I just finished reading an interesting paper by Justin Birru titled: “Day of the week and the cross-section of returns” (reference below). The story is much too simple to be true, but it looks to be so. In fact, I would probably altogether skip it without the highly ranked *Journal of Financial Economics* stamp of approval. However, by the end of the paper I was as convinced as one can be without actually running the analysis.

# Category: Finance and Trading

## Create own Recession Indicator using Mixture Models

## Context

Broadly speaking, we can classify financial markets conditions into two categories: Bull and Bear. The first is a “todo bien” market, tranquil and generally upward sloping. The second describes a market with a downturn trend, usually more volatile. It is thought that those bull\bear terms originate from the way those animals supposedly attack. Bull thrusts its horns up while a bear swipe its paws down. At any given moment, we can only guess the state in which we are in, there is no way of telling really; simply because those two states don’t have a uniformly exact definitions. So basically we never actually observe a membership of an observation. In this post we are going to use (finite) mixture models to try and assign daily equity returns to their bull\bear subgroups. It is essentially an unsupervised clustering exercise. We will create our own recession indicator to help us quantify if the equity market is contracting or not. We use minimal inputs, nothing but equity return data. Starting with a short description of Finite Mixture Models and moving on to give a hands-on practical example.

## Price Movement Prediction – another paper

Just finished reading the paper Stock Market’s Price Movement Prediction With LSTM Neural Networks. The abstract attractively reads: “The results that were obtained are promising, getting up to an average of 55.9% of accuracy when predicting if the price of a particular stock is going to go up or not in the near future.”, I took the bait. You shouldn’t.

## Market intraday momentum

I recently spotted the following intriguing paper: Market intraday momentum.

From the abstract of that paper:

Based on high frequency S&P 500 exchange-traded fund (ETF) data from 1993–2013, we show an intraday momentum pattern: the first half-hour return on the market as measured from the previous day’s market close predicts the last half-hour return. This predictability, which is both statistically and economically significant is stronger on more volatile days, on higher volume days, on recession days, and on major macroeconomic news release days.

Nice! Looks like we can all become rich now. I mean, given how it’s written, it should be quite easy for any individual with a trading account and a mouse to leverage up and start accumulating. Maybe this is so, but let’s have an informal closer look, with as little effort as possible, and see if there is anything we can say about this idea.

## R in Finance highlights

The yearly *R in Finance* conference is one of my favorites:

## Curse of dimensionality part 3: Higher-Order Comoments

Higher moments such as Skewness and Kurtosis are not as explored as they should be.

These moments are crucial for managing portfolio risk. At least as important as volatility, if not more. Skewness relates to asymmetry risk and Kurtosis relates to tail risk.

Despite their great importance, those higher moments enjoy only a small portion of attention compared with their lower more friendly moments: the mean and the variance. In my opinion, one reason for this may be the impossibility of estimating those moments, estimating them accurately that is.

It is yet another situation where Curse of Dimensonality rears its enchanting head (and an idea for a post is born..).

## Portfolio Construction with R

## Preview

Constructing a portfolio means allocating your money between few chosen assets. The simplest thing you can do is evenly split your money between few chosen assets. Simple as it is, good research shows it is just fine, and even better than other more sophisticated methods (for example Optimal Versus Naive Diversification: How Inefficient is the 1/N). However, there is also good research that declares the opposite (for example Large Dynamic Covariance Matrices) so go figure.

Anyway, this post shows a few of the most common to build a portfolio. We will discuss portfolios which are optimized for:

- Equal Risk Contribution
- Global Minimum Variance
- Minimum Tail-Dependence
- Most Diversified
- Equal weights

We will optimize based on half the sample and see out-of-sample results in the second half. Simply speaking, how those portfolios have performed.

## Bitcoin exponential growth

Is bitcoin a bubble? I don’t know. What defines a bubble? The price should drastically overestimate the underlying fundamentals. I simply don’t know much about blockchain to have an opinion there. A related characteristic is a run-away price. Going up fast just because it is going up fast.

## Bitcoin investing

Bitcoin is a cryptocurrency created in 2008. I have never belonged with team “gets it” when it comes to Bitcoin investing, but perhaps time has come to reconsider.

## Visualizing Tail Risk

Tail risk conventionally refers to the risk of a large and sharp draw down of the portfolio. How large is subjective and depends on how you define what is a tail.

A lot of research is directed towards having a good estimate of the tail risk. Some fairly new research also now indicates that investors perceive tail risk to be a stand-alone risk to be compensated for, rather than bundled together with the usual variability of the portfolio. So this risk now gets even more attention.

## Machine Trading – book review

In trading and in trading-related research one could be quickly overwhelmed with the sea of ink devoted to trading strategies and the like. It is essential that you “pick your battles” so to speak. I recently finished reading Machine Trading, by Ernest Chan. Here is what I think about the book.

## Density Confidence Interval

Density estimation belongs with the literature of non-parametric statistics. Using simple bootstrapping techniques we can obtain confidence intervals (CI) for the whole density curve. Here is a quick and easy way to obtain CI’s for different risk measures (VaR, expected shortfall) and using what follows, you can answer all kind of relevant questions.

## Multivariate Volatility Forecast Evaluation

The evaluation of volatility models is gracefully complicated by the fact that, unlike other time series, even the realization is not observable. Two researchers would never disagree about what was yesterday’s stock price, but they can easily disagree about what was yesterday’s stock volatility. Because we don’t observe volatility directly, each of us uses own proxy of choice. There are many ways to skin this cat (more on volatility proxy here).

In a previous post Univariate volatility forecast evaluation we considered common ways in which we can evaluate how good is our volatility model, dealing with one time-series at a time. But how do we evaluate, or compare two models in a multivariate settings, with two covariance *matrices*?

## Why bad trading strategies may perform well? Mathematical explanation

You probably know that even a trading strategy which is actually no different from a random walk (RW henceforth) can perform very well. Perhaps you chalk it up to short-run volatility. But in fact there is a deeper reason for this to happen, in force. If you insist on using and continuously testing a RW strategy, you will find, at some point **with certainty**, that it has significant outperformance.

This post explains why is that.

## The case for Regime-Switching GARCH

GARCH models are very responsive in the sense that they allow the fit of the model to adjust rather quickly with incoming observations. However, this adjustment depends on the parameters of the model, and those may not be constant. Parameters’ estimation of a GARCH process is not as quick as those of say, simple regression, especially for a multivariate case. Because of that, I think, the literature on time-varying GARCH is not yet at its full speed. This post makes the point that there is a need for such a class of models. I demonstrate this by looking at the parameters of Threshold-GARCH model (aka GJR GARCH), before and after the 2008 crisis. In addition, you can learn how to make inference on GARCH parameters without relying on asymptotic normality, i.e. using bootstrap.