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Does non-linearity help us understand, model and forecast UK stock and bond returns: evidence from the BEYR

  • David G. McMillan
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    The usefulness of non-linear models to provide accurate estimates and forecasts remains an open empirical debate. This paper examines the nature of the estimated relationships and forecasting power of smooth-transition models for UK stock and bond returns using a range of financial and macroeconomic variables as predictors. Notably, evidence of non-linearity is stronger when the bond-equity yield ratio is used as the transition variable. This ratio measures whether stocks are over (under)-valued relative to bonds and can act as a signal for portfolio managers. In-sample results reveal noticeable differences regarding the nature of relationships between the linear and non-linear setting, while results of a recursive forecasting exercise reveal both statistical and economic improvement over a linear model. Overall, these results support the view that non-linear estimates and forecasts can provide useful information for stock market traders, portfolio managers and policy-makers.

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    File URL: http://hdl.handle.net/10.1080/02692171.2011.580268
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    Article provided by Taylor & Francis Journals in its journal International Review of Applied Economics.

    Volume (Year): 26 (2012)
    Issue (Month): 1 (March)
    Pages: 125-143

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    Handle: RePEc:taf:irapec:v:26:y:2012:i:1:p:125-143
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