh(" impact of the event on the value of the firm (or its equity). Thus, the
Illcthodology implicitly assumes that the event is exogenous with respect to
lhe change in market value of the security. In other words. the revision in
V<l\Ul' of the firm is caused by the event. In most cases this methodology is
'lppropriate. bllt there are exceptions. There are examples where an event
is triggered by the change in the market value of a security, in which case

. dAi ri .'
J..~-~;f. ..


4. HlIflll-SIIll!y illI(/!y.\i~


the event is endogenous. For these cases, Ihe usual inlerprelalion will be
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 event-related 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

'1',hr I'vIflr/{1'l Mudd

Recall that the market model for security i ami observalion r in event time
U" = u, + Ii,RIIIT + (",
The estimation-window 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 estimation-window 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 market-Illudel parameters. Funher, /-(ivelJ
the assumptions uf Section 4.3, 01.5 is efficient. The 01.5 estimalors of Ihe
lIlarket-model parameters usill/-( all estimatioll window or LI oilserv<ltiollS




1-1 -~ , '

R, -



\V~ next show how to use these OI.S estimators


to l1leasur(' Ihe slatistical

'1. 1. Mf'{/.\IIl'ill~ (II/(I AI/(I~l'Zill~ tlil/Ilml/( I/



propcrti es of ahnol"ln al rdurns. First w(' consid(, r till' "hllornm

l return
proJlcrti es of a given security "nd tlll'n we aggrq;a tl' "lTIIliS senlrilic
4.4.2 S[ali.llim ll'm/wr/il 'J I{ A/IIIII/I/lft! N,'IIIIII.I

(;i\'('ll Ihl' lll<lrkct -Illodd parame ter estimale s, we can measure

alld allalyze
Ihe ,11)1101"111<11 returlls. Let
he the (i~~ x I) S,lIlIplc v('("(or of ahllorm al
1('llirm lilr lirm i frolll the evcllt window, TI + I to /~. Theil
usillg th('
Inarkel Ill(Hkl to IIlcasure the nortnal rclllrll alld Ihl' Ol.'i ('stimato
rs frolll
(1.1.:1), II'l' h,I\'(' lilr the allllortu al n'llIl'Il v('rlor:



R'I -X'O


I U,r,+1

... UI/'1' is all (i,!x I) V('("(OI' of ('I'l'lIt-w illdow returllS,

is <In (/'l x:l) matrix with a \'('('tOI' of olles ill the lirst columll
a.J(lt\)(' v('ctOI' oflllaJ'k el returll ohseJ'va tiolls R;" =c lU",r,. I'"
N"'/11' ill the
~e( ond ('Ohllllll, alld OJ == [a, II, I' is Ih(' (:!x I) pal'<llIl('t('1' I'("('(or
estimate .
COlldili on.d Oil Ihe market rdum over th(' ('vellt willdow, thl'
ahllorlll allTttll'ns will he jointly normall y distrihu ted wilIt a zero cOllditi
ollalme an alld
conditio nal covari,\I \(T lIlatrix V, as showll ill (-I.'l.l'l) alld
(-1.'1.9). resp('cliwl)'.

X; == It R;"I

E[R; -


X; 1

I':[(R; - X;O,) - X;(O, - 0,)




I is Ih(' (I . ! x I ..J identity matrix.

From (I.l.l'l) we sec Ihatth(' ahllol'lll<d n'lIinl \,(('tOI, wilh all
expecta lion of 1.('1"0, is unhiase d. The co"ariall <T Illalrix of Ih(' <lI>IIoJ'lI
Ial return
vector frolll (-I.U)) has two parts. 'I'll(' lirsl I('r11 I ill th(' Slllll
is Ihe variallc( '
due to lhl' futllre disturha llces alld th(' '('C() III I tnlll i~ lIte addilion
al varianc(' dll(' 10 IIt(' salnplin g l'rror ill (),. This .'<lIl1plillg ('1 I'or, which
is COlIllllOll

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

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

1. '1.1 :\g.t:'fl'gillillll II/ Abl/lInllll[ Urlllnls

The almonnal rt'llIrn ohsn\'aliolls mllsl he aggregated in order to draw

o\'erall inli-n'lln'o; ItH' III<' ('\'elll or ill\<I'l's\. The aggregalion is alollg two
diml'nsiolls-through time and across securities. We will (irst considcr aggregalioll Ihrough lilll!' for all iuliil'idual secllrity alld Ihell will consi(\er
aggregalioll hOlh across S('('urilies and Ihrough lillie.
We inlroduCl' Ihl' l'Iulllllali\'c ahnormal reI urn 10 accolllllHHial1' Illultipk salliplilig illll'l'\'als withill the eve II I window. Defille CAR/(rl, r~) a~ the
1'llllllllaliVl' ahnol'mal relllm fill' security i from rl 10 r2 where '1'1 < rl ::::
r~ :::: /~. l.l'I, he all (I 'J X I) v('clor with Olil'S ill posilions rl - '1'1 10 r~ - '1'1
;lllI\1.l'rm's ds('wlwfl'. Th<'11 Wl' ha\'e


('1.4.11 )


T~)\ = O/~(TI' r~)

= ,'ViI'


I! ii,\Iows frolll (1.1.10) Ihal ulHlcr II",

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~)



(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

4.4. Mfll.'iuring and Analyting Abnonnal Returns


degrees of freedom. From the properties of the Student t di~tribution.

the expectation ofSCAR;(rl. r2) is 0 and the variance is (~). For a large
estimation window (for example, 1.1 > 30), the distribution ofSOO;(rl. r2)
will he well approximated by the standard normal.
The above result applies to a sample of one event and must be extended
for Ih(' uSIIal case where a sample of JIlany event observations is aggregated.
To "ggregate across securities and through time, we assume that there is
not any correlation across the abnormal returns of different securities. This
will generally he the case if there is not any clustering, that is, there is not
any overlap in the event windows of the included securities. The absence of
any overlap and the maintained distributional assumptions imply that the
abnormal returns and the cumulative abnormal returns will be independFnt'
across seCllrities. Inferences with clustering will be discussed later.
The individual securities' abnormal returns can be averaged using
frolll (4.4.7). Given a sample of N even ts, defining f as the sample averitge
of the N abnormal return vectors, we have




We can aggregate the elements of this average abnormal returns vectpr

through time using the same approach as we did for an individual security's
vector. Define CAR(, '2) as the cumulative average abnormal return fr<\m
'I to ,~ where TI < " :5 '2 :5 1~ and 'Y again represents an (/1), xl) vect~r
with ones in positions " - T. to '2 - T. and zeroes elsewhere. For the
cUlIIulative average abnormal return we have
Equivalently, to obtain CARCr . r~), we can aggregate using the sample
cUlllulative abnormal return for each security i. For N events we have






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~


since under the null hypothesis the expectation of the ahnormal returns
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 ==



(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)'



Assuming that the evellt windows of the N securities do not overlap in

calendar time, under 11o, SCAR(r,. r2) will be normally distributed in large
samples with a mean of zero and variance (N;C:1)' We can tesl the null
hypothesis lIsing


= (

NU., 1.1 -

4); __

,SCAR(r,. r2) .::. N(O. I).


When doing an eventsllldy one will have to choose betweellllsing 11 or 12

for the test statistic. One would like to choose the statistic with higher power,
and this will depend on thc alternative hypothesis. If the tflle ahnormal
return is constant across securities then the better choice will give more
weight to the securities with the lower abnormal return variance, which is
what Jl docs. On the other hand if the true abnormal return is larger for
\ securities with higher variance, then the beller choice will give e(l"al weight
i to the realized cumubtive abnormal retllrn of each security, which is what 11
Idocs. In most sllldies. the result.~ ,Ire notlikcly to be sensitive to the choice
of 11 versus /~ because thc variance of the CAR is of a similar magnitude
across SeCllnl1es.


4.4.4 .\'cIHililll(V 10 Normal Ul'lllni I'vlodel

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

-I. ,1. Mm.\111711K mul AII(llyzi"K AIJlltlnll{/llIl'lllru,1



constant-mean-return 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


Yar[ [(" Yarl RII I

(x, -

fl, Um ,\

- Ii; Y,III Umll

(I - U;lYar[UIIJ.

(4.4.25 )


is the /{2 of the markel-lIIodel regressioll for security i.
For the cOllstant-mean-rellirn model, the variance of the abnormal retUI'll ~" is the variance of the uncolHlitional retul'll, Yar[ U" J. that is,



YarlU" -II,!




Combining (4.4.25) and (4.4.2li) we have



!;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 constant-mean-return model. This lower variance for
the market model will Gln'Y OVCI' into all the av;v;n-v;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
lIlarket-model 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.

4.4.5 C1R.I for the 1~'(/rnil/g\-AII1/oll/l(flllfllt Exam/lie

The earllin~s-anno\lllcement example illustrale, the use of sample abJlorrnal returns and sample cumulative ahnormal retUrlls. Table 4.1 presents
the abnormal returns averav;el! across the :~() lirIllS as well as the a"cra~ed
cIIllItdative almormal relUnl I()I" each of Ihe IhnT earnings news categories.
Two norlllal return models are considered: the Illarket model and, for
comparison, the constant-Illean-rctlll'n llIodel. 1'1015 of the ctllnulative al)normal retul'llS arc also included, wilh the CAR" hUIIl the market lIlodel
in Figure 1.201 and the CARs frolll the cnmlallt-IllI',lI\-1('tUl1l model ill Figure 4.2h.
The results of this example ar(' lar~ely nJllsisl(,lI1 wilh the exisling- literature on the inforlllation ronll'nl of' earllin~s, The ('vidcnce slrongly

Table 4.1.


/111" (/1/

(1'1'111 ,111111'

"lIlit' ili/iJUI//lliulI

rolllfill "l('(lft/illg' /111-


:.. \I(
















--,177 - "HI


- .1).11


- .:!!".H



-.I).IX -.II'!.!I



--.lUill -.IIHh -.11:1




















- .UP)


-- 11111



-.0111 -.II',!'I


,II 17






_. I'!. I

.. O~)l1


.... :I~J'!.






,OIi' - .W.7 ... 00i:1

.1~lq -.f1'!o
.I'!.M -.101t
,:1:\:1 .1I'!.ti . PI'!.
.'it:, ,II III ,117



























I.Qhtf -.O!"


'.! ',!In




:!.O'.! I


I liB





. F/') '.!.:\".!:\


I ~.


- ,HIIH '.!:\I~.
I Iii
.Ihl :!.1711
IIXI '.!.:\'1H
- .WIH '.!:\ II.'.! Iii - .'!'VI





.1I It

IIXX -- 11111

:! FI:\ - II'.!!)
.OX) '.!.:!'\j
.\7'! '.! .. \("' .W"


- .liM:'

- ,11,111


.- T\'I




_ r,'!7
- .hhl\


.:U I

-.O'!.ti -.OXli -.1'10 -.'!.:.:.

-,IlHli -.172
,1I:m -,~lIi
-,IX:I -.:\'.',
,1l!1!1 -,117
-.O'!.O -.:nr, -.1:111 -.'!.Iili
-,02:, -.:i!I~1 -. nil -..1:IM
,11l1 -,~!IH
.1:1:1 -.:I~:.
.1~li -,172
,lIl1ti -,:II!I
,1:1-1 -,II:IX
,111:1 -,~II
,1I2~ -,I!I'I
,WI - ,11:11
-.11112 ,n7 ,1I1~1 -,Iln
,~HH -.1I2!1
.:H~I -.lItiX -.I'!.U




,UK'.1 -,U:II



,1l1:1 -,IIIH


.fi!",' -.170









- Oljq












- .:!t,li

- .i!)!


LtiHH -, 1Ii,1 - ,<1-111

-.lil:\ -l.lilil

,:1,.7 2,11-1:. -,1711 -,2111

-.0 I:~ '!..II:t\
-.1 :lli
-IIMK 1'11,1 -,I~I -,~77

-,~12 -L~i:1


.H7X -I. 7~r)

.itlt -\ I;\K










1111 -I.'.!XI.J
lIili I.'.l.I:\
- 1111 -1.1:11



-.mrs -.'!.!.ti





-.:\I!I -}17!",




.(J70 -) '1:\
,III~ -1.11-11





I :~II - 1.07'\



- ,II:IH - 1.11'1
,1171 --I.IIIH
.uP) -I.II'!."
-,111:1 1.117~

-.OMI; - I Jrl!'




-.WI7 -.!I:\I
,1-17 :!.I'.!I
.!tln .7:!H
-.01:\ :!.HI7
.0.1:. - .fiX:'
-.II:,-t ~.:':)I
.!!~~I - :\X I





-.1171 -1 I/.-,Ii
,'.!Iii - 7XQ

. IX:\






- .~IIH






- i:!1



-(\(i7 -,,\:.1
-.O'!.I ... 17:,
-.017 ~.OtiM -.U:I~I -':1:\1
,111:1 ~,171 -,II'lii -,',HII

.lI(it; !!.:!:n -.OHM -.ti77

,I HI ~,:\,17
,(\21 --,''''(i



11'1 - 11,1

.1":'1) .
-.fJX!'i .. I.'!.W



.flMX -.!"IIIX





- .11'!.!'i





---------- ---- -----



-.'.!:!i -I.IIIH




. I'.!'


. FlO

.1:\:1 '.!.ltill
'.!.1t17 -.:\II'.! -.1:,0
OliO'.! Iti7 -.PIII -.\I!I


-, III





. - ---"----,,------------


Tlw :-""uph ,u""", HI ~, t\l\.,1 01 I~UI '1'1.\\ \\" Iy ;\1HHIUUn',u,'u\:\ fur ,In- Ihi1 'Y rump.""", iu
IlUII'.IUIII" 11I<I1I,lri,(1 111<1", lUI II,, Ii",... ,,, 1"'1 iu<I JII,"ary I !IH!llo ))"(,('1111)('1' I !)I):1. Twulllutl
t\~ ~\H' nln ... ,tl,'u'd h" tht' HOtU,,\t l~'lUlI\"'. It", m~u ~(:, Inudt,t \I~in~ tht, (:RSl' v.\hH'-\\'liglu(tl
iudex 'I1Ullh(' n,.. ... I;ullIIU', .. I'I'('11I11I lIIeu",!. '1 lit' :IIIIHHllln'IIH'IIIS an' r.llc'god/c.d illin IlIn'('
grollp\, ~ou(ll\("\'~. WI tU'\\':\, ,Hul h.HlIU'\''', c- i .. th ... :-':Utllllt, ,\\'C.'I';.,~c.' ~\hIlUnl1;lllI.,t\lrH hll tltc.'
'Iu"'ili('cl ct.v in ('v('1I1 lillll' ;111(1 ~ i, lilt, !'o,IIlII'It' ;I\'I'raw' C'WllIltlliv(' "hltollll.1I 1'11\11'11 101 d;,y
-':!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',


-1.-1. MI'llSWillg mul A1wlyz.ing A/manllal Returns





Nn-NC'WI Fir"1I

....... .







Event Time

Figure 4.20.

Plot of Cumulative MarketModel Abnormal Return for Earning Announce-

111m I.'








No-Ncws Firml

..... .








