nep-for New Economics Papers
on Forecasting
Issue of 2007‒01‒13
thirteen papers chosen by
Rob J Hyndman
Monash University

  1. An Empirical Study of Asian Stock Volatility Using Stochastic Volatility Factor Model: Factor Analysis and Forecasting By Silvia S.W. Lui
  2. Bias in Federal Reserve Inflation Forecasts: Is the Federal Reserve Irrational or Just Cautious? By Carlos Carmona
  3. Bench Mark Revisions and the U.S. Personal Saving Rate By Leonard I. Nakamura; Tom Stark
  4. Time-Varying U.S. Inflation Dynamics and the New Keynesian Phillips Curve By Kevin J. Lansing
  5. Asymmetric effects and long memory in the volatility of Dow Jones stocks By Marcel Scharth; Marcelo Cunha Medeiros
  6. Monetary Policy Uncertainty: Is There a Difference Between Bank of England and the Bundesbank/ECB? By Iris Biefang-Frisancho Mariscal; Peter Howells
  7. Current Account Reversals and Long Term Imbalances: Application to the Central and Eastern European Countries By Kenza Benhima; Olena Havrylchyk
  8. The yield curve as a predictor and emerging economies By Mehl, Arnaud
  9. Reconciling the Return Predictability Evidence By Martin Lettau; Stijn Van Nieuwerburgh
  10. Evaluating Value-at-Risk models with desk-level data By Jeremy Berkowitz; Peter Christoffersen; Denis Pelletier
  11. What Does the Durables Price - Over - the Rental Cost Valuation Ratio Tell Us About Asset Prices? By Michal Pakos
  12. Death and Development By Peter Lorentzen; John McMillan; Romain Wacziarg
  13. The Empirical Risk-Return Relation: a factor analysis approach By Sydney Ludvigson; Serena Ng

  1. By: Silvia S.W. Lui (Queen Mary, University of London)
    Abstract: This paper is an empirical study of Asian stock volatility using stochastic volatility factor (SVF) model of Cipollini and Kapetanios (2005). We adopt their approach to carry out factor analysis and to forecast volatility. Our results show some Asian factors exhibit long memory that is in line with existing empirical findings in financial volatility. However, their local-factor SVF model is not powerful enough in forecasting Asian volatility. This has led us to propose an extension to a multi-factor SVF model. We also discuss how to produce forecast using this multi-factor model.
    Keywords: Stochastic volatility, Local-factor model, Multi-factor model, Principal components, Forecasting
    JEL: C32 C33 C53 G15
    Date: 2006–12
  2. By: Carlos Carmona (University of California, San Diego)
    Abstract: Inflation forecasts of the Federal Reserve systematically under-predicted inflation before Volcker and systematically over-predicted it afterward. Furthermore, under quadratic loss, commercial forecasts have information not contained in those forecasts. To investigate the cause, this paper recovers the loss function implied by Federal Reserve's forecasts. It finds that the cost of having inflation above an implicit time-varying target was larger than the cost of having inflation below it for the period since Volcker, and that the opposite was true for the pre-Volcker era. Once these asymmetries are taken into account, the Federal Reserve is found to be rational. (JEL C53, E52)
    Keywords: Inflation Forecasts, Asymmetric Loss, Federal Reserve,
    Date: 2005–07–01
  3. By: Leonard I. Nakamura (Federal Reserve Bank of Phildelphia); Tom Stark
    Abstract: Initially published estimates of the personal saving rate from 1965 Q3 to 1999 Q2, which averaged 5.3 percent, have been revised up 2.8 percentage points to 8.1 percent, as we document. We show that much of the initial variations in personal saving rate across time was pure noise. Nominal disposable personal income has been revised upward an average of 8.3 percent: one dollar in twelve was originally missing. We use both conventional and real-time estimates of the personal saving rate to forecast real disposable income, gross domestic product, and personal consumption and show that using the personal saving rate in real-time would have almost invariably made forecasts worse. Thus while the personal saving rate may contain information about later consumption once we know the true saving rate, as Campbell (1987) and Ireland(1995) have shown, as a practical matter, noise in the U.S. personal saving rate makes it uninformative for forecasting purposes
    Keywords: Permanent Income, Saving, Real-time data
    JEL: E01 E21 C82
    Date: 2006–12–03
  4. By: Kevin J. Lansing
    Abstract: This paper introduces a form of boundedly-rational expectations into an otherwise standard New-Keynesian Phillips curve. The representative agent's forecast rule is optimal (in the sense of minimizing mean squared forecast errors), conditional on a perceived law of motion for inflation and observed moments of the inflation time series. The perceived law of motion allows for both temporary and permanent shocks to inflation, the latter intended to capture the possibility of evolving shifts in the central bank's inflation target. In this case, the agent's optimal forecast rule defined by the Kalman filter coincides with adaptive expectations, as shown originally by Muth (1960). I show that the perceived optimal value of the gain parameter assigned to the last observed inflation rate is given by the fixed point of a nonlinear map that relates the gain parameter to the autocorrelation of inflation changes. The model allows for either a constant gain or variable gain, depending on the length of the sample period used by the agent to compute the autocorrelation of inflation changes. In the variable-gain setup, the equilibrium law of motion for inflation is nonlinear and can generate time-varying inflation dynamics similar to those observed in long-run U.S. data. The model's inflation dynamics are driven solely by white-noise fundamental shocks propagated via the expectations feedback mechanism; all monetary policy-dependent parameters are held constant
    Keywords: Inflation Expectations, Phillips Curve, Time-Varying Persistence & Volatility
    JEL: E31 E37
    Date: 2006–12–03
  5. By: Marcel Scharth (Department of Economics - PUC-Rio); Marcelo Cunha Medeiros (Department of Economics PUC-Rio)
    Abstract: Does volatility reflect a continuous reaction to past shocks or changes in the markets induce shifts in the volatility dynamics? In this paper, we provide empirical evidence that cumulated price variations convey meaningful information about multiple regimes in the realized volatility of stocks, where large falls (rises) in prices are linked to persistent regimes of high (low) variance in stock returns. Incorporating past cumulated daily returns as a explanatory variable in a flexible and systematic nonlinear framework, we estimate that falls of different magnitudes over less than two months are associated with volatility levels 20% and 60% higher than the average of periods with stable or rising prices. We show that this effect accounts for large empirical values of long memory parameter estimates. Finally, we analyze that the proposed model significantly improves out of sample performance in relation to standard methods. This result is more pronounced in periods of high volatility.
