Financial Econometric Theory

Financial Econometric Theory

Ideally mathematical or statistical models could predict the behavior of economic and financial phenomena such as market fluctuations. For example, option prices can be calculated using fast Fourier Transform (FFT). Some of the most commonly encountered theoretical concepts in econometric research are outlined below.

Random Walk, ARCH & GARCH. The Random Walk Hypothesis refers to the stochastic (random, non-deterministic) behavior of stock, where no point can be predicted. The scenario is changed with the autoregressive conditional heteroskedasticity (ARCH) model, and its generalized substitute, GARCH. Both concepts account for volatility.

White’s test of heteroskedasticity elucidates the position of residual variance of a variable in a regression model; if the position is constant it is called homoscedasticity. The GARCH model can be used once homoscedasticity is ruled out.

Skedastic function is of interest to mesoeconomists. Mesoeconomics is a new and debated arrival, reserved for items that fail to be easily categorized as pertaining to macro- or microeconomics.

Black Sholes Model. The item would be impossible to explain without mentioning the continuous hedging argument, Girsanov’s Theorem pricing kernel, one-factor Cox-Ingersoll-Ross (CIR) model interest rates, and others, which would fall outside desired conciseness limits. The Black Sholes formula is illustrious. A corresponding option calculator, similar to a mortgage calculator, is easily found online.

It's nice to take a nap after many hours spent in learning the financial economeetric theory. Photo by Elena

Levy Processes. Geometric Brownian motion is a Levy process that was initially intended as a stock price model (Engle, 2001). Levy processes are computational tools to determine price dynamics. Raible (1998) shows exponential Levy process modeling stock price. In the Levy term structure model, term structure refers to the relationship between a bond’s maturity date and the interest rate.

Method-of-Moment. Generalized Methods-of-Moment (GMM) is a reliable method-of-moment based parameters estimation procedure. Maximum Likelihood Estimation (MLE), Quasi-Maximum Likelihood Estimator (QMLE), Efficient Methods-of-Moment (EMM) in addition to Bayesian and adaptive, are all estimation procedures.

CAPM. The Capital-Asset Pricing Model (CAPM) appears eminently in the accounting and financial industries. The CAPM abbreviation is sometimes confused with the Certified Associate in Project Management (also CAPM) certification.

MCMC. Markov Chain Monte Carlo (MCMC) simulation; Markov process. Andrey Markov was a Russian mathematician in the late 1800s – early 1900s. The Monte Carlo method was named after the celebrated Monte Carlo casino. The integration method and study are used to calculate continuous time asset pricing models, to cite an illustration.

Clifford-Hammersley or Hammersley-Clifford theorem, has nearly stole the show as far as financial estimations and predictions go. Authors with reflective names derived the theorem based on the positivity condition. The use is widespread: graphical, spatial models, MCMC, point processes, spatial statistics such as quantitative geography and topographical analysis.

Distributions and methods can be paparametric, semiparametric as well as nonparametric, characteristic criteria apply. Hong & Nekipelov (2010) derive the semiparametric efficiency bound under the monotonicity assumption. The article is rendered available by the open access journal Quantitative Economics and The Econometric Society.

Lastly, seriation plays an important role in statistical analysis. In finance, financial time series often come in handy in elucidating behavior of the stock market over several decades.

References:

    Engle, R. (2001). Financial econometrics – A new discipline with new methods. Journal of Econometrics, 100 (1): 53-56.

    Geweke, J. & Zhou, G. (1996). Measuring the pricing error of the arbitrage pricing theory. The Review of Financial Studies, 9 (2): 557-587.

    Hong, H. & Nekipelov, D. (2010). Semiparametric efficiency in nonleanar LATE models. Quantitative Economics, 1: 279-304.

    Raible, S. (1998). Levy processes in finance: Theory, numerics, and empirical facts. PhD Thesis. Mathematics Faculty, Freiburg University, Freiburg.

Brokerage

Brokerage

The word brokerage usually refers to a brokerage firm or a broker, a person who acts as an intermediary between buyer and seller. Theoretically, a matchmaker in marriage arrangements is also a middleman, just as a real estate agent or the traditional stock market broker. Online brokerage has gained in prominence over the years. Broker services embody the principle-agent relationship and customarily entail a commission.

