Sparse economic scenarios

54 Pages Posted: 22 Mar 2019 Last revised: 6 Aug 2021

See all articles by Paul Schneider

Paul Schneider

University of Lugano - Institute of Finance; Swiss Finance Institute

Date Written: March 22, 2019

Abstract

We propose a low-dimensional scenario tree representation of distributions of financial asset prices. For intertemporal distributions, the scenarios and their martingale probabilities become time-varying persistent factors that naturally accommodate a nonparametric model for the corresponding physical probabilities. In the S&P 500 index market, two to four time-varying scenarios generate sizable out-of-sample predictability. Together, the low-dimensional physical and risk-neutral conditional distributions yield the simplest possible mechanism describing how risk-neutral variance, expected returns, and the variance risk premium are linked. Multivariate low-dimensional scenarios identify cluster risk in its most parsimonious form.

Keywords: options, dimension reduction, factor model, moment problem, scenario analysis, machine learning, RKHS

JEL Classification: G13, G02, G17, C02, C14, C46, C52, C53

Suggested Citation

Schneider, Paul Georg, Sparse economic scenarios (March 22, 2019). Swiss Finance Institute Research Paper No. 19-17, Available at SSRN: https://ssrn.com/abstract=3358388 or http://dx.doi.org/10.2139/ssrn.3358388

Paul Georg Schneider (Contact Author)

University of Lugano - Institute of Finance ( email )

Via Buffi 13
CH-6900 Lugano
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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