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Modelling and forecasting stock returns: exploiting the futures market, regime shifts and international spillovers

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  • Giorgio Valente

    (University of Warwick, Coventry, UK)

  • Lucio Sarno

    (University of Warwick, Coventry, UK and Centre for Economic Policy Research (CEPR), London, UK)

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. Copyright © 2005 John Wiley & Sons, Ltd.

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Bibliographic Info

Article provided by John Wiley & Sons, Ltd. in its journal Journal of Applied Econometrics.

Volume (Year): 20 (2005)
Issue (Month): 3 ()
Pages: 345-376

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Handle: RePEc:jae:japmet:v:20:y:2005:i:3:p:345-376

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Cited by:
  1. Massimo Guidolin & Stuart Hyde, 2009. "What tames the Celtic Tiger? Portfolio implications from a Multivariate Markov Switching model," Applied Financial Economics, Taylor & Francis Journals, vol. 19(6), pages 463-488.
  2. Sarno, Lucio & Valente, Giorgio, 2005. "Empirical exchange rate models and currency risk: some evidence from density forecasts," Journal of International Money and Finance, Elsevier, vol. 24(2), pages 363-385, March.
  3. Vicente Esteve & Manuel Navarro-Ibáñez & María A. Prats, 2013. "The present value model of U.S. stock prices revisited: long-run evidence with structural breaks, 1871-2010," Working Papers 1305, Department of Applied Economics II, Universidad de Valencia.
  4. Chang, Kuang-Liang, 2010. "House price dynamics, conditional higher-order moments, and density forecasts," Economic Modelling, Elsevier, vol. 27(5), pages 1029-1039, September.
  5. Lee, Hsiang-Tai, 2009. "Optimal futures hedging under jump switching dynamics," Journal of Empirical Finance, Elsevier, vol. 16(3), pages 446-456, June.
  6. Vasco Gabriel & Luis Martins, 2011. "Cointegration tests under multiple regime shifts: An application to the stock price–dividend relationship," Empirical Economics, Springer, vol. 41(3), pages 639-662, December.
  7. Dimitris A. Georgoutsos & Petros M. Migiakis, 2009. "Benchmark bonds interactions under regime shifts," Working Papers 103, Bank of Greece.
  8. Lee, Hsiang-Tai, 2010. "Regime switching correlation hedging," Journal of Banking & Finance, Elsevier, vol. 34(11), pages 2728-2741, November.
  9. Giorgio Valente & Mark Taylor & Lucio Sarno & Richard Clarida, 2004. "The Role of Asymmetries and Regime Shifts in the Term Structure of Interest Rates," Working Papers wp04-13, Warwick Business School, Finance Group.
  10. Della Corte, Pasquale & Sarno, Lucio & Valente, Giorgio, 2010. "A century of equity premium predictability and the consumption-wealth ratio: An international perspective," Journal of Empirical Finance, Elsevier, vol. 17(3), pages 313-331, June.
  11. Wagner Oliveira Monteiro & Rodrigo De Losso da Silveira Bueno, 2011. "Dynamic Hedging inMarkov Regimes Switching," Anais do XXXVII Encontro Nacional de Economia [Proceedings of the 37th Brazilian Economics Meeting] 136, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].
  12. Liu, Xiangli & Cheng, Siwei & Wang, Shouyang & Hong, Yongmiao & Li, Yi, 2008. "An empirical study on information spillover effects between the Chinese copper futures market and spot market," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 387(4), pages 899-914.
  13. Chang, Kuang-Liang, 2009. "Do macroeconomic variables have regime-dependent effects on stock return dynamics? Evidence from the Markov regime switching model," Economic Modelling, Elsevier, vol. 26(6), pages 1283-1299, November.

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