Selecting from amongst non–nested conditional variance models: information criteria and portfolio determination

We consider the finite sample properties of model selection by information criteria in conditionally heteroscedastic models. Recent theoretical results show that certain popular criteria are consistent in that they will select the true model asymptotically with probability 1. To examine the empirical relevance of this property, Monte Carlo simulations are conducted for a set of non–nested data generating processes (DGPs) with the set of candidate models consisting of all types of model used as DGPs. In addition, not only is the best model considered but also those with similar values of the information criterion, called close competitors, thus forming a portfolio of eligible models. To supplement the simulations, the criteria are applied to a set of economic and financial series. In the simulations, the criteria are largely ineffective at identifying the correct model, either as best or a close competitor, the parsimonious GARCH(1, 1) model being preferred for most DGPs. In contrast, asymmetric models are generally selected to represent actual data. This leads to the conjecture that the properties of parameterizations of processes commonly used to model heteroscedastic data are more similar than may be imagined and that more attention needs to be paid to the behaviour of the standardized disturbances of such models, both in simulation exercises and in empirical modelling.

Forecasting exchange rate volatility using conditional variance models selected by information criteria

This paper uses appropriately modified information criteria to select models from the GARCH family, which are subsequently used for predicting US dollar exchange rate return volatility. The out of sample forecast accuracy of models chosen in this manner compares favourably on mean absolute error grounds, although less favourably on mean squared error grounds, with those generated by the commonly used GARCH(1, 1) model. An examination of the orders of models selected by the criteria reveals that (1, 1) models are typically selected less than 20% of the time.

Conditional Moments in Asset Pricing

A better understanding of stock price changes is important in guiding many economic activities. Since prices often do not change without good reasons, searching for related explanatory variables has involved many enthusiasts. This book seeks answers from prices per se by relating price changes to their conditional moments. This is based on the belief that prices are the products of a complex psychological and economic process and their conditional moments derive ultimately from these psychological and economic shocks. Utilizing information about conditional moments hence makes it an attractive alternative to using other selective financial variables in explaining price changes. The first paper examines the relation between the conditional mean and the conditional variance using information about moments in three types of conditional distributions; it finds that the significance of the estimated mean and variance ratio can be affected by the assumed distributions and the time variations in skewness. The second paper decomposes the conditional industry volatility into a concurrent market component and an industry specific component; it finds that market volatility is on average responsible for a rather small share of total industry volatility — 6 to 9 percent in UK and 2 to 3 percent in Germany. The third paper looks at the heteroskedasticity in stock returns through an ARCH process supplemented with a set of conditioning information variables; it finds that the heteroskedasticity in stock returns allows for several forms of heteroskedasticity that include deterministic changes in variances due to seasonal factors, random adjustments in variances due to market and macro factors, and ARCH processes with past information. The fourth paper examines the role of higher moments — especially skewness and kurtosis — in determining the expected returns; it finds that total skewness and total kurtosis are more relevant non-beta risk measures and that they are costly to be diversified due either to the possible eliminations of their desirable parts or to the unsustainability of diversification strategies based on them.

Assessment of conditional moment closure models of turbulent autoignition using DNS data

A systematic assessment of the submodels of conditional moment closure (CMC) formalism for the autoignition problem is carried out using direct numerical simulation (DNS) data. An initially non-premixed, n-heptane/air system, subjected to a three-dimensional, homogeneous, isotropic, and decaying turbulence, is considered. Two kinetic schemes, (1) a one-step and (2) a reduced four-step reaction mechanism, are considered for chemistry An alternative formulation is developed for closure of the mean chemical source term , based on the condition that the instantaneous fluctuation of excess temperature is small. With this model, it is shown that the CMC equations describe the autoignition process all the way up to near the equilibrium limit. The effect of second-order terms (namely, conditional variance of temperature excess sigma(2) and conditional correlations of species q(ij)) in modeling is examined. Comparison with DNS data shows that sigma(2) has little effect on the predicted conditional mean temperature evolution, if the average conditional scalar dissipation rate is properly modeled. Using DNS data, a correction factor is introduced in the modeling of nonlinear terms to include the effect of species fluctuations. Computations including such a correction factor show that the species conditional correlations q(ij) have little effect on model predictions with a one-step reaction, but those q(ij) involving intermediate species are found to be crucial when four-step reduced kinetics is considered. The "most reactive mixture fraction" is found to vary with time when a four-step kinetics is considered. First-order CMC results are found to be qualitatively wrong if the conditional mean scalar dissipation rate is not modeled properly. The autoignition delay time predicted by the CMC model compares excellently with DNS results and shows a trend similar to experimental data over a range of initial temperatures.