Event Time


Figure4.2b. Piol of Cumulatillf COll5lanlMfflnRdurnModel Abnormal Return for Earn

ill~ AIlIWWICfllU'1ltS

SlIpports the hypothesis that earnings announcements do indeed convey i~.

fill'lllation IIseful for the valuation of firms. Focusing on the announcement
clay (clay zero) the sample average abnormal relUrn for the good-news fir~




A 1I1/(~sis

using the market model is 0.965%. Sincethe standard error Ilf the one-day
good-news 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 had-news 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 no-news 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 good-news
and the bad-news firms respectively. Both these values are more than two
standard errors from zero. The source of these day-one 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 constant-Illcanrcturn model arc consistent with those from the market modcl. Ilowever.
there is some loss of precision Ilsing the constant-Illean-return lIlodel, as Ihc
variancc'of the avcragc abnormal rcturn increascs for a)) thrcc categorics.
When measuring abnormal rcturns with the constant-mean-relllrll model
the standard crrors increasc from 0.104% to 0.1300/0 for goodnews finns,
from 0.098% to O. I ~4% for no-ncws firms, and from 0.098% to O.I:H %
for~)ad-news 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 good-news
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


In a lalylillg aggrcgatcd abnormal returns, we have thus far assullll'd Ihat

thc hnorrnal rcturns on individual securities arc uncorrc!ated ill titl' cross
sect 011. This will gellcrally he a re.lsonahlc 'ISSlllllption irthe evcnt windows
of tHe includcd securities do not overlap in calcndar tilllc. Thc assulllption
allows us to calculatc thc variancc or the aggregated salllple clllnulativc
abnormal returns wilho\lt concern .Ibotlt covarianccs betwcell individual
sample CARs, sincc they arc I.cm. Ilowcver, when the cvcnt windows do

4.5. Mor/ijrillJ.: 1111' NlIllll)'jJIIlhrJi.1


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),-hy-secllrit)' (\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 F-test 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 tinite-sample propnties, and oftl'lI it
h;I' liuh- power against economiclily rcasonahk altl'rnatiws.

4.5 Modifying the Null Hypothesis

Thus Ell' we have focused on a singl(, null hypolhesis-Ihat Ihe given event
has no imp,'Cl on the hdlavior or secllrity relurns. With Ihis 111111 hypothesis
either a mcan effect or a variance elfel:t rq>n'sl'lllS a violation. Ilowcva.
ill sOIl](, applications we lIlay he inl('resled in testing only for a lIlean effect.
In these cases, W(' lleeci to expand the llullhypolhesis to ,Illow for challv;ing
(usually increasin!{) variances.
To accomplish Ihis, we need to elilllinate all}' rcliallc(' Oil pasl returns
in {'slimalill!{ the variance ur the a!{!{rcg,lted clIlIIltiative ,tilllonnal returns.
Instcad, we lise the cross section of flnlllllative almonn,tl returns to form
all eSlilllator of Ih(' variance. Boehmer, J'vlllsllilleci, ;\1111 PoulsclI (I!I!II)
discuss lhis Illcthotiolov;y, which is bes\ appli('d (Ising tite const<lnl-lIl('allretllrn model 10 IIlCaSllre the abnormal reI urn.
The cross-scuion<ll approach to ('stilllalillg the \'<lrian((' can be applied
to both the avcrav;e ClllIlllLttive abnonnal return (CXR(TI. T~ and the avnag(' slalldanliled cUlllulative al)llOllll;llll"tll1"ll (.~( :XI{( TI. r~) . Using Ihe

-I, J:'1'1'II1-SllIIly A/I(//y,li,

cross senitlll 10 1<11'111 eSlimalors of lilt' vi\I'hll":t's wc havI'

(-1,:1,1 )




N~ I)SCARj(TI. T2) - SCAR(TI' T~", (4,:,,2)


For Ihe,~e I'slilllalOr~ of Ihe v;lriant'l's 10 he consistelll WI' require the

ahllormal relll!'llS III hI' IIl1coITl'I;lll'c1 ill the cross sectioll, An absellce of
clllstering i~ sunicil'lIl for Ihis reqllirclIlcnt. NOlc thai cross-scctiollal holIIoskedaslicil), is 1101 n'qllirl'd iill' (ollsislt'ncy, CiVl'1I Ihese variallcc eslilll;!(or~, Ihe !llIlI hypolhesis Illal till' nllllul"liw allllol'lllal n'lurn~; arc I.I~ro Gill
Ihl'lI hI' It'stl'd usiug lar)!;I' salllpll' thl'ory giVl'1I thc l'Ollsislellll'SlimalOrs Dr
11ll' variancl's ill (.I.:).~) alld (1.:),1),
0111' ilIa), also hI' illll'l'l'stl'c1 ill IIIl' impart of all ('VI'1I1 on Ihl' risk of a
finJl, Thl' rdevalll llIeaSlIre or risk 1II11St hI' ddilled hdi)rt, this iss\lc (all
hI' addressl'd, 011(' dlOil'!' as a risk IIlCaSllre is the llIarkl,t-lIlodcl bela as
implil'd hy Ihl' Capilal Assel Priring Model. Givcn this choict', the markel
lJIollel rail Ill' fOrllllll;lIl'd 10 allow Ihl' hela 10 change over Ihe cwnl window
alld Ihe siahilil)' of Ihe hela call he I'xaluillt'ti, Set' Kalil' alld Unal (I \lHH)
(ill' all applicalioll til' Ihis idea,



4,6 Analysis of Power

'Ii) illll'rprl'l all



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'IlI-SllId)' 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 two-sided lesl "('Ihl' 111111 hypothesis \Ising Ihl' l'\Il\1ulalil'l''1IlIIOl'lllal-n'lllrll-h"~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;( rl, r~) aliI IN'IS Ihl' s'\llIplt: Slfl',
Ulltier Ihl' 111111 hypolhl'sis Ihl' dislrihlltioll 0(' JI is stalldard norlllai. For a
IIVO-silil'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),


4.6. AllalY.fiso/Power


Given an alternative hypothesis HA and the CDF of 11 for this h~pothesis.

tahulate the power of a test of size a lIsing


Pea, H A)

Pr(jl < <l>-I (~)

H A)

Pr(jl > <l>-I (1-~)

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
giving values of -1.96 and 1.96 for <1>-1 (a/2) and <1>-I(I-a/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 one-day
event window. Such a case is likely to give the event-study 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 multi-day event window or to a
one-day 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


4. Event-Stut/.v All11~VJiJ

Tat1e 4.2.
"film is

Power of roml-Jlml)' Ir.<1 .1/f/1;.<I;r./i

10 rrjr<1I11,

11111/ ")'/loil".I;.1 111,,1111,' "/,,/(,, 11/,,/













Abnormal Return

Abnormal Return













(1.1 0
0.1 I
O. ](;



= 4%




O. ((l








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~.



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

4.6. Analysis ,,/Powl'r




<; 0

" .,.















S.IIIII,Il" Sill'









.\1'11'01'11..1 H. 10,," I II'"


------.-.. -.-~-- ..
:\IJlIIIIIII,IIl{,"tllrll It ~I';{'


L....~...L..-'-....L-L-l.-'.....J'-L.....l. . ..-L---1-.1..-.l_-..J..-l~.










Sallll'i,' Sill'

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'


" i\ dillin!ll 10 \(',uh gnl('lal (ollclllSiollS rOIHTl'lIillg till' Ihl' ,Ibilill'

Ill' 1'\'I'llI-SIIIII, IlH'lho<lol<>gl' 10 <I('It'l'1 lIollt,ero a"lIonllal \"l'llIrIlS, \-\'h('11

COlldlll'lillg .111 ('\1'111 ,lIldl' il is IH'c('ssary 10 I'Vallial1' Ihe pow('r gin'lI Ille
parallll'lt'\,s ;llld ohj .. t lil'l's 01 II\(, SllIdl', If Ihe PO"'l'I' SI'I'IIlS slIlIilil'lll Ihl'll
Ollt' elll I'l'oll'('d, <>lh(,I'\\'is(' 0111' ,hollid sl'arch ICII' ways of illlTl'asillg' III('
PO\I'I'r, This clIll)(' dOli I' 1)\' illlT(';Jsillg Ihl' sa III ph- sizl', shorll'llillg' Ihl' ('1'1'111
willdo\,', or hI' dl'l'l'lopillg l1Iol'e spl'cilir prl'din iOlls of I h e nil II IlI'poll H'sis,

4.7 NOllparametric Tests

TII(' IIIl'I IIn(h disllI"I'd 10 til is pOill1 ;111' parallll'l ric ill lIallln', ill tklt spccilic
aSsllIllptiollS hOI\'(' h('('I1 Illadl' aholll lIlt' distrihulioll of ahllol'lllal 1'1'\ II \'Il S,
,\\tnllalil'l' lIollparallll'lri(' approa('hl's an' availahle whi('h an' rn'l' or SPI'dliras'lIll1pliolls ('OIIlTlllillg thl' distrihulioll 0(' 1"('llIl'IIs. III lhis s('('(ioll W(,
disCII's 1\\'0 1't1l\\I\\t)\II\tlllpal'alllt'lri.- lI'sts for ('\'I'llt slIulil'S, Ihl' sigllll'si alld
lhl' I'allk II'S\.
Th .. sigll 1.. ,1. ,dlidl i, hOlS('" Oil Ih(' sigll of lilt' allllClI'Ill;tI \'('1111"11, n'l(uin's lhal IIII' ahllol"l\lal rl'llIrllS (or IllOn~ gl'lll'rally (,1I11l1l!alil'l' abnormal
n'III\'IIs) 011'1' illdq)('IHll'1I1 ;tlTOSS sl'Cllrili('s and Ihal IIII' n:pl'('ll'd proportioll of positiw allllOlIIl.tll'l'llII'IIS 1I11dl'\" I he \lull hypolhesis is 05. The basis
of Ih(' II'SI is Ih;1I IIl1d .. r 111(' 111111 hl'pOlh('sis it is equally prohahll' tlnl 111('
CAR will hI' (losilil'l' or IIq~ati\'l'. IL ((II' l'xample, Ihe altl'rnalil'l' !t"pothl'~is is Ihal Ihen' is;t pmitil'" ~Ihllonllal r('turn associated witll a gin'lI ('\'l'lIt,
Ihe 111111 hl'(lollll'sis is Ilu: II ::: 0,:-. alld Ihl' altt'rnativl' is 11.\: II > lUi IdH'rc
/, == I'r(C,\\{, ::: (1.11). 'Ii. calnll'III' IIII' II'SI sialisli .. WI' Ill'l'd Illl' 1l1l1ll1H'1' oj"
(';lSI'S 11'11('1'1' IIII' ahllolillal l'l'tlll"ll is POSilil'I', N'\ , ane! Ihl' 101011 1IIIIIIhl'r of
casl'S, N. I.cltillg ,It hI' Ihl' tl'st slatislic, 1111'11 asymptolically as N illlTl'aSl'S
11'1' h,ll'!'


] N'/~
-'- - 0.:-. - - ~
[ N


I) ,

For ;III'sl "I"sil(' (I .. tr), Ilu i, n:j('("\('(1 if/:! > 4)-1(0').

t\ II'l'akll(,ss of Ih .. sil-:II \('SI is thai it llIay 1101 he well specilit,d if Ilw
dislrihlliioll ot' allllol"lllal I"I'IIII"IIS is skl'wec!, as call he till' case wilh claily
dala. With sknl'l,d al)lHllllIOIi \('IIII"IIS, IIH' ('xIH'C!e!l proportion 01" positive
ahllllnnal I"I'IIIIIIS 1.111 dill('\" hllill lllll' h,llt' l'l'l'll IIllder thl' 111111 hl'(lOlhl'sis,
III I(,SPOIIS(, 10 IlIi, I'0s\ihl(' SIlOlI('OIl1illg, (:orrado (I~)H~I) proPOSI'S 01 110111'00Iallll'II"ic 1"'lId, 11,,11"1" ;11'"111"111.\1 1"'1 II)nl1.IIKt' i111'V1'1I1 sllIdil'S, 1;\'1' III idly
d('snilll' hi, 1t',1 "I IIIl' 1I111111l'pOI\wsi, Ihal Ih('n' is 110 OIlIlIol'lllal 1'('111111 Oil


4.H. Cross-Sectional Modtls

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
The test statistic for the null hypothesis of no abnonnal return on
event day zefo is:

14 =




K~l - ~ /s(ld

Ll r='1i+1

(~t (K


_ loIJ




(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.
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.

4.8 Cross-Sectional Models

Theoretical models often suggest that there should be an association~be
tween the magnitude of abnormal returns and characteristics specific to
the event observation. To investigate this association, an appropriate tool
is a cross-sectional regression of abnormal returns on the characteristics of
interest. To set up the model, define y as an (Nx 1) vector of cumulative
abnormal return observations and X as an (NxK) matrix of characteristics. The first column of X is a vector of ones and each of the remaining
(K - I) columns is a vector consisting of the characteristic for each event
ohservation. Then, for the model, we have the regression equation

(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


4. El/t'1ll-Sllli(V 1I11f11.\',li,1

For thc OLS estimator wc have

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

Using thc unbiascd cstimator for a~,

a 1/ --

(N - K)


1/1/ ,

wherc r, == y - xiJ, wc call construct I-statistics to asscss the statistical si!{lIiliGIlIce or the clelllel\l~ or 0. Alternatively, without assuming hOl\loskcdastkity, wc can construct hctcroskcdasticity-colISisten t 2-statistics usin!{



= .!. (X'X)-I

[t XIX;r,;]



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 heteroskedasticity-consistent 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
rend-ns, 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 Cfoss-senional rcgression approach. In many situations, the event-window 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


FIII"//I/'I" lUIIt'.!"

illve,tor s ratiollall y IIS(~ firlll characte ristics to f'II'('clst the likeliho

od of the
evcllt oeCllnil lg. III these cases, a lillear rl'l"tion IwtW(,{,1I til('
linn characteristics ;11)(1 the valuatio n e1kct of the ('vellt C;llI 1)(' hiddell.
M"latest a alld
Thulll PSOll (I ~JH:J) alld I.anell and Thomps oll (I !)HH) provide
example s of
this situation .
Technic ally, the relation betweel lthe linu ch;ll<lct nistics ami
the degree
of anticipa tion of the event introduc es a selectio n bias. The
assumpt ion
that the regressi on residual is IIIKorrc lated with th(' rcgresso
rs, E[X'71 J = 0,
breaks down and the OLS estimato rs arc inconsis tellt. COllsist
ent estimato rs
can be derived by explicitl y allowing f(Jr the sdel'lio n hi~ls.
Adlarya (IY!:!H,
10!J:1) and Eckbo, MaksinlO vic, and William s (I ~)!)()) provi(le
example s of
this. Prabhal a (19!)5) pruvides a good discussi on of this problell
l and the
possible wlutiol\ S. He argues that, despite misspec ilicatioll
, ulldn weak
conditio lls, the OLS approac h can be uscd for illfnelln~s and
the I-statistic s
can he illtcrpre ted as lower bounds Oil the Iruc signilic llln'
level of thc
estimatc s.

4.9 Further Issues

A IlIunllCr of further issues OftCII aris(, whell cOllduct illg an
('\'Cllt study. We
di~cuss sOllie of these in this section.
4.9./ Rolf o/lllr Slllllj}/ill f; Ill/i'/HI!

