Asset Price & Volatility Behavior and Predictability

Mads Bruun-Simonsen & Simon Karim Helledie

Student thesis: Master thesis

Abstract

This paper discusses market movements and the behavior and volatility of such. The EMH has been challenged severely in acknowledgeable research, however, no indicative consensus about the degree of efficiency on asset price movements has been reached. This paper presents anomalies of all degrees of efficiency and investigates the Fama & French factor models and if asset price predictability is possible by analyzing the stochastic process out-of-sample. This paper examines if including a fourth factor, a volatility factor, through a cross-sectional approach can improve the predictability and explanation of the model. The volatility’s behavior is thus discussed and estimated through the BlackScholes-Merton-, GARCH(1,1), and SABR models to obtain a proxy for the true volatility measure used to deduce our factor. The SABR model, estimated conventionally and unconventionally, yields comparatively tremendous fits, and accurately describes the actual volatility process, even if the option chain is lacking, furthermore, yields robust parameters through time. The VOL factor attempts to capture human biases and irrationalities, by including a risk premium regarding implied volatility, following the Fama and French methodology. The findings suggest a significant relationship between the VOL factor, introduced in this paper, and the return it is tested on, both in a rolling regression and cross-sectional regression in addition to improving the explanatory power of the 3-factor model made by Fama and French.

EducationsMSc in Accounting, Strategy and Control, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2021
Number of pages129