In statistics, outliers are as thorny topic as it gets. Is it legitimate to treat the observations seen during global financial crisis as outliers? or are those simply a feature of the system, and as such are integral part of a very fat tail distribution?
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.
The mean is arguably the most commonly used measure for central tendency, no no, don’t fall asleep! important point ahead.
We routinely compute the average as an estimate for the mean. All else constant, how much return should we expect the S&P 500 to deliver over some period? the average of past returns is a good answer. The average is the Maximum Likelihood (ML) estimate under Gaussianity. The average is a private case of least square minimization (a regression with no explanatory variables). It is a good answer. BUT:
We all use models. We all continuously working to improve and validate our models. Constant effort is made trying to estimate: how good our model actually is?
A general term for this estimate is error rate. Low error rate is better than high error rate, it means our model is more accurate.
Sometimes I read academic literature, and often times those papers contain some proofs. I usually gloss over some innocent-looking assumptions on moments’ existence, invariably popping before derivations of theorems or lemmas. Here is one among countless examples, actually taken from Making and Evaluating Point Forecasts:
Extreme Value Theory (EVT) is busy with understanding the behavior of the distribution, in the extremes. The extreme determine the average, not the reverse. If you understand the extreme, the average follows. But, getting the extreme right is extremely difficult. By construction, you have very few data points. By way of contradiction, if you have many data points then it is not the extreme you are dealing with.
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?
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.
I often write about bootstrap (here an example and here a critique). I refer to it here as one of the most consequential advances in modern statistics. When I wrote that last post I was searching the web for a simple explanation to quickly show how useful bootstrap is, without boring the reader with the underlying math. Since I was not content with anything I could find, I decided to write it up, so here we go.
We are now collecting a lot of data. This is a good thing in general. But data collection and data storage capabilities have evolved fast. Much faster than statistical methods to go along with those voluminous numbers. We are still using good ole fashioned Fisherian statistics. Back then, when you had not too many observations, statistical significance actually meant something.
Few weeks back I gave a talk in the R/Finance 2016 conference, about forecast combinations in R. Here are the slides:
The laws of large numbers are the cornerstones of asymptotic theory. ‘Large numbers’ in this context does not refer to the value of the numbers we are dealing with, rather, it refers to a large number of repetitions (or trials, or experiments, or iterations). This post takes a stab at explaining the difference between the strong law of large numbers (SLLN) and the weak law of large numbers (WLLN). I think it is important, not amply clear to most, and I will need it as a reference in future posts.
Especially in economics/econometrics, modellers do not believe their models reflect reality as it is. No, the yield curve does NOT follow a three factor Nelson-Siegel model, the relation between a stock and its underlying factors is NOT linear, and volatility does NOT follow a Garch(1,1) process, nor Garch(?,?) for that matter. We simply look at the world, and try to find an apt description of what we see.
Errors-in-variables, or measurement error situation happens when your right hand side variable(s); your $x$ in a $y_t = \alpha + \beta x_t + \varepsilon_t$ model is measured with error. If $x$ represents the price of a liquid stock, then it is accurately measured because the trading is so frequent. But if $x$ is a volatility, well, it is not accurately measured. We simply don’t yet have the power to tame this variable variable.
Unlike the price itself, volatility estimates change with our choice of measurement method. Since no model is a perfect depiction of reality, we have a measurement error problem on our hands.
Ignoring measurement errors leads to biased estimates and, good God, inconsistent estimates.
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.
