Solutions for Problem Set 2

Prepared by Indrajit Mitra

October 9, 2014

Q1. Predictability of returns

The results of the regression for 1, 2, and 5 year return horizon are tabulated below. We find
that the slope coefficient b is positive and statistically significant in every case. A positive
value of b indicates that higher values of the D/P ratio, i.e. lower current prices relative
to dividends, predict higher returns in the future. As the return horizon increases, we find
that the R2 of the regression systematically increases. At a 5 year horizon, about 20% of the
variation in returns can be forecast.

Return Horizon

t-stat

R2

1 year

3.23

2.17

0.06

2 year

6.29

2.84

0.09

5 year

17.32

4.37

0.20

0.90

0.91

0.92

RMSE (104 )

4.0422

4.0410

4.0424

0.93

0.94

4.0472 4.0566

Q2. EWMA on daily S&P 500 Returns

1. The plot of daily volatility is shown in Figure 1.
2. The auto-correlation coefficient b is 0.9941 with a t-stat of 680. The R2 is 0.99. The
2
auto-correlation is high by construction since the formula t2 = 0.94t1
+ 0.06Rt2 .

3. Figure 2 plots the unpredictable component of volatility. From the plot we see that
positive surprises, although less frequent, are larger in magnitude.
4. The slope coefficient B is very significant (the t-stat is 173.4). B is positive which is
what I expect a higher VIX predicts a higher EWMA volatility. The R2 is also high
at 0.85.
5. The table shows the RMSE for four values of . From the table, the optimal value
of is expected to be between 0.90 and 0.92. Using the optimizer, I get a value of
? = 0.910.
6. The optimal value of MLE = 0.947.
Q3: EWMA on Shanghai Stock Exchange A and B Shares
1. Figure 3 shows the exchange rate. No, it is not volatile at all.
2. (a) The sample mean daily return of A shares is 0.04% with a standard deviation of
1.94%. For the B shares, the mean is 0.04% and the standard deviation is 2.18%.
(b) 2 /2 for the A shares is about 2000, while for the B shares, this ratio is about
2700. The fact that the mean is so much smaller than the variance justifies ignoring
the former.
1

3. Figure 4 plots the daily volatility of the A and B shares. We see that the A shares are
less volatile on average than the B shares. Moreover, from around 2002, the time series
of volatility of both these series co-move more closely. This is probably because from
this time on, both the shares have the same investor base.
4. This correlation plot is shown in Figure 5. From the plot, we see clearly that from
around 2002, the returns of these shares have a very high correlation for the reason
mentioned above.

102

4
3
2
1
0
90

92

94

96

98

00
02
Year

04

06

08

10

12
105

08

10

12
105

Figure 1: Daily EWMA volatility with = 0.94.

102

0.8

0.6
0.4
0.2
0
0.2
90

92

94

96

98

00
02
Year

04

06

Figure 2: Unpredictable component of .

Exchange rate

8.5
8
7.5
7
6.5
6
94

96

98

00

02

04

06

Year
Figure 3: RMB/USD exchange rate.

08

10

12
105

0.08

0.07

0.06

0.05

0.04

0.03

0.02

0.01

0
94

96

98

00

02

04

06

08

10

12

Year

Figure 4: EWMA daily volatility of A and B shares. The blue curve is the volatility of the A shares and the
red curve that of B shares.

1
0.8

(rA , rB )

0.6
0.4
0.2
0
0.2
0.4
94

96

98

00

02

04

06

08

Year
Figure 5: EWMA daily correlation of A and B share returns.

10

12
105