Financial Econometrics, Mathematics

and Statistics
Cheng-Few Lee Hong-Yi Chen
• •

John Lee

Financial Econometrics,
Mathematics
and Statistics
Theory, Method and Application

123
Cheng-Few Lee Hong-Yi Chen
Department of Finance and Economics Department of Finance
Rutgers Business School National Chengchi University
Rutgers University Taipei, Taiwan
Piscataway, NJ, USA

John Lee
Center for PBBEF Research
Morris Plains, NJ, USA

ISBN 978-1-4939-9427-4 ISBN 978-1-4939-9429-8 (eBook)

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Preface

We draw upon our years of teaching, research, and practice on the subjects of
financial econometrics, mathematics and statistics for this textbook. Overall,
our goal is to provide an advanced level book that reviews, discusses, and
integrates financial econometrics, mathematics and statistics.
We focus on five principles to frame our presentation of this book:

(1) To discuss the basic methodology of financial econometrics, mathe-

matics and statistics,
(2) To show how econometric methodologies can be used in finance and
accounting-related research, which includes single equation, multiple
regression, simultaneous regression, panel data analysis, time-series
analysis, spectral analysis, nonparametric analysis, semiparametric
analysis, GMM analysis, and other methods,
(3) To show how financial mathematics such as Itô’s calculus is important
to derive the intertemporal capital asset pricing model and option
pricing model,
(4) To demonstrate how statistics distribution, such as normal distribution,
stable distribution, and lognormal distribution, has been used in research
related to portfolio theory and risk management,
(5) To show how binomial distribution, lognormal distribution, noncentral
chi-square distribution, Poisson distribution, and others have been used
in studies related to option and futures.

In order to comprehend this book, the reader needs two semesters of

econometrics, two semesters of mathematical statistics, and one semester of
multivariate statistics.
We divide this book into four parts: Regression and Financial Econo-
metrics; Time-Series Analysis; Statistical Distributions, Option Pricing
Model, and Risk Management; and Statistics, Itô’s Calculus, and Option
Pricing Model.

PART I: Regression and Financial Econometrics

There are seven chapters in this part. In Chap. 2, we discuss the assumptions
of the multiple regression model, estimated parameters of the multiple
regression model, the standard error of the residual estimate, and the
coefficient of determination. We also investigate tests on sets and individual

v
vi Preface

regression coefficients and the confidence interval for the mean response and
prediction interval for the individual response.
In Chap. 3, we discuss various topics associated with the regression
analysis, including multicollinearity, heteroscedasticity, autocorrelation,
model specification and specification bias of the regression model, nonlinear
regression models, lagged dependent variables in the regression model,
dummy variables in the regression model, and regression model with inter-
action variables. We also apply the regression approach to investigate the
effect of alternative business strategies and apply the logistic regression
model to credit risk analysis.
In Chap. 4, we extend single-equation models to simultaneous equation
models. Specifically, we discuss simultaneous equation system, two-stage
least squares method, and three-stage least squares method. In Chap. 5, we
discuss an econometric approach to financial analysis, planning, and fore-
casting. The issue of simultaneity and the dynamics of corporate-budgeting
decisions will be explored by using finance theory. We also investigate the
interrelationships among the programming, the simultaneous equations, and
the econometrics approaches.
Chapter 6 addresses one of the important issues related to panel data
analysis. We introduce the dummy variable technique and the error com-
ponent model for analyzing pooled data. We investigate the possible impacts
of firm effect and time effect on choosing the optimal functional form of a
financial research study. In this chapter, we also discuss the criteria of using
fixed effects or random effects approach.
Chapter 7 discusses how errors-in-variables estimation methods are used
in finance research. We show how errors-in-variables problems can affect the
estimators of the linear regression model, as well as discuss the effects they
have on the empirical research cost of capital, asset pricing, capital structure,
and investment decision. Chapter 8 provides three alternative
errors-in-variables estimation models in testing the capital asset pricing
model. Specifically, we present three alternative correction methods for the
errors-in-variables problem. In Chap. 9, we discuss the issue of spurious
regression and data mining in both conditional asset pricing models and
simple predictive regression. We also discuss the impact of spurious
regression and data mining on conditional asset pricing.

