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34

CAPM as an allocation strategy. Market efficiency was predicated on several falicious ideas, including: Everyone can borrow (and lend) at the same rate, indefinitely (i.e. no matter their leverage) All information is known instantaneously by all market participants. There are no transaction costs. Rational behavior. One conclusion is that the ...


34

Correlation Correlations are notoriously unstable in financial time series - yet one of the most used concepts in quant finance because their is no good theoretical substitute for it. You could say theory is not working with it yet neither without it. For example the concept is used for diversification of uncorrelated assets or for the modelling of ...


27

Everybody's favourite whipping boy: Identically and independently distributed returns, i.e. draws from $N(mu, sigma)$ to describe returns. We could of course split this is arguing identically distributed (and mixture modeling as well as robust methods help) independently distributed (and everybody agrees that there is some serial correlation though a ...


23

Value at Risk The great idea to have systematic indicator for risk exposure but the problems arise when it's used as main or single indicator without looking at other risks (e.g Credit risk or Liquidity risk). Emanuel Derman wrote about it recently in his blog: But they (GS) did it not with a new formula or a single rule. They did it by being ...


16

Easily, the Efficient Market Hypothesis For many reasons. First, many adherents and critics support it for the wrong (often ideological) reasons. This applies even to well-known economists like John Quiggin. Second, because even fewer people know the extent and scope of the anomalies. The literature can get very technical. So even smart people ...


15

To explain why a negative sloping yield curve is bad, you have to start with a theory of the yield curve. The dominant theories for the term structure of interest rates are the rational expectations, liquidity preference, and market segmentation. (The first two theories are quite compatible with each other and have more standing so let's assume that view.) ...


13

Perfect delta hedging I my opinion delta hedging is also a dangerous one, but it definitely should teach though. In the BS framework, it is an allegedly perfect way of covering the risk incurred by buying (or selling) a derivative product (such as call and put in simplest cases). Nevertheless due to several real world facts this doesn't work that well ...


12

Big Picture Time-series variance is driven mostly by discount rates, whereas expected cash flows dominate the cross-sectional variance. These results are important because they highlight the value of focusing on both dimensions of stock prices and returns: time-series and cross-section. On the other hand, however, they also show that a single mechanism is ...


12

Short Version : Two main uses I'm doing an arbitrage/statarb strategy (volatility for instance) which should not be dependant on the Delta (I'm an arbitragist). I HAVE to keep a product in my portfolio, but I don't want to be EXPOSED to it (I'm a market maker). Long Version : The goal of Dynamic Hedging is not down the line to earn risk free rate of ...


12

Weak form market efficiency says that you can't predict prices based on past prices. Or that technical analysis doesn't work. I think that the tests of weak form market efficiency are pretty conclusive and show that the US stock market is weak-form efficient; at least on a a timeline longer than a few minutes. That's not to say that markets are "efficient". ...


11

My second best is Copulas I won't go as far as declaring gaussian copula The formula that killed Wall Street" (warning: lousy article), but will defer to T. Mikosch in his very good paper on misuses of copulas.


8

Backtesting - pure and simple. Its the logical and obvious thing to do right? Yet, so many pitfalls lie in wait. Be very careful people. Do it as little as possible and as late as possible.


7

To trust yourself. Concepts must be based on logical ideas and proper premises. It is easy to forget a premise and then misuse a model such as CAPM as asset-allocation method as suggested by Shane so Y-Recheck-things. Do not make things personal. Do not abuse models with too complicated schemes (you may abuse some basic assumption) -- and even then ...


7

The $R^2$s are usually close to zero for single stock regressions. The big $R^2$s that a lot of asset pricing research shows is by forming portfolios. Forming portfolios cancels a lot of the idiosyncratic returns, which has a smoothing effect. The $R^2$s should be low here, although I don't see any in the paper for you to compare. This probably means they ...


6

A discrete-time model only works in no-arbitrage land with discrete asset values. Furthermore, the number of allowable asset values per timestep is limited by the number of available securities. The tree is the classic example of this. Binomial trees "work", but if you make a one-step trinomial tree, you will find that you can no longer form a risk-free ...


6

I would recommend Marc Wildi's work on signal extraction.


6

If you look in the portfolio management sections of the CFA (chartered financial analyst) curriculum, you'll find a listing of commonly used portfolio management techniques. It is by no means exhaustive, but the content in the CFA curriculum comes directly from industry professionals, so it is reasonable current and applicable. CFA Candidate Body of ...


6

This isn't particularly insightful, but worth pointing out in this thread. Many people get caught up in the elegance and beauty of the mathematics and tend to be disconnected from the real world.


6

General answer to a very general question: If you find a significant pattern which distinguishes between structure and noise you understand something about that system. You have a model about it so you can extrapolate and forecast. On that basis you can use this model to make money. In that sense mean-reversion and trend-following are also "only" ...


5

Corporate Actions do not happen. That is to say, both the models and psychology tend to ignore the possibility of such behavior as takeovers, spinouts, significant changes in leverage (ratio of debt to equity) by issuing or redeeming bonds, and the like. Now, there are desks (such as merger arb) that specifically play these, and fundamental analysts ...


5

It is dangerous when large proportions of the trading population "religiously" believe [as a matter of unexamined faith] that certain necessary assumptions which govern the accuracy of the models they use will always hold. It is best to really understand how the models have been derived and to have a skeptics understanding of these assumptions and their ...


5

That value stocks are necessarily riskier than growth; that there has to be a hidden risk factor that we haven't yet found. The Lakonishok, Shleifer, and Vishny abstract says it better than I can: For many years, stock market analysts have argued that value strategies outperform the market. These value strategies call for buying stocks that have low ...


5

You have to differentiate here between the risk-taking and the market-making side. As a risk-taker, like e.g. a hedge-fund, you are right, you could just buy the bond! But as a market-maker you sell these options but don't want to bear the risk, so you have to counterbalance it. You could of course counterbalance it with another option which would be the ...


5

If you have the mathematical sophistication, you should review the original papers referenced on the Equity Premium Puzzle page, particularly Mehra and Prescott (1985). Note, however, that contrary to other opinions on this page, the puzzle is NOT that there is an equity risk premium. On the contrary, the puzzle is that the premium had been so high, at ...


5

Some of the used heavy-tail distributions are: Log-Cauchy and Log-Gamma Lévy Burr and Weibull Mixed normal Here two papers that cover some of them and others: http://ect-pigorsch.mee.uni-bonn.de/data/research/papers/Financial_Economics,_Fat-tailed_Distributions.pdf http://www.rff.org/RFF/Documents/RFF-DP-11-19-REV.pdf


4

I think there is an error implicit in your question. Dynamic delta hedging, even assuming the underlying process is a continuous martingale and trading entails zero transaction costs, only eliminates the directional risk. A number of residual risks remain, most notably volatility risk, embodied in both the gamma and vega. A dynamically hedged portfolio of ...


4

In my opinion you should question EVERYTHING. Recently I read this article Ten Things We Should Know About Time Series by Michael McAleer which is to my opinion a good summary of some common issues in time series analysis. These ten things are: Knowledge of Econometrics and Statistics is Essential Be Aware of Measurement Errors Test for Zero Frequency, ...


4

Yes. Check out Time-Series Analysis by Shumway and Stoffer. Spectral Analysis and Filtering is covered in Chapter 4.



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