The principle-agent relationship refers to the fact that the principle and agent fail to necessarily share the same interests. In the corporate world, the problem may arise if a given manager or even CEO (Chief Executive Officer) acts in a way that fails to benefit the owners (shareholders). In real estate, the dilemma would arise if a realtor wants to sell a property fast and thus at a lower price, while the proprietor is interested in a higher selling price despite the time that it may take.

In Quebec, some of the main real estate agencies are Remax, Royal LePage, La Capitale and Groupe Immobilier Londono. Condominiums, houses and other properties can also be sold by the owner him or herself, using Proprio Direct. The commission charged ranges from approximately 4 to 7% depending on the agent. Although some commercial properties can be found in regular MLS listings (sponsored by the Canadian Real Estate Association), Quebec Commerce specializes in buying and selling of businesses in the province.

Chen & Hitt (2002) examined the switching costs and ability to retain customers associated with diverse online brokerage firms. The importance of the inquiry is underscored with the importance that customer retention has in the contemporary, highly competitive business world. The authors found that firms differed considerably, but that service quality and product variety helped businesses retain clients and create brand loyalty in their study.

It's hard to find a good broker. Photo : Elena

Benjamin et al. (2005) covered 1,700 observations to establish the liaison linking Internet usage to residential brokerage. The analysts discovered that with greater Internet use, both gross and net profits were larger, while net margin was smaller. In their sample, online presence was also positively associated with consumer affiliation.

Womack (1996) wonders whether brokerage analysts’ recommendations in fact serve a positive, constructive function. He concludes that security analysts are exceptionally good at timing the market and picking stock. However, there appears to be a post-event discrepancy between pre-recommendation and actual values in pricing.

Finally, in a review article by Yavas (1996), brokerage literature is decorticated and future research suggested. For example, Walrasian auctioneer (perfect competition where traders can sell and buy any quantity at market price) is essential to achieve efficient market allocation. However, the author explains that the argument rests on the perfect information premise, which apparently rarely holds in the housing and other markets.

References:

    Benjamin, J. D., Chinloy, P., Jud, G. D. & Winkler, D. T. (2005). Technology and real estate brokerage firm financial performance. Journal of Real Estate Research, 27 (4): 409-426.

    Chen, P-Y. (S) & Hitt, L. M. (2002). Measuring switching costs and determinats of customer retention in Internet-Enabled Businesses: A study of the online brokerage industry. Information Systems Research, 13 (3): 255-274.

    Womack, K. L. (1996). Do brokerage analysts’ recommendations have investment value? The Journal of Finance, 51 (1): 137-167.

    Yavas, A. (1994). Economics of brokerage: An overview. Journal of Real Estate Literature, 2 (2): 169-195.

Behavioral Finance

Behavioral Finance

Financial theory usually rests on the assumption that individuals are rational, however this fails to always be the case in real life. The preceding statement is the realm of behavioral finance, a field that studies how irrationality influences the financial world, outlined in a paper by Barberis & Thaler (2003).

The main tenet of the limits of arbitrage assertion is that in real life markets, there are both rational and irrational players. Therefore, irrationality influences outcomes, such as prices, despite what traditional financial models have postulated.

The traditional efficient markets hypothesis (EMH) states that prices will reflect the true value of products, behavioral finance counters that even if some shares are under- or overpriced, investors who notice it may be unable to correct the situation as would be expected under the EMH. The situation is complicated further by the fact that most investors have professionals manage their money for them.

Furthermore, the role of psychology becomes evident as soon as one understands the impact that people’s preconceptions have in matters related to financial economics. The following concepts recurrently cloud people’s judgments: wishful thinking, overconfidence and representativeness. Representativeness can be seen in the situation proposed by Kahneman & Tversky (1974). The author of the present text has simplified and altered their setting, but tried to keep the basic idea intact. Given the description below, please choose Kesha’s likely occupation:

Kesha is artistic, majored in fine arts, and strongly believes in the end of the world in 2012 caused by the mysterious planet X or Nibiru (imagine the year is 2111). What does Kesha do for a living?

a.    fortune teller

b.    grocery store cashier

Psychology is defined as the scientific study of the mind and behavior. Image : © Megan Jorgensen (Elena)

Many respondents will choose ‘a’ despite the fact that statistically speaking, ‘b’ is much more likely to hold, since very few persons hold jobs as fortune tellers as opposed to grocery store cashiers. Such a failure to weigh probabilities is called the sample size neglect, but may also be explained by a hasty jump to conclusions.