If the timing of an evellt is known precisely , thell tht' ability

to statistica lly
identify the effect of the event will be highn ((Jr a shOrln samplin
g interval.
The increase results frOIll reducin g the varianec of the aiJnonn
al relllrn
willH)lll changin g the mean. We cvaluate the enlpiric d importa
nce of this
issue by cUlllpar ing the analytic al formula for the power of
the test statistic
JI with a daily salllplin g interval to thc pO\\,l'I' with a w('ekly and a monthly
interval. We assUllle that a week cOllsists of liv(' days and a month
is 22 days.
The varianc( , of the almorm al return for an individu al evellt
observa tion is
assumed LO bc (4%)~ on a daily hasis and lillear ill tilll(,.
[II Figu,!: 4.1, we plot the power of the test 01
110 ('vellt-e llen agaillst
the alternat ivc of all abnorm al rcturn of I % fiJI' I to 200
securitie s. As
olle \\'ould expect givell the allalysis of S('( tioll 4.(;, the d('(Tcas
e in power
going frolll a daily interv~d to a mOllthly illterval is se\'('I('.
For example ,
with :JO sentritie s lhe (lower for a !i% test using d;lily data is
O.!J4, whereas
the power using weekly alld IIIonthly data is only O.:FJ ;llld 0.12,
respcetiv ely.
The clear llIessage is that there is a substant ial payolf ill terms
of increase d
power from reducill g the lellgth of til!' ('VI' II I willdow. 1'"lors(' (
I !JH1) prescnts
detailed analysis olthe choi(:l' of daily V('l'SUS IllOllthly data
alld draws the
same COII( lusioll.


1:IJrI/I-Sll/fly Al/aly.I;.!



-.- " - O, ... W,,k III'm.,1


OJl('-MlIlllh Inh'l\,11













S;lIIII'''" Sill'

Figllre 4.4.

1',,/1 1,"1


1-."1'1'II1-SllIIly 'li'll Slal;I/;I".h III Jlpjrd Ihp NIIII "Y{i(llhl'.lil Ihal Ihp

I,m . ./111" /Ji//i-mll Sfllll/J/iIlK IIIIPlVoll. II'lim Ihp S,/lIf11P /llIot

AI'rllIK" I inial/II' II/thl' ..\11/1111"11/111 HI'IIII"II .. lfllI.\I Finll.1 1.1 ,,'X. fill" Ihp /Jail\' 1IIII'nllli

:lhllllnllal JlpllIlIl il

lit IIII'

A sampling illll'II';ti of OIl(' d;I\' is nol Ihl' shorll'sl ililer"al possible,

Wilh Ihl' inITl'aSl'd al'aibhilill' of 11;lnsa('lion dala, re('elll sllIdies hal'l' used
ohselvalion illll'll'als of dUlalion slioller Ihan Olll' day. The USl' of' inlradaily Iiaia in\'oll'l's SOIlll' ('oJllplicalions, however, or Ihe sor! dis(wsecl in
Chapin :\, and so lli{' 111'1 \ll'ndil of wry shon inlervals is IIndear. H"l'rlay
and [.ilt"II\wlgl'l' (Il)HH) discllss Ihl' IISl' of in Ira-daily dala inl'l'elll sllIdies .

./, f). 2 III/m'IIn'1 willi FIIf'III-f)(Ilf' lIlIl"rrlaillly

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 days-dal' 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.

-I. '.J. Furtiu-r Issues

flail and Torous (1988) investigate this issue. They develop a maximumlikelihood estimation procedure which accommodates event-date 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.

4.9.3 Possible Biases

Event studies arc subject to a number of possible biases. Nonsynchronous

trading can introduce a bias. The nontrading or nonsynchr~nous trading
effect arises when prices are taken to be recorded at time intervals of one
length when in fact they are recorded at time intervals of other possibly
irregular lengths. For example, the daily prices of securities usually employed in event studies are generally "closing" prices, prices at which the
last transaction in each of those securities occurred during the trading day,
These closing prices generally do not occur at the same time each day, but by
calling them "daily" prices, we have implicitly and incorrectly assumed that
they arc equally spaced at 24-hour intervals. As we showed in Section 3.1
of Chapter 3, this nontrading effect induces biases in the momenl5 and
co-momenl5'of returns.
The influence of the nontrading effect on the variances and covariances
of individual stocks and portfolios naturally feeds into a bias for the marketmodel beta. Scholes and Williams (1977) present a consistent estimator of
beta in the presence of nontrading based on the assumption that the true
return process is uncorrelated through time. They also present some empirical evidence showing the nontrading-adjusted beta estimates of thinly
traded securities to be approximately 10 to 20% larger than the unadjusted
estimates. However, for actively traded securities, the adjustmenl5 are gencrally small and unimportant.
.Jain (1986) considers the influence of thin trading on the distribution
of the abnormal returns from the market model with the beta estimated
IIsing the Scholes-Williams approach. He compares the distribution of these
ahnormal returns to the distribution of the abnormal returns using the'usual
01.') betas and finds Ihat the differences are minimal. This suggesl5 that in
gcneral the adjustment for thin trading is not important.
The statistical analysis of Sections 4.3, 4.4, and 4.5 is based on the assumption that returns are jointly normal and temporally liD. Departures
from this assumption can lead to biases. The normality assumption is important for the exact finite-sample resull5. Without assuming normal!\)', all
results would be asymptotic However, this is generally not a problem for
event studies since the test statistics converge to their asymptotic distributiolls rather quickly. Brown and Warner (1985) discuss this issue.

4. Euenl-Sllu(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 ohservalionby-obselVation 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 low-market-capitalization finns which
have, ill percentage terms, wide bid-ask spre;lds. III these cases the bias Gill
be cjminated by considering cUllIulative ahnormal returns that represent
bUY-ind-hold strategies.

4.10 Conclusion

In c1jsin g, we briefly discuss examples of evelll-study 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
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

4.10. COllrill.li oll


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
Eckbo (I ~IH:1) explicitl y addresse s Ihe role of increase d markel
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
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
survcys or this work.
A number of robust results havc bcclI dcvelop cd from cvent
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
that tile two-day 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 two-day 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 event-st 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 cvent-st 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'nt-st udy IIlelhodolol-.'Y- The
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

Ihe vahlt, of a IOIPOl;lIioll as Ih(' probahilily of Ihe change heillg adopled

\);11111 alld .lallH's (1~IH:!) discllss Ihis isslle ill Iheir sludy of Ihc illlpaci
of t\cposil illll'n'sl ralc t"\'ilillgs Oil Ihrili illSlilllliolls. They look OIl challges
ill ralc ('(jlillgs, hili dccidc 1101 10 cOllsider a changc ill I!173 hecallsc il was
lhlt' 10 Icgislalivc aClioli aud 11('11('(' was likely 10 have Iwcll anlicipalcd hy Ihe
market. Schipper alld TIIOIllPSOII ( I !IH:{, I !IH5) also ('nCO\llller Ihis prohll'lIl
ill a sllidy or lIIergl'l'-I"I'lall'lI rcgulaliolls. They allclIlJlI 10 cirnllllvc:nl Ihe
problelll of allticipated reglllatory changes by idenlifying dalf's when the
I'rohahilil)' of a IcgUiatol'l' challgc illcrcascs or decreases. Ii owevc 1', lhcy
find largely illsigllilicalll nslllts.lcaving 0JlCJI Ihe possihilily Ihallhc absellce
of dislinn evelll datt's accounls {ill' I h(' \;tck or wealth effeclS.
Much has I)('clilcal'll('d frolll Ih(' hody ofrf'sf'an:h thaI uses ('V('llt-sludy
lJlt'llloC\ology. Mosl gCJlnally. ('venl sllldi('s have showll Ihat. as we would
(')(.)1('('( ill a r;lliOlI'.llllIarktlp!a('(. prin's do r('sJlond 10 new inrOI'III;lIioll. We
('''1)('('\ Ihal CV('llI~llIdi('s will (,Olililllll' 10 Ill' a vaillable allel widely IIsed 1001
ill I'UllIOlllics alld lillaIH ....

4,1 Show Ihal whellllsillg till' 1\I;1I1;.('IIIIOd('IIO nu'aSlllT allllol"lllal retlll"\lS,

Ihe salllple ahllol'lllal rellll"JlS frolll eqllalioJl (4.4.7) an' aSYlllplolically illc\ept'llIl('1I1 as Ihe knglh 01 lIlt' ('slilllalioll ",inllow (1. 1) ill('J'('as('s 10 inlinily.



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(' (,vcnl-window 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?

The Capital Asset Pricing M0ge1

ONE OF TilE IMPORTANT PROBLEMS of modern financial economics is Ihe

CluantifIcation of the tradeoff between risk and expected return. A1tho~gh
common sense suggests that risky investments such as the stock market will
generally yield higher returns than investments free of risk, it was only 'tith
the development of the C~pital Asset Pricing Model (CAPM) that economists
were able to Cluantify risk and the reward for hearing it. The CAPM implies
lhatlhe expected return of an asset Illust be linearly related to the covariance
of ils return with the return of the market portfolio. In this chapter we
discuss the econometric analysis of this model.
The chapter is organized as follows. In Section 5.1 we briefly review
the CArM. Section 5.2 presents some results from efficient-set mathematics, including those that are important for understanding the intuition of
econometric tests of the CAPM. The methodology for estimation and testing
is presenled in Section 5.3. Some tests are based on large-sample statistical
theory making the size of the test an issue, as we discuss in Section 5.4. Section 5.5 considers the power of the tests, and Section 5.6 considers testing
with weaker distributional assumptions. Implementation issues are covered
in Section 5.7, and Section 5.8 considers alternative approaches to testing
hased on cross:sectional regressions.

5.1 Review of the CAPM

Markowitz (1959) laid the groundwork for the CAPM. In this seminal research, he cast the investor's portfolio selection problem in terms of expeeled return and variance of return. He argued that investors would optimally hold a mean-variance efficient portfolio, that is, a portfolio with the
highest expected return for a given level of variance. Sharpe (1964) and
l.intner (I !l65b) built on Markowitz's work to develop economy-wide implicatiolls. They showed that if investors have homogeneous expectations


5. The Capital And 1'lirillK M{)(M

a~d optimally hold mean-variance ellicient portfolios then, in the ahsclKl'

o market frictions, the portfolio of all invested wealth, or the market port~ lio, will itself be a mean-variance ef/lcient portfolio. The IIsllal CAI'M
e~uation is a direct implication of the mean-variance efficiency or the mark~t portfolio.
. The Sharpe and l.intner derivations of the CAl'M aSSllllle the eXisH~IIlT
o~ lending and borrowing at a riskfree rate of interest. for this version or
tlie CAPM we have for the expected return of asset i,




+ fiilll(E[R",]



Covlll" Nm ]
Var[Ntn ]

-- IV)


wi erC Il m is thc relltrn on the market portfolio, and Ilj is the return 011 the
ris free asset. The Sharpe-Lintner 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,
H. - Hj . Then for the Sharpe-Lintner CAPM we have






Covl1.j , 1.111 J

(:>.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 Sharpe-Lintner version employs excess returns and thus uses (5.1.4).
Empirical tests of the Sharpe-Lintner CAPM have focused on three implications of (5.1.3); (1) The intercept is zero; (2) Beta completely captures
the cross-sectional 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.era-het'l return is linearly related
to ito; beta. Specifically, for the expected return of asset i, E[ R,l. wt' havc




+ 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




oflhl' CAI'M


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 =

Cov I N,. N", I

V.u"[l{", I

Econoilletric analysis of the Black version or the CAI'M treats the I.('IO-h('ta
ponfolio rellll'll as an u1Iobserved qu.,ntit)', making the 'lll'll),sis more con.plicatcd than that of the Sharpe-Lilll1l('" vl'l'sioll. The Black vlTsion Gill he
tested as a restrictioll on the re;!I-retul'll market III(HIl'I. For the real-retltrn
m'lrkct model we have
E[N;] = u""+/i""E[N,,,I,

"Ild tht' ill'lllicati()11 or the Black vt'l'sioll is

ex"" = E[N"",]

(I -




III \I'ol'ds, the Black model restricts thl' ;I~set-spt'cilit illtlTt't'j>l of the realretul'll market modcl to be equal to the ('xlH't'tt'd l('lo-Ill'ta portli,lio retul'll
tilll('s olle minlls the asset's beta.
The CAI'M is a single-period 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 time-series 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 Sharpe-Lintller 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 event-study '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('('SS-rt'llIf'11 market
model, that is, the heta ill thl' n'f.(rt'ssioll ('qllatioll

\\'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.

5.2 Results from Efficient-Set Mathematics

III this secliotl lI'e 1('I'ie\\' Ihe IlIath('fllatics of lIleall-variallcc cfficielll s('h,
The illln,'sll'd Il'adn is I'l'fiolTcd 10 MlTlolI (I \J7~) alld Roll (l \In) lill'
d('tailed 111';11 II 1('11 Is. :\11 IIt1dclslalldillg of this topic is IIselitl for illierpletillg IlIlIrl! of th,' 1'lllpiric;t\ITsl';lrch rdatillg 10 the CAI'M, hecallse Ihe key
tcslahle ill'l,lical iOIl of lite (:1\ I'M is 11t;,t Ihl' markel porlldio of risky assels
is a lIH'all-l'ari;IIII'1' <'IIi, i"111 portfolio. Effici"IlI-set malhemalicsalsoplal.s a
mit- ill lltl' ,tl\;tlysis "f Illltllibclor pridllg mOllels ill CIt;lpln 'i.
\\'e slarl wilh SOIllI' 1I0laiioli. 1.1'1 there he N risky assels wilh JIlean
VCI'lol' It ;\1111 cO\';lIiallll' IIlalrix 0. t\ ss III Ill' lhat II\(' l'xlll'ned n'III\"I\S of al
It'asl 1\\'0 assl'lS dilkl ;l1l1llhal Ihe covariance malrix is of filII rallk. Define
w" as the (Nx I) \'ector ofporti()lio weights for an arbitrary portfolio II \I'ith
w,,'J.', and
weip;hls sllInlllinp; to \1\1 it)'. Portlellio a has llH'an return /1"
w"'Ow,,. The covariance hctwcen any two portfolios II 'Illti
b is w,,'f!w/,. (:i\'{'11 till' poplIl;ltioll of assets wc IICXI ('ollsitin minimulllvariance I'0rtli.lios ill Ihl' ah"'IHT of a riskfn'e asset.

(1,; =

Defillitioll. ['fIIl/i,lill /, i.1 till' illilli))/u))/-T'llfitlllff /)()rljc,/io of a/l/)()rlf()/ios wilh


/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



(!. ~.I




Ii. sol\'(' thi~ 1'1"11111,'111, WI' ".nullll' I.agl'all(!;iall functioll I., dil"!i-relliiale 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'


5.2. Ur.lIIlI.I /IT!1It i-Jfirifllt-.'ifl MalitfllUllirs

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
2nw - Oill. - 02L = O.
COlllbining (:).2.5) with (:).2.2) ane! (5.23) we find the solution
whnt' g and hare (N xl) vectors.


. h


anel.A == L'n-IJ-L, n == /l.'n-I/l., C == L'n-1L, anel D::::: Be - A2,
Next we summari7.e a. number of resU!IS from efficient-sel malhen1atics
for minimum-variance portfolios. These results follow from the form of the
sohllion for thc ~ininHim-variance portfolio weights in (5.2.6).

Result 1: The minimum-variance frontier can be gcnerated from any two

C\islinct minimum-variance porlfolios.
Result I': Any portfolio of minimum-variance portfolios is also a minimumvariance portfolio.
Result 2: Let p and r be any two minimum-variance portfolios. The covariance of the return of p with the return of r is
Cov[H,,, H,]

C ( /J.p - C
A') (/J.r - CA) + C'1
= D


Result 3: Define portfolio g as the global minimum-variance portfolio. For

portfolio g, we have

f..l x


-In-I L



(5.2.11 )


(5.2.) 2)

Result 4: For e,tch minill1l1l1l-vari,\llce portfolio /1, except the global minililt I Ill-variance portfolio g. lhere exists a unique minimum-variance porllil!io that has zero covariance with /1. This portfolio is called the zero1I("la portfolio wilh respe<.:t 10/1.

