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Multivariate models
(6)
Solving for P,
Q
S u Q T v
(7)
Rearranging (6),
P P T S v u
( ) P ( ) T S (v u)
P
vu
T
S
(8)
Q Q T S u v
( )Q ( ) T S ( u v)
Q
u v
T
S
(8) and (9) are the reduced form equations for P and Q.
(9)
( X ' X ) 1 X ' ( X u )
( X ' X )1 X ' u
P 10 11T 12 S 1
(10)
Q 20 21T 22 S 2
(11)
We CAN estimate equations (10) & (11) using OLS since all the RHS
variables are exogenous.
But ... we probably dont care what the values of the coefficients are;
what we wanted were the original parameters in the structural
equations - , , , , , .
More than one set of structural coefficients could be obtained from the
reduced form.
Introductory Econometrics for Finance Chris Brooks 2008
1 2
3 3
Y2 0 1Y3 2 X1 u2
Y3 0 1Y2 u3
Introductory Econometrics for Finance Chris Brooks 2008
(14)-(16)
Solution
G = 3;
If # excluded variables = 2, the eqn is just identified
If # excluded variables > 2, the eqn is over-identified
If # excluded variables < 2, the eqn is not identified
Equation 14: Not identified
Equation 15: Just identified
Equation 16: Over-identified
(17)-(19)
v3
Estimate the reduced form equations (17)-(19) using OLS, and obtain the
fitted values,
Y1 , Y2 , Y3
Introductory Econometrics for Finance Chris Brooks 2008
(20)
Recursive Systems
Consider the following system of equations:
Y1 10
Y2 20 21Y1
11 X1 12 X 2 u1
21 X 1 22 X 2 u2
(21-23)
Y3 30 31Y1 32Y2 31 X1 32 X 2 u3
Assume that the error terms are not correlated with each other. Can we estimate
the equations individually using OLS?
Equation 21: Contains no endogenous variables, so X1 and X2 are not correlated
with u1. So we can use OLS on (21).
Equation 22: Contains endogenous Y1 together with exogenous X1 and X2. We
can use OLS on (22) if all the RHS variables in (22) are uncorrelated with that
equations error term. In fact, Y1 is not correlated with u2 because there is no Y2
term in equation (21). So we can use OLS on (22).
Introductory Econometrics for Finance Chris Brooks 2008
Estimation of Systems
Using Two-Stage Least Squares
In fact, we can use this technique for just-identified and over-identified
systems.
Two stage least squares (2SLS or TSLS) is done in two stages:
Stage 1:
Obtain and estimate the reduced form equations using OLS. Save the
fitted values for the dependent variables.
Stage 2:
Estimate the structural equations, but replace any RHS endogenous
variables with their stage 1 fitted values.
Introductory Econometrics for Finance Chris Brooks 2008
Estimation of Systems
Using Two-Stage Least Squares (contd)
Example: Say equations (14)-(16) are required.
Stage 1:
Estimate the reduced form equations (17)-(19) individually by OLS and
obtain the fitted values, Y1 , Y2 , Y3 .
Stage 2:
Replace the RHS endogenous variables with their stage 1 estimated values:
Y1 0 1Y2 3Y3 4 X1 5 X 2 u1
Y2 0 1Y3 2 X1 u2
(24)-(26)
Y3 0 1Y2 u3
Now Y2 and Y3 will not be correlated with u1, Y2 will not be correlated with u2 ,
and Y3 will not be correlated with u3 .
Introductory Econometrics for Finance Chris Brooks 2008
Estimation of Systems
Using Two-Stage Least Squares (contd)
It is still of concern in the context of simultaneous systems whether the
CLRM assumptions are supported by the data.
If the disturbances in the structural equations are autocorrelated, the
2SLS estimator is not even consistent.
The standard error estimates also need to be modified compared with
their OLS counterparts, but once this has been done, we can use the
usual t- and F-tests to test hypotheses about the structural form
coefficients.
Instrumental Variables
Recall that the reason we cannot use OLS directly on the structural
equations is that the endogenous variables are correlated with the errors.
One solution to this would be not to use Y2 or Y3 , but rather to use some
other variables instead.
We want these other variables to be (highly) correlated with Y2 and Y3, but
not correlated with the errors - they are called INSTRUMENTS.
How Might the Option Price / Trading Volume and the Bid / Ask Spread
be Related?
