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On the Difficulty of Measuring Forecasting Skill in Financial Markets

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  • Satchell, S.
  • Williams, O.J.
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    Abstract

    The use of correlation between forecasts and actual returns is commonplace in the literature, often used as a measurement of investors’ skill. A prominent application of this is the concept of the Information Coefficient (IC). Not only can IC be used as a tool to rate analysts and fund managers but it also represents an important parameter in the asset allocation and portfolio construction process. Nevertheless, theoretical understanding of it has typically been limited to the partial equilibrium context where the investing activities of each agent have no effect on other market participants. In this paper we show that this can be an undesirable oversimplification and we demonstrate plausible circumstances in which conventional empirical measurements of IC can be highly misleading. We suggest that improved understanding of IC in a general equilibrium setting can lead to refined portfolio decision making ex ante and more informative analysis of performance ex post.

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    File URL: http://www.econ.cam.ac.uk/research/repec/cam/pdf/cwpe1039.pdf
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    Bibliographic Info

    Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 1039.

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    Date of creation: 26 Aug 2010
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    Handle: RePEc:cam:camdae:1039

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    Web page: http://www.econ.cam.ac.uk/index.htm

    Related research

    Keywords: Performance measurement; skill; financial forecasting; active management; Information Coefficient; Information Ratio;

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