5. The Capital A~set l'rid111i Modrl


esult 4': The covariance of the return of the global miniIlIlIlJl-Variallc('

portfolio g with any asset or portfolio of asseL~ a is
Cov[llg'I1,,} =


Figure 5.1 illustrates the set of minimum-variance portfolios ill the

a sence of a riskfree asset in mean-standard deviation space. Minimumv riance portfolios with an expected return greater than or eqll<ll to the
c~pected return of the globalminillllll1l-variance portfolio arc efficient pOIlfulios. These portfolios have the highest expected return of all portfolios
wilh an equal or lower variance of relUrn. In Figure 5.1 the lIIinimulIJvariance portfolio is Ii. Portfolio /) is all efficient portfolio. Portfolio 0/) is
the zero-beta portfolio with respect to p. It can be showlI that it plots ill
the location shown in Figure 5.1, that is, the expected return 011 the zerobeta portfolio is the expected return 011 portfolio I). less the slo[>(' of Ihl'
millimulll-variance frontier 011/) limes Ihe standard deviation of ponli)lio I).
Result 5: Consider a multiple regression of the return 011 any asset or [Jollfolio ll" on the return of any minimum-variance portfolio l?p (exrept for
the globaiminilllllm-varianfe portfolio) alld the return or its associat{'([
zero-beta ponlolio R'1"

For the regression



we have

Cov[ Un. RI,I




COV! Un' I~,)



I - {J"p




== 0

where l1al' is the beta of assel (j with respect to portfolio

Result 5': For the expecled return of a we have

'1wc J1~xt

Ii" = (I - fia/,)Il,,/,

+ /3,,/,/J./,.


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.


5.2. UI'S II lis from FJjirielll-Sfl Malhl'/lwlirJ



" _. - - -' - - _ - - - - - -'"


Figure 5.1.

MilliJlllllll\'rllilll/(f'I'orl/oliol lVii/will fli.lk/i,e A.ufl

Given ;\ riskfree asset with return UJ tilt" minillllllll-\'ariance portfc"fio with

expected return ill' will be the solution to the constrained optimization
mill w'Dw

sul~iect to


As in the prior problem, we form the Lagrangian fUllctioil I., differentiate

it with respect to w, set the resultillg equations to zero, alld thcll solvc for
w. For the Lagrallgian function we have



+ 8 (PI' -


W'IL - (I - w'L)IIJ ).


Differentiatillg I. with respect to wand settillg the resllit equal to I.em, we

2 nw - 8(IL - II,L) = O.
Combinillg (5.2.23) wilh (5.2.21) we have
(J.l.p - 'V)
----'--;-"---n -I (IL
{JL -

IVL),n-1 (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,



Thlls wilh;) riskfnT aSse'1 alllllilliIlHIIIl-I'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'
w'l =
rrl(/t - HIt},


(/1 -


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
lIlillillllllll-variann' 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,

\ : :;:

I'" - lit


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'arr-I';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.:) Statistical Framework for Estimation and Testing

Illilially 1\'1' IISC till' ;1\SIII"l'lillll Ilral ill\'cslllrs call horrow alit! !clld al a
riskfn'c rail' or 11'111111, alld \\'c l'ollSit\n lire Sharpc-Lillillcr v('lsioll of'llrl'
CAI'M, 'I'lli'll, 1\'(' c1illlill;IIC Ilris a~Slllllpli()" ;1Ilc\ analyzt' 11r!' Black versioll,

. 5.3.

St(lti~tim{ Fmmt!luorhfor Estimation


and Jesting






" ,,'"

R /",

Figure 5.2.

MinimumVariance Portfolios With RUkjne Ami

5.3.1 Slw1'/Je-Lintner Version

Define Z, as an (Nx 1) vector of excess returns for N assets (or portfolios
of assets). For these N assets, the excess returns can be described using the
excessreturn market model:



+ (3 lm, + f/


E[ftl = 0


E[f/f/l =:E
E[l.. ,]

Jl .. ,

E[(l,., - Jlm)2]

Cov[l.. "


= O.




{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

disturbances, respectively. As will be the case throughout this chapter wb

have suppressed the dependence of 0:, (3, ancl "" on the market portfolio or
its proxy. For cOllvenience, with the SharpeLintner version. we redefine I!
10 refer to the expected excess return.


5. The Capital Asset Priring Melilri

The imp licat ion of the Sha rpe- I.int

ner vers ion of the CAI'M fi)r (:J.:t
that all of the elem ellts of the vect
or are zero . This imp lkat ion
from com pari ng the unco ll<li tiona
l expe ctati on of (!i.3.1) to (5.1
.3) and
form s the prin cipa l hypo thes is for
tesL~ of the mod e!. If all
clem ents o/" ( l
arc zero then In is the tang ency
We usc the maxilJlulll like liho
od appr oach to deve lop estilll.lto
rs of
the unco nstr aine d mod el. Ord inar
y leas t squa res (OL S) regr essiu lls
by asse t lead to the sam e estim
ator s for Ct and f3. To star! , we
the prob abil ity dens ity func tion
(pdf ) of exce ss retu rns cond ition
al 011 the
exce ss retu rn of the mar ket. Give
n the assu med join t norm ality uf
exce ss
retu rns'f or the pdf ofZ/> we have


and sillc e exce ss retu rns are temp

oral ly liD, give n T obse rvat ions
, the join t
prob abili ty dens ity func tioll is
J(ZI , Z2, ... , Z-r

I 7.",1, Z",2 ... , Z",T)




I 7.,.,)


== n(27T)-~I~I-~

Given (!i.3.M) alld the exce ss-re

turn ohsel-vations, the para lllet
ers o/"
th' exce ss-re turn mar ket mod el
call be estil llate d usin g maximum
Th's appr oach is desi rabl e beca
use, given cerla ill regu larit y cond
ition s,
1II1xirlllllJllikclihood cstil llato rs
are cons istel ll, asym ptot icall y c/lic
ielll . alld
asym ptoti cally norm al. To defi
ne the lIIaxilJlulIl like liho od estim
ator , we
form the log-likelihood JUllctioll, that
is, the loga rithm of the join t prob
;lhil ity
del1sity func tion viewed as a func
tioll of the unkn owll par; ullet ers,
n, /3, ;Ind
~'IDenotillg . as the log- likel
ihoo d fUllction we h;i'vc,;:

r(Ct.f3. E)



-T log(27T) - -;zT logl EI

I T .

- ~ L(Z, - (} - (:J7.,,")'E- I(Z, ~I


(!i.:t !l)

5.3. Slllli.lliml Fm7llflllorkjor l~lilllllli(}11 a/l(l 'jfJlil'K


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



t(Z, -

1;-1 [



U,.:t 10)


ta, -

:E- 1 [

0: -


([/.3.11 )


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


solve fur the maxi-


,,1' (.


M)(Z"" - {i m )
A) .

Z",I -

Jim ....



JL =

TI "L..,Z,




As already Iloted. the~e are just the /()\'JIlUlas fill' OLS estimaturs of the
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.


II/t' (,1/1'1/1/11\.1.\1'1 I'Hfll//!.


Tht' (,(lIl1liliollal dislribuliolls arc


(0'r~ [I + Ii;',]

(:l.:t Hi)


where /i", is as pn'vious\1' .!dill(d all.!

- '.

" .
TI 'L.."(Z",,

_ ,.




The nOlalion W.v(

~. ~) illdicalt's Ihal Ihe (N x N) malrix TY;, has a
,,,'ishan dislrihlllioll wilh (T - ::!) degrees of freed 0 III and covariance maIrix
This disirilllllion is a 1I11tllivarialt' generalizalion of Ihe chi-square
dislrihillioll. Andl'l'soll (1~IHl) allel Muirheael (\9R::\) provide discussions of
its propeni('s.


'I'll(' ctl\'ari;lIICl'


c"\ alld ii is

_~ [ii.III]~.



E is inekpt'lldelli .,rholh c"\ alld j-J.

Using Ih(' lIJ\colIslraillt'd cSlimalors, we call form a Wald It'SI slatisti': of
Iht' nllll h),polhcsis,
II,,: n = 0
against the ;Iltnllat in' hypot hesis,

The Walcll('sl slalislic is

/i;,,]-I (\-'",,-I n,

'J' [I -I- -



WIl('ITW(' kl\'('slIhslillllnl (rolll (r.. :I.I(i) forVar!c\!. Ulltler Ihe lIuli hypolhesis./" will have ;1 chi-s'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.


5. J. St(ltiltira{ Framnllork Jor /,!itilll(ltio/l Ilmi Tflting

Ilowever, in this case we need 1I0t resort (0 large-sample distribution theto draw inferences using a Wald-type test. The finite-sample 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):


Theorem. 1.1'1


di.\IJ-ivu/ni W",(n, 0) with

x VI' di51riiJull'li N(O, D), il't thl' (rnx m) matrix A hI'

(71 ~ 111), and lrl x (lnd Ave indepmdrot. Thm:



-'------xA x


1-", ... _ +1.



To apply this theorem we ~et x = JT[I + Ji;./a;1-1/2 ,A :: 7r'E,

= N, and n :: (T - 2). Then defining JI as the test statistic we havel






"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 finite-sample F-test JI usi:ng
only the estimators from the unconstrained model, that is, the excess-retll-n
market Jllodel: To consider a third test, the likelihood ratio test, we need
Ihe estimators of the constrained model. For the constrained model, the
Sharpe-I .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





TI "
~(Z/ - f3 Zm/)(Z, - f3 Z.. /)'.



The distributions of the constrained estimators under the null hypothesis


N({3'+['21111l+I GJE)





(:in'lI bOlh the unconstrained and constrained maximum likelihood esti1\l,llors, we can test the restrictions implied by the Sharpe-Lintner version


; :


5. The Capital Asset lJriejll/{ /Hodel


using the likelihood ratio test. This test is based 011 the lo'garithm of the likelihood ratio, which is the value of the collstrained log-likelihood function
minus the ullconstrained log-likelihood fUllction evaluated at the maximum
likelihood eSlimators. Denoting CR as the log-likelihood ratio. we have



-~(logIE I-IogIEI].


whcrc C reprcscnts the constrained log-likelihood function. To derive

(5.3.28) we havc used the (act that summation in the last terlll in hoth
thc unconstrained and constrained likelihood function evaluated at the
maximum likelihood estimators simplifies to NT. We now show this for
the unconstrained function. For the summation of'the last term in (5.3.9),
evaluated at the maximum likelihood estimators, wc have

})Z/ -

0: - j3z,.,)'t-

(Z, -


0: -



= L trace[t- I (Z, -

6 - j3ZIII')(Z, - it -

137... ,)']

(:. 3.30)



L,.(Z, -

trace E


Q - (3Zm')(Z, - Q - (3Z",,)' ]





(TE)] = Ttracc[l] = NT.

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 chi-square with
d grees of freedom equal to lh(' IIlllJlher of restrictions untler II". That is,
w call test 110 using




I. Interestingly. here we need not reson to large-sample 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

5.3. S/(//islim/ FramnuorkJor /,:I/i/llu/ioll




('stimators call be expressed ill terms of the UIHollstnlillCd estimators. For

WI' have





!-J + ~--.-~ n.


+ 111

-/~ ",,)(Z, -('1 ",,)'


~ [ (ZI- n.- 'In",,)

-I- ( I .

I ,=t


[ (ZI

0: -

' . +(I fJ1,ntl

Ii '"

",1 )
u. ]



fi '" Z"'I ) .] I
~--'i a

-t- (fm


- 0:. -fJ' Z-..1 )' (
1- '
1 ", 1.-ml ~ )






we have

-. = ~ + ( _~ a;' . ~ ),_'

J1. m


+ am

Taking the determinant of both sides we have


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


+ I]


[t]i - I )


and for./I we have


(T - N - I) (


which is a mOllotonic transformation of J~. This shows that JI can be interpreted as a likelihood ratio test.
Since the finite-sample distribntion of./I is known, equation (5.3.40)
can also be used to derive the finite-sample distriblltion of./l. A~ we shall



I.<l/,lialll.l.lr( 1'l1flllg ;\/lJilt'/

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" fillile-sample properties, Dl'iilling JI as
Ihe llIodified slalislic, \\'1' 11;1\'1'
(J' _. ~ - ~)


(r--;-~)llogrt'I-logltl]:' X~,

\Vt' will visil IIII' isslI!' of Ihl' fillilc-sample 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('nl-sc( ma(h('malics, Gihbons, Ross, and Shankl'n
(1!1H!) show IhOlI

_ CJ'- N -

;;: -


/1 - - - - -




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,


,.2 1111/111 Vt'nillll

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('nl-ill'''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' Ino-Ill'\;1 )lortlillio ('xI)('cll'd 1'1'1111'11 as y, Ihe I\brk vl'\"sioll


+ (~(El a,",l -




Wilh Iht' mack Illodd, lire 11l1("ollstraill('c11ll0l1l'l is thl' ("('al-relurn markl't


5.3. SIIIIi51irlli Framework/or E51imation lind Te51ing

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 real-return market model is




+ {3R mt + ft


E[Rill' 1




Cov[Rmt> Ed




{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

(~- (3)y.


This implication is more complicated to test than the zero-intercept restriction of the Sharpe-Lintner 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 real-return market model in (5.3.44), are identical to the
estimators of the excess-return 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 -

jJ.)(R ml - ft )

(5.3.51 )

'L.~I(Ulnl - ftm)2

L(Rt -

ex - j3R,.t)(R, - ex - {In,,.,)',


1 T




5. The Capital Asset Priring Me}(M


Conditional on the real relllrll of the markel, R"",

butions are


.. , , U,. /", the distri-


am :::

Tle covariance of it and


T1 \.""""""'
L(I~.I -




jJ is

It .. ]
Cov[a,i3J = - [ ~


\ For the conslrained modd, that is, the Black version of the CAI'M, the
log-likelihood function is
C(y. i3. E)


= -T


log(2JT) -

-21 'L" (R , -

y(t -

log lEI

m - i3R

ml ) '

E- ,


)( (R, - y(t -

m - i3R",I)'


Oil crcntiating with respect to y. i3. and E. we have





== -- E- 1 + - E- 1




(R , -


Y{L -

m - i3U


S (R, -

ml )


yU -

(R, - y (t


(J}--- (JJ{ml)

~ m- i3Rmt)'] E- 1 (5.3JiO)

5.3. Slatistirtll Fmllll'work Jor /::ltilll(lfiOIl lIwl /"Ifill!!.


Selling (5.:!.!)!)), (:).:1.59), alld (~).:\'(i()) to {<TO, we ralllio~'for lhc lII01ximUIll likelihood estilllOltors. TIJ('sc arc:



+. t(R



(it -




- li)'1:


(j Ii.,,)




" ..

(I, -,

0 )



Y' (~- b') - /3' Uml)(R , - Y' (L -

i~') -- /3' U>nl)'.



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


A likelihood ratio lest can be cOllstructed ill a lIlallll\T analogolls to the test
constructed 1'01' the Sharpe-Lintner versioll in (:).:1.:tl), Ddillillg Jl as the
test statistic, we have

Notice that the degrees of freedoJll of tbe null distributioll is N - I. Relative
to Ihe Sh'lrpc-l.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/,cro-hct<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,.

dC'veloped lhi~ ('!<of.