PART II: Time-Series Analysis and Its Applications

The purpose of Chap. 10 is to describe the components of time-series
analyses and to discuss alternative methods of economic and business fore-
casting in terms of time-series data. Specifically, we discuss a classical
description of three time-series components, the moving-average and sea-
sonally adjusted time series, linear and log-linear time trend regressions,
exponential smoothing and forecasting, autoregressive forecasting model,
ARIMA model, and composite forecasting.
In Chap. 11, we attempt to achieve two goals. First, we present alternative
theories for deriving optimal hedge ratios. We discuss various estimation
methods and the relationship among lengths of hedging horizon, maturity of
Preface vii

futures contract, data frequency, and hedging effectiveness. Second, we show

how SAS program can be used to estimate hedge ratio in terms of ARCH
method, GARCH method, EGARCH method, GJR-GARCH method, and
TGARCH method.

PART III: Statistical Distributions, Option Pricing Model and Risk

Management
Statistical distributions such as binomial distribution, multinomial distribu-
tion, normal distribution, lognormal distribution, Poisson distribution, central
chi-square distribution, noncentral chi-square distribution, copula distribu-
tion, nonparametric distribution, and other distributions are important in
finance research. In Chap. 12, we will discuss how binomial and multinomial
distribution can be used to derive the option pricing model. In Chap. 13, we
show how to use two alternative binomial option pricing model approaches
to derive Black–Scholes option pricing model.
In Chap. 14, we will discuss how normal and lognormal distribution can
be used to derive the option pricing model. In Chap. 15, we will show how
copula distribution can be used to do credit risk analysis. In Chap. 16, we will
show how multivariate analyses such as factor analysis and discriminant
analysis can be used to do financial rating analysis. In Part IV, we will
continue to discuss how statistics distribution can be used to derive option
pricing model. In addition, we will also show how Itô’s calculus can be used
to derive option pricing model.

PART IV: Statistics, Itô’s Calculus, and Option Pricing Model

In Chap. 17, we will show how characteristic function and noncentral
chi-square can be used to analyze stochastic volatility option pricing model.
In Chap. 18, we will discuss alternative methods to estimate implied vari-
ance. In Chap. 19, we will show the numerical valuation of Asian options
with higher moments in the underlying distribution. Both European and
American options will be discussed in this chapter. In Chap. 20, we will first
review Itô Lemma and stochastic differential equation, and then we will show
how this mathematical technique can be used to derive option pricing model.
In Chap. 21, we will discuss the relationship between binomial option pricing
model and Black–Scholes option pricing model. In addition, we also show
how to use stochastic calculus to derive Black–Scholes model in detail. In
Chap. 22, we will show how to use noncentral chi-square distribution to
derive constant elasticity of variance option pricing model. In Chap. 23, we
will discuss option pricing and hedging performance under stochastic
volatility and stochastic interest rates. Finally, in Chap. 24, we will show how
nonparametric distribution can be used to derive option bounds. Some
empirical studies or option bounds are also provided.
This textbook can be used for the quantitative finance program and Ph.D.
programs in economics, statistics, and finance. It demonstrates how to apply
different econometrics and statistical methods in finance research. In
viii Preface

addition, applications of Itô’s calculus in deriving option pricing model are

also discussed in some detail.
It is well known that financial econometrics, mathematics and statistics are
three of the most important tools to solve theoretical and practical issues of
quantitative finance. This textbook uses real-world data to show how these
three quantitative tools can be used to solve quantitative finance issues in
asset pricing, option pricing models, risk management, and other quantitative
finance issues. This textbook uses a traditional approach by combining
research papers from journals, handbooks, and textbooks to streamline these
topics. We take advantage of using our own research papers, edited hand-
book, and textbook to formulate a meaningful, unique, comprehensive
textbook. We heavily draw upon Handbook of Quantitative Finance and Risk
Management (Springer 2009), Statistics for Business and Financial Eco-
nomics, 3rd ed. (Springer 2013), and Essentials of Excel, Excel VBA, SAS
and Minitab for Statistical and Financial Analyses (Springer 2016), as well
as Review of Quantitative Finance and Accounting and other journals with
which we have published relevant papers.
Note that this textbook is intended to be used in its entirety instead of
chapter by chapter. Readers may find the aforementioned Springer volumes’
useful references during the learning process. For example, there are several
chapters wherein we draw from Handbook of Quantitative Finance and Risk
Management—here, the reader can refer to the handbook. Similarly, Chaps.
2 and 3 are expanded versions of Statistics for Business and Financial
Economics, 3rd ed.
There are undoubtedly some errors in the finished product such as con-
ceptual, grammatical, or methodological. We would like to invite readers to
send their suggestions, comments, criticisms, and corrections to the author,
Professor Cheng F. Lee at the Department of Finance and Economics, Rut-
gers University at 100 Rockafeller Road, Room 5188, Piscataway, NJ 08854.
Alternatively, readers can send this information by email to either Cheng Few
Lee (cfl[email protected]) or Hong-Yi Chen ([email protected]).

