Jump Risk, Time-Varying Risk Premia, and Technical Trading Profits

Chenyang Feng and Stephen D. Smith
Federal Reserve Bank of Atlanta
Working Paper 97-17
November 1997

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In this paper we investigate the recently documented trading profits based on technical trading rules in an asset pricing framework that incorporates jump risk and time-varying risk premia. Following Brock, Lakonishok, and LeBaron (1992), we apply popular technical trading rules to the daily S&P 500 index over a long period of time. Trading profits are examined using bootstrap simulation to address distributional anomalies. We estimate a variety of asset pricing models, including the random walk, autoregressive models, a combined jump diffusion model, and a combined model of jump-diffusion and autoregressive conditional heteroscedasticity. Technical trading profits are shown to be statistically significant for the pure diffusion models and autoregressive models, yet become less significant when jump risk is incorporated into the model and virtually disappear for an asset pricing model that incorporates both jump risk and time-varying risk premia. The empirical evidence suggests that technical trading profits could be fair compensation for the risk of price discontinuity as well as time-varying risk premia of asset returns. Alternatively, technical trading profits provide a test of specification of asset pricing models; in this vein the evidence provides support for the incorporation of jump risk into asset pricing models.

JEL classification: G12, G14

Key words: asset pricing, information and market efficiency

The views expressed here are those of the authors and not necessarily those of Providian Financial Corporation, the Federal Reserve Bank of Atlanta, or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Chenyang Feng, Analyst, Credit Group, Providian Financial Corporation, 201 Mission Street, San Francisco, California 94105, 415/278-4107, 415/278-6013 (fax), Chenyang_Feng@ providian.com; and Stephen D. Smith, H. Talmage Dobbs Jr. Chair of Finance, Georgia State University and Visiting Scholar, Federal Reserve Bank of Atlanta, 104 Marietta Street, NW, Atlanta, Georgia 30303-2713, 404/498-8873, 404/498-8810 (fax), stephen.d.smith@atl.frb.org.