Detecting and Measuring Nonlinearity

Rachidi Kotchoni

Econometrics, 2018, vol. 6, issue 3, 1-27

Abstract: This paper proposes an approach to measure the extent of nonlinearity of the exposure of a financial asset to a given risk factor. The proposed measure exploits the decomposition of a conditional expectation into its linear and nonlinear components. We illustrate the method with the measurement of the degree of nonlinearity of a European style option with respect to the underlying asset. Next, we use the method to identify the empirical patterns of the return-risk trade-off on the SP500. The results are strongly supportive of a nonlinear relationship between expected return and expected volatility. The data seem to be driven by two regimes: one regime with a positive return-risk trade-off and one with a negative trade-off.

Keywords: conditional expectation; nonlinearity; orthogonal polynomials; return-risk trade-off (search for similar items in EconPapers)
JEL-codes: B23 C C00 C01 C1 C2 C3 C4 C5 C8 (search for similar items in EconPapers)
Date: 2018
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Working Paper: Detecting and Measuring Nonlinearity (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:gam:jecnmx:v:6:y:2018:i:3:p:37-:d:162892

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