Piscataway, USA Cheng-Few Lee

Taipei, Taiwan Hong-Yi Chen
Morris Plains, USA John Lee
May 2019
Contents

1 Introduction to Financial Econometrics, Mathematics,

and Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Regression and Financial Econometrics . . . . . . . . . . . . . 2
1.2.1 Single-Equation Regression Methods . . . . . . . . 2
1.2.2 Simultaneous Equation Models . . . . . . . . . . . . 4
1.2.3 Panel Data Analysis . . . . . . . . . . . . . . . . . . . . . 4
1.2.4 Alternative Methods to Deal
with Measurement Error . . . . . . . . . . . . . . . . . 4
1.2.5 Time-Series Analysis . . . . . . . . . . . . . . . . . . . . 5
1.3 Financial Statistics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.3.1 Statistical Distributions . . . . . . . . . . . . . . . . . . 5
1.3.2 Principle Components and Factor Analysis . . . 6
1.3.3 Nonparametric and
Semiparametric Analyses . . . . . . . . . . . . . . . . . 6
1.3.4 Cluster Analysis . . . . . . . . . . . . . . . . . . . . . . . . 6
1.4 Applications of Financial Econometrics, Mathematics
and Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.4.1 Asset Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.4.2 Corporate Finance . . . . . . . . . . . . . . . . . . . . . . 6
1.4.3 Financial Institution . . . . . . . . . . . . . . . . . . . . . 7
1.4.4 Investment and Portfolio Management . . . . . . . 7
1.4.5 Option Pricing Model . . . . . . . . . . . . . . . . . . . 7
1.4.6 Futures and Hedging . . . . . . . . . . . . . . . . . . . . 7
1.4.7 Mutual Fund . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.4.8 Credit Risk Modeling. . . . . . . . . . . . . . . . . . . . 7
1.4.9 Other Applications . . . . . . . . . . . . . . . . . . . . . . 7
1.5 Overall Discussion of This Book . . . . . . . . . . . . . . . . . . 8
1.5.1 Regression and Financial Econometrics . . . . . . 8
1.5.2 Time-Series Analysis and Its Application . . . . 9
1.5.3 Statistical Distributions and Option Pricing
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.5.4 Statistics, Itô’s Calculus and Option Pricing
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

ix
x Contents

1.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Appendix: Keywords for Chaps. 2–24 . . . . . . . . . . . . . . . . . . . . 11
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Part I Regression and Financial Econometrics

2 Multiple Linear Regression . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.2 The Model and Its Assumptions . . . . . . . . . . . . . . . . . . . 20
2.3 Estimating Multiple Regression Parameters . . . . . . . . . . . 23
2.4 The Residual Standard Error and the Coefficient
of Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.5 Tests on Sets and Individual Regression Coefficients . . . 26
2.6 Confidence Interval for the Mean Response
and Prediction Interval for the Individual Response . . . . 30
2.7 Business and Economic Applications . . . . . . . . . . . . . . . 33
2.8 Using Computer Programs to Do Multiple Regression
Analyses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
2.8.1 SAS Program for Multiple Regression
Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
2.9 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Appendix 1: Derivation of the Sampling Variance
of the Least Squares Slope Estimations . . . . . . . . . . . . . . . . . . . . 48
Appendix 2: Cross-sectional Relationship Among Price Per
Share, Dividend Per Share, and Return Earning Per Share . . . . . . . . 49
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
3 Other Topics in Applied Regression Analysis . . . . . . . . . . . . . 55
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
3.2 Multicollinearity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3.3 Heteroscedasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
3.4 Autocorrelation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
3.5 Model Specification and Specification Bias . . . . . . . . . . . 70
3.6 Nonlinear Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
3.7 Lagged Dependent Variables . . . . . . . . . . . . . . . . . . . . . . 79
3.8 Dummy Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3.9 Regression with Interaction Variables . . . . . . . . . . . . . . . 92
3.10 Regression Approach to Investigating the Effect
of Alternative Business Strategies . . . . . . . . . . . . . . .... 96
3.11 Logistic Regression and Credit Risk Analysis:
Ohlson’s and Shumway’s Methods for Estimating
Default Probability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
3.12 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Appendix 1: Dynamic Ratio Analysis . . . . . . . . . . . . . . . . . . . . . 100
Appendix 2: Term Structure of Interest Rate . . . . . . . . . . . . . . . . 100
Appendix 3: Partial Adjustment Dividend Behavior
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 102
Appendix 4: Logistic Model and Probit Model . . . . . . . . . . .... 108
Contents xi

