Applications of state space models in finance

Chapter 1
Introduction
“Economists study the economy both for the sheer intellectual
pleasure of trying to understand the world in which they live
and with the hope that improved knowledge will lead to better
economic policy and performance.”
Blanchard and Fischer (1989, p. 614)
A central conception of finance is the generally accepted trade-off between risk and expected
return. The assessment of risk and the required risk premium is usually modeled
by an asset pricing model, in which the common variation in returns is accounted for by
a possibly multivariate set of risk factors. The first and still widely used pricing model
is the single-factor Capital Asset Pricing Model (CAPM), proposed by Sharpe (1964)
and Lintner (1965). It implies a linear relationship between an asset’s expected return
and its systematic risk, also referred to as beta. 1 In testing the validity of the static
CAPM, various studies have demonstrated the possibility to earn risk-adjusted excess
returns by forming portfolios according to fundamental attributes, such as firm size or
valuation. These market anomalies, so-called because the abnormal returns related to
these patterns cannot be explained under the CAPM, motivate the alternative use of
pricing models that allow for multiple sources of risk. Depending on the choice of variables,
important variants include fundamental and macroeconomic multifactor models.
Irrespective of the number of considered systematic factors, all of these pricing models
share one common property: in their basic representation, the beta coefficients are
assumed to be constant over time.
In an inherently dynamic world that is characterized by changing relationships between
economic agents over time (cf. Chow 1984) the paradigm of beta constancy has
to be questioned. Given theoretical arguments and empirical stylized facts of financial
return series, the true degree of beta can be assumed to depend on the available information
at any given date. This thesis addresses the explicit modeling of time-varying
1 As the focus of this thesis is on the econometric modeling of time-varying financial sensitivities
and not on portfolio theory, it is not intended to provide a comprehensive derivation of
factor pricing models and their assumptions. For a summary of the basic foundations of asset
pricing theory and further references, see Appendix A.