    Keywords: Realized volatility, long memory, nonlinear models, asymmetric effects, regime switching, regression trees, smooth transition, value-at-risk, forecasting, empirical finance.
    Date: 2006–11
  6. By: Iris Biefang-Frisancho Mariscal; Peter Howells (School of Economics, University of the West of England)
    Abstract: It is widely believed that institutional arrangements influence the quality of monetary policy outcomes. Judged on its ‘transparency’ characteristics, therefore the Bank of England should do better than both the Bundesbank and ECB. However, studies based on market evidence show that on average, agents anticipate policy moves by both banks equally well. Since benefits from transparency should also show in a narrowing of the diversity in cross sectional forecasts, this paper extends the existing literature in an attempt to reconcile the contradictory evidence on ‘transparency’ of both banks. We show that the diversity in interest rate forecasts is greater under the Bundesbank/ECB than the Bank of England. Other factors than ‘transparency’ do not seem to affect interest rate uncertainty in Germany. Increasing difficulty in forecasting inflation appears to explain in part UK interest rate forecast dispersion.
    Keywords: transparency, yield curve, forecasting uncertainty, Bank of England, Bundesbank, ECB
    JEL: E58
    Date: 2006–11
  7. By: Kenza Benhima; Olena Havrylchyk
    Abstract: In our study we investigate the evolution of short-term and long-term external positions in the CEECs and make an attempt at predicting their future paths. First, we analyze the long term relationship between net foreign assets and a set of explanatory variables and construct a measure of imbalances which equals the deviation of net foreign assets from their equilibrium level. Later we incorporate this measure in our prediction of current account reversals and compare the forecasts of this model with the baseline model that does not account for this disequilibrium measure. We show that the inclusion of stock disequilibrium measures improves the model’s performance in and out-of-sample. By doing this, we fill the gap in the literature on external sustainability, which despite the recent emphasis on stock adjustment (Calderon et al., 2000, Lane and Milesi-Ferretti, 2001), has not yet assessed the effectiveness of stocks in predicting sudden current account reversals. Finally, we apply this methodology to the CEECs. We find that net foreign assets lie below their long-term equilibrium level in all countries except Slovenia and Baltic States, but we predict current account reversals only for Hungary and Estonia.
    Keywords: Current account deficits, current account reversals, net foreign assets
    JEL: F21 F32
    Date: 2006–12
  8. By: Mehl, Arnaud (BOFIT)
    Abstract: This paper investigates the extent to which the slope of the yield curve in emerging economies predicts domestic inflation and growth. It also examines international financial linkages and how the US and euro area yield curves help to predict. It finds that the domes-tic yield curve in emerging economies contains in-sample information even after control-ling for inflation and growth persistence, at both short and long forecast horizons, and that it often improves out-of-sample forecasting performance. Differences across countries are seemingly linked to market liquidity. The paper further finds that the US and euro area yield curves also contain in- and out-of-sample information for future inflation and growth in emerging economies. In particular, for emerging economies with exchange rates pegged to the US dollar, the US yield curve is often found to be a better predictor than the domes-tic curves and to causally explain their movements. This suggests that monetary policy changes and short-term interest rate pass-through are key drivers of international financial linkages through movements at the low end of the yield curve.
