Solutions to the Review Questions at the End of Chapter 12 1.

(a) The scope of possible answers to this part of the question is limited only by the imagination! Simulations studies are useful in any situation where the conditions used need to be fully under the control of the researcher (so that an application to real data will not do) and where an analytical solution to the problem is also unavailable. In econometrics simulations are particularly useful for e!amining the impact of model mis"specification on the properties of estimators and forecasts. #or e!ample what is the impact of ignored structural brea$s in a series upon %&'() model estimation and forecasting* +hat is the impact of several very large outliers occurring one after another on tests for &'()* In finance an obvious application of simulations as well as those discussed in (hapter 1, is to producing -scenarios. for stress"testing ris$ measurement models. #or e!ample what would be the impact on ban$ portfolio volatility if the correlations between /uropean stoc$ indices rose to one* +hat would be the impact on the price discovery process or on mar$et volatility if the number and si0e of inde! funds increased substantially* (b) 1ure simulation involves the construction of an entirely new dataset made from artificially constructed data while bootstrapping involves resampling with replacement from a set of actual data. +hich technique of the two is the more appropriate would obviously depend on the situation at hand. 1ure simulation is more useful when it is necessary to wor$ in a completely controlled environment. #or e!ample when e!amining the effect of a particular mis"specification on the behaviour of hypothesis tests it would be inadvisable to use bootstrapping because of course the boostrapped samples could contain other forms of mis" specification. (onsider an e!amination of the effect of autocorrelation on the power of the regression F"test. 2se of bootstrapped data may be inappropriate because it violates one or more other assumptions 3 for e!ample the data may be heteroscedastic or non"normal as well. If the bootstrap were used in this case the result would be a test of the effect of several mis"specifications on the F"test! 4ootstrapping is useful however when it is desirable to mimic some of the distributional properties of actual data series even if we are not sure quite what they are. #or e!ample when simulating future possible paths for price series as inputs to ris$ management models or option prices bootstrapping is useful. In such instances pure simulation would be less appropriate since it would bring with it a particular set of assumptions in order to simulate the data 3 e.g. that returns are normally distributed. To the e!tent that these assumptions are not supported by the real data the simulated option price or ris$ assessment could be inaccurate. (c) 5ariance reduction techniques aim to reduce 6onte (arlo sampling error. In other words they see$ to reduce the variability in the estimates of the quantity of interest across different e!periments rather li$e reducing the standard errors in a regression model. This either ma$es 6onte (arlo simulation more accurate for a given number of replications ma$ing the

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Introductory Econometrics for Finance Chris Brooks 2008

answers more robust or it enables the same level of accuracy to be achieved using a considerably smaller number of replications. The two techniques that were discussed in (hapter 1, were antithetic variates and control variates. 6athematical details were given in the chapter and will therefore not be repeated here. &ntithetic variates try to ensure that more of the probability space is covered by ta$ing the opposite (usually the negative) of the selected random draws and using those as another set of draws to compute the required statistics. (ontrol variates use the $nown analytical solutions to a similar problem to improve accuracy. 7bviously the success of this latter technique will depend on how close the analytical problem is to the actual one under study. If the two are almost unrelated the reduction in 6onte (arlo sampling variation will be negligible or even negative (i.e. the variance will be higher than if control variates were not used). (d) &lmost all statistical analysis is based on -central limit theorems. and -laws of large numbers.. These are used to analytically determine how an estimator will behave as the sample tends to infinity although the behaviour could be quite different for small samples. If a sample of actual data that is too small is used there is a high probability that the sample will not be representative of the population as a whole. &s the sample si0e is increased the probability of obtaining a sample that is unrepresentative of the population is reduced. /!actly the same logic can be applied to the number of replications employed in a 6onte (arlo study. If too small a number of replications is used it is possible that -odd. combinations of random number draws will lead to results that do not accurately reflect the data generating process. This is increasingly unli$ely to happen as the number of replications is increased. 1ut another way the whole probability space will gradually be appropriately covered as the number of replications is increased. (e) (omputer generated (-pseudo".) random numbers are not random at all but are entirely deterministic since their generation e!actly follows a formula. In intuitive terms the way that this is done is to start with a number (a -seed. usually chosen based on a numerical representation of the computer8s cloc$ time) and then this number is updated using modular arithmetic. 1rovided that the seed and the other required parameters that control how the updating occurs are set carefully the pseudo"random numbers will behave almost e!actly as true random numbers would. (f) Simulation methods are particularly useful when an analytical solution is unavailable 3 for e!ample for many problems in econometrics or for pricing e!otic options. In such cases they may be the only approach available. )owever in situations where analytical results are available simulations have several disadvantages. #irst simulations may require a great deal of computer power. There are still many problems in econometrics that are unsolvable even with a brand new supercomputer! The problems seem to grow in dimension and comple!ity at the same rate as the power of computers!