Appendix 5: SAS Code for Hazard Model in

Bankruptcy Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
4 Simultaneous Equation Models . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.2 Discussion of Simultaneous Equation System . . . . . . . . . 116
4.3 Two-Stage and Three-Stage Least Squares Method . . . . . 116
4.3.1 Identification Problem . . . . . . . . . . . . . . . . . . . 117
4.3.2 Two-Stage Least Squares . . . . . . . . . . . . . . . . . 119
4.3.3 Three-Stage Least Squares . . . . . . . . . . . . . . . . 119
4.4 Application of Simultaneous Equation in Finance
Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 121
4.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 123
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 123
5 Econometric Approach to Financial Analysis, Planning,
and Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.2 Simultaneous Nature of Financial Analysis, Planning,
and Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.2.1 Basic Concepts of Simultaneous
Econometric Models . . . . . . . . . . . . . . . . . . . . 126
5.2.2 Interrelationship of Accounting
Information . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
5.2.3 Interrelationship of Financial Policies . . . . . . . 127
5.3 The Simultaneity and Dynamics
of Corporate-Budgeting Decisions . . . . . . . . . . . . . . . . . . 127
5.3.1 Definitions of Endogenous and Exogenous
Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
5.3.2 Model Specification and Applications . . . . . . . 127
5.4 Applications of SUR Estimation Method in Financial
Analysis and Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
5.4.1 The Role of Firm-Related Variables
in Capital Asset Pricing . . . . . . . . . . . . . . . . . . 137
5.4.2 The Role of Capital Structure
in Corporate-Financing Decisions . . . . . . . . . . 140
5.5 Applications of Structural Econometric Models
in Financial Analysis and Planning . . . . . . . . . . . . . . . . . 141
5.5.1 A Brief Review . . . . . . . . . . . . . . . . . . . . . . . . 141
5.5.2 AT&T’s Econometric Planning Model . . . . . . . 142
5.6 Programming Versus Simultaneous Versus
Econometric Financial Models . . . . . . . . . . . . . . . . . . . . 142
5.7 Financial Analysis and Business Policy Decisions . . . . . 144
5.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
Appendix: Johnson & Johnson as a Case Study . . . . . . . . . . . . . 146
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
xii Contents

6 Fixed Effects Versus Random Effects

in Finance Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
6.2 The Dummy Variable Technique and the Error
Component Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
6.3 Impacts of Firm Effect and Time Effect on Stock Price
Variation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
6.4 Functional Form and Pooled Time-Series
and Cross-Sectional Data . . . . . . . . . . . . . . . . . . . . . . . . 164
6.5 Clustering Effect and Clustered Standard Errors . . . . . . . 170
6.6 Hausman Test for Determining Either Fixed Effects
Model or Random Effects Model . . . . . . . . . . . . . . . . . . 170
6.7 Efficient Firm Fixed Effects Estimator and Efficient
Correlated Random Effects Estimator . . . . . . . . . . . . . . . 171
6.8 Empirical Evidence of Optimal Payout Ratio Under
Uncertainty and the Flexibility Hypothesis . . . . . . . . . . . 171
6.9 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Appendix: Optimal Payout Ratio Under Uncertainty and
the Flexibility Hypothesis: Theory and Empirical Evidence . . . . 175
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
7 Alternative Methods to Deal with Measurement Error. . . . . . 181
7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
7.2 Effects of Errors-in-Variables in Different Cases . . . . . . . 183
7.2.1 Bivariate Normal Case . . . . . . . . . . . . . . . . . . . 183
7.2.2 Multivariate Case . . . . . . . . . . . . . . . . . . . . . . . 183
7.3 Estimation Methods When Variables Are Subject
to Error . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
7.3.1 Classical Estimation Method . . . . . . . . . . . . . . 185
7.3.2 Grouping Method. . . . . . . . . . . . . . . . . . . . . . . 188
7.3.3 Instrumental Variable Method . . . . . . . . . . . . . 189
7.3.4 Mathematical Method . . . . . . . . . . . . . . . . . . . 190
7.3.5 Maximum Likelihood Method . . . . . . . . . . . . . 192
7.3.6 LISREL and MIMIC Methods . . . . . . . . . . . . . 193
7.3.7 Bayesian Approach . . . . . . . . . . . . . . . . . . . . . 194
7.4 Applications of Errors-in-Variables Models in Finance
Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
7.4.1 Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . 195
7.4.2 Capital Asset Pricing Model . . . . . . . . . . . . . . 199
7.4.3 Capital Structure . . . . . . . . . . . . . . . . . . . . . . . 204
7.4.4 Measurement Error in Investment
Equation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
7.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
8 Three Alternative Methods in Testing Capital Asset Pricing
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
Contents xiii