Characterization of Probability Distributions by Variance Bounds and its Applications

Department of Statistics, Cochin University of Science and Technology

Autoregressive conditional kurtosis

This article proposes a new model for autoregressive conditional heteroscedasticity and kurtosis. Via a time-varying degrees of freedom parameter, the conditional variance and conditional kurtosis are permitted to evolve separately. The model uses only the standard Student’s t-density and consequently can be estimated simply using maximum likelihood. The method is applied to a set of four daily financial asset return series comprising U.S. and U.K. stocks and bonds, and significant evidence in favor of the presence of autoregressive conditional kurtosis is observed. Various extensions to the basic model are proposed, and we show that the response of kurtosis to good and bad news is not significantly asymmetric.

Estimating conditional volatility with neural networks

It is well known that one of the obstacles to effective forecasting of exchange rates is heteroscedasticity (non-stationary conditional variance). The autoregressive conditional heteroscedastic (ARCH) model and its variants have been used to estimate a time dependent variance for many financial time series. However, such models are essentially linear in form and we can ask whether a non-linear model for variance can improve results just as non-linear models (such as neural networks) for the mean have done. In this paper we consider two neural network models for variance estimation. Mixture Density Networks (Bishop 1994, Nix and Weigend 1994) combine a Multi-Layer Perceptron (MLP) and a mixture model to estimate the conditional data density. They are trained using a maximum likelihood approach. However, it is known that maximum likelihood estimates are biased and lead to a systematic under-estimate of variance. More recently, a Bayesian approach to parameter estimation has been developed (Bishop and Qazaz 1996) that shows promise in removing the maximum likelihood bias. However, up to now, this model has not been used for time series prediction. Here we compare these algorithms with two other models to provide benchmark results: a linear model (from the ARIMA family), and a conventional neural network trained with a sum-of-squares error function (which estimates the conditional mean of the time series with a constant variance noise model). This comparison is carried out on daily exchange rate data for five currencies.

Experimental investigation of a turbulent reacting plume

An experimental investigation has been made of a round, non-buoyant plume of nitric oxide, NO, in a turbulent grid flow of ozone, 03, using the Turbulent Smog Chamber at the University of Sydney. The measurements have been made at a resolution not previously reported in the literature. The reaction is conducted at non-equilibrium so there is significant interaction between turbulent mixing and chemical reaction. The plume has been characterized by a set of constant initial reactant concentration measurements consisting of radial profiles at various axial locations. Whole plume behaviour can thus be characterized and parameters are selected for a second set of fixed physical location measurements where the effects of varying the initial reactant concentrations are investigated. Careful experiment design and specially developed chemilurninescent analysers, which measure fluctuating concentrations of reactive scalars, ensure that spatial and temporal resolutions are adequate to measure the quantities of interest. Conserved scalar theory is used to define a conserved scalar from the measured reactive scalars and to define frozen, equilibrium and reaction dominated cases for the reactive scalars. Reactive scalar means and the mean reaction rate are bounded by frozen and equilibrium limits but this is not always the case for the reactant variances and covariances. The plume reactant statistics are closer to the equilibrium limit than those for the ambient reactant. The covariance term in the mean reaction rate is found to be negative and significant for all measurements made. The Toor closure was found to overestimate the mean reaction rate by 15 to 65%. Gradient model turbulent diffusivities had significant scatter and were not observed to be affected by reaction. The ratio of turbulent diffusivities for the conserved scalar mean and that for the r.m.s. was found to be approximately 1. Estimates of the ratio of the dissipation timescales of around 2 were found downstream. Estimates of the correlation coefficient between the conserved scalar and its dissipation (parallel to the mean flow) were found to be between 0.25 and the significant value of 0.5. Scalar dissipations for non-reactive and reactive scalars were found to be significantly different. Conditional statistics are found to be a useful way of investigating the reactive behaviour of the plume, effectively decoupling the interaction of chemical reaction and turbulent mixing. It is found that conditional reactive scalar means lack significant transverse dependence as has previously been found theoretically by Klimenko (1995). It is also found that conditional variance around the conditional reactive scalar means is relatively small, simplifying the closure for the conditional reaction rate. These properties are important for the Conditional Moment Closure (CMC) model for turbulent reacting flows recently proposed by Klimenko (1990) and Bilger (1993). Preliminary CMC model calculations are carried out for this flow using a simple model for the conditional scalar dissipation. Model predictions and measured conditional reactive scalar means compare favorably. The reaction dominated limit is found to indicate the maximum reactedness of a reactive scalar and is a limiting case of the CMC model. Conventional (unconditional) reactive scalar means obtained from the preliminary CMC predictions using the conserved scalar p.d.f. compare favorably with those found from experiment except where measuring position is relatively far upstream of the stoichiometric distance. Recommendations include applying a full CMC model to the flow and investigations both of the less significant terms in the conditional mean species equation and the small variation of the conditional mean with radius. Forms for the p.d.f.s, in addition to those found from experiments, could be useful for extending the CMC model to reactive flows in the atmosphere.