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Introductory Econometrics for Finance Chris Brooks 2008

Second simulations may be inaccurate if an insufficient number of replications are used. /ven if variance reduction techniques are employed the required number of replications to achieve acceptable accuracy could be very large. This is especially true in the case of simulations that require accurate estimation of e!treme or -tail. events. #or e!ample the pricing of deep out of the money options is difficult to do accurately using simulation since most of the replications will give a 0ero value for the option. /qually it is difficult to measure the probability of crashes or to determine 19 critical values accurately. Third a corollary of the second point is that simulations by their very nature are difficult to replicate. The random draws used for simulations are usually calculated based on a random number seed that is set according to the cloc$ time of the computer. So run two simulations one ten minutes after the other and you will get two completely different sets or random draws. 7bviously again this problem would disappear if enough replications are used but the required number of replications may be infeasibly large. #inally there is a real danger that the results of a 6onte (arlo study will be specific to the particular sets of parameters investigated. &n analytical result on the other hand if available may be generally applicable. The answer given below for question : shows that for a multi"dimensioned problem a lot of wor$ is required to do sufficient e!periments to ensure that the results are sufficiently general. ;. &lthough this is a short question a good answer would be quite involved. 'ecall the null and alternatives for the <=ung"4o! (<4) test> ),> 1 ? , and ; ? , and @ and m ? , ),> 1 , or ; , or @ or m , The question does not state the number of lags that should be used in the <4 test so it would be advisable to design a framewor$ that e!amined the results using several different lag lengths. I assume that lag lengths m ? 1 A and 1, are used for sample si0es T ? 1,, A,, 1,,,. 1robably the easiest way to e!plain what would happen is using pseudo"code. I have written a single set of instructions that would do the whole simulation in two goes although it is of course possible to separate it into several different e!periments (e.g. one for si0e and a separate one for power and separate e!periments for each sample si0e etc). 1art 1> Simulation with no %&'() as benchmar$. 1. %enerate a sample of length T from a standard normal distribution 3 call these draws ut. The si0e of a test is e!amined by using a B%1 that is correct under the null hypothesis 3 in this case we want a series that is not autocorrelated. Thus the data for e!amination would be ut. Set xt ? ut to avoid any later confusion.

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Introductory Econometrics for Finance Chris Brooks 2008

The power of the test would be e!amined by using a B%1 that is wrong under the null hypothesis. 7bviously the power of the test should increase as the null becomes more wrong. To evaluate the power of the test generate the following data> yt ? yt"1 C ut with ? ,.1 ,.A and ,.D (assume y, ? , in each case). ;. #or each sample of xt and yt construct the <=ung"4o! test for each lag length m and perform the test. :. 'epeat steps 1 and ; N times where N is the number of replications. &ssume that N has been set to 1, ,,,. The si0e of the test will be given by the percentage of times that the null hypothesis on xt is correctly not re=ected. The power of the test will be given by the percentage of times that the null on yt is correctly re=ected. 1art ;> Simulation with %&'(). 'epeat steps 1 to : above e!actly but generate the data so that ut follows a %&'()(1 1) process. This would be achieved given that ut has been drawn. Some parameters for the %&'() process would have to also be assumed. #or xt use the equations>

t; ? ,.,,,1 C ,.1xt"1; C ,.Dt"1; with ,; ? ,.,,1. xt ? tut

and for yt>

t; ? ,.,,,1 C ,.1xt"1; C ,.Dt"1; with ,; ? ,.,,1. yt ? yt"1 C tut

#inally the effect of %&'() would be investigated by comparing the si0e and power under parts 1 and ;. If the si0e increases from its nominal value or the power falls when the %&'() is added it would be concluded that %&'() does have an adverse effect on the <4 test. :. (a) This would be a very easy simulation to do. The first thing would be to choose the appropriate values of to use. It would be tempting to choose a spread of values say from , to 1 in units of ,.; (i.e. , ,.; .. ,.D 1) but this would not be optimal since all of the interesting behaviour will occur when gets close to 1. Therefore the values are better s$ewed towards 1 e.g. , ,.A ,.D ,.E ,.EA ,.EE and 1. This gives F values of which should give the flavour of what happens without the results being overwhelming or the e!ercise becoming too tedious.

