Working Paper: CEPR ID: DP4380
Authors: Lucio Sarno; Giorgio Valente
Abstract: This Paper proposes a vector equilibrium correction model of stock returns that exploits the information in the futures market, while allowing for both regime-switching behaviour and international spillovers across stock market indices. Using data for three major stock market indices since 1989, we find that: (i) in sample, our model outperforms several alternative models on the basis of standard statistical criteria; (ii) in out-of-sample forecasting, our model does not produce significant gains in terms of point forecasts relative to more parsimonious alternative specifications, but it does so both in terms of market timing ability and in density forecasting performance. The economic value of the density forecasts is illustrated with an application to a simple risk management exercise.
Keywords: Asset Prices; Forecasting; International Spillovers; Nonlinearity
JEL Codes: F31; G10; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| futures market information (G13) | stock returns (G12) |
| nonlinearities and international spillovers (F44) | empirical model's ability to explain stock returns (G17) |
| MSVECM (E17) | forecasting ability (C53) |
| regime-switching behavior (C34) | forecasting accuracy (C53) |
| spot prices (G13) | futures prices (G13) |
| cointegration between spot and futures prices (G13) | mean reversion in futures basis (G13) |