Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2000:18: The Compass Rose Pattern of the Stock Market: How Does it Affect Parameter Estimates, Forecasts, and Statistical Tests?

Henrik Amilon () and Hans Byström ()
Additional contact information
Henrik Amilon: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden
Hans Byström: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

Abstract: A "compass rose" pattern sometimes appears when stock returns are plotted against themselves with a one-day lag, since stock prices move in discrete steps. In this paper, we perform a Monte Carlo study on simulated stock price series rounded in different ways to mirror the behavior of stocks on the Stockholm Stock Exchange. We find AR-GARCH parameter estimates to be affected by the discreteness imposed by rounding. Based on the compass rose and the discreteness, we investigate, theoretically and empirically, different possibilities of improving predictions of stock returns. The distributions of the BDS test as well as Savit and Green's dependability index are also influenced by the compass rose pattern. However, throughout the paper, we must impose unrealistically heavy rounding of the stock prices to find significant effects on our estimates, forecasts, and statistical tests.

Keywords: discrete prices; GARCH; forecasts; correlation integral statistics

JEL-codes: C15; C22; G19

22 pages, November 6, 2000

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