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Introductory Econometrics for Finance Chris Brooks 2008

Gote that the question says nothing about the sample si0es to use and in fact the impact of a unit root (i.e. ? 1) will not disappear asymptotically. & good researcher however would choose a range of sample si0es that are empirically relevant (e.g. 1,, A,, and ;,,, observations) and would conduct the simulation using all of them. &ssuming that a sample si0e of A,, is used the ne!t step would be to generate the random draws. & good simulation would generate more than A,, draws for each replication to allow for some start"up observations that are later discarded. &gain nothing is stated in the question about what distribution should be used to generate the random draws. 2nless there is a particular reason to do otherwise (for e!ample if the impact of fat tails is of particular importance) it is common to use a standard normal distribution for the disturbances. +e also need to select a starting value for y 3 call this y1 and set this starting value to 0ero (note> the reason why we allow for start"up observations is to minimise the impact of this choice of initial value for y). 7nce a set of disturbances are drawn and the initial value for y is chosen the ne!t stage is to recursively construct a series that follows the required &'(1) model> y; ? y1 C u; y: ? y; C u:

yA,, = yHEE + uA,, The ne!t stage would be to estimate an &'(1) and to construct and save the t" ratios on the coefficient for each replication. Gote that this estimated regression should include an intercept to allow for a simulated series with a non"0ero mean even though y has a 0ero mean under the B%1. It is probably sensible and desirable to use the same set of random draws for each e!periment that has different values of . 1roducing the /5iews or '&TS code for this problem is left for readers and should not be difficult given the e!amples in the chapter! )owever some pseudo"code could be S/T G264/' 7# '/1S S/T S&61</ SII/ S/T 5&<2/S 7# 1)I 3 (&<< T)/6 1)I1 T7 1)IF (</&' &''&JS #7' J 2S/B #7' /&() 5&<2/ 7# 1)I 3 J1 T7 JF S/T IGITI&< 5&<2/S #7' T)/ J8S T7 I/', 3 J1(1)?, J;(1)?, /T( ST&'T '/1<I(&TI7GS <771 %/G/'&T/ '&GB76 B'&+S 2 #7' S&61</ SII/ 1<2S ;,, ST&'T"21 74S/'5&TI7GS ST&'T '/(2'SI5/ J %/G/'&TI7G <771 +IT) K?; J1(K)?1)I1LJ1(K"1)C2(K) J;(K)?1)I;LJ;(K"1)C2(K) J:(K)?1)I:LJ:(K"1)C2(K) JH(K)?1)IHLJH(K"1)C2(K) JA(K)?1)IALJA(K"1)C2(K) "/6 Introductory Econometrics for Finance Chris Brooks 2008

JM(K)?1)IMLJM(K"1)C2(K) JF(K)?1)IFLJF(K"1)C2(K) /GB J %/G/'&TI7G <771 '2G & <IG/&' '/%'/SSI7G 7# J1 7G & (7GST&GT &GB T)/ <&%%/B 5&<2/ 7# J1 &GB '/1/&T T)IS #7' /&() 7# J; J: /T( S&5/ T)/ S<71/ (7/##I(I/GT T"'&TI7S &GB ST7'/ T)/S/ /GB '/1<I(&TI7GS <771 This will yield a set of estimated t"ratios for each of the values of . These could be plotted or summarised as desired. (b) The broad structure of the appropriate simulation for part (b) would be similar to that for part (a) but there is now the added dimension of the si0e of the sample for each replication. This is therefore a multi"dimensioned problem> we want to produce a simulated series for each value of and for each sample si0e. The easiest way to achieve this if the answer to part (a) had already been constructed would be to run separate simulations as above for different sample si0es. Gote also that in part (b) it is the estimated values of the coefficients rather than their t"ratios that are of interest. +hat we would e!pect is that the average of the estimates across the replications would converge upon their actual value as the sample si0e increases. H. &gain this is a fairly simple e!ercise given the code that was presented in the chapter. &ll that is required is to add a clause in to the recursive generation of the path of the underlying asset to say that if the price at that time falls below the barrier then the value of the $noc$"out call for that replication is 0ero. It would also save computational time if this clause also halted the simulation of the path for that replication and went straight on to the ne!t replication.

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Introductory Econometrics for Finance Chris Brooks 2008