On the Economic Evaluation of Volatility Forecasts
CREATES Research Paper 2009-56
24 Pages Posted: 28 Nov 2009
Date Written: November 25, 2009
We analyze the applicability of economic criteria for volatility forecast evaluation based on unconditional measures of portfolio performance. The main theoretical finding is that such unconditional measures generally fail to rank conditional forecasts correctly due to the presence of a bias term driven by the variability of the conditional mean and portfolio weights. Simulations and a small empirical study suggest that the bias can be empirically substantial and lead to distortions in forecast evaluation. An important implication is that forecasting superiority of models using high frequency data is likely to be understated if unconditional criteria are used.
Keywords: Forecast evaluation, Volatility forecasting, Portfolio optimization, Mean-variance analysis
JEL Classification: C32, C53, G11
Suggested Citation: Suggested Citation