8.2 Empirical Test on Capital Asset Pricing Model. . . . . . . . 213

8.2.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
8.2.2 Grouping Method for Testing Capital Asset
Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . . 214
8.2.3 Instrumental Variable Method for Testing
Capital Asset Pricing Model . . . . . . . . . . . . . . 218
8.2.4 Applying Instrumental Variable Methods
into Grouping Sample . . . . . . . . . . . . . . . . . . . 221
8.2.5 Maximum Likelihood Method for Testing
Capital Asset Pricing Model . . . . . . . . . . . . . . 221
8.2.6 Asset Pricing Model Tests with Individual
Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
8.3 Normality Test for Time-Series Estimators and Future
Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
8.4 The Investment Horizon of Beta Estimation . . . . . . . . . . 226
8.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
9 Spurious Regression and Data Mining in Conditional Asset
Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
9.2 Model Specification . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
9.3 Spurious Regression and Data Mining in Predictive
Regressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
9.4 Spurious Regression, Data Mining, and Conditional
Asset Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
9.5 The Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
9.6 The Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
9.6.1 Predictive Regressions . . . . . . . . . . . . . . . . . . . 250
9.6.2 Conditional Asset Pricing Models . . . . . . . . . . 251
9.7 Results for Predictive Regressions. . . . . . . . . . . . . . . . . . 252
9.7.1 Pure Spurious Regression . . . . . . . . . . . . . . . . 252
9.7.2 Spurious Regression and Data Mining . . . . . . . 256
9.8 Results for Conditional Asset Pricing Models . . . . . . . . . 261
9.8.1 Cases with Small Amounts of Persistence . . . . 261
9.8.2 Cases with Persistence . . . . . . . . . . . . . . . . . . . 261
9.8.3 Suppressing Time-Varying Alphas . . . . . . . . . . 264
9.8.4 Suppressing Time-Varying Betas . . . . . . . . . . . 265
9.8.5 A Cross Section of Asset Returns . . . . . . . . . . 267
9.8.6 Revisiting Previous Evidence . . . . . . . . . . . . . . 267
9.9 Solutions to the Problems of Spurious Regression
and Data Mining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
9.9.1 Solutions in Predictive Regressions . . . . . . . . . 269
9.9.2 Solutions in Conditional Asset Pricing
Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
9.10 Robustness of the Asset Pricing Results . . . . . . . . . . . . . 271
9.10.1 Multiple Instruments . . . . . . . . . . . . . . . . . . . . 271
xiv Contents

9.10.2 Multiple-Beta Models . . . . . . . . . . ......... 271

9.10.3 Predicting the Market Return . . . . . ......... 272
9.10.4 Simulations Under the Alternative
Hypothesis . . . . . . . . . . . . . . . . . . . ......... 272
9.11 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 272
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 274

