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Macroeconomic state variables as determinants of asset price covariances

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  • John Ammer
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    Abstract

    This paper explores the possible advantages of introducing observable state variables into risk management models as a strategy for modeling the evolution of second moments. A simulation exercise demonstrates that if asset returns depend upon a set of underlying state variables that are autoregressively conditionally heteroskedastic (ARCH), then a risk management model that fails to take account of this dependence can badly mismeasure a portfolio's "Value-at-Risk" (VaR), even if the model allows for conditional heteroskedasticity in asset returns. Variables measuring macroeconomic news are constructed as the orthogonalized residuals from a vector autoregression (VAR). These news variables are found to have some explanatory power for asset returns. We also estimate a model of asset returns in which time variation in variances and covariances derives only from conditional heteroskedasticity in the underlying macroeconomic shocks. Although the data give some support for several of the specifications that we tried, neither these models nor GARCH models that used only asset returns appear to have much ability to forecast the second moments of returns. Finally, we allow asset return variances and covariances to depend directly on unemployment rates -- proxying for the general state of the economy -- and find fairly strong evidence for this sort of specification relative to a null hypothesis of homoskedasticity.

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    File URL: http://www.federalreserve.gov/pubs/ifdp/1996/553/default.htm
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    File URL: http://www.federalreserve.gov/pubs/ifdp/1996/553/ifdp553.pdf
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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 553.

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    Date of creation: 1996
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    Publication status: Published in Risk measurement and systemic risk: joint central bank research conference (1995: November 16-17)
    Handle: RePEc:fip:fedgif:553

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    Related research

    Keywords: Asset-liability management;

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    1. Chan, K. C. & Karolyi, G. Andrew & Stulz, ReneM., 1992. "Global financial markets and the risk premium on U.S. equity," Journal of Financial Economics, Elsevier, vol. 32(2), pages 137-167, October.
    2. Bollerslev, Tim, 1986. "Generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 31(3), pages 307-327, April.
    3. Chen, Nai-Fu & Roll, Richard & Ross, Stephen A, 1986. "Economic Forces and the Stock Market," The Journal of Business, University of Chicago Press, vol. 59(3), pages 383-403, July.
    4. Anthony P. Rodrigues, 1995. "Why do volatilities sometimes move together?," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 123-146.
    5. Campbell, J.Y. & Ammer, J., 1991. "What Moves The Stock And Bond Markets? A Variance Decomposition For Long- Term Asset Returns," Papers 127, Princeton, Department of Economics - Financial Research Center.
    6. John Ammer, 1993. "Macroeconomic risk and asset pricing: estimating the apt with observable factors," International Finance Discussion Papers 448, Board of Governors of the Federal Reserve System (U.S.).
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