    Keywords: emerging economies; yield curve; forecasting; international linkages
    JEL: C50 E44 F30
    Date: 2006–12–20
  9. By: Martin Lettau; Stijn Van Nieuwerburgh (Finance Department New York University)
    Abstract: Evidence of stock return predictability by financial ratios is still controversial, as documented by inconsistent results for in-sample and out-of-sample regressions and by substantial parameter instability. This paper shows that these seemingly incompatible results can be reconciled if the assumption of a fixed steady-state mean of the economy is relaxed. We find strong empirical evidence in support of shifts in the steady-state and propose simple methods to adjust financial ratios for such shifts. The forecasting relationship of adjusted price ratios and future returns is statistically significant, stable over time, and present in out-of-sample tests. We also show that shifts in the steady-state are responsible for the parameter instability and poor out-of-sample performance of unadjusted price ratios that are found in the data. Our conclusions hold for a variety of financial ratios and are robust to changes in the econometric technique used to estimate shifts in the steady-state
    Keywords: return predictability,
    JEL: G12 G14 G10
    Date: 2006–12–03
  10. By: Jeremy Berkowitz (University of Houston); Peter Christoffersen (McGill University); Denis Pelletier (Department of Economics, North Carolina State University)
    Abstract: We present new evidence on disaggregated profit and loss and VaR forecasts obtained from a large international commercial bank. Our dataset includes daily P/L generated by four separate business lines within the bank. All four business lines are involved in securities trading and each is observed daily for a period of at least two years. Given this rich dataset, we provide an integrated, unifying framework for assessing the accuracy of VaR forecasts. A thorough Monte Carlo comparison of the various methods is conducted to provide guidance as to which of these many tests have the best finite-sample size and power properties. The Caviar test of Engle and Manganelli (2004) performs best overall but duration-based tests also perform well in many cases.
    Keywords: risk management, backtesting, volatility, disclosure
    JEL: G21 G32
    Date: 2005–10
  11. By: Michal Pakos (Finance Tepper School of Business CMU)
    Abstract: I propose a new valuation ratio: durables price over the rental cost of capital, which is a direct analogue of the price-dividend ratio. I show that it is a rational forecast of future discount rates and future growth rates of the rental cost. In order to impute the unobservable rental cost, I develop a dynamic rational expectations economy with Beckerian household production. Investors' preferences are defined over the nondurables and the services flow from the household capital, the stock of durables. I assume investors "produce" services flow in the household sector. I carefully model the sector's returns to scale and find decreasing returns to scale in the household capital, ceteris paribus. The result is crucial as specifications used in the previous literature lead to a misspecified rental cost of capital, and thus errors-in-variables problems in predictive regressions. In contrast to price-dividend ratio, I construct the durables price-rental cost valuation ratio as an affine function of a co-integrating residual. I evaluate its predictive power and discover that it strongly forecasts excess returns on 25 Fama-French portfolios, especially small and value stocks. In particular, I can predict small-minus-big portfolio (SMB) with $R^2$ around 30\% at 4 year horizon
    Keywords: Predictability, Durable Goods, Household Production, Price Dividend Ratio
    JEL: E13 E21 E32 E44
    Date: 2006–12–03
  12. By: Peter Lorentzen (Graduate School of Business Stanford University); John McMillan; Romain Wacziarg
    Abstract: Analyzing a variety of cross-national and sub-national data sources, we show that high adult mortality reduces economic growth by shortening time horizons. Higher adult mortality is associated with increased levels of risky behavior, higher fertility and lower investment in physical and human capital. Furthermore, the feedback effect from economic prosperity to better healthcare implies that mortality could be the source of a poverty-trap. In our regressions, adult mortality explains almost all of Africa's growth tragedy over the past forty years. Our analysis also supports grim forecasts of the long-run economic costs of the ongoing AIDS epidemic.
    Keywords: mortality, fertility, human capital, growth, investment
    JEL: I10
    Date: 2006–12–03
  13. By: Sydney Ludvigson; Serena Ng (University of Michigan)
    Abstract: Financial economists have long been interested in the empirical relation between the conditional mean and conditional volatility of excess stock market returns, often referred to as the risk-return relation. Unfortunately, the body of empirical evidence on the risk-return relation is mixed and inconclusive. A key criticism of the existing empirical literature relates to the relatively small amount of conditioning information used to model the conditional mean and conditional volatility of excess stock market returns. To the extent that financial market participants have information not reflected in the chosen conditioning variables, measures of conditional mean and conditional volatility--and ultimately the risk-return relation itself--will be misspecified and possibly highly misleading. We consider one remedy to these problems using the methodology of dynamic factor analysis for large datasets, whereby a large amount of economic information can be summarized by a few estimated factors. We find that several estimated factors contain important information about one-quarter ahead excess returns and volatility that is not contained in commonly used predictor variables. Moreover, the factor-augmented specifications we examine predict an unusual 16-20 percent of the one-quarter ahead variation in excess stock market returns, and exhibit remarkably stable and strongly statistically significant out-of-sample forecasting power. Finally, in contrast to several pre-existing studies that rely on a small number of conditioning variables, we find a positive conditional correlation between risk and return that is strongly statistically significant, whereas the unconditional correlation is weakly negative and statistically snginficant
    Keywords: predictability, conditioning information, large dimension factor models
    JEL: G12 G10
    Date: 2006–12–03

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