Part II Time-Series Analysis and Its Applications

10 Time Series: Analysis, Model, and Forecasting . . . . . . . . . . . . 279

10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
10.2 The Classical Time-Series Component Model . . . . . . . . . 280
10.3 Moving Average and Seasonally Adjusted
Time Series . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
10.4 Linear and Log Linear Time Trend Regressions . . . . . . . 288
10.5 Exponential Smoothing and Forecasting . . . . . . . . . . . . . 294
10.6 Autoregressive Forecasting Model . . . . . . . . . . . . . . . . . 300
10.7 ARIMA Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
10.8 Autoregressive Conditional Heteroscedasticity . . . . . . . . 306
10.8.1 Autoregressive Conditional
Heteroscedasticity (ARCH) Models . . . . . . . . . 306
10.8.2 Generalized Autoregressive Conditional
Heteroscedasticity (GARCH) Model . . . . . . . . 306
10.8.3 The GARCH Universe . . . . . . . . . . . . . . . . . . . 306
10.9 Composite Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . 308
10.9.1 Composite Forecasting of Livestock Prices . . . 308
10.9.2 Combined Forecasting of the Taiwan
Weighted Stock Index . . . . . . . . . . . . . . . . . . . 309
10.10 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Appendix 1: The Holt–Winters Forecasting Model for
Seasonal Series . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
Appendix 2: Composite Forecasting Method . . . . . . . . . . . . . . . . 314
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
11 Hedge Ratio and Time-Series Analysis . . . . . . . . . . . . . . . . . . 317
11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
11.2 Alternative Theories for Deriving the Optimal Hedge
Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
11.2.1 Static Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
11.2.2 Dynamic Case . . . . . . . . . . . . . . . . . . . . . . . . . 324
11.2.3 Case with Production and Alternative
Investment Opportunities . . . . . . . . . . . . . . . . . 325
11.3 Alternative Methods for Estimating the Optimal Hedge
Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
11.3.1 Estimation of the Minimum-Variance (MV)
Hedge Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
11.3.2 Estimation of the Optimum Mean-Variance
and Sharpe Hedge Ratios . . . . . . . . . . . . . . . . . 329
Contents xv

11.3.3 Estimation of the Maximum Expected Utility

Hedge Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
11.3.4 Estimation of Mean Extended-Gini (MEG)
Coefficient-Based Hedge Ratios . . . . . . . . . . . . 330
11.3.5 Estimation of Generalized Semivariance
(GSV) Based Hedge Ratios . . . . . . . . . . . . . . . 331
11.4 Hedging Horizon, Maturity of Futures Contract, Data
Frequency, and Hedging Effectiveness . . . . . . . . . . . . . . 331
11.5 Empirical Results of Hedge Ratio Estimation . . . . . . . . . 332
11.5.1 OLS Method . . . . . . . . . . . . . . . . . . . . . . . . . . 333
11.5.2 ARCH GARCH . . . . . . . . . . . . . . . . . . . . . . . . 333
11.5.3 EGARCH. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
11.5.4 GJR-GARCH . . . . . . . . . . . . . . . . . . . . . . . . . . 334
11.5.5 TGARCH. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
11.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
Appendix 1: Theoretical Models . . . . . . . . . . . . . . . . . . . . . . . . . 337
Appendix 2: Empirical Models . . . . . . . . . . . . . . . . . . . . . . . . . . 339
Appendix 3: Monthly Data of S&P 500 Index
and Its Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353

Part III Statistical Distributions, Option Pricing Model

and Risk Management

12 The Binomial, Multinomial Distributions, and Option

Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
12.2 Binomial Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
12.3 The Simple Binomial Option Pricing Model . . . . . . . . . . 361
12.4 The Generalized Binomial Option Pricing Model . . . . . . 364
12.5 Multinomial Option Pricing Model . . . . . . . . . . . . . . . . . 368
12.5.1 Derivation of the Option Pricing Model . . . . . . 368
12.5.2 The Black and Scholes Model as a Limiting
Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
12.6 A Lattice Framework for Option Pricing . . . . . . . . . . . . . 371
12.6.1 Modification of the Two-State Approach
for a Single-State Variable . . . . . . . . . . . . . . . . 371
12.6.2 A Lattice Model for Valuation of Options
on Two Underlying Assets. . . . . . . . . . . . . . . . 373
12.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
13 Two Alternative Binomial Option Pricing Model
Approaches to Derive Black–Scholes Option Pricing
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
13.2 The Two-State Option Pricing Model of Rendleman
and Bartter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
xvi Contents

