## Forecasting Financial Markets – Part 1: Time Series Analysis

The presentation in this post covers a number of important topics in forecasting, including:

• Stationary processes and random walks
• Unit roots and autocorrelation
• ARMA models
• Seasonality
• Model testing
• Forecasting
• Dickey-Fuller and Phillips-Perron tests for unit roots

Also included are a number of detailed worked examples, including:

## Master’s in High Frequency Finance

I have been discussing with some potential academic partners the concept for a new graduate program in High Frequency Finance.  The idea is to take the concept of the Computational Finance program developed in the 1990s and update it to meet the needs of students in the 2010s.

The program will offer a thorough grounding in the modeling concepts, trading strategies and risk management procedures currently in use by leading investment banks, proprietary trading firms and hedge funds in US and international financial markets.  Students will also learn the necessary programming and systems design skills to enable them to make an effective contribution as quantitative analysts, traders, risk managers and developers.

I would be interested in feedback and suggestions as to the proposed content of the program.

## A Practical Application of Regime Switching Models to Pairs Trading

In the previous post I outlined some of the available techniques used for modeling market states.  The following is an illustration of how these techniques can be applied in practice.    You can download this post in pdf format here.

The chart below shows the daily compounded returns for a single pair in an ETF statistical arbitrage strategy, back-tested over a 1-year period from April 2010 to March 2011.

The idea is to examine the characteristics of the returns process and assess its predictability.

The initial impression given by the analytics plots of daily returns, shown in Fig 2 below, is that the process may be somewhat predictable, given what appears to be a significant 1-order lag in the autocorrelation spectrum.  We also see evidence of the
customary non-Gaussian “fat-tailed” distribution in the error process.

An initial attempt to fit a standard Auto-Regressive Moving Average ARMA(1,0,1) model  yields disappointing results, with an unadjusted  model R-squared of only 7% (see model output in Appendix 1)

However, by fitting a 2-state Markov model we are able to explain as much as 65% in the variation in the returns process (see Appendix II).
The model estimates Markov Transition Probabilities as follows.

P(.|1)       P(.|2)

P(1|.)       0.93920      0.69781

P(2|.)     0.060802      0.30219

In other words, the process spends most of the time in State 1, switching to State 2 around once a month, as illustrated in Fig 3 below.

In the first state, the  pairs model produces an expected daily return of around 65bp, with a standard deviation of similar magnitude.  In this state, the process also exhibits very significant auto-regressive and moving average features.

Regime 1:

Intercept                   0.00648     0.0009       7.2          0

AR1                            0.92569    0.01897   48.797        0

MA1                         -0.96264    0.02111   -45.601        0

Error Variance^(1/2)           0.00666     0.0007

In the second state, the pairs model  produces lower average returns, and with much greater variability, while the autoregressive and moving average terms are poorly determined.

Regime 2:

Intercept                    0.03554    0.04778    0.744    0.459

AR1                            0.79349    0.06418   12.364        0

MA1                         -0.76904    0.51601     -1.49   0.139

Error Variance^(1/2)           0.01819     0.0031

CONCLUSION
The analysis in Appendix II suggests that the residual process is stable and Gaussian.  In other words, the two-state Markov model is able to account for the non-Normality of the returns process and extract the salient autoregressive and moving average features in a way that makes economic sense.

How is this information useful?  Potentially in two ways:

(i)     If the market state can be forecast successfully, we can use that information to increase our capital allocation during periods when the process is predicted to be in State 1, and reduce the allocation at times when it is in State 2.

(ii)    By examining the timing of the Markov states and considering different features of the market during the contrasting periods, we might be able to identify additional explanatory factors that could be used to further enhance the trading model.

## Regime-Switching & Market State Modeling

The Excel workbook referred to in this post can be downloaded here.