Consider 3 possibilities:
1. Market makers equalise spreads across options.
2. The spread might be a constant proportion of the option value.
3. Market makers might equalise marginal costs across options irrespective
of trading volume.
Introductory Econometrics for Finance Chris Brooks 2008
The S&P 100 Index has been traded on the CBOE since 1983 on a
continuous open-outcry auction basis.
Transactions take place at the highest bid or the lowest ask.
Market making is highly competitive.
The Data
All trading days during 1989 are used for observations.
The average bid & ask prices are calculated for each option during the
time 2:00pm 2:15pm Central Standard time.
The following are then dropped from the sample for that day:
1. Any options that do not have bid / ask quotes reported during the hour.
2. Any options with fewer than 10 trades during the day.
The option price is defined as the average of the bid & the ask.
We get a total of 2456 observations. This is a pooled regression.
The Models
For the calls:
CBAi 0 1CDUMi 2Ci 3CLi 4Ti 5CRi ei
(1)
(2)
(3)
(4)
where PRi & CRi are the squared deltas of the options
Results 1
(6.55)
(6.56)
0.08362
(16.80)
0.06114
(8.63)
0.01679
(15.49)
0.00902
(14.01)
-0.00228
(-12.31)
-0.15378
(-12.52)
-3.8542
(-10.50)
46.592
(30.49)
-0.12412
(-6.01)
0.00406
(14.43)
0.00866
(4.76)
Adj. R2
0.688
Adj. R2
0.618
Note: t-ratios in parentheses. Source: George and Longstaff (1993). Reprinted with the permission of
the School of Business Administration, University of Washington.
Results 2
0.05707
(15.19)
0.03258
(5.35)
0.01726
(15.90)
0.00839
(12.56)
-0.00120
(-7.13)
-2.8932
(-8.42)
46.460
(34.06)
-0.15151
(-7.74)
0.00339
(12.90)
0.01347
(10.86)
(6.57)
(6.58)
Adj. R2
5
-0.08662
0.675
(-7.15)
Adj. R2
0.517
Note: t-ratios in parentheses. Source: George and Longstaff (1993). Reprinted with the permission of
the School of Business Administration, University of Washington.
Comments:
Adjusted R2 60%
etc.
The paper argues that calls and puts might be viewed as substitutes
since they are all written on the same underlying.
So call trading activity might depend on the put spread and put trading
activity might depend on the call spread.
The results for the other variables are little changed.
Conclusions
Bid - Ask spread variations between options can be explained by reference
to the level of trading activity, deltas, time to maturity etc. There is a 2 way
relationship between volume and the spread.
The authors argue that in the second part of the paper, they did indeed find
evidence of substitutability between calls & puts.
Comments
- No diagnostics.
- Why do the CL and PL equations not contain the CR and PR variables?
- The authors could have tested for endogeneity of CBA and CL.
- Why are the squared terms in maturity and moneyness only in the
liquidity regressions?
- Wrong sign on the squared deltas.
Introductory Econometrics for Finance Chris Brooks 2008
or
y2t 20 21 21 y2t 1 u2t
= 0
g1
+ 1 yt-1
gg g1
+ ut
g1
+ 2 yt-2
gg g1
+...+ k yt-k + ut
gg g1 g1
We can also extend this to the case where the model includes first
difference terms and cointegrating relationships (a VECM).
Cross-Equation Restrictions
Suppose that a bivariate VAR(8) estimated using quarterly data has 8 lags
of the two variables in each equation, and we want to examine a restriction
that the coefficients on lags 5 through 8 are jointly zero. This can be done
using a likelihood ratio test
LR T log r log u
Introductory Econometrics for Finance Chris Brooks 2008
MAIC
ln 2k / T
MSBIC ln ln(T)
T
2k
ln(ln(T))
MHQIC ln
T
where all notation is as above and k is the total number of regressors in all
equations, which will be equal to g2k + g for g equations, each with k lags
of the g variables, plus a constant term in each equation. The values of the
information criteria are constructed for 0, 1, lags (up to some prespecified maximum k ).
y2t 20 21 21 y2t 1 0 22 y1t u2t
22 1 y2t 20 21 21 y2t 1 u2t
or
B yt = 0 + 1 yt-1 + ut
We can then pre-multiply both sides by B-1 to give
yt = B-10 + B-11 yt-1 + B-1ut
or
yt = A0 + A1 yt-1 + et
This is known as a standard form VAR, which we can estimate using OLS.