13.2.1 The Discrete-Time Model . . . . . . . . . . . . .... 380

13.2.2 The Continuous Time Model . . . . . . . . . . .... 382
13.3 The Binomial Option Pricing Model of CRR . . . . . .... 385
13.3.1 The Binomial Option Pricing Formula
of CRR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
13.3.2 Limiting Case . . . . . . . . . . . . . . . . . . . . . . . . . 385
13.4 Comparison of the Two Approaches . . . . . . . . . . . . . . . . 388
13.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
Appendix: The Binomial Theorem . . . . . . . . . . . . . . . . . . . . . . . 389
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
14 Normal, Lognormal Distribution, and Option Pricing
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
14.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394
14.2 The Normal Distribution . . . . . . . . . . . . . . . . . . . . . . . . . 394
14.3 The Lognormal Distribution . . . . . . . . . . . . . . . . . . . . . . 395
14.4 The Lognormal Distribution and Its Relationship
to the Normal Distribution . . . . . . . . . . . . . . . . . . . . . . . 396
14.5 Multivariate Normal and Lognormal Distributions . . . . . 397
14.6 The Normal Distribution as an Application
to the Binomial and Poisson Distributions . . . . . . . . . . . 399
14.7 Applications of the Lognormal Distribution in Option
Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402
14.8 The Bivariate Normal Density Function . . . . . . . . . . . . . 403
14.9 American Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . 405
14.9.1 Price American Call Options by the Bivariate
Normal Distribution . . . . . . . . . . . . . . . . . . . . . 405
14.9.2 Pricing an American Call Option:
An Example . . . . . . . . . . . . . . . . . . . . . . . . . . . 406
14.10 Price Bounds for Options . . . . . . . . . . . . . . . . . . . . . . . . 409
14.10.1 Options Written on Nondividend-Paying
Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409
14.10.2 Options Written on Dividend-Paying
Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410
14.11 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
Appendix 1: Microsoft Excel Program for Calculating
Cumulative Bivariate Normal Density Function . . . . . . . . . . . . . 414
Appendix 2: Microsoft Excel Program for Calculating the
American Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
15 Copula, Correlated Defaults, and Credit VaR . . . . . . . . . . . . . 419
15.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420
15.2 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421
15.2.1 CreditMetrics . . . . . . . . . . . . . . . . . . . . . . . . . . 421
15.2.2 Copula Function . . . . . . . . . . . . . . . . . . . . . . . 424
15.2.3 Factor Copula Model . . . . . . . . . . . . . . . . . . . . 426
Contents xvii

15.3 Experimental Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427

15.3.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427
15.3.2 Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429
15.3.3 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430
15.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
16 Multivariate Analysis: Discriminant Analysis and Factor
Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439
16.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439
16.2 Important Concepts of Linear Algebra . . . . . . . . . . . . . . 440
16.3 Two-Group Discriminant Analysis . . . . . . . . . . . . . . . . . 445
16.4 k-Group Discriminant Analysis . . . . . . . . . . . . . . . . . . . . 449
16.5 Factor Analysis and Principal Component Analysis . . . . 451
16.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 451
Appendix 1: Relationship Between Discriminant Analysis
and Dummy Regression Analysis . . . . . . . . . . . . . . . . . . . . . . . . 452
Appendix 2: Principal Component Analysis . . . . . . . . . . . . . . . . 454
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456

Part IV Statistics, Itô’s Calculus and Option Pricing Model

17 Stochastic Volatility Option Pricing Models . . . . . . . . . . . . . . 461

17.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461
17.2 Nonclosed-Form Type of Option Pricing Model . . . . . . . 462
17.3 Review of Characteristic Function. . . . . . . . . . . . . . . . . . 466
17.4 Closed-Form Type of Option Pricing Model . . . . . . . . . . 467
17.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471
Appendix: The Market Price of the Risk . . . . . . . . . . . . . . . . . . . 471
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472
18 Alternative Methods to Estimate Implied Variance: Review
and Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473
18.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473
18.2 Numerical Search Method and Closed-Form
Derivation Method to Estimate Implied Variance . . . . . . 474
18.3 MATLAB Approach to Estimate Implied Variance . . . . . 481
18.4 Approximation Approach to Estimate Implied
Variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
18.5 Some Empirical Results . . . . . . . . . . . . . . . . . . . . . . . . . 487
18.5.1 Cases from USA—Individual
Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . 487
18.5.2 Cases from China—ETF 50 Options . . . . . . . . 487
18.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
xviii Contents

