ABSTRACT
In this chapter we introduce some of the econometric and time series techniques that are needed to model the physical measure. We begin with a theoretical summary of the literature related to forecasting asset prices including the efficient market hypothesis, several documented market anomalies and the seminal concept of risk premia. We then cover the mathematical techniques that can be used to build these types of models, beginning with standard linear regression models, and then proceeding to introduce time series and panel regression models. Additionally, we cover several other important concepts central to quants modeling the physical measure, including principal component analysis, bootstrapping, and the core concept of diversification. Finally, we provide some perspective on the important differences in modeling the risk-neutral measure, as detailed in chapter 2, and the physical measure, as detailed in this chapter.
