Investment Strategy Using Returns Transmission Effects

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 returns 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.

B) Calculate the overall return from your strategy for the entire period of the analysis.

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).

B) Discuss the obtained results by commenting on the profitability of the strategy, its risk and the stability of the returns.

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:

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.  

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.

Question 5

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.

Where coursework is submitted without approval, after the published hand-in deadline, the following penalties will apply.

For coursework submitted up to 1 working day (24 hours) after the published hand-in deadline without approval, 10% of the total marks available for the assessment (i.e.100%) shall be deducted from the assessment mark.

For clarity: a late piece of work that would have scored 65%, 55% or 45% had it been handed in on time will be awarded 55%, 45% or 35% respectively as 10% of the total available marks will have been deducted.

The Penalty does not apply to Pass/Fail Modules, i.e. there will be no penalty for late submission if assessments on Pass/Fail are submitted up to 1 working day after the published hand-in deadline.

Coursework submitted more than 1 working day (24 hours) after the published hand-in deadline without approval will be regarded as not having been completed. A mark of zero will be awarded for the assessment and the module will be failed, irrespective of the overall module mark.