Estimation error on apparent arbitrage, Applied Statistics

This question explores the effect of estimation error on apparent arbitrage opportunities in a controlled simulation setting. We simulate returns for N = 10 assets over T = 30 years. We will use the first 20 years for estimation and the selection of the hedge portfolio ("in-sample"), and the remaining 10 years as "out-of-sample" performance evaluation period. Start out with a market return RM that is normally distributed with mean μM = 0:05 and standard deviation σM = 0:15, and assume a risk-free rate Rf = 0. All assets follow the factor model Rn,t = αn + βnRM,t + εn,t, where we assume n = 1 for all n.

We will consider three sets of parameters for the return generating process.

1428_Estimation error on apparent arbitrage.png

For each parameterization, perform 100 simulations (data table) for returns on market-neutral zero-investment portfolios and report the average holding period mean return and how often you investment loses money over the performance evaluation period assuming that

i) You know the parameters of the return generating process and invest equal amounts in every stock with positive alpha and short equal amounts of every stock with negative alpha

ii) You estimate the parameters and invest $1 in the stock with the highest alpha (if there is one), and short $1 of the stock with the most negative alpha (if there is one)

iii) You estimate the parameters and invest equal amounts in every stock with positive alphas (if there are) and short equal amounts of every stock with negative alphas (if there are)

iv) You estimate the parameters and come up with a more sophisticated investment strategy. Compare and explain your findings.

Notes

  • Start out with fewer simulations in your data table until you are con dent everything works
  • Your investment should hedge out all market risk (using your best estimates)
  • Take great care programming the portfolio weights in (ii)-(iv). If everything is done right, changing parameters and running the simulations should not take much time.
Posted Date: 2/25/2013 12:22:20 AM | Location : United States







Related Discussions:- Estimation error on apparent arbitrage, Assignment Help, Ask Question on Estimation error on apparent arbitrage, Get Answer, Expert's Help, Estimation error on apparent arbitrage Discussions

Write discussion on Estimation error on apparent arbitrage
Your posts are moderated
Related Questions

(i) Plot the step responses of the following second order systems and state the nature of each system. For each case, find the poles and plot the location of the poles in the compl

Circles or Pie Diagram: Circles or pie diagrams are alternative to squares. These are used  for the same purpose i.e. when  the values are differing  widely in their magnitude

Under the standard cost method which is also referred as the standard cost method ,stock receipts are assigned a standard cost. Any variations between the actual cost and standard

The weight of the engine in kN is given in P2 and is suspended from a vertical chain at A. A second chain round the engine is attached at A, with a spreader bar between B and C. Th

A medical researcher has 100 bone cancer patients in a study. Every patient's condition is one of six types, type \A" to type \F". The 100 patients split as follows: x There


Question: (a) Shale Oil, located in the island of Aruba, has a capacity of 600,000 barrels of crude oil per day.  The final products from the refinery include two types of unle

A researcher hypothesized that the pulse rates of long-distance athletes differ from those of other athletes. He believed that the runners’ pulses would be slower. He obtained a ra

Why are graphs and tables useful when examining data? A researcher is comparing two middle school 7th grade classes. One class at one school has participated in an arts program