WI' rail also

.f;. as thl'

1 ht' (;II/JlIIII ,Iul'/ I',-irillg ,1/lIdt'1



./1 to improve IIHlillitt-samplt propt,rtit's. Ddillillg

tl'St ,tatistic I\'C han'


lillillite salllplt-s, 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 Iirst-ordn
fllllditions. St'cond, tht' t('st is hased 011 largt'-sample theory and call haw
wry poor flllite-salltpk 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 lillite-salltple 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.,'1'0-1)('1;\ relllrll y:

R, .-




(J(ll"" -


+ 10,.


ASSlIllle y is kIlOWIl. Theil Iht' IItaxilllllJII likelihood estimators fi.n the IlItcOllstraitll'(IIlIOdcl an'

j1. - YI. - /3(it", - y),


L,=I(R, - p.)(RIII , -/1",)






+:LIR,-it-/J(/(m,-ilmlIIR,-iL-{3{1l""-(I,,,)J'. (:).:DI)

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
log-likelihood rllllctioll ('\,alll;lIl'<I at Iht' JIIaXi1ll1l1l1 likt'lihood t'stitllat"r' is

II'hirh dOl's Ilot dl'pl'lld Oil )'.



IOlfIEI- h

5. J.


Frmnt'l/Jork for r.Jli/llflliOIl (lwl





to be zero, the constrained estimators are




"")( (RI - y(~ - 13) - 13 R,.I)'.


and the value of the constrained likelihood function is




== - - log(2rr) - 2




Note that the constrained function does depend on y. Fonning the logarithm of the likelihood ratio we have

== C(y) - [.

-~ [log IE\Y)l-log lEI].


The value of y that minimizes the value of the logarithm of the likelihood ratio will be the value which maximizes the constrained log-likelihood
fUllction and thus is the maximum likelihood estimator of y.
Using the same development as for the Sharpe-Lintner version, the
log-likelihood ratio can be simplified to





)"o:(y):, - I o:(y)

-~2 log [( (-11m _ a~2

~) [jL y +0 ..

[jL -

y~ -

yL -

13 ([i... - y)]

(3 (il .. -

+ I] .

y)l' E-


Minimizing CR with respect to y is equivalent to maximizing G where


= (' _ a~2 +

[jL-YL-13(tlm-y)l'E- [jL-YL:"'(3(il ... -y).

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( y)

A y2

+ By + C,


5. The Cal)i/a/ Anl'l I',irillg Mill""



-;-;z (t




1+ .;




(It - {3/1",) - -::-:; (t - {3)




(t-f3)- .~


/1 ~

+ ii",.
a;;' (J1. -


(t -


(p.-{3(;.",)':E (jt-{-J(J.",)



(1+ am..;' )


(t - j.3)':E



, {, -- I .

(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 mean-variance 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 Sharpe-l.intnC!' version F-test in (5.3.23) applies to testing
the null hypothesis that the zero-heta exn'ss-relllnl nl<lrket-Illodcl intenTpt
is zero. The test st.llistic is
,-1 . .
a(y):E a(y) ~ /'.'1./-.'1-1.
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 log-likelihood 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.cro-beta 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

5.4. Siu (if/i'.III ,

This estimator can be evaluated at the maximllm likelihood estimates. and
then inferences concerning the vallie of yare possihle giwn the asymptotic
normality of y'.

5.4 Size of Tests

In some econometric models there arc no analytical re.~uIL~ on the finitesample properties of estimators. III sllch rases. it is UJlllmOn to rely on Iaq!;esample statistics to draw inferences. This reliance opens lip the possibility
that the size of the test will be incorrect if the sample sile is not large enough
for the asymptotic resulLS to provide a good apPlOximalioll. Because there
is no stalldard sample size for which large-sample Iheory can he applied. it
is good practice to investigate the appropriateness of the theory.
The lIlultivariate F-test we have developed provides all ideal framework
fiJI' illustrating the problems that GUI arise if' OIl(' rdies ou as)'mptotic distriL'llion theory for inference. Using the known finite-sample distrihution of
tht: F-test statistic }I. we can calclliate the !illite-sample sile for the variolls
aSyll1 ptotic tests. Such calculatiolls arc possihk h(,CllISC the ,\syllljltotic test
statistics arc monotonic transformations of '/1,
We draw on the relations orfl to the 1.lIg('-sanql\c I('sl statistics. COIlIp;'ring equalions (:).:t22) and (:).:1.2:1) 101 ./" WI' II.'v('


('I' - N .- I)

= -



and for }:l from (5.'1.2) and ([1.:1.4 J).






Under the llltil hypothesis. }o. }~. alld ./1 arc all asymptotically distributed
chi-square 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 large-sample 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 chi-square 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



to a nitical \'ahll' of I A~l:, lill' '/1, Cin'1I that the (');an

(Iislrihlliioll 01'./1 is /: wilh 10 dt'grecs offrecdolll illlht' Illlilleralor alld
I~l degrees olll("nloill ill til(' d("lIollliliator, a lest IIsilig Ihi~ niticd \'ahlt' for
./1 has;1 sil(' of 17.0')!,. Thlls, 1111' aSYIliplotic !,'y" lest has a sil(' of 17.0';' ill
a salllpk 01'(;0 11I(llllh~: il reilTls Ihe 111111 hypolhl'sis ilion' Ih;lIlll1r('e lillll'S
'Elhle :,.1 PII'S('IIIO; Ihis Cliclll;tliOlilill' .A" J~, alld./I IIsillg Ill, ~Il, ;llId1O
Ii II' valll(,s of ,v all(1 IIsill)!; (iO, 1~(), 1HO, ~40. alld :~(iO f(lr \';II\I('s of r. It is
appan'lIl 111;11 Ill(' lillile-s;lIl1ple sil(' of Ihe lesls is largn Ihall Ihe aSYlIlplolic
silt, or r,I;;,. Thus Ihe large-s;lIl1plc lesls will n:il'rl Ih(' IHlli h),polhl'sis 100
oft(,lI. This prohll'lll is sn'nl' li,r Ihl' aSYlllplolic lesls hased 011 ./t, alld ,h.
Whell N = 10 Ihl' prohl('1Il is 11I0sily il1lpOl'lalil lill' Ihl' low valll(,s of
For I'xalllpk, Ihl' lillih'-~;II11pk ~i/l' or a test with <Ill as}'Illptotir sill' of :)'};,
is 17.0')!, alld (l.(i'Y" lill'./t, alld.h. n'spI'clivdy. As N illnl'ases Ihl' sl'\'('rilv of
Ihe prohkl1l illcu'ases, Whl'lI N = <Ill alld T = (iO the /illile-salllple silt' of
all aSYlllptolic :,';;, It'sl is \1H.:,';;, Ii II' .1<, all<l H05% (ill' ,h. III Ihese C;ISI'S, Iltl'
111111 hypolhesis will hI' rejl'cted 1Il0si or III(' tillle evell whl'lI il is IrIiC. \\,ilh
N = '\0, Ihl' si/(' of a r,I:{, aSl'IIlJllolic Il'si is slill oVl'rslalerl cOllsic\t-rahly 1'\'1'11
wh(,11 T = :\(iO.
Thl' aSYIlIJlIOI;" I(',sl \\'ilh a lillill'-salllJlk adjllstllH'1I1 hasl'd 011 ./1 pnforms 111111'11 IWIII'r ill lillih' s;llIIpks thall docs its 1I1l;llljllsted cOllntcrparl.
Oilly ill the CISI' of N = ,Ill and 'J' = (iO is thl' exact sizl' sigllilicalilly on'rstall'eI. This shows Ihat lillill'-salllJlII' adjllslllll'lIts ofasYlllplotic tl'sl statistics
(';111 play all iIiIPOr(;1I11 rok.



5.5 Power of Test'>

\\'111'11 drawing illli-n'lHTs nsillg a gin'lI It'si slalistic II IS 11111)(11 Ian I 10 COIIsidn ils IH,\\,l'r. The pown is lite prohahililY Iltal lite 111111 hypolhesis will
Ill' n:jl'cl('d gin'lI Ihal all aitnllaliw hypolhl'sis is 11'111'. Low pown agaillsl
all ililen'slillg aiterllalin' slIggl'SIS Ihal Ihe It'sl is 1101 IIsl'fliliO disnil1lillall'
11I'1\\'l'I'1i Ill(' ait('III;lIiv(' alld Ihl' 111111 hypolhesis. Oil Ihl' othn halld, ir Ihl'
1'01\'('1' is high. Ihl'lI till' Il'si elll he very illlill'llIalivl' hili il lIIay also rl'jl'l'I
IIII' 111111 hvpollll'sis ;Igaillst all(,)lIali\'('s Ihal an' dose 10 Ihl' 111111 ill ('1'0lIolllie "'I IllS. III Ihis case ;1 rl'j"('lioll llIav hI' dill' to slllall. "COllolllicdhIIl1illlportalll d('li<lliolls 1'1'0111 Ihl' 111111.
To t\Ot'llllwllt III\' powcr oLllt'st, it is IWITssar)' 10 spl'('il~' thl' alll'rllali\'('
data-gl'IIIT<llillg I"'l('~s alld IIIl' sil(' of Ihl' lest. Thl' (l0I\'('I' li,l' a givl'lI sizl'
ofll'sl is Ihl'l"olo;lloilill'lhallhl' t,',1 sl<ltislic is greater thalllhl' crilical I;dlle
IIl1d('l' Ihe 111111 h\'pOIIIl',is, gin'lI Ihat 11)(' aiteruali\'c hypol Itesis is IllIe.
'Ii, iIlIlSII;II, Ihe pOller or I('sls or Ih,' <:AI'M. W(' \\'ill foclls oil 1111' Inl or
Ihl' Shal'fll'-I.illllll'r \'('I'sioll IIsillg ,/I rrolll (:,.:\.~:\). Thl' (lO\\'('I' or this Il'si


5.5. /'0/(1" of Tests

Table 5.1 .

Finilf'-5f1111/'iP liu oj 1,.. 15 of IIIf Sllflrp,..Ulllwr r.APM wing lnrgt-1am4u. Itsl









0.051 :




0.050 \







0.050 I
0.050 '




0.050 i




0.057 ,












0.050 :



























The exaCt finite-sample 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 large-sample 101
stalislies. jl. fl. and j,. N is Ihe number of dependent portfolio!. and Tis Ihe number of


should be representative, and it is convenient to document since the exact

finite-sample distribution of J) is known under both the null and alternative
hypotheses. Conditional on the excess return of the market portfolio, for
the distribution of Jt as defined in (5.3.23). we have
where 8 is the noncentrality parameter of the F distribution and

J) under both tbe null and the alternative

hypotheses. w.e need to specify 8. N. and T.

'Ii) specify the distribution of


5. Thr Ca/Jila/ t\.l.Irl/'ririllg A1(}(h'/

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':E-la. 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,





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 values-60, t20, 240, and 360-which 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.


/'111/'1''' '1 F/~.l1 II} SI/lII/ItI.inlll"'/Ii



r ==


'J" == 210
"f'= :11;0

Alternative 2:





-r = 1;0



= 120






-r = :11;0
Alternative :~:

Il'l ""

== (iO

"f' = 240
'f'= :1(;0

Alternative 4:
'J" = IiI)
"f'= 120
'f' = 2,10
'f'= :\liO







= I

0.1 !1I


(:~/'t\I /llilll: I/,//il/i,

== 1:1.0%

















0.1 III


= II;')(,

= lIi%

= lIi%



;llIcllI.tlivc h)'I)('lh('~is i~ rli;u'aru'li/C'cI

h)' lht'

\'.1111(' of llit' ("xllI'(l('d ('X("('!'oS 1'1111"11


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.

5.6 Nonnormal and Non-liD Returns

III this Sl'l'liOIl \\'t' ~\rt' l"IlIll"l'IIH'd wilh illrcn'llct~s when 1ht,I'(' are dcviations
/i'Ofll IIII' asslllllplioll 111011 rellll'llS an'.iointly norfllal and liD throll!!;11 tiflle,
We cOllsidn tcst~ whirll al'l'Ollllllolbtc non-norlllality, lll'tl'l'Oskl'dasticity,
antitelllporal dependellcc of' rellll"llS. Slich tests are ofilltel't'st fill' two reaSOliS. Firsl, while Ihl' lloJ'lllality asslllll)ltioll is sufficil'llt, it is llotlll'CCSsal'Y to
derive the CAI'M as OJ theol't'til'allliodd. Rather, the Ilonllality aSSlIlllptioll
is adopled fill' stalislical purposes. Williont this aSSIIIllI>lioll, fillile-Salllpll'
)ll'Opt'J'lil's oLlssel pricillJ,!; Illodel IcslS arc dirticult to derive. Sl'colld, departun's of' IlHllllhly scrllrilY ITIlll'llS \'rOIlI Ilormality have heen dOl'llllll:llIed.:1
There is also ahllndalll Cl'idell(,(' of ht'lel'Oskedasticity and telllporal dqJl'ndl'lKC ill stock rl'lllllls.1 Evcn though temporal depl'ndellce Ill"kl's tht'
CAI'M ulllikely 10 hold as all cxan IheOJ'etiralllloclcl, il is still of illll'rl'st to
exalllille Ihl' ('llIpiril'al )ll'l'fill'lllalll'l' of the lllodei. It is Ihl'l'di)l'e desirahk
to ronsidcr tIll' dfl'rts of' rclaxing these statistic,,1 assumplions.
Rohllsl IcslS of' IIIl' <:1\1\-1 rail IIc constructed using a Cl'lleralizeti
Method 01' 1\!OIllI'IlIS ;MM) I'rallwwOIk. We focus 011 tests of Ihe Sharpl'1.'IlllIll'l'\crsioll: IIm\,('\'('I', rohllsi I('sl s or II II' B1ark vcrsion (';1/ I I)l' rOllsl I'll ned
illlhe salllc 111;111111'1'. \\'itllill til<' (;1\11\1 f'rallll'wol'k,llIedislrilllllioll of'relllrllS
('olldilioll;\1 011 IlIl' IlIark('1 rellll'lI CII\ 1)(' bOlh serially <Iepl'\lIklll and ('onditiollall), IlI'tl'l'Os\..l'daslil'. \\'c IIl'ed ollly assullle that CXCl'SS assel retllrns
arc Slaliollarl' and ngodi( wilh lillill' filllrlh nlllllll'IIlS. The suhsequcnt
analysis draws 011 SI'(liol\ i\.~ of Ihl' Appendix whit'h contains a W'llt'ral
dl'\'doplllclll of Ihl' Cl\1M IIIClhodolo).,'Y. We contilllle with a salllple of 'f'
lillie-series oi>sl'l'valions atld N assl'ls. Following the Appendix, we necd 10
setup the vl'ctor of 1l101liellt cOlldil ions with zero expectalion. The reqllired
1II0lllellt l'OluliliollS ",lIo\\' 1'1'0111 1IIl' ('X(('SS-relllrnlllarkellllOdd. The residual vector provides N III0llll'lII ('ollditions, ant! the product of the ('X(,css
I'l'tU/'ll of lite llIarkl'l ;11111 Ihe rl'sidual vector provicles allother N 11IOl1lCnt
cOllditiolls. Usillg Ihl' Ilolalioll of' Ihe Appendix, fill' f(O) we have
(:,.1;.1 )
where h; = (I /."" (, (", = Z, - n - (J /."''' alld 0' = (0' ,13'].
The spl'cilicali,," or IIII' C'x('('ss-retllJ'n market 1l1l)(ld illlplies Ihl' 11101111'111 cOlldilioll 1':1 f,(OIl) I =- 0, \\'111'('(' 011 is the Ii'll<' par;UIlI'I('I' vector. This
IlIOllll'nt cOlldition lorllls Ihe hasis lill'l'stilllalion and lesting using a C~'IM
approarh. (;Mt-.I chooses till' l'stililalor so that linear cOIlIi>inatiolls or Ihe
salllple avc'ragl' oflhis 1lI0llll'IlI (,(llldition arc zero. For thl' salllpl(' avcragl"
(I'll;',. 1!17Iil. 111.,"111"1-: ,,,,,ICCI'lC'ell" (1"171), l\lfI(.. ~t:r.I\I' a",1 ~kIlClII."eI
a,"1 '\:,hl" 1.1 ill (:10,,1"'" I.
'StT (:h"IHC.'I"" '.! .uul I'.!. ,HHI ,IH' I ('klc',u C'!'. 14ln'u in 11\0'\' ("h~'ptt,~.

