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A technical note on auto-regressive unsmoothing methods

By Nerone M. de Brito Jr.

Citigroup Alternative Investments/Quantitative Research Group
Date: 09/15/2006
Intuition and Major Hypothesis:
The smoothed price (appraisal value) observed today is a weighted average function of the economic
and unobserved (unsmoothed) price today and the smoothed prices (appraised values) observed in
previous periods.
Mathematically, we have:

i 1

i 1

Pt S (1 wi )PtU wi Pt S i


Pt S = Observed Smoothed price at time t

PtU = Unobserved Unsmoothed price at time t
wi = Weight applied to lag i observed price
p = number of lags
Taking first differences in equation (1) and transforming into returns, we have:

i 1

i 1

RtS (1 wi )RtU wi RtSi

where all R variables denote the returns analogous to the price definitions above.
Note the resemblance of equation (2) to the auto-regressive process AR(p) for Rt , which has the


RtS i RtSi ~t
i 1

Comparing equations (2) and (3) we have:


wi i for all i and

(1 w )R U ~

i 1

Equation (3) can be estimated using traditional time-series estimation techniques (OLS, MLE 1). Once
we get the estimates for the lag coefficients i , we can use equations (2) to (5) to recover the
unobserved unsmoothed returns

RtU from the observed smoothed returns RtS . After some algebraic

manipulation, we arrive at the formula for the new unsmoothed return series:



RtS i RtSi
i 1

(1 i )
i 1

For estimation of time-series models please refer to Hamiltons Time Series Analysis book. See
References at the end of the article


Note that the weighted average assumption of the model implies that for time-series with considerable
number of observations, the process for the unsmoothed returns under equation (6) is mean preserving.
So, it can be shown that:

E ( RtU )

E ( RtS ) i E ( RtSi )
i 1

(1 i )

(1 i ) E ( RtS )

i 1


i 1

(1 i )

E ( RtS )

i 1


plim E ( RtS ) plim E ( RtSi ) E ( RtS ) for any i T


By applying the variance operator to (3) while using the relationships in (4) and (5), one can arrive at a
formulation for the variance of the unsmoothed series. However, an analytical formula to the variance
of the unsmoothed series can become cumbersome for increasing lags (p). Hence, the most practical
way to calculate the variance and volatility is to use the recursive formula (6) to estimate the
unsmoothed series and then numerically estimate variance and volatility. A tractable formula for
variance can be provided for an AR(1) unsmoothing process. If we apply variance to (3), we arrive at:

Equation (7) implies that the volatility of the AR(1) unsmoothed series scales the volatility of the
smoothed return series by

1 12
(1 1 ) 2

Blundell, G., Ward, 1987, Property Portfolio Allocation, Land Development Studies 4, pp. 145-56
Quan, Daniel C.; Quigley, John M.; Follain, James R, 1989, Inferring An Investment Return Series
For Real Estate Form. AREUEA Journal; v.17, 2; pg. 218
Muhlhofer, T., 2004, Income vs. Appreciation: The Investment Value of Real Estate Investment
Trusts, Working Paper, London School of Economics
Hamilton, J. 1994, Time Series Analysis, Princeton University Press
Cochrane, J., 2005, Time Series Analysis for Macroeconomics and Finance, Graduate School of
Business, The University of Chicago
Scherer, B., 2003, Portfolio Construction and Risk Budgeting, Risk Books