Kinetic Component Analysis

24 Pages Posted: 8 Apr 2014 Last revised: 8 Aug 2016

Marcos Lopez de Prado

AQR Capital Management, LLC; Cornell University - Operations Research & Industrial Engineering; RCC - Harvard University

Riccardo Rebonato

University of Oxford - Mathematical Institute

Date Written: May 12, 2014

Abstract

We introduce Kinetic Component Analysis (KCA), a state-space application that extracts the signal from a series of noisy measurements by applying a Kalman Filter on a Taylor expansion of a stochastic process. We show that KCA presents several advantages compared to other popular noise-reduction methods such as Fast Fourier Transform (FFT) or Locally Weighted Scatterplot Smoothing (LOWESS): First, KCA provides band estimates in addition to point estimates. Second, KCA further decomposes the signal in terms of three hidden components, which can be intuitively associated with position, velocity and acceleration. Third, KCA is more robust in forecasting applications. Fourth, KCA is a forward-looking state-space approach, resilient to structural changes. We believe that this type of decomposition is particularly useful in the analysis of trend-following, momentum and mean-reversion of financial prices.

An instrument exhibits financial inertia when its price acceleration is not significantly greater than zero for long periods of time. Our empirical analysis of 19 of the most liquid futures worldwide confirms the presence of strong inertia across all asset classes. We also argue that KCA can be useful to market makers, liquidity providers and faders for the calculation of their trading ranges.

Keywords: Kinetic Component Analysis, Time Series, Principal Component Analysis, LOWESS, Fourier Analysis, Kalman Filter

JEL Classification: G0, G1, G2, G15, G24, E44

Suggested Citation

López de Prado, Marcos and Rebonato, Riccardo, Kinetic Component Analysis (May 12, 2014). Available at SSRN: https://ssrn.com/abstract=2422183 or http://dx.doi.org/10.2139/ssrn.2422183

Marcos López de Prado (Contact Author)

AQR Capital Management, LLC ( email )

One Greenwich Plaza
Greenwich, CT 06830
United States

HOME PAGE: http://www.aqr.com

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

HOME PAGE: http://www.orie.cornell.edu

RCC - Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

HOME PAGE: http://www.rcc.harvard.edu

Riccardo Rebonato

University of Oxford - Mathematical Institute ( email )

United Kingdom

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