"SI'I' F."".,

).6. Nonnonllai a1ld Non-JlV Helurns

we have

1 T

= T L f (9).



Thc GMM estimator iJ is chosen to minimize the quadratic form

whcrc W is a positive definite (2Nx2N) weighting matrix. Since in this case
we have '2N moment condition equations and 2N unknown parameters, the
systcm is exactly identified and iJ can be chosen to set the average of the
sample moments gT(O) cquallO zero. The GMM estimator will not depend
011 W since QT(O) will attain its minimum o[zero for any weighting matrix.
The estimators from this GMM procedure are equivalent to the maximum
likelihood estimators in (5.3.13) and (5.3.14). The estimators are

jL -



L;~I(ZI - [J,)(Zml - ft.m)


L...I=I (

-ml - 11m)


Thc importance of the GMM approach for this application is that a

robust covariance matrix of the estimators can be formed. The variances


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





E[f l (l;l)f l _I(9)'].


The asymptotic distrihution of iJ is normal. Thus we have

Tlw application of the distributional result in (5.6.9) requires consistent

csrilllarors of Do and So since they are unknown. In this case, for Do we ha~e


= -[ )l",



u",+J1 m


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 chi-square test of the Sharpe-Lintner modd
as in (5.3.22). The test statistic is
Under the null hypothesis a

= O.

YMacKinlay and Richardson (1991) illustrate Ihe bias in standard CAl'M

tes~ statistics that can result from violations of the standard distributional
ass~mptions. Specifically. they consider the case of contemporaneous conditiOllal heteroskedasticity. With contemporaneous conditional heteroskedasticiiy. the variance of the market-modd residuals of equation (r).3.:~) depel~ds on the contemporaneous market return. In their example. the as5111 ption that excess returns are 110 aruljointly lIlultivariate Student Ile;\(ls
to onditional heteroskedasticity. The lIlultivariate Student 1 assumption
for xcess returns can be motivated both empirically and theoretically. One
em irical stylized fact from the distribution of returns literature is that ITtun s have fatter tails and arc more peaked than one would expect from a
nor a1 distribution. This is consistent with returns coming from a multivari Ite Stude III I. Further. the multivariate Studellll is a rethrn distribution
for vhich mean-variance analysis is consistent with expected utility maximiz tion. making the choice theoretically appealil1g.~
he bias in the size of the standard CAI'M test for the Student I case
'depbnds on the Sharpe ratio of the market portfolio and the degrees of
freehom of the Student I. MaeKinlay and Richardson (1991) present sOllie
estil~lates of the potential hias for various Sharpe ratios and for Student I
degrees of freedom equal to 5 and 10. They find that in general the hias is
small. uut if the Sharpe ratio is high and the degrees of freedom slllali. the
hias can be suhstantial and lead to incorrect iniCrences. Calculation of the
lest statistic 17 based on the CMM fral\lework provides a simple check for the
possibility that the rejection of the modd is the result of heteroskedastirity
in the data.


ImIJ/i'IIII'lIla/ioll o/Tr.ll.l


5.7 Implementation of TcsL'i

thi~ SI"I lion we considcr issues rd.lling III (~Illpiri("al illlplnllcnt<ltioll of
the test mcthodology. A summary of cmpirical rcsuIL~. all illustrative implemenlatioll. and discllssion o\" thc ohservahility of the market ponfolio arc


5.7.1 SllInmmy oj Eml,iri((l/ ElIitlrnrr

An enormolls amolillt of literatllre presenting elllpirical evidence 011 the
CAI'M has cvolved since the development of the model in the 1960s. The
early cvidence was largely positive. with B1ark .IellSen. and Scholes (HI72).
Fama and MacBeth (1973), and B1l1me and Friend (1973) all reponing evidence cOlISistellt with the lIIean-v"ri"nce efficienty of the markel portfolio.
There was some evidence against the Sharpe-Lintner version of lhe aPM
as Ihe esti!nated mean return onlhe zero-heta port[(llio was Iligher than the
ri~Hree return. hut this could he accoullted for by the Black version of the
In the late I ~170s less favorable evidence for the CAI'M began to appear
inlhe s(}-callcd ,lIIomalies literature. III the contexi orthe tests discllssed in
this chaplCf. the ,Illolllalies call he thonght o\" as lirm charallerislics which
can be nsed to group asselS together so that the tangency portfulio of the
included portfolios has a high I'X 110,11 Sharpe ratio relative to Ihe Sharpe ratio
of Ilw market proxy. Alternalively. COlllra!), 10 Ihe preC\inioll of Ihe CAPM.
Ihe [inn charaueristics provide explallatory power for lire noss seclion of
~alllple mean returns beyond the heta of lire CAP!'.-!.
Early anomalies included Ihe price-earnings-ratio cllect and Ihe si7.e
circe\. l\asu (1977) first reported Ihe price-cHrnings-r.ttio elTeu. BaSll's
Ii nding is Ihatthe market portfolio appears nol to he l\Iean-variance emdent
rel.ttive to portfolios forllled on Ihe hasis of the price-earnings ratios of
linns. Firms wilh low price-carnings ralios howe higher sample retllrns, and
linlls with high price-earnings ralios have lower lIIean returns Ihall wOllld
he Ihe case if the market portli)lio was lIIean-v.u-iallce efficient. The sil.e
clfert. which was [irsl doculllented by Bani, '( I ~}H I). is the resllit that low
lII,trkct rapilali/,alioll linns have higher sample lIIean returns Ih<ln would
be experlcd if Ihe market port((llio was meall-Vari<lIlCe dIirient. These two
anonlalies arc <II least parti<llly related, as the low prire-e'!lIIings-ralio lirms
IClld 10 he slllal!.
A Illllnber oj' other OlllUm<llies have 1)('('11 dis('()\'cred 11101 e recelllly.
Failla alHI French (I~}~}:l. 1~1!I:~) lind Ih,ll bela call1lot explain the dillcr('II Ct ill relllrll helween portfolios lill'lIH'd 011 rll(' basis ol'lhe ralio of hook
vallie or equity to market value of equily. Firllls Willi high book-market ralios have higher average relllrns lhall is pr('diclcrl hy rll(' CAI'M. Similarly,



(,11/1/(111 .. 1,.\t'( I'm'jllg


IkBolld l alld Th;dn (1~1H:1) alld ,'q~adeesh alld Titlllall

(I~}~}:,) filld lil;11
a porlli,li o lilllll'd III bllrill)!; slocks whose \'allll' has dt'c1illl'
d ill Iht' 1);1,1
(/11.\/'/'\) ;lIul sellillg slo('k, lI'ilo,,1' \'allll' has risell ill Ihe pasl
(lI';lIlIl'n ) h;IS a
hi)!;hl'l' an'r;lg(' .1'111111 Ilwl III(' C:/\1'~1 prl'dicls , Failla (1~}~1I)
pro\'idl' s ;.
good discllssi oll ollhl'sl ' alld 01111'1' ;lIuH.lal il's,
Alt hOllgh I Ill" reslllt,\ ill till' a 01l.;t1i,'s lill'rat 111'1' Il.a\, si)!;lIal
('rollolll ir;dl\'
ill.porla lll d('\i;lIio lls IHIIII till" (:AI'~I, t11('J'(' is lillie IIll'oreli
('al IIIOli\'al ioll
li,r Ihl' linll (hara('( '. iSlics "llIdil'd ill Ihis lileralllr e, This
opells lip Ih('
possibilil~' Ih"l Ihe ('\'id('IIt' (, a)!;;lil.sl Ihl' CAI'M is
O\'l'rslat t'd Iw('allsl ' 01 d;lIasiloopill) !; alld salllpll' sd('('lio ll bia,('s, WI' hridly disCllss Ihl'SI'
possibili Li""
I lala-sllo opillg biaSI'S rdi'r 10 Ih(' biasI'S ill slatislic al ill li-rl'II
('(' Ihal r('slIll
11'0.11 IIsill)!; illlillllla Lioll 11'0111 dal;1 10 )!;lIid(' Sll bS('1) 1)('11 I
rl'search wiLh Lhl'
sallll' or relal('(1 Ibl;1. Thl'''' hi;ISt's an' allllosl illlpossi hll'
10 ,,\,oid dill' 10
Ihl' 1101I('xp ('rillll'lIl al 11,,1111'1' of 1'('OIlOIl.i('s, \Ne do .UII han'
Ihl' It.XIIJ'\' of
rllllllillg "lIolht'l ' I'xpl'rilll('111 10 (,),I'al(' a III'W dala S('I. 1.0
alld Mad\'ill lal'
( I ~}~}Oh) illllSI raIl' III(' pOlnll i;d 1I.;lglI illule ofdala-sI IOOpill) !;
hias('s ill a I('SI of
I h(' Sharpe-I .i.II.It'l' \'t'I'sioll 011 hI' ( :AI'M, They cOllsili n Iht'
('ase II'h('l'(' 11ll'
d.ara('( nisl ic lI",d 10 )!;I'OII P slocks illlo porI folios (t' ,)!;, sill'
or pric(,-I'a rllill)!;s
r;lIio) is sd"t'l(,t! 1101 11'0111 Ih('orl' bill 1'1'0111 pre\'ioll s obs('rl'"
liolls 01 III ('a II
\Itu'k 1'('1 II I'IIs IJsillg ''('/;'.1'<1 <1;11,1. (:"lIIpar isolls "flhl' 111111 dislriblJ
lioll 01'1111'
Il'sl SI;llislic \\'iLh ;11 It I \\'ilholll d;\I"-Sll oopillg SII)!;g('SIS Ihallhl'
IIl"gllill ld(' of
Iht' hias('s ('all 1)(' illllllt'lIS t', Ilm\'(,\,('I', ill praclic( ', il is dilli(,1I1t
10 spl'rih' 11t(,
adjllslllu 'lIllh;1l shollid Ill' .1I"d(,li, rdala-sIl OOpill)! ;, Thus,lh
(' lIIailllll l'ssagt'
is a \\';.l'IIillg Ih;11 Ihl' hi;lst's sl,olllt! ;11 leas I b(' cOllsidt' l'l'd
;IS a pol('IILi;t1
t'xplalla lioll for II10dd dl'l'ialio lls,
Salllpll' s('Il'('lio ll hi",,'s ('all arisl' II'h('1I daLa a\'ailabi lily leads
10 t't rl;lill
Sllhst'ls of slo('k, beillg ('xl'illd( 'd 1'1'0111 Ihl' allalysis , For ('xa.llpl
e, KOlh,'ri ,
Shallkl'l I, alld Sloall ( I ~l~l:,) argllt' I hal dala r('qllin'I IIt'lllS for
sliltlit's look i II)!;
al hook-lII arkl'l ralios Il'ad Lo bilillg sLo(,ks Iwill)!; ('xcitul( 'd
;lIld a rt'sllitill g
slIJ'\'il'o rship hias, Sillt'(, IIII' 1;lilill)!; slorks wOlild he ('xP('('ll
'd 10 han' lo\\'
It'IIII'IIS alld high ilook-Ill arkt'l ralios, Ihl' al'erage n'tlll'll ofth(,
illcllld(' d high
hook-lII arkl'l-ra lio SIOI ks 1I'01iid hal'l' allllpwa rd hias, KOlhari
, Shallkl'l I, alld
SIO;III ( I ~}~I.',) a rg 11(' I hal !I,i, hi a, is 1;lrgd), J'('spolIs ibl('IIII' lhc
previolls ly ci 1('(1
rl'sllit of Falll;1 alld FII'IIl'l, (I~I~}:!, 1~I~n), I I ow('\,e 1', tht' iJllporta
llre of II,is
pal'li(,lI larslll'\'i n ,rship hia\ is 1101 I II II\' lI'sol\'t'd as Failla ;lIld
FrclIl'l1 (I ~}~}(ib)
displIl(' Ihl' ('tlllllll\ ioIlS 01 Kolh;lIi, Sh;llIk('I I, alld Sioall,
III aliI' I'\'('IIL. il is
d .. ;II' 11,;\1 1!',\t';lrt"llt'l'.s sl,ollld 1)(' ;111';11 (' of Ihl' pOI(,lItia l prtlhll'll
I\ Ihat ('all
arisl' 1'1'011. s;lIl1pll' sl'i('t'lio ll hi;,,(",

'i, 7,2 "III"lIllh -/'


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,:!:!


5.7. /1Il/,ll'1l1l'1llalioll o/TrIls

. 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 value-wei~ted
within the portfolios. The CRSP value-weighted index is used as a proxy
fi}r the market portfolio, and the one-month 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 ten-year subperiods,
and six five-year 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 chi-square 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 chi-square
The empirical results are reponed in Table 5.3. The results present
evidence against the Sharpe-Lintner CAPM. Using JI' the jrvalue for the
overall thirty-year period is 0.020, indicating that the null hypothesis is rejected at the 5% significance level. The five- and ten-year 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

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 finite-sample adjustment to }l works well
as inferences with}l are almost identicalLO those with JI.

5.7.3 UTlObsmlabilily o/the Markel Portfolio

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 equal-weighted 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



5. Tile Callilat AS.ll'll',il;IIK Modd

Table 5.3. I:m/liriml ".w/I.! for Iroflof of Ihr Shm/lr.l,ill/llrr ,,,,,,,iOIl 11/hr eM'/II.










Five-year subperiods



20./lli7 0.022

1/l.1~2 O.O4/l

n.IU!', n.u I:.






19.179 OJnH
17.47ti 0.()(i4



21.712 O.UI7
1!/.7H4 0.031




13.:\78 0.20:1




IH.164 OJ/52

I1.HI8 0.297
1(i.()15 0.098








12.1i1l0 0.212


11.200 0.:142
94.151 0.003


27.922 0.002
1:I.(Hi!; 0.22U
](UII :. 0.07(;
12.:\79 (1.2(iO


ten-year rubperiods

\ I/r"-12174



23.883 O.OOH

22.190 O.oJ:1

24.1i19 O.O()!;




22503 O.OI?>

2J.190 0.020

27.192 0.002




\9.281 0.037

18.157 0.052

16.373 O.OH'.I





fiJ.8:!7 0.001




2Uil2 0.017

21.192 0.020

n.17(; O.OJol



irty-year period

\*Le~~ than 0.0005.

