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Least Squares Predictions and Mean-Variance Analysis

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  • Enrique Sentana

Abstract

We compare the Sharpe ratios of traders who combine one riskless and one risky asset following (i) buy and hold strategies; (ii) timing strategies with forecasts from simple; or (iii) multiple regressions; and (iv) passive allocations of (i) and (ii) with mean-variance optimizers. We show that (iv) implicitly uses the linear forecasting rule that maximizes the Sharpe ratio of managed portfolios, but the remaining rankings are unclear. We also suggest generalized method of moments (GMM) estimators to make (iv) operational and evaluate their significance with spanning tests. Finally, we characterize the equivalence between (iii) and (iv), and propose moment tests to assess it. Copyright 2005, Oxford University Press.

Suggested Citation

  • Enrique Sentana, 2005. "Least Squares Predictions and Mean-Variance Analysis," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 3(1), pages 56-78.
  • Handle: RePEc:oup:jfinec:v:3:y:2005:i:1:p:56-78
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbi002
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    References listed on IDEAS

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    1. Hansen, Lars Peter & Richard, Scott F, 1987. "The Role of Conditioning Information in Deducing Testable," Econometrica, Econometric Society, vol. 55(3), pages 587-613, May.
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    3. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
    4. Chen, Zhiwu & Knez, Peter J, 1996. "Portfolio Performance Measurement: Theory and Applications," Review of Financial Studies, Society for Financial Studies, vol. 9(2), pages 511-555.
    5. Arellano, Manuel, 1989. "On the efficient estimation of simultaneous equations with covariance restrictions," Journal of Econometrics, Elsevier, vol. 42(2), pages 247-265, October.
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    Cited by:

    1. Davide Pettenuzzo & Francesco Ravazzolo, 2016. "Optimal Portfolio Choice Under Decision‐Based Model Combinations," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 31(7), pages 1312-1332, November.
    2. Patton, Andrew J. & Timmermann, Allan, 2007. "Properties of optimal forecasts under asymmetric loss and nonlinearity," Journal of Econometrics, Elsevier, vol. 140(2), pages 884-918, October.
    3. Peñaranda, Francisco & Sentana, Enrique, 2012. "Spanning tests in return and stochastic discount factor mean–variance frontiers: A unifying approach," Journal of Econometrics, Elsevier, vol. 170(2), pages 303-324.
    4. Enrique Sentana, 2009. "The econometrics of mean-variance efficiency tests: a survey," Econometrics Journal, Royal Economic Society, vol. 12(3), pages C65-C101, November.
    5. Patton, Andrew J & Timmermann, Allan G, 2003. "Properties of Optimal Forecasts," CEPR Discussion Papers 4037, C.E.P.R. Discussion Papers.
    6. René Garcia & Éric Renault & Georges Tsafack, 2007. "Proper Conditioning for Coherent VaR in Portfolio Management," Management Science, INFORMS, vol. 53(3), pages 483-494, March.
    7. Penaranda, Francisco, 2007. "Portfolio choice beyond the traditional approach," LSE Research Online Documents on Economics 24481, London School of Economics and Political Science, LSE Library.

    More about this item

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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