Financial Risk Manager Part 1

Explanation

A $q^{th}$-order moving average process, denoted as MA(q), is a time series model where the current value depends on the current error term and $q$ past error terms. The purpose of using a higher-order MA process is:

1. To capture more complex autocorrelation patterns in the time series data
2. To provide a more robust set of estimates by including additional lagged error terms
3. To better model the dependency structure when the autocorrelation function shows significant correlations at multiple lags

Option C correctly identifies that the purpose is to add as many additional lagged variables as needed to produce robust estimates. The specific order $q$ is determined based on the autocorrelation structure of the data, not necessarily fixed at 3 or 5 (as suggested in options A and B).

Option D is incorrect because inversion of the moving average representation relates to converting MA processes to AR processes for stationarity, which is not the primary purpose of using a $q^{th}$-order MA process.

Key points:

• MA(q) model: $X_t = \mu + \epsilon_t + \theta_1\epsilon_{t-1} + \theta_2\epsilon_{t-2} + ... + \theta_q\epsilon_{t-q}$
• Higher $q$ allows modeling of more complex autocorrelation patterns
• The optimal $q$ is typically determined using information criteria (AIC, BIC) or examining the autocorrelation function