Market state models are amongst the most useful analytical techniques that can be helpful in developing alpha-signal generators.  That term covers a great deal of ground, with ideas drawn from statistics, econometrics, physics and bioinformatics.  The purpose of this short note is to provide an introduction to some of the key ideas and suggest ways in which they might usefully applied in the context of researching and developing trading systems.

Although they come from different origins, the concepts presented here share common foundational principles:

1. Markets operate in different states that may be characterized by various measures (volatility, correlation, microstructure, etc);
2. Alpha signals can be generated more effectively by developing models that are adapted to take account of different market regimes;
3. Alpha signals may be combined together effectively by taking account of the various states that a market may be in.

Market state models have shown great promise is a variety of applications within the field of applied econometrics in finance, not only for price and market direction forecasting, but also basis trading, index arbitrage, statistical arbitrage, portfolio construction, capital allocation and risk management.

REGIME SWITCHING MODELS

These are econometric models which seek to use statistical techniques to characterize market states in terms of different estimates of the parameters of some underlying linear model.  This is accompanied by a transition matrix which estimates the probability of moving from one state to another.

To illustrate this approach I have constructed a simple example, given in the accompanying Excel workbook.  In this model the market operates as follows:

Where

Yt is a variable of interest (e.g. the return in an asset over the next period t)

et is an error process with constant variance s2

S is the market state, with two regimes (S=1 or S=2)

a0 is the drift in the asset process

a1 is an autoregressive term, by which the return in the current period is dependent on the prior period return

b1 is a moving average term, which smoothes the error process

This is one of the simplest possible structures, which in more general form can include multiple states, and independent regressions Xi as explanatory variables (such as book pressure, order flow, etc):

The form of the error process et may also be dependent on the market state.  It may simply be that, as in this example, the standard deviation of the error process changes from state to state.  But the changes can also be much more complex:  for instance, the error process may be non-Gaussian, or it may follow a formulation from the GARCH framework.

In this example the state parameters are as follows:

 Reg1 Reg 2 s 0.01 0.02 a0 0.005 -0.015 a1 0.40 0.70 b1 0.10 0.20

What this means is that, in the first state the market tends to trend upwards with relatively low volatility.  In the second state, not only is market volatility much higher, but also the trend is 3x as large in the negative direction.

I have specified the following state transition matrix:

 Reg1 Reg2 Reg1 0.85 0.15 Reg2 0.90 0.10

This is interpreted as follows:  if the market is in State 1, it will tend to remain in that state 85% of the time, transitioning to State 2 15% of the time.  Once in State 2, the market tends to revert to State 1 very quickly, with 90% probability.  So the system is in State 1 most of the time, trending slowly upwards with low volatility and occasionally flipping into an aggressively downward trending phase with much higher volatility.

The Generate sheet in the Excel workbook shows how observations are generated from this process, from which we select a single instance of 3,000 observations, shown in sheet named Sample.

The sample looks like this:

﻿

As anticipated, the market is in State 1 most of the time, occasionally flipping into State 2 for brief periods.

It is well-known that in financial markets we are typically dealing with highly non-Gaussian distributions.  Non-Normality can arise for a number of reasons, including changes in regimes, as illustrated here.  It is worth noting that, even though in this example the process in either market state follows a Gaussian distribution, the combined process is distinctly non-Gaussian in form, having (extremely) fat tails, as shown by the QQ-plot below.

If we attempt to fit a standard ARMA model to the process, the outcome is very disappointing in terms of the model’s poor explanatory power (R2 0.5%) and lack of fit in the squared-residuals:

ARIMA(1,0,1)

