Forecasting with Factor-Augmented Regression: A Frequentist Model Averaging Approach

28 Pages Posted: 27 Nov 2012

See all articles by Xu Cheng

Xu Cheng

University of Pennsylvania - Department of Economics

Bruce Hansen

University of Wisconsin - Madison - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: October 1, 2012

Abstract

This paper considers forecast combination with factor-augmented regression. In this framework, a large number of forecasting models are available, varying by the choice of factors and the number of lags. We investigate forecast combination using weights that minimize the Mallows and the leave-h-out cross validation criteria. The unobserved factor regressors are estimated by principle components of a large panel with N predictors over T periods. With these generated regressors, we show that the Mallows and leave-h-out cross validation criteria are approximately unbiased estimators of the one-step-ahead and multi-step-ahead mean squared forecast errors, respectively, provided that N, T —› ∞. In contrast to well-known results in the literature, the generated-regressor issue can be ignored for forecast combination, without restrictions on the relation between N and T. Simulations show that the Mallows model averaging and leave-h-out cross-validation averaging methods yield lower mean squared forecast errors than alternative model selection and averaging methods such as AIC, BIC, cross validation, and Bayesian model averaging. We apply the proposed methods to the U.S. macroeconomic data set in Stock and Watson (2012) and find that they compare favorably to many popular shrinkage-type forecasting methods.

Keywords: Cross-validation, factor models, forecast combination, generated regressors, Mallows

JEL Classification: C52, C53

Suggested Citation

Cheng, Xu and Hansen, Bruce, Forecasting with Factor-Augmented Regression: A Frequentist Model Averaging Approach (October 1, 2012). PIER Working Paper No. 12-046, Available at SSRN: https://ssrn.com/abstract=2180921 or http://dx.doi.org/10.2139/ssrn.2180921

Xu Cheng (Contact Author)

University of Pennsylvania - Department of Economics ( email )

Ronald O. Perelman Center for Political Science
133 South 36th Street
Philadelphia, PA 19104-6297
United States

HOME PAGE: http://www.sas.upenn.edu/~xucheng/

Bruce Hansen

University of Wisconsin - Madison - Department of Economics ( email )

1180 Observatory Drive
Madison, WI 53706
United States