A Theoretical Comparison Between Integrated and Realized Volatilies

In this paper, we provide both qualitative and quantitative measures of the cost of measuring the integrated volatility by the realized volatility when the frequency of observation is fixed. We start by characterizing for a general diffusion the difference between the realized and the integrated volatilities for a given frequency of observations. Then, we compute the mean and variance of this noise and the correlation between the noise and the integrated volatility in the Eigenfunction Stochastic Volatility model of Meddahi (2001a). This model has, as special examples, log-normal, affine, and GARCH diffusion models. Using some previous empirical works, we show that the standard deviation of the noise is not negligible with respect to the mean and the standard deviation of the integrated volatility, even if one considers returns at five minutes. We also propose a simple approach to capture the information about the integrated volatility contained in the returns through the leverage effect.

An Eigenfunction Approach for Volatility Modeling.

In this paper, we introduce a new approach for volatility modeling in discrete and continuous time. We follow the stochastic volatility literature by assuming that the variance is a function of a state variable. However, instead of assuming that the loading function is ad hoc (e.g., exponential or affine), we assume that it is a linear combination of the eigenfunctions of the conditional expectation (resp. infinitesimal generator) operator associated to the state variable in discrete (resp. continuous) time. Special examples are the popular log-normal and square-root models where the eigenfunctions are the Hermite and Laguerre polynomials respectively. The eigenfunction approach has at least six advantages: i) it is general since any square integrable function may be written as a linear combination of the eigenfunctions; ii) the orthogonality of the eigenfunctions leads to the traditional interpretations of the linear principal components analysis; iii) the implied dynamics of the variance and squared return processes are ARMA and, hence, simple for forecasting and inference purposes; (iv) more importantly, this generates fat tails for the variance and returns processes; v) in contrast to popular models, the variance of the variance is a flexible function of the variance; vi) these models are closed under temporal aggregation.

Risk Aversion, Intertemporal Substitution, and Option Pricing

This paper develops a general stochastic framework and an equilibrium asset pricing model that make clear how attitudes towards intertemporal substitution and risk matter for option pricing. In particular, we show under which statistical conditions option pricing formulas are not preference-free, in other words, when preferences are not hidden in the stock and bond prices as they are in the standard Black and Scholes (BS) or Hull and White (HW) pricing formulas. The dependence of option prices on preference parameters comes from several instantaneous causality effects such as the so-called leverage effect. We also emphasize that the most standard asset pricing models (CAPM for the stock and BS or HW preference-free option pricing) are valid under the same stochastic setting (typically the absence of leverage effect), regardless of preference parameter values. Even though we propose a general non-preference-free option pricing formula, we always keep in mind that the BS formula is dominant both as a theoretical reference model and as a tool for practitioners. Another contribution of the paper is to characterize why the BS formula is such a benchmark. We show that, as soon as we are ready to accept a basic property of option prices, namely their homogeneity of degree one with respect to the pair formed by the underlying stock price and the strike price, the necessary statistical hypotheses for homogeneity provide BS-shaped option prices in equilibrium. This BS-shaped option-pricing formula allows us to derive interesting characterizations of the volatility smile, that is, the pattern of BS implicit volatilities as a function of the option moneyness. First, the asymmetry of the smile is shown to be equivalent to a particular form of asymmetry of the equivalent martingale measure. Second, this asymmetry appears precisely when there is either a premium on an instantaneous interest rate risk or on a generalized leverage effect or both, in other words, whenever the option pricing formula is not preference-free. Therefore, the main conclusion of our analysis for practitioners should be that an asymmetric smile is indicative of the relevance of preference parameters to price options.

Cognition in Seemingly Riskless Choices and Judgments.

We instillate rational cognition and learning in seemingly riskless choices and judgments. Preferences and possibilities are given in a stochastic sense and based on revisable expectations. the theory predicts experimental preference reversals and passes a sharp econometric test of the status quo bias drawn from a field study.

Exact Nonparametric Two-Sample Homogeneity Tests for Possibly Discrete Distributions.

In this paper, we study several tests for the equality of two unknown distributions. Two are based on empirical distribution functions, three others on nonparametric probability density estimates, and the last ones on differences between sample moments. We suggest controlling the size of such tests (under nonparametric assumptions) by using permutational versions of the tests jointly with the method of Monte Carlo tests properly adjusted to deal with discrete distributions. We also propose a combined test procedure, whose level is again perfectly controlled through the Monte Carlo test technique and has better power properties than the individual tests that are combined. Finally, in a simulation experiment, we show that the technique suggested provides perfect control of test size and that the new tests proposed can yield sizeable power improvements.

