KianGuanLim TheoryandEconometricsofFinancialAssetPricing Kian Guan Lim Theory and Econometrics of Financial Asset Pricing | ISBN978-3-11-067385-2 e-ISBN(PDF)978-3-11-067395-1 e-ISBN(EPUB)978-3-11-067401-9 LibraryofCongressControlNumber:2022939228 BibliographicinformationpublishedbytheDeutscheNationalbibliothek TheDeutscheNationalbibliothekliststhispublicationintheDeutscheNationalbibliografie; detailedbibliographicdataareavailableontheInternetathttp://dnb.dnb.de. ©2022WalterdeGruyterGmbH,Berlin/Boston Coverimage:MarcusLindstrom/E+/GettyImages Typesetting:VTeXUAB,Lithuania Printingandbinding:CPIbooksGmbH,Leck www.degruyter.com | Tomyfamily Preface Thisbookispedagogicalinnatureandwillprovideafirmfoundationintheunder- standing of financial economics applied to asset pricing. The covered materials in- cludeanalysesof stocks,bonds,futures,and options.Existinghighlycitedfinance modelsareexplainedandusefulreferencesareprovided.Thediscussionoftheoryis accompaniedbyrigorousapplicationsofeconometrics.Econometricscontaineluci- dationsofboththestatisticaltheoryaswellasthepracticeofdataanalyses.Linear regressionmethodsandsomenonlinearmethodsarecovered. Thecontributionofthisbook,andatthesametime,itsnovelty,isinsynergisti- callyemployingmaterialsinprobabilitytheory,economicsoptimization,economet- rics,anddataanalysestogethertoprovideforrigorouslearningininvestmentandem- piricalfinance.Thisbookiswrittenatalevelthatisacademicallyrigorousformasters levelaswellasadvancedundergraduatecoursesinfinance,financialeconometrics, andquantitativefinance.Itisalsousefulforfinanceandbankingprofessionalswho wishtobetterequipthemselves. June2022 KianGuanLim https://doi.org/10.1515/9783110673951-201 Contents Preface|VII 1 ProbabilityDistributions|1 1.1 BasicProbabilityConcepts|1 1.1.1 CollectionofEvents|1 1.1.2 RandomVariables|4 1.1.3 DistributionFunction|5 1.1.4 SomeMoments|6 1.1.5 Independence|8 1.2 ProbabilityDistributions|8 1.2.1 BinomialDistribution|8 1.2.2 Application:GamesofChance|10 1.2.3 PoissonDistribution|13 1.2.4 Application:CreditDefaultSwap|17 1.2.5 UniformDistribution|17 1.2.6 NormalDistribution|18 1.2.7 RelatedDistributions|20 1.3 EstimationandHypothesisTesting|22 1.3.1 StatisticalTesting|25 2 SimpleLinearRegression|28 2.1 SimpleLinearRegression|28 2.2 OLSMethod|31 2.2.1 Forecasting|38 2.3 Gauss–MarkovTheorem|40 2.4 Decomposition|43 2.5 StockIndexFutures|46 2.5.1 CostofCarryModel|47 2.6 Hedging|54 3 CapitalAssetPricingModel|57 3.1 ExpectedUtilityTheory|57 3.1.1 ChoicesUnderUncertainty|58 3.2 UtilityFunctions|62 3.2.1 TaylorSeriesExpansion|64 3.2.2 MaclaurinSeries|66 3.3 RiskAversion|66 3.3.1 ApplicationofVMExpectedUtility|69 3.3.2 ValueofInformation|69 3.4 Single-PeriodCAPM|71 X | Contents 3.4.1 Estimation|76 3.4.2 Application:CAPMRegression|78 3.4.3 InterpretationofRegressionResults|80 3.4.4 Testing|83 3.5 PerformanceMeasures|85 4 EventStudies|90 4.1 SetOperations|90 4.1.1 Bayes’Formula|91 4.2 MarketEfficiency|92 4.3 ConditionalExpectation|94 4.3.1 Application:Value-at-Risk|97 4.4 MovingAcrossTime|98 4.4.1 LawofIteratedExpectations|105 4.4.2 Application:AssetPricing|106 4.5 Events|108 4.5.1 TestingFramework|109 4.5.2 Benchmark|110 4.5.3 TestStatistics|115 4.6 CaseStudy:BankofAmericaAcquiresMerrillLynch|119 5 TimeSeriesModeling|123 5.1 StochasticProcess|123 5.1.1 SomeImportantInequalities|124 5.2 LawofLargeNumbers|124 5.2.1 ConvergenceConcepts|125 5.3 CentralLimitTheorem|131 5.3.1 Applications|134 5.4 StockReturnRates|135 5.4.1 TestofNormality|137 5.4.2 CaseStudy:AmericanExpressCompanyStockReturns|137 5.5 TimeSeriesModels|140 5.6 AutoregressiveProcess|143 5.7 MovingAverageProcess|145 5.8 AutoregressiveMovingAverageProcess|145 5.8.1 ChangingConditionalMeans|146 5.9 SampleAutocorrelationFunction|147 5.10 TestofZeroAutocorrelationsforAR(1)|149 5.10.1 InvertibleMAProcesses|151 5.10.2 Yule-WalkerEquations|152 5.11 PartialAutocorrelationFunction|153 5.11.1 Application:GDPGrowth|155