Smoothing and de-smoothing of returns

Prof. Jayanth R. Varma

Desmoothing when smoothing parameter is known

Smoothing model
Rt = smoothed return at time t
Rt = true return
Rt = (1 )Rt + Rt1
Var(R) = (1 )2 Var(R ) + 2 Var(R) =

Desmoothing
Rt Rt1 = (1 )Rt or
Rt Rt1
.
Rt =
1
(1 )2
Var(R )
1 2

(1 )2
0.04
1
=
= = 0.1111. The true variance is greater than the observed variance by a
2
1
0.36
9
factor of 9 while the true standard deviation will be greater by a factor of 3
If = 0.8,

How to estimate the smoothing parameter ?

Assume market efficiency
In an efficient market (random walk hypothesis), returns should have no serial correlation. In this case,
we should desmooth the observed returns with equal to the autocorrelation of the observed returns.
This is because if the true return has zero autocorrelation and it is smoothed with smoothing
parameter , then the autocorrelation of the smoothed return Rt is .
Cov(Rt , Rt1 ) = Cov((1 )Rt + Rt1 , Rt1 ) = Var(R)
where we use the fact that Rt is uncorrelated with Rs for s < t and is therefore also uncorrelated with
Rs for s < t.
Rt Rt1
We shall let R denote the series obtained by desmoothing with = . Rt =
or
1
Rt = (1 )Rt + Rt1 where is the auto correlation of the observed return.
Even if the true return is itself an autoregressive process (the random walk hypothesis is violated), the
series R is useful because it has zero autocorrelation as seen below.

)
Cov(Rt , Rt1

=
=
=

Cov(Rt Rt1 , Rt1 Rt2 )

(1 )2
1
[Cov(Rt , Rt1 ) Cov(Rt , Rt2 ) Cov(Rt1 , Rt1 ) + 2 Cov(Rt1 , Rt2 )]
(1 )2
Var(R)
[ 3 + 3 ] = 0
(1 )2

where we have used the fact that Cov(Rt , Rt2 ) = 2 (exponential decline of the autocorrelations of
higher order for any autoregressive process).

Replicate the estimated volatility of the asset

It is often desired to choose an to match some estimate of the volatility of the true returns. For
example, in case of real estate, the estimated volatility can be half of equities or average of stocks and
bonds or survey expectations of risk relative to equities/bonds. The required to replicate a desired
volatility can be obtained by trial and error or by solving a non linear equation as shown below.
Rt Rt1
Suppose the true return is given by Rt =
for 6= .
1
Rt Rt1 = (1 )Rt + Rt1 Rt1 = (1 )Rt + ( )Rt1 .
1

Var(Rt ) =

(1 )2 Var(Rt ) + ( )2 Var(Rt1 )
(1 )2

where we use the fact that Rt is uncorrelated with Rs for s < t and is therefore also uncorrelated with
Rs for s < t.
Let 2 denote the variance of the observed smoothed returns (Rt ), 2 be the variance of the artificial
uncorrelated (random walk) series (Rt ) and 2 be the variance of the true returns (Rt ). We then have
(1 )2 2 + ( )2 2
(1 )2 2

2
2 =
.
Since
R
=
(1

)R
+
R
,
it
is
seen
that

=
. We
t
t1
t
(1 [)2
1 2
]
2
2
2
2
2
2

(1 ) (1 )

1 + 2
1 + 2
. We have
get 2 =
+ ( )2 or 2 =
=
2
2
2
(1 )
(1 )

(1 )
1 + 2 2
obtained a non linear equation for in terms of the known or assumed variances 2 and 2 and the
known autocorrelation . This equation can be solved numerically.
( )(1 )
The autocorrelation of R is
as computed below.
1 + 2 2

Cov(Rt , Rt1
) =

=
=

1
Cov((1 )Rt + ( )Rt1 , Rt1 Rt2 )
(1 )2
( ) 2 ( ) 2
( )(1 ) 2
=

(1 )2
(1 )2
( )(1 ) (1 )2
( )(1 ) 2
2 =

(1 )2
1 + 2 2
1 + 2 2

Other Methods of estimating

1. Replicate or maximise correlations to other assets: In case of real estate for example, we may
solve for that maximizes the correlation with listed property (REIT) which is assumed to be
free of smoothing biases.
2. Replicate professional asset portfolios which are assumed to be efficient: This is a reverse
optimization problem to find the which produce variance and covariance estimates that
generate optimal portfolios that are closest to observed portfolios.

Numerical Simulation
Given below are the results of simulating 5,000 returns from a normal distribution with = 10 and
= 0.75, and desmoothing these returns with = 0.4):

9.995

12.411

26.168

0.756

0.445

0.000

For comparison, the theoretical values using the formulas derived earlier are:

10.000

12.472

26.458

0.750

0.437

0.000

Note:
is the standard deviation and is the autocorrelation of the observed return series without any
desmoothing
is the standard deviation and is the autocorrelation of the true return series obtained by
desmoothing with = 0.50
is the standard deviation and is the autocorrelation of the random walk series obtained by
desmoothing with = .