Academic journal article Business: Theory and Practice

Market Price Forecasting and Profitability-How to Tame Random Walk?

Academic journal article Business: Theory and Practice

Market Price Forecasting and Profitability-How to Tame Random Walk?

Article excerpt

Introduction

The main contribution of this financial engineering study is to complexly assess opportunities of the market price directional forecasting of liquid investment instruments and also discuss how to use the possible forecasting improvement for a financial profit making. In this context we identify and discuss the price directional dependency on the past, which is the core of each forecasting, discuss its quantification and also complexly describe the economic situations offering the better directional forecasting. Consequently we discuss and try to quantify the profit realizing opportunities which are logically arising from the directional dependence which has been possibly found. The purpose of this research is also to simplify the difficulties for practitioners due to the complicated theoretical background of this financial market topic. Some effects within the financial markets which are related to the directional dependence can be explained using both the directional and the volatility dependence models. As these models has the different impact on forecasting we also discuss the validity of the models which use the volatility dependence on one hand and the models using the market price directional dependence on the other hand. For such purpose we do the complex simulation of empirically measured financial markets distributions of returns with the usage of the volatility dependence and then study its possible economic interpretation.

While many papers focusing on the construction of optimal portfolio (Markowitz 1952; Sharpe 1963) in this study we try to resolve the problematic of market price directional forecasting of the individual asset. There are many studies on the topic of future price directional dependence. We meet many interesting detailed works, case studies or forecasting tools in the area of the development direction dependence (Fama 1966; Henriksson, Merton 1981; Anatolyev, Gerko 2005; study of the connection of liquidity and market crashes done by Huang, Wang 2010; Tresl, Blatna 2007). Some works are connected to the prediction of business cycles (Pesaran, Timmermann 1995; Birchenhall, Osborn, Sensier 2001; Lillo, Farmer 2004; "Predicting UK Business Cycle Regimes"; Dzikevicius, Vetrov 2012; etc.) or direction of change ideas (Rydberg, Shephard 1999). Market price directional dependence is the base for Technical Analysis which is trying to predict future market price development using geometric shapes inside the historical price charts. We can consider Technical Analysis to be the prediction tool, but its benefit is still under the discussion. Some works indicates that several technical indicators do provide a little forecasting improvement and may have some practical value (Lo, Mamaysky, Wang 2000). The price directional dependence is also taking place in the primary feedback process according to behavioral finance concept where upward trend is more likely to be followed by another upward movement (Schiller, "From Efficient Markets Theory to Behavioral Finance" 2003) or in some other researches like for example momentum studies (Stankeviciene, Gembickaja 2012, etc.), short term trend trading strategy in futures market based on chart pattern recognition (Masteika, Rutkauskas 2012), forecasting models (Wei, Yoshiteru, Shou-Yang 2005), development of the decisions strategy in capital and money markets (Rutkauskas, Miecinskiene, Stasytyte 2008). We have to mention also works of Larrain (1991), who states that long term memory exists inside the financial market or other similar works of Hsieh (1991), Peters (1989) which are focusing mainly on measurement of probability diversions from normality, also using Hurst coefficient, but these theories are not solving in details their economic explanation using processes and elements existed within the real financial market.

The Dynamic Financial Model (Stadnik 2011) is solving completely the problematic of the direction dependence. …

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