An even more rudimentary mistake is the gambler’s fallacy, the irrational belief that a randomly determined streak of losses must be followed by a win. From probability theory, one knows that a fair coin tossed five times with the same result of tails each time, still has the same 50% chance of exhibiting tails.

Other cognitive biases are anchoring and belief perseverance. People tend to seek familiarity, and when in doubt, find an anchor, staying close to, or within a comfortable range of, some predetermined or fortuitous value or number. Belief perseverance simply means that the human mind often clings to its beliefs in spite of contradictory evidence.

References:

    Barberis, N. & Thaler, R. (2003). Chapter 18: A survey of behavioral finance. Handbook of the Economics of Finance, 1(2): 1053-1128.

    Kahneman, D. & Tversky, A. (1974).  Judgment under uncertainty: Heuristics and biases. Science, 185 (September): 1124-1131.

Marketing

Marketing

The purpose of the present business essay is to discuss fundamentals of marketing. As mentioned in previous posts, a future accountant must take several courses in order to complete all the requirements for a Bachelor of Commerce (BComm) or Bachelor of Business Administration (BBA) program. Introductory courses cover related subjects, such as finance, accounting, statistics and marketing, to name a few.

Introduction to Marketing covers fundamental concepts such as the marketing mix (price, product, place and promotion) and advertising basics. However, marketing is not only about sales and advertisement, and includes many other areas.

Isolement. Win lose situations may be zero-sum games. Image: Megan Jorgensen (Elena)

Thus, to remain competitive, a firm must offer customers a product they value. Still, pricing a product depends on the nature of the offering. For instance, a luxury item, such as a Prada bag or a pair of Fendi shoes, may be priced well above available quality bags and shoes, but the designer premium is reflected in the prestige, status or fashion statement conveyed by the brand. Also, professional marketers emphasize that it is impossible to generate consumer needs, only to shape wants. After all, an individual may simply prefer less flashy (and much less expensive!) items, regardless of fashion trends.

Product life-cycle is also covered among the basics of Marketing 101. To illustrate, a product at maturity must add value in order to remain competitive, although what is perceived as valuable to the customer may differ from what the marketer sees as desirable features. Therefore, at least from a marketer’s perspective, beauty truly is in the eye of the beholder… Thus, the aim of the present paper was to discuss marketing at an introductory level.

Instead of naming the fields where they are used, it would be more intriguing to try to name a discipline without theories. The feat is impossible since a discipline is by definition full of them; an ideology is a collection of related theories. But what about the real world, where can the aforementioned be applied?

Individual fields such as marketing have their own managerial framework. Gummesson (2002) discusses marketing managerial theory.

An interesting alternative to the know what, know how and know why is presented. The Vedic variant divides knowledge into the methodology, researcher and result. The author also recounts personally experiencing the inaccuracy of marketing college and university material in depicting the non-scholastic world, and even casts doubt on the peer-review shortcomings of certain publications.

Nepotism and in-group favouritism have been encountered. General marketing theory appears to be stagnating. A strong network of connections for marketing professionals in the U.S. started expanding in the 1970, with the establishment of several associations, and has grown since. The development is very important if one recalls the significance that personal contacts have for sales, and even advertising. Traditionally, the US has been a marketing pioneer. An interesting point raised in the paper is the uncomfortable truth that sometimes scientists with better getting along skills get published over someone with higher quality material. Another problem with the academic methodology is that if all references are within the last decade, then old forgotten truths risk becoming the new bewildering discoveries.

An office. Illustration by Elena

The marketing mix, the 4Ps, consists of place, promotion (also called distribution), price and product. As you may recall, markets are influenced by a plethora of conditions of their surrounding: the legal, political, commercial, social and environmental. Indeed, today’s companies are very involved in environment protection and global long-lived welfare (the socio-environmental ethical perspective).

A basic concept is relationship marketing, which has as its goal to capture client lifelong value, the reason why younger generations are often the target audiences (as can be seen in this video of a Chrysler commercial with artist Eminem). The postulate is also explanatory for why ads running with the Super Bowl are likely to differ from those scheduled for Sunday afternoon Tele-Toons.