19 Numerical Valuation of Asian Options with Higher

Moments in the Underlying Distribution . . . . . . . . . . . . . . . . . 491
19.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492
19.2 Definitions and the Basic Binomial Model . . . . . . . . . . . 493
19.3 Edgeworth Binomial Model for Asian Option
Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494
19.4 Upper Bound and Lower Bound for European-Asian
Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
19.5 Upper Bound and Lower Bound for American-Asian
Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
19.6 Numerical Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501
19.6.1 Pricing European-Asian Options
Under Lognormal Distribution . . . . . . . . . . . . . 502
19.6.2 Pricing American-Asian Options Under
Lognormal Distribution . . . . . . . . . . . . . . . . . . 506
19.6.3 Pricing European-Asian Options
Under Distributions with Higher Moments . . . 510
19.6.4 Pricing American-Asian Options Under
Distributions with Higher Moments . . . . . . . . . 513
19.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
20 Itô’s Calculus: Derivation of the Black–Scholes Option
Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517
20.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518
20.2 The Itô Process and Financial Modeling . . . . . . . . . . . . . 518
20.3 Itô Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
20.4 Stochastic Differential Equation Approach
to Stock-Price Behavior . . . . . . . . . . . . . . . . . . . . . . . . . 522
20.5 The Pricing of an Option . . . . . . . . . . . . . . . . . . . . . . . . 526
20.6 A Reexamination of Option Pricing . . . . . . . . . . . . . . . . 529
20.7 Remarks on Option Pricing . . . . . . . . . . . . . . . . . . . . . . . 532
20.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534
Appendix: An Alternative Method to Derive the
Black–Scholes Option Pricing Model . . . . . . . . . . . . . . . . . .... 534
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 539
21 Alternative Methods to Derive Option Pricing Models . . .... 541
21.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 542
21.2 A Brief Review of Alternative Approaches
for Deriving Option Pricing Model . . . . . . . . . . . . . .... 544
21.2.1 Binomial Model . . . . . . . . . . . . . . . . . . . . .... 544
21.2.2 Black–Scholes Model. . . . . . . . . . . . . . . . .... 547
21.3 Relationship Between Binomial OPM
and Black–Scholes OPM . . . . . . . . . . . . . . . . . . . . . .... 547
Contents xix

21.4 Compare Cox et al. and Rendleman and Bartter

Methods to Derive OPM . . . . . . . . . . . . . . . . . . . . . . . . . 551
21.4.1 Cox et al. Method . . . . . . . . . . . . . . . . . . . . . . 551
21.4.2 Rendleman and Bartter Method . . . . . . . . . . . . 554
21.5 Lognormal Distribution Approach to Derive
Black–Scholes Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 558
21.6 Using Stochastic Calculus to Derive Black–Scholes
Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561
21.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564
Appendix: The Relationship Between Binomial Distribution
and Normal Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 565
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567
22 Constant Elasticity of Variance Option Pricing Model:
Integration and Detailed Derivation . . . . . . . . . . . . . . . . . .... 571
22.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 571
22.2 The CEV Diffusion and Its Transition Probability
Density Function . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 572
22.3 Review of Noncentral Chi-Square Distribution . . . . .... 574
22.4 The Noncentral Chi-Square Approach to Option
Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575
22.4.1 Detailed Derivations of C1 and C2 . . . . . . . . . . 575
22.4.2 Some Computational Considerations . . . . . . . . 579
22.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580
Appendix: Proof of Feller’s Lemma . . . . . . . . . . . . . . . . . . . . . . 580
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 582
23 Option Pricing and Hedging Performance Under Stochastic
Volatility and Stochastic Interest Rates . . . . . . . . . . . . . . . . . . 583
23.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584
23.2 The Option Pricing Model . . . . . . . . . . . . . . . . . . . . . . . 587
23.2.1 Pricing Formula for European Options. . . . . . . 588
23.2.2 Hedging and Hedge Ratios . . . . . . . . . . . . . . . 590
23.2.3 Implementation . . . . . . . . . . . . . . . . . . . . . . . . 594
23.3 Data Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 595
23.4 Empirical Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597
23.4.1 Static Performance . . . . . . . . . . . . . . . . . . . . . . 598
23.4.2 Dynamic Hedging Performance . . . . . . . . . . . . 603
23.4.3 Regression Analysis of Option Pricing and
Hedging Errors . . . . . . . . . . . . . . . . . . . . . . . . 612
23.4.4 Robustness of Empirical Results . . . . . . . . . . . 614
23.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617
Appendix 1: Derivation of Stochastic Interest Model
and Stochastic Volatility Model . . . . . . . . . . . . . . . . . . . . . . . . . . 617
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 619
xx Contents

24 Nonparametric Method for European Option Bounds . . . . . . 623

24.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623
24.2 The Bounds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624
24.3 Comparisons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 628
24.4 Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632
24.5 Empirical Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 634
24.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639
Appendix 1: Related Option Studies Adopting
Nonparametric Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 640
Appendix 2: Asset Pricing Model with a Stochastic
Kernel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 640
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 641
Author Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 643
Subject Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 653