Semi-Parametric Weak Instrument Regressions with an Application to the Risk-Return Trade-off

Recent work shows that a low correlation between the instruments and the included variables leads to serious inference problems. We extend the local-to-zero analysis of models with weak instruments to models with estimated instruments and regressors and with higher-order dependence between instruments and disturbances. This makes this framework applicable to linear models with expectation variables that are estimated non-parametrically. Two examples of such models are the risk-return trade-off in finance and the impact of inflation uncertainty on real economic activity. Results show that inference based on Lagrange Multiplier (LM) tests is more robust to weak instruments than Wald-based inference. Using LM confidence intervals leads us to conclude that no statistically significant risk premium is present in returns on the S&P 500 index, excess holding yields between 6-month and 3-month Treasury bills, or in yen-dollar spot returns.

Jumps in the Volatility of Financial Markets.

Recent work suggests that the conditional variance of financial returns may exhibit sudden jumps. This paper extends a non-parametric procedure to detect discontinuities in otherwise continuous functions of a random variable developed by Delgado and Hidalgo (1996) to higher conditional moments, in particular the conditional variance. Simulation results show that the procedure provides reasonable estimates of the number and location of jumps. This procedure detects several jumps in the conditional variance of daily returns on the S&P 500 index.

Finite-Sample Inference Methods for Simultaneous Equations and Models with Unobserved and Generated Regressors

We propose finite sample tests and confidence sets for models with unobserved and generated regressors as well as various models estimated by instrumental variables methods. The validity of the procedures is unaffected by the presence of identification problems or \"weak instruments\", so no detection of such problems is required. We study two distinct approaches for various models considered by Pagan (1984). The first one is an instrument substitution method which generalizes an approach proposed by Anderson and Rubin (1949) and Fuller (1987) for different (although related) problems, while the second one is based on splitting the sample. The instrument substitution method uses the instruments directly, instead of generated regressors, in order to test hypotheses about the \"structural parameters\" of interest and build confidence sets. The second approach relies on \"generated regressors\", which allows a gain in degrees of freedom, and a sample split technique. For inference about general possibly nonlinear transformations of model parameters, projection techniques are proposed. A distributional theory is obtained under the assumptions of Gaussian errors and strictly exogenous regressors. We show that the various tests and confidence sets proposed are (locally) \"asymptotically valid\" under much weaker assumptions. The properties of the tests proposed are examined in simulation experiments. In general, they outperform the usual asymptotic inference methods in terms of both reliability and power. Finally, the techniques suggested are applied to a model of Tobin’s q and to a model of academic performance.

Inflation dynamics and the New Keynesian Phillips Curve: an identification robust econometric analysis

In this paper, we use identification-robust methods to assess the empirical adequacy of a New Keynesian Phillips Curve (NKPC) equation. We focus on the Gali and Gertler’s (1999) specification, on both U.S. and Canadian data. Two variants of the model are studied: one based on a rationalexpectations assumption, and a modification to the latter which consists in using survey data on inflation expectations. The results based on these two specifications exhibit sharp differences concerning: (i) identification difficulties, (ii) backward-looking behavior, and (ii) the frequency of price adjustments. Overall, we find that there is some support for the hybrid NKPC for the U.S., whereas the model is not suited to Canada. Our findings underscore the need for employing identificationrobust inference methods in the estimation of expectations-based dynamic macroeconomic relations.

Identification, Weak Instruments and Statistical Inference in Econometrics

We discuss statistical inference problems associated with identification and testability in econometrics, and we emphasize the common nature of the two issues. After reviewing the relevant statistical notions, we consider in turn inference in nonparametric models and recent developments on weakly identified models (or weak instruments). We point out that many hypotheses, for which test procedures are commonly proposed, are not testable at all, while some frequently used econometric methods are fundamentally inappropriate for the models considered. Such situations lead to ill-defined statistical problems and are often associated with a misguided use of asymptotic distributional results. Concerning nonparametric hypotheses, we discuss three basic problems for which such difficulties occur: (1) testing a mean (or a moment) under (too) weak distributional assumptions; (2) inference under heteroskedasticity of unknown form; (3) inference in dynamic models with an unlimited number of parameters. Concerning weakly identified models, we stress that valid inference should be based on proper pivotal functions —a condition not satisfied by standard Wald-type methods based on standard errors — and we discuss recent developments in this field, mainly from the viewpoint of building valid tests and confidence sets. The techniques discussed include alternative proposed statistics, bounds, projection, split-sampling, conditioning, Monte Carlo tests. The possibility of deriving a finite-sample distributional theory, robustness to the presence of weak instruments, and robustness to the specification of a model for endogenous explanatory variables are stressed as important criteria assessing alternative procedures.