R~,ult\ are for ten valueweighted portfolios (N = HI) wilh slOe\<..\ assigned 10 III,' 1'''' I(olios
ha.\ed 00 market value of equity. The CRSP valuc-w"ighled index is "sed "'" Ill""""', .. I'll ...
n;arkel portfolio and a one-monlh Treasury bill is used as a measure of Ihe risH..... fa,,. Th"
lesL. are b.sed on mOlHhly dala frolll.lalluary 196:, 10 D"cemher 1994.

been suggested to considcr if inferences are scnsitive to the lise of a proxy

in place of the market portrolio.
One approach is advanced in Stambaugh (1982). He examilles the
sensitivity of tests to the exclusion of assets by considering a Ilumber of
broader proxies ror the market portrolio." Be shows that illkrellces al'e
similar whether one uses a stock-based proxy, a stock- and bond-based proxy,
or a stock-, bond-, and real-cstate-hased proxy. This suggesL~ that infercnces
are not sellSitive to the error in the proxy when viewed as a Illeasure of the
market portfolio and thus Roll's concern is not all empirical problem.
liRc.'lfflcd work c0I1~idc.r5 Ih(' pos.."ihility of an:oul1ling for the n'(llrn Oil human Clpit.lI. SCt'
May"" (1972), Campllt'll (19!)(;a). ;1I111.1a~;UII"l\han and Wang (1~/!U;).


(: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.

5.8 Cross-Sectional Regressions

So far in lhis chapler we have fOCllSc(1 Oil Ihe lllean-varialHT efficiellcy of
Ihe markct ponfolio, Another view of Ihe CAPM is Ilral il implies a linear relalion bclwecn expcclcd relUI'llS and markel helas which completely
explain tlte cross seClion of expecled reI urns. These implicalions can be
les'ed IIsin~ a cross-seClional regrl'ssioll lIIelhodoloh'Y'
Fama and Maclklh (1973) lirsl (lcve\oped Ihe cross-sct'lional I{'grcssion
"ppm.lrlL The h<lsic idea is, for each cross seClioll, \0 pn~j('(\ Ihe relurns on
Ihe 1)('las and Ihell ,I~~n:~ale Ihe l'slilllaies inllte lillll' dilll!'llsioll. ASSlllllill~
Ihal Ih(' belas arc kllown, lilc regr('s~ioll Illodd f(lr Iii!' IliI cross s(,(,(ion or
N assels is
I, = YIII L + )'1, {"J,,, + 11,.
wilere I, is Iii!' (N xl) vcclor of CX:ss assel returlls for lillie period I, L is all
(Nx I) veClor oroncs, and fJln is the (Nx I) vcdor orCAI'M helas.
Impklllcnialion of the Fama-Maclklh approach illvol\'cs lIfO sleps.
First, ).;ivcll '{' periods of data, (!U-l. I) is estilll;lln[ lISill~ Or.'; ((1I' each t.
I = I ..... '1', ~i\'ing Ihe T eslilnates of YOt alltl YI t. Then in Ihe second
step, the lilll!: scri{~s of YOt'S and YII'S arc analyzed. Dclillill~ Yo :::= E[ YOt 1
and YI = 1:'[Ylt], Ihe implications oflhe Sharpe-Lilllller CAI'M arc Yo = 0
(zelO illlercept) alld YI > 0 (positive llIarkel risk prelllium). Because the
retllrns arc lIormally dislribuled and Icmporally lID. till' ~allllllas will also
he Ilormally dislribuled and lID. llence. ~i\'t'll tillle st:rics or Yu, alld YIt,
I = I ..... T, W(' Gill tesl l!tese implic;\liol\s using Ilw IISI"II I-Icst. Ddilling
1"(Y,) ;IS thl' t-St;\liSlir. W(' have




The <lisirilllllioll of w(y,) is Silldelli I wilh (,/,-1) clq~rees or frccdolll ;1I\(1

asymplolically is \I:tlldanl normal. Ci\'cll Ihc lesl slalislics, illrcJ"('lIccs rail
he iliadI' ill Ihe IIslial fashioll,
The Fama-Madklh approach is particularly useful hecause il call easil~'
1)(' lIIodili,'d III anclIlIlIHHlall' addiliollal risk IIlI'aSlIreS hcyolld Ihc (;,\1'1\1
hela. By adclill~ addiliollal risk mcaSllres, we call exalllillc Ihl' h~volhc
sis 111011 hela cOlllplelcll' ,Iescrihcs IIII' <Toss-sectional varialion ill CXp('rlc,1
I'l'l urns. For I'xa III pll' , 1\'(' call considcr if linn sizc has cxplallalory powC\'
lill' Ihl' tToss-sel'liOIl of I'xp('('(l'd relllrns where firm sil.c is dclillcd ,IS Ihc
10~aritll1l1 01 1111' 111,11 kl'l I'allle of cqllily. Deli\lill~', as Ille (N x I) wetill'
wilh dClIlI'lIlS corrcspolldill~ 10 linll si!.(' al Ihe be~iJlllin~ of period 1,11'('
can ,lIlgllll'nl (.edt I) 10 illvl'sligall' if linn sin' has cxplanalory power 1101
C''I'llIil'd hI' Ihl' 111,11\;.1'(1)('(;1:

I, = YII/" -I- YII 0",

+ Y~I " + 1/"

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,I-i\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 nrors-ill-variahles complicalioll. Thc l'I"rors-i'lI'ariahlt-s prohlt'lIl elll hc addrl'sscd ill IWO ways, OIlC approach, adopted
hy Fama and Macl\elh, is (0 11lillillli/e Ihe errors-in-variahles 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'rors-illvariahles, Shallkl'lI sllgg('SIS lIIultiplyill),\ lr;, ill (!'UI.4) hy all a<\jusIJlleJlI
faClor (I + (ji", - f',,)'!/lr;;.). While Ihis approach elilllillales liIe errors-illvariahks 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'oss-seclioll,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 cross-sel'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




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.llized-least-squares
(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.
Another important subject is Bayesian analysis of mean-variance 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 stock-market 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, data-snooping, or sample-selection bias; and yet
others claim that no risk-based 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.

Problems-Chapter 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 minimum-variance portfolio Rp (except
ror the glohal minimum-variance portfolio) and the return of its associated


5. 'JIu' Calli/ai A.\Jr/ /'ririllK Mllr/ri



/3np, /31

/~, I?" = /3n+/31/~11+~2/?p+Ei:'

/311 ==

=I -

/l"i" and

the regression codlkiellts

O. Show tillS.

5.\2 Show that the intercept or the excess-retllrn market model,

if;the market portfolio is the tangency portfolio.


is I.ero

5! Using monthly returns from the \D-year 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 Sharpe-Lintner Capital Asset Pricing Model.
5.3.1 Using the entire to-year sample, regress excess retlll'llS or each
stock on the excess (value-weighted) market return, and perforlll t('sts
with a sizc of 5% that the illlercept is zero. Report the point estim.lll's,
I-statistics, and whether or not you r<:ject the CAPM. Perrorm regression
ragnostics to check yoIII' specification.

. 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 equal-weighted portfi)lio
and re-do 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
5.3.4 'Jointly test that the intercepts for all three stocks are zero using the
P-test statistic JI in (5.3.23) for the whole sample and for each subsalllple.


Derive the Gibbons, Ross, and Shanken result in equation (55.3).

Multifactor Pricing Models

AT '1'111' END OF CIIAI'TER [} we SUllllllaril.cd cillpirical cvidcllcc illdicatillg

that the CAI'M beta does not completely explaill the cross section of cxIHTtecl asset retllrllS. This evidellce suggests that (llle or morc additiollal
L("[ors lIIay be required to t:haracteril.c tire hehavior "fexpeoed returns alld
nal:lrally leads to consideration of IIIlIlliElctor pricing models. Theoretical
arglllllenL~ ;Jlso suggesl lhal more than onl" fa('(or is nqllired, sin(l~ oilly
\llIder strollj.\ ass\llllptiollS willtlle CAI'M ~'pply period l>y pniod. Two main
thnm:lical approaches exist. The Arbitrage l'ricillj.\ Theory (APT) developed by Ross (I !J7li) is based 011 arhitrage argunlClits alld the Intenemporal
Capilal Assetl'ricillg Model (ICAI'M) developed hy Mellon (I !173a) is bascd
on equilihriulIl argumcllLs. III this chapter we will cOllsider Ihe ecollolllclric
an.t1ysis of multifaclUr models.
Thc chaplcr procceds as follows. Senioll li.1 brid Iy disc\lsses the theoretical background of thc multifanor approachcs. In Scction G.2 we consider estimation and tcsling of the models wilh known faclOrs, whilc ill
Scction li.3 we develop estimators for risk premia and expened returns.
Since lire factors are 1I0t always provided by theory, we discuss ways to COIIstrllCt lhem ill Sectioll G.4. Scctioll G.!i presenL~ empirical rcsulLs. Becausc
of tire Jack of specificity of thc modds, dcviatiolls Gin always be cxplaillcd
by additiollal !;rcwrs. This raises all issul" of illlcrprt"lill~ model violations
whkh we discuss ill Section (i.G.

6.1 'Theoretical Background

The Arbitrage Pricing Thcory (APT) was illtrodllced hy Ross (1976) as all
alternative to the Capital A%ct Pricill):( Model. The APT can hc morc general than the CAPM ill lhat il allows for lIIultiple risk (;rclors. Also, unlike
the CAPM, the APT does not reCfuire Ihe idelllificalioll of Ihe market ponfolio. Ilowe\'("I", Ihis generality is 1101 wilhollt cosls. III ils mosl gelieral/<>rI1I

6. AI 1/11 i/ill'I!)/" J'ririllg ,\Ji!lll'l.\

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



Elf, I fl

(/, + h; f + E,

(i.L1 )

(;, 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,


Eiff' I fl




;. \.(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' wcll-diversilicd portfolios vanishes,'!
This n'qllires Ihalllle dislurhaltce I('nlls be slIfficit'lIlly IIlu'olTcialed across
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.,'\'o-I)('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 .It-h,''I' Ill' IllI' 1I'.\I"hilil)' III II .. APT. '-;I>;lIlkt-1l (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\' \\dl-di\"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

let ~ represent a cOllfonnin~ vector of ones, The relation in (6.1.7) is

proximate as a finite lIumber of assets can be arbitrarily mispriced. Because
(;.1.7) is only an approximation, it does not produce directly testable restric ;~,~:':
tiollS for ,Isset returns. To obtain restrictions we need to impose additional~,;'~
5t l'lIctlIl'e so that the approximation hecomes exact.
~ ,::~~~,; .
Connor (1984) presenL~ a competitive equilibrium version of the APT'i,:~!:
which h,lscxact factor pricill~ as a feature. In Connor's model the additional,~~.:.~.!.
reCJuirelllenL~ are that the market portfolio be well-<liversified and that the .~w.:
factors be pervasive. The market portfolio will be well-<iiversified ifno single ;'::f.;-;.
asset in the economy accounts for a significant proportion of aggregate .: ~>
wealth. The requirement that the factors be pervasive permits investors to
diversify away idiosyncratic risk without restricting their choice offactor risk
Dybvig (1985) and Grinblatt and Titman (1985) take a different approach. They investigate the potential magnitudes of the deviations from
exact factor pricing given structure on the preferences of a representative
agent. Both papers conclude that given a reasonable specification of the
parameters of the economy, theoretical deviations from exact factor pricing
arc likely to he negligible. As a consequence empirical work based on the
exact pricin~ relation isjustified.
Exact factor pricing can also be derived in an intertemporal asset pricing
framework. The lntertemporal Capital Asset Pricing Model developed in
M(~non ( 1973a) combined with assumptions on the conditional distribution
of returns delivers a n1Ultifactor model. In this model, the market portfolio
serves as one factor and state variables serve as additional factors.! The
additional factors arise from investors' demand to hedge uncertainty'about
futllre investment opportunities. Breeden (1979), Campbell (1993a, 1996),
and Failla (1993) explore this model, and we discuss it in Chapter 8 ..
In this chapter, we will generally not differentiate the APT from the
ICAPM. We will analyze models where we have exact factor pri!=ing, t~at is,


= tAo + B>'K.


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

6. Multi/actor Pdrill/!. MI}{ft./.1

6.2 Estimation and Testing

In this section we consider the estimation and testing of various forms of the
ex ICt factor pricing relation. The starting point for the econometric analysis
of the model is an assumption about the time-series behavior of retul'lls.
W will assume that returns conditional on the factor realizations arc II [)
th ough time and joilltly multivariate 1I0rmai. This is a strong assumption,
bl~t it docs allow for limited dependence in returns through the time-series
behavior of the factors. FunhernlOre, this assllmption can be relaxe(1 by
casting the estimation and testing problem in a Generalized Method or
Moments framework as outlined in the Appendix. The GMM approach for
llIultifactor models isjllst a generali7.ation of the GMM approach to testing
the CAPM presented ill Chapter 5.
As previously mentioned, the multil;lCtor models specify neither the
number of factors nor the identification of the factors. Thus to estimate and
test the model we need to detCl'minc the bctors-an issue we will address in
Section GA. In this section we will proceed by taking the JIlllnber of brtms
and their identification as given.
We consider fOllr versions of the exact factor pricing model: (I) F,tctors are portfolios of traded asseL~ amI a riskfree asset exisL~: (2) Factors arc
portrolios of traded asseL~ and there is not a riskfree asset; (:{) Factors are
1I0t portfolios of traded assets; and (4) Factors arc portfolios of traded assets
and the factor portfolios span the mean-variance frontier of risky asseL~. We
lise maximum likelihood estimation to handle all fOllr cases. See Shanken
(1992h) for a treatmenl of the same fOllr cases lIsing a cross-sectional n:gression approach.
Given thejointllormality assumption for the retnrns condition.1! 011 the
factors, we can construct a test of any of the fOllr cases using the likelihood
ratio. Since derivation of the test statistic parallels the derivatioll of the
likelihood ratio test of the CAI'M presented in Chapter 5, we will not re)leat
it here. The likelihood ratio test statistic for all cases takes the sal\le gelll"J"al
form. DeflllingJ as the test statistic we have


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 time-series 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 flllite-sample null distrihution

0,2, 1'.:~/i/ll(l/iuli



Ihl' lar).';l' ~;\lIIpll' distriIHltioll.: 1 The hlq.;e sample distrihutiull of} ulldl'\'
Ihl' lIull hypothesis will he chi-sqllare wilh Ihe dq.;n(s offrecdolll eCjllallo
Ihe 1I(11111)('r ofreslrictiolls im(lo!;('d hy Ihe 111111 h),pollH'sis.


6.2. I !'orljiJiiu,\


Iin/o/,I wilh


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!;, + :,












= 0,


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 variancc-covariance matrix
of lile distllrbances, and n/\ is the variance-covarialHT 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:



.J.L -- -TILr Z'








For Ihe (oll,nailled Illodel, wilh a cOllslrailled

likelihood ('slilllalllls all'

tIIulli/ilt"/1If I'liring t\llIdl'l.~


he zero, Ihl'maximllm

(G. ~. \())

+. Z)Z, - n'z"" )(Z, - nz",,)'.

