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A dynamic model of the financial–real interaction as a model selection criterion for nonparametric stock market prediction

  • Peter Woehrmann
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    Inspired by findings of low–dimensional nonlinearities and the Theorem of Takens (1983) forecasting models of financial time series are often built upon nonparametric, i.e. universal nonlinear, univariate relationships. Empirical investigations, however, are seriously contaminated by the problem of overfitting. Since statistical model selection theory in the nonlinear case is still in its infancy we would like to suggest the application of economic model selection criteria. It is a method of combining the flexibility of nonparametric regressions and important structural information in dynamic economic models. Therefore, conditions of economic models are imposed on the embedded nonlinear dynamical system to be estimated nonparametrically. In our empirical investigations we apply an univariate nonparametric forecasting model of stock returns, implemented via the Local Linear Maps of Ritter (1991), by an economic model selection criterion based on a discretized form of a continuous–time dynamic model on the interaction of real activity and asset markets. The dynamic economic model is estimated based on the Maximum Entropy inference since unobservable variables are involved. Results for monthly U.S. data show that nonparametric model selection is improved by this economic model selection criterion. On the other hand this result may be interpreted as support for the economic model.

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    Paper provided by Institute for Empirical Research in Economics - University of Zurich in its series IEW - Working Papers with number 226.

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    Handle: RePEc:zur:iewwpx:226
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    1. G. William Schwert, 1990. "Why Does Stock Market Volatility Change Over Time?," NBER Working Papers 2798, National Bureau of Economic Research, Inc.
    2. Estrella, Arturo & Hardouvelis, Gikas A, 1991. " The Term Structure as a Predictor of Real Economic Activity," Journal of Finance, American Finance Association, vol. 46(2), pages 555-76, June.
    3. William A. Brock, 1982. "Asset Prices in a Production Economy," NBER Chapters, in: The Economics of Information and Uncertainty, pages 1-46 National Bureau of Economic Research, Inc.
    4. Jean-Pierre DANTHINE & John B. DONALDSON & Rajnish MEHRA, 1992. "The Equity Premium and the Allocation of Income Risk," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9203, Université de Lausanne, Faculté des HEC, DEEP.
    5. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
    6. Schwert, G William, 1990. " Stock Returns and Real Activity: A Century of Evidence," Journal of Finance, American Finance Association, vol. 45(4), pages 1237-57, September.
    7. Gallant, A.R. & Tauchen, G., 1988. "Seminonparametric Estimation Of Conditionally Constrained Heterogeneous Processes: Asset Pricing Applications," Papers 88-59, Chicago - Graduate School of Business.
    8. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    9. Chiarella Carl & Semmler Willi & Mittnik Stefan & Zhu Peiyuan, 2002. "Stock Market, Interest Rate and Output: A Model and Estimation for US Time Series Data," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 6(1), pages 1-39, April.
    10. Detemple, Jerome B, 1986. " Asset Pricing in a Production Economy with Incomplete Information," Journal of Finance, American Finance Association, vol. 41(2), pages 383-91, June.
    11. Hamilton, James D & Gang, Lin, 1996. "Stock Market Volatility and the Business Cycle," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 11(5), pages 573-93, Sept.-Oct.
    12. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
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