Return Forecasting by Quantile Regression QWAFAFEW December 20101 Larry Pohlman and Lingjie M Outline • • • • The Math Examples Multivariate Model Results 2 The Math and Code y Xb u • Model • OLS Estimation • QR Estimation ˆ OLS T 2 minb ( y i xi b) T T ˆ QR minb ( yi xi b) ( 1)( yi xi b) yi xiT yi xiT b • R, S+, Stat, SAS 3 What does QR do? Sample Quantile: Fy P robY y , Q f y : Fy , 0,1 Conditional Quantile: y xT β ( xT δ )u Fy1 x xT xT Fu1 () Qy x xT ( Fu1 ()) xT 4 Example: Book to Price 5 Why QR? A natural question is under what conditions will QR be “better” than OLS? 1. Full picture view: heterogeneity If there is heterogeneity, then QR will provide a more complete view of the relationship between variables through the effects of independent variables across quantiles of the response distribution. 2. Robustness: fat-tail distribution If the conditional return distribution is not Gaussian but fat-tailed, the QR estimates will be more robust and efficient than the conditional mean estimates 6 Example Price Momentum 7 Example Return on Equity 8 Multivariate Model • • • • • • • Book to Price Earnings to Price Cashflow to Enterprise Value Balance sheet Accruals Return on Equity Price Momentum (9 months) Earnings Momentum (9 months) 9 Model Variable Plots 10 Results: Equal Weight Quintiles 11 Results: Cap Weighted Qunitiles 12 Optimized Portfolios TE=3% 13 Optimized Portfolios TE=6% 14 Conclusion ■Conditional mean method is still attractive ■QR provides a full-picture distributional view ■Link between distribution estimates and point portfolio. 15