Market timing and return prediction under model instability

Pesaran, M. Hashem and Timmermann, Allan (2002) Market timing and return prediction under model instability. Discussion paper (412). Financial Markets Group, London School of Economics and Political Science, London, UK.

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Abstract

Despite mounting empirical evidence to the contrary, the literature on predictability of stock returns almost uniformly assumes a time-invariant relationship between state variables and returns. In this paper we propose a two-stage approach for forecasting of financial return series that are subject to breaks. The first stage adopts a reversed ordered Cusum (ROC) procedure to determine in real time when the most recent break has occurred. In the second stage, post-break data is used to estimate the parameters of the forecasting model. We compare this approach to existing alternatives for dealing with parameter instability such as the Bai-Perron method and the time-varying parameter model. An out-of-sample forecasting experiment demonstrates considerable gains in market timing precision from adopting the proposed two-stage forecasting method.

Item Type:	Monograph (Discussion Paper)
Official URL:	http://fmg.lse.ac.uk
Additional Information:	© 2002 The Authors
Divisions:	Financial Markets Group
Subjects:	H Social Sciences > HF Commerce H Social Sciences > HG Finance H Social Sciences > HB Economic Theory
Sets:	Research centres and groups > Financial Markets Group (FMG) Collections > Economists Online Collections > LSE Financial Markets Group (FMG) Working Papers
Date Deposited:	20 Aug 2009 09:59
Last Modified:	20 Sep 2021 00:43
URI:	http://eprints.lse.ac.uk/id/eprint/24932

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