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Infering Forward Looking Financial Market Risk Premia from Derivatives Prices

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This paper focuses on a topical and important area of theory and practice ie. The risk premium in financial markets. While there exists a vast amount of research into its behaviour, particularly in US markets, this is largely based on regression based techniques which do not capture well the dynamic and forward looking nature of the risk premium. In this paper the variation of the unobserved risk premium is modelled by a system of stochastic differential equations connected by arbitrage arguments between the spot equity market, the index futures and options on index futures. Although various processes for the dynamic of the risk premium may be considered, we motivate and analyse a mean-reverting form. The diffusion part is specified such that the risk premium remains positive. Since the risk premium is not directly observable, information on it is extracted using an unobserved component state space formulation of the system and filtering methodology. As an initial application of the methodology, the results from daily Australian market data from the SFE over a period of twelve months are presented. The small sample properties of the parameter estimates are also examined by bootstrapping the state space system. It is well known in the filtering literature that the estimation of state space system by Kalman filter is sensitive to the specification of the quantities such as initial state variables and the prior covariance matrix. The paper also carries out approximate sensitivity analysis in this respect.

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File URL: http://www.business.uts.edu.au/qfrc/research/research_papers/rp42.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 42.

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Date of creation: 01 Apr 2000
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Handle: RePEc:uts:rpaper:42

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  1. Bos, T & Newbold, P, 1984. "An Empirical Investigation of the Possibility of Stochastic Systematic Risk in the Market Model," The Journal of Business, University of Chicago Press, vol. 57(1), pages 35-41, January.
  2. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  3. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
  4. Andrew W. Lo, 1986. "Maximum Likelihood Estimation of Generalized Ito Processes with Discretely Sampled Data," NBER Technical Working Papers 0059, National Bureau of Economic Research, Inc.
  5. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  6. R. Bhar & C. Chiarella, 1997. "Transformation of Heath?Jarrow?Morton models to Markovian systems," The European Journal of Finance, Taylor & Francis Journals, vol. 3(1), pages 1-26.
  7. Bollerslev, Tim & Engle, Robert F & Wooldridge, Jeffrey M, 1988. "A Capital Asset Pricing Model with Time-Varying Covariances," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 116-31, February.
  8. Geert Bekaert & Campbell R. Harvey, 1994. "Time-Varying World Market Integration," NBER Working Papers 4843, National Bureau of Economic Research, Inc.
  9. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
  10. 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.
  11. Evans, Martin D D, 1994. " Expected Returns, Time-Varying Risk, and Risk Premia," Journal of Finance, American Finance Association, vol. 49(2), pages 655-79, June.
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