Introductory Econometrics for Finance Chris Brooks 2008
2t 20 21
22 y 2t 1 21 22 y 2t 2 21 22 y 2t 3 u 2t
Implied Restriction
21 = 0 and 21 = 0 and 21 = 0
11 = 0 and 11 = 0 and 11 = 0
12 = 0 and 12 = 0 and 12 = 0
22 = 0 and 22 = 0 and 22 = 0
Each of these four joint hypotheses can be tested within the F-test
framework, since each set of restrictions contains only parameters drawn
from one equation.
These tests could also be referred to as Granger causality tests.
Granger causality tests seek to answer questions such as Do changes in y1
cause changes in y2? If y1 causes y2, lags of y1 should be significant in the
equation for y2. If this is the case, we say that y1 Granger-causes y2.
If y2 causes y1, lags of y2 should be significant in the equation for y1.
If both sets of lags are significant, there is bi-directional causality
Impulse Responses
VAR models are often difficult to interpret: one solution is to construct
the impulse responses and variance decompositions.
Impulse responses trace out the responsiveness of the dependent variables
in the VAR to shocks to the error term. A unit shock is applied to each
variable and its effects are noted.
Consider for example a simple bivariate VAR(1):
y1t 10 11 y1t 1 11 y2 t 1 u1t
y2t 20 21 y2 t 1 21 y1t 1 u2 t
A change in u1t will immediately change y1. It will change change y2 and
also y1 during the next period.
We can examine how long and to what degree a shock to a given equation
has on all of the variables in the system.
Variance Decompositions
Variance decompositions offer a slightly different method of examining
VAR dynamics. They give the proportion of the movements in the
dependent variables that are due to their own shocks, versus shocks to the
other variables.
This is done by determining how much of the s-step ahead forecast error
variance for each variable is explained innovations to each explanatory
variable (s = 1,2,).
The variance decomposition gives information about the relative importance
of each shock to the variables in the VAR.
Brooks and Tsolacos (1999) employ a VAR methodology for investigating the
interaction between the UK property market and various macroeconomic variables.
Monthly data are used for the period December 1985 to January 1998.
It is assumed that stock returns are related to macroeconomic and business
conditions.
The variables included in the VAR are
FTSE Property Total Return Index (with general stock market effects removed)
The rate of unemployment
Nominal interest rates
The spread between long and short term interest rates
Unanticipated inflation
The dividend yield.
The property index and unemployment are I(1) and hence are differenced.
Lags of Variable
Dependent variable SIR
DIVY
SIR
0.0000
0.0091
DIVY
0.5025
0.0000
SPREAD
0.2779
0.1328
UNEM
0.3410
0.3026
UNINFL
0.3057
0.5146
PROPRES
0.5537
0.1614
SPREAD
0.0242
0.6212
0.0000
0.1151
0.3420
0.5537
UNEM
0.0327
0.4217
0.4372
0.0000
0.4793
0.8922
UNINFL
0.2126
0.5654
0.6563
0.0758
0.0004
0.7222
PROPRES
0.0000
0.4033
0.0007
0.2765
0.3885
0.0000
DIVY
SPREAD
UNEM
UNINFL
PROPRES
Months ahead
II
II
II
II
II
II
0.0
0.8
0.0
38.2
0.0
9.1
0.0
0.7
0.0
0.2
100.0
51.0
0.2
0.8
0.2
35.1
0.2
12.3
0.4
1.4
1.6
2.9
97.5
47.5
3.8
2.5
0.4
29.4
0.2
17.8
1.0
1.5
2.3
3.0
92.3
45.8
3.7
2.1
5.3
22.3
1.4
18.5
1.6
1.1
4.8
4.4
83.3
51.5
12
2.8
3.1
15.5
8.7
15.3
19.5
3.3
5.1
17.0
13.5
46.1
50.0
24
8.2
6.3
6.8
3.9
38.0
36.2
5.5
14.7
18.1
16.9
23.4
22.0
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
-0.02
-0.04
-0.06
0.12
0.1
0.08
0.06
0.04
0.02
0
-0.02 1
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
-0.04
-0.06
-0.08
Steps Ahead