The Basics of Financial Econometrics: Tools, Concepts, and Asset Management Applications

CHAPTER 15

Formulating and Implementing Investment Strategies Using Financial Econometrics

After reading this chapter you will understand:

• The financial econometrics research aspect of the quantitative research process.
• The purpose of using financial econometric tools is to identify any persistent pattern in financial data and convert that information into implementable and profitable investment strategies.
• The three phases of the quantitative research process: (1) develop an ex ante justification based on financial economic theory, (2) select a survivorship-free sample, and (3) estimate a parameter-free model.
• Common fallacies in the use of financial econometrics to develop investment strategies.
• Considerations in deciding on which and how many explanatory variables should be included in a financial econometrics model.
• Why in attempting to identify profitable investment strategies there is concern with overmining of data.
• The pitfalls of using insufficient data.
• Why a safeguard against data snooping is to scrutinize the model once through time.
• Why after developing a strategy based on some financial econometric model it is always prudent to test the model against an artificial data set.

In Chapters 3 and 4, we explained how to build, diagnose, and test a multiple linear regression model. In this chapter, we provide a blueprint as to how to apply financial econometrics to quantitative asset management. The objective of quantitative asset management is to identify any persistent ...