Another clever marketing strategy is reimbursements and reward points, such as the Air Miles, Guess and Optimum (Pharmaprix) client cards. What most shoppers forget is that on some occasions, the benefit must be claimed before a certain date or the accumulated gets automatically erased.

Some other marketing basics say that the target audience must not only be an interested, but a profitable clientele. Also, the immovability of needs; and thus, the necessity to concentrate on shaping them into wants, and brand loyalty.

As always in business, moral dilemmas can arise as in the case of TV show Skins. The US version is an adoption of the U.K. Skins, a highly controversial, accused of illicit pornography, show revolving around the lives (sex, drugs and rock ‘n’ roll) of teenagers. Condom companies have jumped at the opportunity, but the show and ads are now being pulled off.

Social reception is important; offensive content is restricted. An advertisement that was banned (in Europe?) featured a child throwing an inexcusable tantrum at the grocery store, while a tall young man stands embarrassed and confused. Then, a line across the screen reads something about the foresight of using preservatives.

Global warming and environmental crises have been a threatening yet popular topic of discussion for decades. The ozone layer perforation started taking place in the 1970s. The Kyoto Protocol and quotas on pollution production have been put in place in many industrialized nations. Catastrophe movies, such as 2012, have show-casted the disastrous consequences of a cataclysm as vigorous as complete meting of the ice caps. Corporations have now become ecologically aware, and so has marketing. Marketing professionals now pay attention to fabricating marketing campaigns respectful of, and sometimes in a crusade for, the ecology.

Reference:

• Gummesson, E. (2002). Practical value of adequate marketing management theory. European Journal of Marketing, 36 (3): 325-349.

Musical Commerce

Musical Commerce

People are strange when you’re a stranger – Jim Morison for the Doors, lyrics

Commercialization of musical talents has revealed that success depends on a large audience. Alleyne (2009) feels that due to globalization some art ends up selling out. Although the notice has been discussed before, it may be a slight exaggeration. Many have mean things to say about pop artists and how they trade their souls for money and so on and so forth. Musicians deplore dilution likewise; Rihanna has commented on how generic some of her contemporaries’ tunes sounded. Mass marketing demands some changes (that can be very profitable). A fascinating 80% of market share belongs to the four major music corporations: Universal Music, EMI, Sony Music International and Warner Music Group.

Stephens (2007) provides insight into the digital music industry of the Atlanta region. The author defines digital music simply as “music that has been digitally constructed” (Ibid. p. 13), the recording software used are Compact Disk and MP3. Other channels are ringtones, online radio, and synthesizers. Ringtones seem to be gradually replacing traditional CDs. However, the exact figure seems hard to pinpoint in the literature. Sources’ estimations are that ringtone sales for 2005 amounted to $600 000 in the US, while analysts forecast 800,000 Euros in European sales for 2007. But, predictions about 2010 went as far up as 11 billion by 2010, while CD and DVD sales represent close to 5 billion in the US and 20 billion globally.

Music of the square. Photo by Elena

In addition to aiding individualism and social cohesiveness, music also generates profits. At least since the 1900s a certain commercialisation of music went on, although not unheard of since even troubadours made somewhat of a living playing instruments a thousand years ago. As elsewhere in oligopolistic business, a few large companies have divided the market among themselves. The digital music industry differs from the traditional one along the value chain. The value chain is a managerial accounting concept and refers to the path travelled by a product from its invention and design through ordering, production, packaging, sale and customer aftercare. Because of the informational nature of the product advertising and distribution expenses are lower for digital music than for non-digital music. Production costs are similarly reduced. Atlanta’s digital art form is explicated in terms of the Porter Diamond framework, which encompasses competitive strategies, customer needs, resources and support system. Electric guitar sounds were excluded from the digital sample of analysis (Ibid).

References:

    Alleyne, M. (2009). Globalisation and commercialisation of Caribbean music. World Music: Roots and Routes. Studies across Disciplines in the Humanities and Social Sciences 6. Helsinki Collegium for Advanced Studies, 76-101.

    Stephens, A. R. -M. (2007). Atlanta’s digital music industry: Implications for workforce and economic development. Master’s Degree Thesis. School of Public Policy and College of Architecture, Georgia Institute of Technology.