Forecasting time-varying value-at-risk

In this thesis we are interested in financial risk and the instrument we want to use is Value-at-Risk (VaR). VaR is the maximum loss over a given period of time at a given confidence level. Many definitions of VaR exist and some will be introduced throughout this thesis. There two main ways to measure risk and VaR: through volatility and through percentiles. Large volatility in financial returns implies greater probability of large losses, but also larger probability of large profits. Percentiles describe tail behaviour. The estimation of VaR is a complex task. It is important to know the main characteristics of financial data to choose the best model. The existing literature is very wide, maybe controversial, but helpful in drawing a picture of the problem. It is commonly recognised that financial data are characterised by heavy tails, time-varying volatility, asymmetric response to bad and good news, and skewness. Ignoring any of these features can lead to underestimating VaR with a possible ultimate consequence being the default of the protagonist (firm, bank or investor). In recent years, skewness has attracted special attention. An open problem is the detection and modelling of time-varying skewness. Is skewness constant or there is some significant variability which in turn can affect the estimation of VaR? This thesis aims to answer this question and to open the way to a new approach to model simultaneously time-varying volatility (conditional variance) and skewness. The new tools are modifications of the Generalised Lambda Distributions (GLDs). They are four-parameter distributions, which allow the first four moments to be modelled nearly independently: in particular we are interested in what we will call para-moments, i.e., mean, variance, skewness and kurtosis. The GLDs will be used in two different ways. Firstly, semi-parametrically, we consider a moving window to estimate the parameters and calculate the percentiles of the GLDs. Secondly, parametrically, we attempt to extend the GLDs to include time-varying dependence in the parameters. We used the local linear regression to estimate semi-parametrically conditional mean and conditional variance. The method is not efficient enough to capture all the dependence structure in the three indices —ASX 200, S&P 500 and FT 30—, however it provides an idea of the DGP underlying the process and helps choosing a good technique to model the data. We find that GLDs suggest that moments up to the fourth order do not always exist, there existence appears to vary over time. This is a very important finding, considering that past papers (see for example Bali et al., 2008; Hashmi and Tay, 2007; Lanne and Pentti, 2007) modelled time-varying skewness, implicitly assuming the existence of the third moment. However, the GLDs suggest that mean, variance, skewness and in general the conditional distribution vary over time, as already suggested by the existing literature. The GLDs give good results in estimating VaR on three real indices, ASX 200, S&P 500 and FT 30, with results very similar to the results provided by historical simulation.

Estimating equations for removal data analysis

We consider the problem of estimating a population size from successive catches taken during a removal experiment and propose two estimating functions approaches, the traditional quasi-likelihood (TQL) approach for dependent observations and the conditional quasi-likelihood (CQL) approach using the conditional mean and conditional variance of the catch given previous catches. Asymptotic covariance of the estimates and the relationship between the two methods are derived. Simulation results and application to the catch data from smallmouth bass show that the proposed estimating functions perform better than other existing methods, especially in the presence of overdispersion.

Parameterizing Unconditional Skewness in Models for Financial Time Series

In this paper we consider the third-moment structure of a class of time series models. It is often argued that the marginal distribution of financial time series such as returns is skewed. Therefore it is of importance to know what properties a model should possess if it is to accommodate unconditional skewness. We consider modeling the unconditional mean and variance using models that respond nonlinearly or asymmetrically to shocks. We investigate the implications of these models on the third-moment structure of the marginal distribution as well as conditions under which the unconditional distribution exhibits skewness and nonzero third-order autocovariance structure. In this respect, an asymmetric or nonlinear specification of the conditional mean is found to be of greater importance than the properties of the conditional variance. Several examples are discussed and, whenever possible, explicit analytical expressions provided for all third-order moments and cross-moments. Finally, we introduce a new tool, the shock impact curve, for investigating the impact of shocks on the conditional mean squared error of return series.