Testing the Economic Value of Asset Return Predictability

FRB of St. Louis Working Paper No. 2012-049A

38 Pages Posted: 24 Oct 2012

See all articles by Michael W. McCracken

Michael W. McCracken

Federal Reserve Banks - Federal Reserve Bank of St. Louis

Giorgio Valente

Hong Kong Institute for Monetary and Financial Research (HKIMR)

Date Written: October 1, 2012

Abstract

Economic value calculations are increasingly used to compare the predictive performance of competing models of asset returns. However, they lack a rigorous way to validate their evidence. This paper proposes a new methodology to test whether utility gains accruing to investors using competing predictive models are equal to zero. Monte Carlo evidence indicates that our testing procedure, that can account for estimation error in the asymptotic variance of the test statistic, provides accurately sized and powerful tests in empirically relevant sample sizes. We apply the test statistics proposed in the paper to revisit the predictability of the US equity premium by means of various predictors.

Keywords: Utility-based comparisons, economic value, out-of-sample forecasting, predictability

JEL Classification: C53, C12, C52

Suggested Citation

McCracken, Michael W. and Valente, Giorgio, Testing the Economic Value of Asset Return Predictability (October 1, 2012). FRB of St. Louis Working Paper No. 2012-049A. Available at SSRN: https://ssrn.com/abstract=2166321 or http://dx.doi.org/10.2139/ssrn.2166321

Michael W. McCracken (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

411 Locust St
Saint Louis, MO 63011
United States

Giorgio Valente

Hong Kong Institute for Monetary and Financial Research (HKIMR) ( email )

One Pacific Place, 10th Floor
88 Queensway
Hong Kong
China

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