How Costly is it to Ignore Breaks When Forecasting the Direction of a Time Series?

Empirical evidence suggests that many macroeconomic and financial time series are subject to occasional structural breaks. In this paper we present analytical results quantifying the effects of such breaks on the correlation between the forecast and the realization and on the ability to forecast the sign or direction of a time-series that is subject to breaks. Our results suggest that it can be very costly to ignore breaks. Forecasting approaches that condition on the most recent break are likely to perform better over unconditional approaches that use expanding or rolling estimation windows provided that the break is reasonably large.

[1]  Sarbajit Sengupta,et al.  Delegating Recruitment Under Asymmetric Information , 2002, SSRN Electronic Journal.

[2]  Andrew Ang,et al.  International Asset Allocation With Regime Shifts , 2002 .

[3]  Allan Timmermann,et al.  Firm Size and Cyclical Variations in Stock Returns , 2000 .

[4]  C. Granger,et al.  Efficient Market Hypothesis and Forecasting , 2002 .

[5]  P. Patnaik.  THE NON-CENTRAL χ2- AND F-DISTRIBUTIONS AND THEIR APPLICATIONS , 1949 .

[6]  H. White,et al.  Monitoring Structural Change , 1996 .

[7]  Stephen Taylor,et al.  Forecasting Economic Time Series , 1979 .

[8]  J. Durbin,et al.  Techniques for Testing the Constancy of Regression Relationships Over Time , 1975 .

[9]  Michael P. Clements,et al.  Forecasting economic processes , 1998 .

[10]  C. Granger,et al.  Economic and Statistical Measures of Forecast Accuracy , 1999 .

[11]  N. L. Johnson,et al.  Continuous Univariate Distributions. , 1995 .

[12]  J. Stock,et al.  Evidence on Structural Instability in Macroeconomic Time Series Relations , 1994 .

[13]  René Garcia,et al.  Série Scientifique Scientific Series an Analysis of the Real Interest Rate under Regime Shifts , 2022 .

[14]  R. Oaxaca.  Another Look at Tests of Equality between Sets of Coefficients in Two Linear Regressions , 1974 .

[15]  C. Kool,et al.  The Phillips Curve, the Persistence of Inflation, and the Lucas Critique: Evidence from Exchange-Rate Regimes: Comment , 2000 .

[16]  A. Timmermann.  Structural Breaks, Incomplete Information, and Stock Prices , 2001 .

[17]  Graham Elliott,et al.  Optimally Testing General Breaking Processes in Linear Time Series Models , 2003 .

[18]  D. Andrews.  Tests for Parameter Instability and Structural Change with Unknown Change Point , 1993 .

[19]  Donald W. K. Andrews,et al.  Optimal changepoint tests for normal linear regression , 1996 .

[20]  Michael P. Clements,et al.  FORECASTING ECONOMIC TIME SERIES , 2000, Econometric Theory.

[21]  S. Chib.  Estimation and comparison of multiple change-point models , 1998 .

[22]  P. Veronesi,et al.  Option Prices with Uncertain Fundamentals Theory and Evidence on the Dynamics of Implied Volatilities Alexander David Board of Governors of the Federal Reserve System , 1999 .

[23]  Andrew Ang,et al.  Regime Switches in Interest Rates , 1998 .

[24]  M. Hashem Pesaran,et al.  A Simple Nonparametric Test of Predictive Performance , 1992 .

[25]  Bruce E. Hansen,et al.  Tests for Parameter Instability in Regressions with I(1) Processes , 1992 .

[26]  P. Perron,et al.  Computation and Analysis of Multiple Structural-Change Models , 1998 .

[27]  M. Sola,et al.  Testing the term structure of interest rates from a stationary switching Regime VAR , 1992 .

[28]  P. Perron,et al.  Estimating and testing linear models with multiple structural changes , 1995 .

[29]  Gordon Leitch,et al.  Economic Forecast Evaluation: Profits versus the Conventional Error Measures , 1991 .

[30]  P. Patnaik.  The Non-central X^2- and F- distribution and Their Applications , 1949 .

[31]  M. Solá,et al.  Testing the term structure of interest rates using a stationary vector autoregression with regime switching , 1994 .

[32]  W. Krämer,et al.  A new test for structural stability in the linear regression model , 1989 .

[33]  G. C. Tiao,et al.  Use of Cumulative Sums of Squares for Retrospective Detection of Changes of Variance , 1994 .

[34]  D. Andrews.  Tests for Parameter Instability and Structural Change with Unknown Change Point , 1993 .

[35]  A. Timmermann,et al.  Market timing and return prediction under model instability , 2002 .

[36]  Stephen Gray.  Modeling the Conditional Distribution of Interest Rates as a Regime-Switching Process , 1996 .

[37]  James D. Hamilton.  A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle , 1989 .