(Ii.:!. 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 F-It'sl of Ihe Ilull
hY(lotlH'sis. Iklillill(.!;.h as Ihe II'SI stalistic we have


Ulld('1' 11\('IIUIl hypolhesis,./I is II II ('01 I! Ii liollally e1islriblltl'd cCIIll'al Fwith N

dl'gn'('s of fn'('dolll ill tl\(' 1IIIIIIel'atol' alld ('j' - N - f.:.) dq!;l'cl'S or frecdolll
ill IiiI' (kIlOlllillalol'. This tcst call he very IIseflll sillc(' it can elimillate thc
prohleJlls thai call an'onlpallY fhe usc of asymptotic distrihutioll tiICory.
Johson al\(I Korkil' (I ~1H: J'()\'id(' a derivation of jl.
6.2.2 I'(I/'/ji}/im


Fur/on wi/holl/a Ri.lkJrl'l' Anl'/

III tile ahs('llce of a liskfre(' aSSl't, there is a zero-beta 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('('o-beta 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







and 'Jesting

E(RKI - J-LK) (RKI - J-LK)']

COV[RKio ;]

= OK

= O.



B is the (N x K) matrix of faClor sensitivities, R K , is the (K x 1) vector of

factor portfolio real returns, and a and I are (N xl) vectors of asset return
intercepts and disturbances, respectively. 0 is a (KxN) matrix of zeroes.
For the untonstrained model in (6.2.14) the maximum likelihood estimators are




Ii =

[t(RI - iL)(R KI - {LK)'] [t(RKI - iLK) (R K1 - iLK),r




= T 2:= R,




= T 2:= R K1 .



In the constrained model real returns enter in excess of the expected

zero-bela portfolio return yo. For the constrained model, we have




+ B(RKI -


+ ,



The constrained model estimators are:



T1 l)R


LYo -

B (R Kt - LYo)l




2261 .

6. Multifactor Pricing Modl'ls

The:maximum likelihood estimates can hc ohtaincd by iterating over (i.'L23)

to (~.2.2:). B frolll (G.2.20) and :E from (1i.2.21) can bc uscd as starling
values for Band :E in (6.2.25).
Exact maximulll likelihoud estimators can also be calculatcd without
iteration for this case. The IlIcthudulu!,'Y is a generalization of the ,lpproach
outlincd for the Black version of the CAPM in Chapter 5; it is presentcd
hy Shanken (I985a). The estimator uf Yu is the solution of a fjuadratic
equatiun. Givcn y(), the constrained maximum likelihoud estimators or B
and :E follow from (6.2.23) and (6.2.24).
The restrictions of the cunstrained lIludd in (6.2.22) Oil the unconstrained model in (6.2.14) arc


(t - Bt)yu.

These restncltons can be tested using the likelihood ratio statistic .I in

(6.2.1). Under the null hypothesis the degree5 of freedom of the null distribution will be N -I. Therc is a reduction uf one degrec of freedom ill
comparison to the case with a riskfrec asset. A degree of freedom is used
up in estimating the zero-beta expccted return.
For use in Section 6.3, we note that the asymptotic variance of Yo evaluated at the maximum likelihood estimators is



(1 + (11" - y()dn~t (jL" -


x [(L-BL)':E-t(L-BLW t .

6.2.3 Macroeconomic Variables




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 K-f;IClor linear




I Elf",) =




== :E

-,Ltd (f", -ILf ,,)'}

Cov[f"/. f;1 = O.




6.2. Estimation and TesliTlg



B is the

(N x K) matrix of factor sensitivities,

is the (K x I) Vl'l'\or of factor
realiJ.ations, and a and (;, arc (Nx I) Vl'('\ors of asset return intercepts and
distlll'\)'Illl'CS, respectively. 0 is a (/\ x N) lIlat rix of lero(s.
For the unconstrained model in (I;.:!. H) thl' Ill<lxi 1111 I III likcrlliood l'stilIlators arc



L..,(R , = T1 '\'

a - Bf",)(R, - a - fif"l) ,




It =

T1 '\'
L.., R,



The constraincd model is l1Iostl'ollv('niclltly hll'lllulatcd hy comparing

thl' unconditiollal expectation of (11.:!.:!H) wilh (1i.I.H). The IlIlConciitional
l'xpectation of ((i.:!.2H) is

/L = a
where J.LI"
we havl'

+ B/L/".


== Elf",]. Equating the right hand sides or (li.I.H) and (1i.2.36)



+ 8(>'" -



Delining y" as Ihe zero-heta 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
Thl' constrained model estimators



6. MIII/ijf/r/llr Prjr;lIg MIII"'.1

(n. ~.40)

whl'rt' ill (li.:!.II) X == 11,11'1 and I == I Yo 1'1 J'.

The Illaxillllllll likelihood estilllatt's call be obtai lied hr iteratillg o\'er

(li.'139) to (li.'1..1 I), B hom ).~.:H) and

from (li.2.:); Gill he \lsnl as
stOlrlillg vOIlllcs fill B alld }:; ill (n.~.'II).
The rcstriniolls of (1;.2.:IH) Oil (1;.~.2H) are

Thl'sl' n'stl'll"tlllllS em he tested \Ising the likelihood ratio statisti<: .I ill

(li.2.1). lhull'!" lIlt" 111111 hypolh('sis the dcgrecs or rrcedolll of the null distrihulion is N - K - l. Th('l'e arc N rcslrictiolls but one degrce orfreectOIll
i~ lost t'stilllatiu),( Yo, alld K d('),(I'!'l's of frcl'dom are used eSlimatillg the K
('h-nlt'nls of AA'.
The ;1~Yllll'tOlic \';11 i;II",(, 01 :y follows frolll Ihe lIIaxillluln likelihood
approach, The 1';1Ii;IIICe ('\';IIl1all'd OIl Ihl' JIIaXilllUIII likelihood I'stilllalOrs is

Applrillg thc partitiolled illVt'lse rule

compolIl'nts of:Y \\'c ha\'c cstilllators


(1i.2.4:\). fe)r the variances of t)le

+(I + (:y I + ill 1.;>'1i~ (:YI + P-j IJ) (B"t,-llh- 1





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' MfilIl-l'a/'illllC/' 1-I1I1IIit,.

\,\'hclI 1~\('lOr pOI'I.lios span Ihe Illean-I'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. i:'sti11l(l/ion and 7fSlill/(

Thus this case retains the simplicity of the first case with the riskfree asset. In
the context of the APT, spanning occurs when two well-diversified portfolios
arc Oil the minimum-variance boundary. Chamberlain (1983a) provides
discussion of this case.
The unconstrained model will be a K-factor model expressed in real
retll\'lls. Define R, as an (Nx I) vector of real returns for N assets (or
portfolios of assets). Then for real returns we have a K-factor linear mode!',:



(6.2.47 )



n is the (N x K) matrix offactor sensitivities, RJ\, is the (Kx I) vector offactor

portfolio real returns, and a and f., are (N x \) vectors of asset return interr
cepts and disturhances, respectively. 0 is a (K x N) matrix of zeroes. The
restrictions on (6.2.46) imposed by the included factor portfolios spannin~
the mean-variance frontier are:




(6.2.5\ )

To understand the intuition behind these restrictions, we can return to

:he Black version of the CAPM from Chapter 5 and can construct a spanning example. The theory underlying the model differs but empirically the
restrictions are the same as those on a two-factor APT model with spanning.
The unconstrained Black model can he written as

= a+

f3 0mRol + f3rn Rrn, + f."


where ROIl' and Ro, arc the return on the market portfolio and the associated
zcro-beta 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. Multifactor PricillK MrHlrLl



I '"
I.L. = TL.....RI



To estimate the constrained lIIodel, we consider the uncolJStrained

model in (6.2.46) with the matrix B partitioned into an (N xl) cO\lIlIIn vector
b l and an (Nx(K-I matrix BI illldthe factor portfolio vector partitioned
into the first row RI! and the last (K-l) rows R K,!. With this partitioning
the constraint B ~ == ~ can be written hi + BI ~ == to For the lI11colIStrailled
model we have

Substitllling a

== 0 and b l ==

L -

BI L into (G.2.56) gives the constrained

R, - ~RII = BI (R h ,! - ~RII)

+ E,.


Using (6.2.57) the maxillllllll likelihood estimators are





~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. '


}~,\lill/(/li(}1/ o/UiJ/, /'mllia ami }';x/}('(/t'li UI'IIII7I.~


Defining.h as Ihc lest slatistic we haw

(T -- N - h')

[1i--;;-:;'1 -I,]



U\ld("\" Ih(~ \lull hypothesis, J'l is IIIKoll(litionally disllilHltnl n~ntral F with

2N degrecs o\" frcedom ill the 1I11111crator and :2( '{-N -- K) (\egrees o\" freed011l ill thc dCllolllillator. lIuhcrmall alld KUHlel
tion o\" Ih is Icsl.


prescnt a deriva-

6.3 Estimation of Risk Premia and Expected Returns

AI! the exact/;IClor pricing models allow one to estimate the expected retllrn
on a givcII asset. Since the expecte(1 rclurn relation is It = LAu + B>' . , , olle
lIe.:ds lIl.:aSllrcs of the faclOr sellsitivily malrix B, Ihe risk\"ree rate or the
zcro-bcla expccted retllrJI Au, alld thc LInnI' risk prcmia >'1:. Ohtainillg
mcasures of B and the riskfree ratc or the expectcd I,ero-heta return is
stra;~lllforwanl. For the given case the constrained maximllm likelihood
estimator S' Gill be IIsed lor B. The observcd riskli'cc 1'.11(' is appropriate
li)r the riskl'rec asset or, ill the GIS(~S without a riskCnT asset, the maximum
likelihood estim,l\or Yo Can be IIscd for the cxpertctl L('w-lJeta r('tllm.
Furthcr estimation is lIeccssary to form ('~Iimalcs of the Linor risk premia. Thc appropri,lIe procedure varics across the [(Jill' cascs of cxact htctor
pririllg. [II the case where the fa<:lors an~ thc exn~ss retllrllS Oil traded portfolios, til, risk prl'mia (',111 he estim;l\l'd directly frolll Ihe salllple mealls or
the exccss rctllrns Oil the pOrllillios. For this (".I.'C we ha\'c
(li.:t \)

An estilllator o\" th(' variance of ).1: is

[Il tile rasc whlTe j>orLfo[ios are /;\('101" I)\n tlln(' is no riskfree asset,
the EIClOr risk prelllia (all be estimatcd IIsing Ihe !lith-rCl\cc bctween thc
Slll1lplc IIIcall of the factor portl(Jlios and thc estilllalcd {(To-beta rctllrn:


III this casc, an estilllator of the v;lriall(T or >.1;




ill 11//1/1111111 "ril"illg .\lII/It'll

II'hnl' \-;;;-rl)'ul i\ InJlII (;.:.!.~7). Till' tic! Ihal

alld Yu are indl'pI'llIll'nl
lias 1)('1'11 Jllili/l'd 10 WI IIII' covariancl' Il'rlll ill (Ii.:!.'!) 10/('('0.
In Ihl' C\SI' I\'hert Ihl' btlors an' 11111 Iradl'd portfolios, an eSlilllator Ill'
till' Vl'nor 01 bClo .. ri~k prl'lIIia AA' is Ihl' S\lIn of Ihl' I'sliJllalor of Ihe lIIeall
oflhe 1;1('(01' n';tli/;lliolls alld Ihl' I'slimator of' YI,



All I'slilnalor of II\(' ";lriaJl(,(' of >-i-: is



(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'an-variancl'
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 - /\) .. _.


'~AA VarIA ...




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)!;


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 two-pass cross-sectional regression approach. In the firsl pass ,he
f;ICtor sensitivities are estimated asset-by-asset 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- period-bylime-period in the second pass. The second-pass regression is



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 zero-beta 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.

6.4 Selection of Factors

The estimation and testing results in Section 6.2 assume that the identity
of the factors is. known. In this section we address the issue of specifying
the factors. The approaches fall into two basic categories, statistical and
theoretical. The statistical approaches, largely motivated by the AYf, involve
building factors from a comprehensive set of asset returns (usually much
laqJ;er than the set of returns llsed to estimate and test the model). Sample
data on these returns are used to construct portfolios that represent factors.
The theoretical approaches involve specifying factors based on argumen,ts
that the factors capture economy-wide systematic risk~.

6.4. J S/a/is/iral Approaches

Ollr startillg point for the statistical construction of factors is the linear
hlclOr model. We present the analysis in terms of real returns. The samf
;In;llysis will apply to excess retnrns in cases with a riskfree asset. Recall th*


lilr the linear llIodd we have

R, = a

+ B f, + (,


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

\ ~slil11ali()n using f~IClOr analysis involves a Iwo-slep prOl:c<illl'e. First Ih('

iIClor sensilivity matrix B alld the <iistl\l'h~l\Ice covariance lIIalrix r: ar(' est i!\IOlled and thell these estimales arc IIsed to (,{lIIstrllctllleaSllrl'S of the f,,('lor
realizatiuns. Fur standard faClor analysis il is assnl\led Ihal Ihere is a ,I/rirl
J(/(tor structure. Wilh Ihis slruclure K factors account for alllhc cross covariance of assel relurns and hence r: is diagonal. (Russ imposes Ihis slructure
in his original developmenl of the APT.)
Given a slrict faclOr slruclure and K f;lclOrs, we can express Ihl' (N x N)
'ovariance malrix of assel returus as lhe sum of two cOlllponeuts, Ihl' variajion frqnl the faclors plus the residual variation,


n ::: 8n" 8'

+ D,


n" and r: == D 10 indicate it is diagonal. With the bClors

a rotatioual iJl(\clerllliuacy exisls alld B is idclllilinl ouly up to
;\ lIollSingular transformation. This rolalional indeterlllinacy Gill he dillliIrated by restricling' the faclors to be orthogonal III each olher and to have
~ltJit variance. In this case we have 0/\ == I and B is uniquc lip to an 01'thoKonallrans/'Ol'lIIatioll. A1ltralls((JI'IIIS GG are equivalent ((II' an)' (K x K)
orlhogollallransforlllalion matrix G, i.e., GG' = I. Wilh th('se r('~lI inions
in place we Gill express the rei II I'll covariallc(' lIIalrix as


J:'lf, r,l ==


= GB'

+ D.


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 first-order 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.

Olle illlnprd<l(ioll ol"llll' lIl;\xill\"lIllikdihood l'slilll,Hor orB giVl'llthl'

maxill\"111 likl'lihood l'stilllator or D is thaI 0- 1 lillH'S the eSlilllalor o\" B has
the eigellv('('\ors or D-"In ;\ssoci;Ill'(lwilh IIIl" I\. larg('sl eigenvalues as ils
COIIlIlIlIS, For clt-Iails o\" Ihe estilllalioll lite inle("nl('c\ ("eaeler ("all sn: Ihl'se
papns, or Morrison (I\)\)(), chapler \) ,IIHI ("e((-ITllles Ihnein,
The se("ollel slep in Ihe l'slilll<llioll procedure is to eslilllale lhl' fanors
!!;in:1l B <llld }:, Sillce lhe (~\(IOrs arc derivl"<l froll\ Ihe ("(l\'ari'II\("(' slrlll"lllre,
the 1II(',IIIS 01("(' Ilol sped lied ill (liA,I), WithlHII loss of );l"lll"l"alily, we rail
reslriu Ihl' 1;Il"IOl's to have 1,('\"1) IlH'ans alld ('xpn'ss I Ill' fanol' mockl illle("lIls
or deviations aho"t the means,

(R, -



B f, -I- <-,.

Civell ({i.-I 5), a candidale to prox), lor Ih(' 1;lclO(" re;ili/;llions lor lillie pniocl
I is Iltt.: cross-s('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

I kre


are eSlilllatillg f, by ("eg("essillg (R, -

il) 01110


The factor real-

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!'

R h", = AWR"

allel A is ddilll'd as a dia~ollalll\alrix Wilh 1/ II; ;\s till' JIll di;rgollal d<.'llIt'III,
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