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i 1
i 1
Pt S (1 wi )PtU wi Pt S i
Where:
i 1
i 1
where all R variables denote the returns analogous to the price definitions above.
S
Note the resemblance of equation (2) to the auto-regressive process AR(p) for Rt , which has the
form:
(3)
RtS i RtSi ~t
i 1
i 1
Equation (3) can be estimated using traditional time-series estimation techniques (OLS, MLE 1). Once
we get the estimates for the lag coefficients i , we can use equations (2) to (5) to recover the
unobserved unsmoothed returns
RtU from the observed smoothed returns RtS . After some algebraic
manipulation, we arrive at the formula for the new unsmoothed return series:
p
(6)
RtU
RtS i RtSi
i 1
p
(1 i )
i 1
For estimation of time-series models please refer to Hamiltons Time Series Analysis book. See
References at the end of the article
(R)(1)(R)
Note that the weighted average assumption of the model implies that for time-series with considerable
number of observations, the process for the unsmoothed returns under equation (6) is mean preserving.
So, it can be shown that:
p
E ( RtU )
E ( RtS ) i E ( RtSi )
i 1
p
(1 i )
(1 i ) E ( RtS )
i 1
Since:
i 1
(1 i )
E ( RtS )
i 1
2tU122tS
By applying the variance operator to (3) while using the relationships in (4) and (5), one can arrive at a
formulation for the variance of the unsmoothed series. However, an analytical formula to the variance
of the unsmoothed series can become cumbersome for increasing lags (p). Hence, the most practical
way to calculate the variance and volatility is to use the recursive formula (6) to estimate the
unsmoothed series and then numerically estimate variance and volatility. A tractable formula for
variance can be provided for an AR(1) unsmoothing process. If we apply variance to (3), we arrive at:
(7)
Equation (7) implies that the volatility of the AR(1) unsmoothed series scales the volatility of the
smoothed return series by
1 12
(1 1 ) 2
References:
Blundell, G., Ward, 1987, Property Portfolio Allocation, Land Development Studies 4, pp. 145-56
Quan, Daniel C.; Quigley, John M.; Follain, James R, 1989, Inferring An Investment Return Series
For Real Estate Form. AREUEA Journal; v.17, 2; pg. 218
Muhlhofer, T., 2004, Income vs. Appreciation: The Investment Value of Real Estate Investment
Trusts, Working Paper, London School of Economics
Hamilton, J. 1994, Time Series Analysis, Princeton University Press
Cochrane, J., 2005, Time Series Analysis for Macroeconomics and Finance, Graduate School of
Business, The University of Chicago
Scherer, B., 2003, Portfolio Construction and Risk Budgeting, Risk Books