Common nonstationary components of asset prices
ABSTRACT This paper presents a stock-flow consistent macroeconomic model in which financial fragility in firm and household sectors evolves endogenously through the interaction between real and financial sectors. Changes in firms' and households' financial practices produce long waves. The Hopf bifurcation theorem is applied to clarify the conditions for the existence of limit cycles, and simulations illustrate stable limit cycles. The long waves are characterized by periodic economic crises following long expansions. Short cycles, generated by the interaction between effective demand and labor market dynamics, fluctuate around the long waves.
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Article: Cointegration and Structural Breaks[Show abstract] [Hide abstract]
ABSTRACT: In this paper we propose a LM-Type statistic to test the null of coin-tegration allowing for the possibility of a structural break, both in the deterministic and the cointegration vector. The test can be used as a com-plement of the usual non-cointegration tests in order to get stronger evi-dence of cointegration. We consider both cases, when the break date is known and when it is not. In this last case, three different procedures to estimate the date of the break are analysed. We show that the usual ways to estimate the break date do not produce good results and propose a new procedure that works. Finally, the behaviour of the tests is studied through Monte Carlo experiments.
Article: Dynamic Spread Trading[Show abstract] [Hide abstract]
ABSTRACT: This paper is concerned with a dynamic trading strategy, which involves multiple synthetic spreads each of which involves long positions in a basket of underlying se-curities and short positions in another basket. We assume that the spreads can be modeled as mean-reverting Ornstein-Uhlenbeck (OU) processes. The dynamic trading strategy is implemented as the solution to a stochastic optimal control problem that dynamically allocates capital over the spreads and a risk-free asset over a finite horizon to maximize a general constant relative risk aversion (CRRA) or constant absolute risk aversion (CARA) utility function of the terminal wealth. We show that this stochastic control problem is computationally tractable. Specifically, we show that the coefficient functions defining the optimal feedback law are the solutions of a system of ordinary differential equations (ODEs) that are the essence of the tractability of the stochastic optimal control problem. We illustrate the dynamic trading strategy with four pairs that consist of seven S&P 500 index stocks, which shows that the performance achieved by the dynamic spread trading strategy is significant and robust to realistic transaction costs.
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ABSTRACT: A major problem that frequently occurs in the VAR approach to modelling multiple time series is the large number of parameters that need to be estimated from relatively small samples. Litterman (1980) proposed a Bayesian version which has random walks as priors. Recently, that approach has been adapted to Vector Error Correction (VEC) models. In this paper, a new method of reducing the parameter space is proposed that combines VEC modelling, Box and Tiao's (1977) canonical approach, and Bayesian priors. The procedure is illustrated with an application to a six-equation forecasting model of the US economy.