You are required to answer all the following questions in this coursework
assignment.
Question 1: (10 Marks)
Construct an investment strategy using the international stock market indices
data (from the database provided on the Blackboard site of the module). The
strategy should be based on the return’s transmission effects across the stock
markets in different geographical zones worldwide. In particular, the strategy
will focus on the idea of “heat waves” and “meteor showers” effects originally
introduced by Engle, Ito and Lin (1990).
Requirements:
You will estimate the parameters of the respective econometric models in the
computer lab (examples of estimations will be covered in the workshop
sessions during the semester). Those results will serve as the basis for the
construction of an investment strategy and generation of signals for
hypothetical trading transactions. Your task will be to use the obtained results
and simulate the chosen strategy in Excel. In particular, you should do the
following:
A) Briefly discuss the econometric model, which you have chosen to use for
your trading strategy, and the relationships between the stock market indices,
which it explains. (4 marks, 200 words approx.)
B) Calculate the overall return from your strategy for the entire period of the
analysis. (6 marks, 100 words approx.)
Question 2: (20 Marks)
Using the results for your model from Question 1 above, perform further
analysis of the performance of your trading strategy:
A) Assess the forecasting performance of the model and your strategy: you
can use the direction quality measures (or any other measures of forecasting
performance, which you find appropriate and can reasonably justify their use).
(10 marks, 200 words approx.)
B) Discuss the obtained results by commenting on the profitability of the
strategy, its risk and the stability of the returns. (10 marks, 500 words
approx.)
Question 3: (10 Marks)
Estimate the following VAR model with appropriate lag-order containing four
macroeconomic variables: annual inflation rate, output growth, Federal Funds
Rate and market risk premium for the US:
�� = � + ∑�.��−�
�
�
+ ��
where: the vector � � ≡ [�, �,�,���] � is the annual CPI inflation rate, � is
growth rate of Index of Industrial Production, � is the Federal Funds Rate and
��� is the market risk premium in the US. The Market Risk Premium is the
excess return on a broad stock market index, such as the S&P 500 index, over
risk-free rate such as the rate on one-month US treasury bills. � is a vector of
constants, � is a matrix of coefficients, � is the lag order and �� is a IID shocks
with expected mean zero and covariance matrix Ω.
The data required to answer this question is uploaded on the Blackboard site
of this module. The name of the file is “VAR Data for Assignment”. Sample
Size January 1985 to November 2018. (Please note that you will have to
calculate the growth rate of Index of Industrial Production. Similarly, you will
have to calculate the returns on S&P 500 index to calculate the ���). You are
required to perform following tasks:
A) Determine the optimum lag order p of the above model using suitable
information criteria and check the stability of the model. Comment on the
stability of the model.
B) Estimate and present the impulse response of the market risk premium to
shocks in interest rate (r), inflation and output growth over the next twelve
months and comment on the result. (10 marks, 400 words approx.)
Question 4: (20 Marks)
Construct a pairs trading strategy between five pairs of assets using
cointegration technique. The assets could be shares of individual companies
or commodities or stock indices or commodity indices. You should use at least
10 years of data at daily frequency for all the assets. You are, however, free to
choose the start and end date of the sample. Requirements A) You are
required to test for stationarity of the data using appropriate unit-root tests,
test for cointegration and establish that there is a long-run relation between
the asset pairs.
B) Present and briefly discuss the parameters of the five cointegrating models
between five pairs of assets C) Design pair-trading strategy for all the five
pairs of assets based on the cointegrating model estimated in the above
question and evaluate the profitability of the strategy.
(20 Marks, 600 words approximately)
Question 5 (20 Marks)
Estimate Error Correction Models (ECMs) between the five pairs of assets that
you have identified in Question 4 and answer following:
A) Explain the short- and the long-run relationship between the identified five
pairs of assets. B) Comment on the speed at which the long-run relationship
between these five pairs of assets is corrected. (20 Marks, 1000 words
approximately)