Paper: arXiv 2302.07935

Authors: Victor Olkhov

Abstract

This paper describes the dependence of market-based statistical moments of returns on statistical moments and correlations of the current and past trade values. We use Markowitz’s definition of value weighted return of a portfolio as the definition of market-based average return of trades during the averaging period. Then we derive the dependence of market-based volatility and higher statistical moments of returns on statistical moments, volatilities, and correlations of the current and past trade values. We derive the approximations of the characteristic function and the probability of returns by a finite number q of market-based statistical moments. To forecast market-based average and volatility of returns at horizon T, one should predict the first two statistical moments and correlation of current and past trade values at the same horizon. We discuss the economic reasons that limit the number of predicted statistical moments of returns by the first two. That limits the accuracy of the forecasts of probability of returns by the accuracy of the Gaussian approximations. To improve the reliability of large macroeconomic and market models like BlackRock’s Aladdin, JP Morgan, and the U.S. Fed., the developers should use market-based statistical moments of returns.

Complexity vs Empirical Score

  • Math Complexity: 6.5/10
  • Empirical Rigor: 2.5/10
  • Quadrant: Lab Rats — theoretically deep, empirically untested

Why this score: The paper presents a rigorous theoretical framework deriving market-based statistical moments and characteristic functions based on Markowitz’s definition. However, it lacks robust empirical testing, empirical validation, or backtesting on real-world market datasets.

Research Flowchart

  flowchart TD
    A[Research Goal: Derive Market-Based Probability & Moments of Returns] --> B[Input: Current & Past Trade Values, Volatilities, & Correlations]
    B --> C[Methodology: Apply Markowitz Value-Weighted Portfolio Return Definition]
    C --> D[Mathematical Derivation: Moments & Characteristic Function of Returns]
    D --> E[Approximation: Predict 1st & 2nd Moments for Horizon T Forecasts]
    E --> F[Findings: Gaussian Bounds Limit Return Accuracy; Recommends Updating Macro-Models e.g., Aladdin]