Optimal Forecasts in the Presence of Structural Breaks (Updated 14 November 2011)

This paper considers the problem of forecasting under continuous and discrete structural breaks and proposes weighting observations to obtain optimal forecasts in the MSFE sense. We derive optimal weights for continuous and discrete break processes. Under continuous breaks, our approach recovers exponential smoothing weights. Under discrete breaks, we provide analytical expressions for the weights in models with a single regressor and asympotically for larger models. It is shown that in these cases the value of the optimal weight is the same across observations within a given regime and differs only across regimes. In practice, where information on structural breaks is uncertain a forecasting procedure based on robust weights is proposed. Monte Carlo experiments and an empirical application to the predictive power of the yield curve analyze the performance of our approach relative to other forecasting methods.