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Preparing for Asset Pricing Research: Econometrics Before Stochastic Calculus

Article Quant Q&A · Author: Sachin
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Summary

The document addresses how a reader with undergraduate probability and statistics can approach an empirical currency risk paper that uses asset pricing concepts such as stochastic discount factors, linear beta pricing, and efficient portfolios. The response characterizes the paper as an asset pricing and econometrics study applied to foreign exchange, rather than a guide to pricing FX options.

It recommends building familiarity with econometrics and statistics, especially stochastic discount factor frameworks and the generalized method of moments, and suggests asset pricing and financial econometrics texts as study paths. The response says stochastic calculus tools such as Itô’s lemma are not required for this paper. These are reading recommendations rather than a replication guide; the answer notes that the paper may be unclear and that product knowledge could still be useful.

Key ideas

  • The paper discussed applies asset pricing econometric methods to currency data.
  • Stochastic discount factors and beta pricing are among the concepts a reader may need to study.
  • The response prioritizes econometrics and statistics over stochastic calculus for this paper.
  • Background in probability and statistics can support further study, with review recommended if those foundations are rusty.
  • The suggested resources provide preparation, but the document does not give a step-by-step replication method.

Tags

ForexStatisticsFixed income
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# Reading Academic Papers in Quantitative Finance


# Reading Academic Papers in Quantitative Finance












I am currently reading a paper from the Journal of Finance, Pricing Currency Risk, by Chernov, Dahlquist, and Lochstoer, as part of a project I am doing. I am coming from a pure math background (at the undergraduate level) and this is my first exposure to these financial concepts. I understand probability theory and statistical inference, but I have not done any stochastic calculus. From what I have been told, I have the prerequisites to be able to understand this paper, however as I am reading I am coming across concepts I have definitely seen before, but am not totally confident dealing with as they are written.

To give an example, the paper seems to assume familiarity with things like Stochastic Discount Factor, Unconditional Linear Beta Pricing Relation, the difference between unconditional and conditional mean variance efficient portfolios, etc...

All of these are things that I can google and get a surface-level understanding of in order to continue reading the paper. However, I am not totally comfortable with these concepts. I can read the definitions, search a little bit about them, but not have confidence in manipulating these objects or defining them rigorously as I am used to in pure math.

I the paper just way over my head, or is this normal in reading academic research, and should I keep trying to plug along and fill in the gaps as I go?

For context, eventually I am going to try to replicate the results of the paper.

## Answer by Dimitri Vulis (score 4)

https://quant.stackexchange.com/a/85474

I found the paper, edited the question, and added a link to the paper. (I do wish people posting questions would do that.) I haven't read it in detail, but only browsed through it, and frankly it should have been written more clearly.

This paper is not really about FX, but rather about asset pricing, applying to FX the econometric techniques commonly used for other asset classes. So if you look at books about pricing FX options, like Alexander Lipton - Mathematical Methods for Foreign Exchange: A Financial Engineer's Approach, or Iain Clark - Foreign Exchange Option Pricing: A Practitioner's Guide, or Uwe Wystup - FX Options and Structured Products - they will not discuss concepts like a "stochastic discount factor". They're good books about FX options, which is why I mention them, but they're not what you need to read this paper.

You don't need the likes of Itô's lemma for this. Rather, you need to read up on econometrics and statistics. A good start is John Cochrane - Asset Pricing. He discusses a lot SDF framework, and the general method of moments, and the math is rigorous enough for my tastes. The old John Campbell, Andrew Lo, A. Craig MacKinlay - The Econometrics of Financial Markets - is great too. Chapter 8 "Intertemporal Equilibrium Models" starts out with the discussion of SDS. Turan Bali, Robert Engle, and Scott Murray - Empirical Asset Pricing: The Cross Section of Stock Returns - is not as mathematically rigorous, but very practical, and has an interesting discussion of empirically observable anomalies.

If you still remember your undergraduate probability theory / statistics, then you should be able to read an econometrics book, else brush up on probability theory.

I also suggest Dirk Willer, Ram Bala Chandran, Ken Lam - Trading Fixed Income and FX in Emerging Markets: A Practitioner's Guide if you need to understand the product better.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.