Monte Carlo Tests with Nuisance Parameters: A General Approach to Finite-Sample Inference and Nonstandard Asymptotics

The technique of Monte Carlo (MC) tests [Dwass (1957), Barnard (1963)] provides an attractive method of building exact tests from statistics whose finite sample distribution is intractable but can be simulated (provided it does not involve nuisance parameters). We extend this method in two ways: first, by allowing for MC tests based on exchangeable possibly discrete test statistics; second, by generalizing the method to statistics whose null distributions involve nuisance parameters (maximized MC tests, MMC). Simplified asymptotically justified versions of the MMC method are also proposed and it is shown that they provide a simple way of improving standard asymptotics and dealing with nonstandard asymptotics (e.g., unit root asymptotics). Parametric bootstrap tests may be interpreted as a simplified version of the MMC method (without the general validity properties of the latter).

Statistical Inference for Computable General Equilibrium Models with Application to a Model of the Moroccan Economy

We study the problem of measuring the uncertainty of CGE (or RBC)-type model simulations associated with parameter uncertainty. We describe two approaches for building confidence sets on model endogenous variables. The first one uses a standard Wald-type statistic. The second approach assumes that a confidence set (sampling or Bayesian) is available for the free parameters, from which confidence sets are derived by a projection technique. The latter has two advantages: first, confidence set validity is not affected by model nonlinearities; second, we can easily build simultaneous confidence intervals for an unlimited number of variables. We study conditions under which these confidence sets take the form of intervals and show they can be implemented using standard methods for solving CGE models. We present an application to a CGE model of the Moroccan economy to study the effects of policy-induced increases of transfers from Moroccan expatriates.

Simulation-Based Finite-Sample Normality Tests in Linear Regressions

In the literature on tests of normality, much concern has been expressed over the problems associated with residual-based procedures. Indeed, the specialized tables of critical points which are needed to perform the tests have been derived for the location-scale model; hence reliance on available significance points in the context of regression models may cause size distortions. We propose a general solution to the problem of controlling the size normality tests for the disturbances of standard linear regression, which is based on using the technique of Monte Carlo tests.

Paretian Quasi-Orders: Two Agents.

We characterize Paretian quasi-orders in the two-agent continuous case.

Tests multiples simulés et tests de normalité basés sur plusieurs moments dans les modèles de régression

Cet article illustre l’applicabilité des méthodes de rééchantillonnage dans le cadre des tests multiples (simultanés), pour divers problèmes économétriques. Les hypothèses simultanées sont une conséquence habituelle de la théorie économique, de sorte que le contrôle de la probabilité de rejet de combinaisons de tests est un problème que l’on rencontre fréquemment dans divers contextes économétriques et statistiques. À ce sujet, on sait que le fait d’ignorer le caractère conjoint des hypothèses multiples peut faire en sorte que le niveau de la procédure globale dépasse considérablement le niveau désiré. Alors que la plupart des méthodes d’inférence multiple sont conservatrices en présence de statistiques non-indépendantes, les tests que nous proposons visent à contrôler exactement le niveau de signification. Pour ce faire, nous considérons des critères de test combinés proposés initialement pour des statistiques indépendantes. En appliquant la méthode des tests de Monte Carlo, nous montrons comment ces méthodes de combinaison de tests peuvent s’appliquer à de tels cas, sans recours à des approximations asymptotiques. Après avoir passé en revue les résultats antérieurs sur ce sujet, nous montrons comment une telle méthodologie peut être utilisée pour construire des tests de normalité basés sur plusieurs moments pour les erreurs de modèles de régression linéaires. Pour ce problème, nous proposons une généralisation valide à distance finie du test asymptotique proposé par Kiefer et Salmon (1983) ainsi que des tests combinés suivant les méthodes de Tippett et de Pearson-Fisher. Nous observons empiriquement que les procédures de test corrigées par la méthode des tests de Monte Carlo ne souffrent pas du problème de biais (ou sous-rejet) souvent rapporté dans cette littérature – notamment contre les lois platikurtiques – et permettent des gains sensibles de puissance par rapport aux méthodes combinées usuelles.