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Hidden Predictability in Economics: The Case of the Chilean Exchange Rate

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  • Pablo Pincheira B.

Abstract

In this paper we give arguments in support of conducting inference when models are evaluated by their ability to predict out of sample. It is argued that simple decision rules based upon direct comparisons of out-of-sample Mean Squared Prediction Errors (MSPE) may be equivalent to carrying out inference with a confidence level of only 50%. In addition, following McCracken (2007) and Clark and West (2006), we provide evidence via Monte Carlo simulations, of the non-normality of the asymptotic distribution of the difference of MSPE when models are nested. This means that when comparing predictive ability against a random walk, this simple model may outperform an alternative and true data-generating process. This anomaly is called “hidden predictability” meaning that the true predictability of a time series may be hidden behind a veil of parameter uncertainty affecting the true model. “Hidden Predictability” may be detected with some recently developed tests. We illustrate the detection of this type of predictability providing examples from two previous papers that explore the ability to predict Chilean exchange rate returns

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Bibliographic Info

Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 435.

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Date of creation: Nov 2007
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Handle: RePEc:chb:bcchwp:435

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  1. repec:att:wimass:9417 is not listed on IDEAS
  2. Clark, Todd E. & West, Kenneth D., 2007. "Approximately normal tests for equal predictive accuracy in nested models," Journal of Econometrics, Elsevier, vol. 138(1), pages 291-311, May.
  3. Kenneth D. West, 1994. "Asymptotic Inference About Predictive Ability," Macroeconomics 9410002, EconWPA.
  4. Newey, Whitney K & West, Kenneth D, 1994. "Automatic Lag Selection in Covariance Matrix Estimation," Review of Economic Studies, Wiley Blackwell, vol. 61(4), pages 631-53, October.
  5. Diebold, Francis X & Mariano, Roberto S, 2002. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 134-44, January.
  6. Todd E. Clark & Kenneth D. West, 2004. "Using out-of-sample mean squared prediction errors to test the Martingale difference hypothesis," Research Working Paper RWP 04-03, Federal Reserve Bank of Kansas City.
  7. McCracken, Michael W., 2007. "Asymptotics for out of sample tests of Granger causality," Journal of Econometrics, Elsevier, vol. 140(2), pages 719-752, October.
  8. Pablo Pincheira, 2006. "Shrinkage Based Tests of the Martingale Difference Hypothesis," Working Papers Central Bank of Chile 376, Central Bank of Chile.
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