Estimate  Std. Err.   t Ratio  p-Value

Intercept                      0.00037    0.00032     1.164    0.244

AR1                            0.57261     0.1697     3.374    0.001

MA1                           -0.63292    0.16163    -3.916        0

Error Variance^(1/2)           0.02015     0.0004    ——   ——

Log Likelihood = 7451.96

Schwarz Criterion = 7435.95

Hannan-Quinn Criterion = 7443.64

Akaike Criterion = 7447.96

Sum of Squares =  1.2172

R-Squared =  0.0054

R-Bar-Squared =  0.0044

Residual SD =  0.0202

Residual Skewness = -2.1345

Residual Kurtosis =  5.7279

Jarque-Bera Test = 3206.15     {0}

Box-Pierce (residuals):         Q(48) = 59.9785 {0.115}

Box-Pierce (squared residuals): Q(50) = 78.2253 {0.007}

Durbin Watson Statistic = 2.01392

KPSS test of I(0) =  0.2001    {<1} *

Lo’s RS test of I(0) =  1.2259  {<0.5} *

Nyblom-Hansen Stability Test:  NH(4)  =  0.5275    {<1}

MA form is 1 + a_1 L +…+ a_q L^q.

Covariance matrix from robust formula.

* KPSS, RS bandwidth = 0.

Parzen HAC kernel with Newey-West plug-in bandwidth.

However, if we keep the same simple form of ARMA(1,1) model, but allow for the possibility of a two-state Markov process, the picture alters dramatically:  now the model is able to account for 98% of the variation in the process, as shown below.

Notice that we have succeeded in estimating the correct underlying transition probabilities, and how the ARMA model parameters change from regime to regime much as they should (small positive drift in one regime, large negative drift in the second, etc).

Markov Transition Probabilities

P(.|1)       P(.|2)

P(1|.)            0.080265      0.14613

P(2|.)             0.91973      0.85387

Estimate  Std. Err.   t Ratio  p-Value

Logistic, t(1,1)              -2.43875     0.1821    ——   ——

Logistic, t(1,2)              -1.76531     0.0558    ——   ——

Non-switching parameters shown as Regime 1.

Regime 1:

Intercept                     -0.05615    0.00315   -17.826        0

AR1                            0.70864    0.16008     4.427        0

MA1                           -0.67382    0.16787    -4.014        0

Error Variance^(1/2)           0.00244     0.0001    ——   ——

Regime 2:

Intercept                      0.00838     2e-005   419.246        0

AR1                            0.26716    0.08347     3.201    0.001

MA1                           -0.26592    0.08339    -3.189    0.001

Log Likelihood = 12593.3

Schwarz Criterion = 12557.2

Hannan-Quinn Criterion = 12574.5

Akaike Criterion = 12584.3

Sum of Squares =  0.0178

R-Squared =  0.9854

R-Bar-Squared =  0.9854

Residual SD =  0.002

Residual Skewness = -0.0483

Residual Kurtosis = 13.8765

Jarque-Bera Test = 14778.5     {0}

Box-Pierce (residuals):         Q(48) = 379.511     {0}

Box-Pierce (squared residuals): Q(50) = 36.8248 {0.917}

Durbin Watson Statistic = 1.50589

KPSS test of I(0) =  0.2332    {<1} *

Lo’s RS test of I(0) =  2.1352 {<0.005} *

Nyblom-Hansen Stability Test:  NH(9)  =  0.8396    {<1}

MA form is 1 + a_1 L +…+ a_q L^q.

Covariance matrix from robust formula.

* KPSS, RS bandwidth = 0.

Parzen HAC kernel with Newey-West plug-in bandwidth.

There are a variety of types of regime switching mechanisms we can use in state models:

Hamiltonian – the simplest, where the process mean and variance vary from state to state

Markovian – the approach used here, with state transition matrix

Explained Switching – where the process changes state as a result of the influence of some underlying variable (such as interest rate volatility, for example)

Smooth Transition – comparable to explained Markov switching, but without and explicitly probabilistic interpretation.

This example is both rather simplistic and pathological at the same time:  the states are well-separated , by design, whereas for real processes they tend to be much harder to distinguish.  A difficulty of this methodology is that the models can be very difficult to estimate.  The likelihood function tends to be very flat and there are a great many local maxima that give similar fit, but with widely varying model forms and parameter estimates.  That said, this is a very rich class of models with a great many potential applications.