Detecting and Measuring Nonlinearity
This paper proposes an approach to measure the extent of nonlinearity of the exposure of a financial asset to a given risk factor. The proposed measure exploits the decomposition of a conditional expectation into its linear and nonlinear components. We illustrate the method with the measurement of t...
| Main Author: | |
|---|---|
| Format: | Article |
| Language: | English |
| Published: |
MDPI AG
2018-08-01
|
| Series: | Econometrics |
| Subjects: | |
| Online Access: | http://www.mdpi.com/2225-1146/6/3/37 |
| Summary: | This paper proposes an approach to measure the extent of nonlinearity of the exposure of a financial asset to a given risk factor. The proposed measure exploits the decomposition of a conditional expectation into its linear and nonlinear components. We illustrate the method with the measurement of the degree of nonlinearity of a European style option with respect to the underlying asset. Next, we use the method to identify the empirical patterns of the return-risk trade-off on the SP500. The results are strongly supportive of a nonlinear relationship between expected return and expected volatility. The data seem to be driven by two regimes: one regime with a positive return-risk trade-off and one with a negative trade-off. |
|---|---|
| ISSN: | 2225-1146 |