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Forecasting Stock Returns Under Economic Constraints

57 Pages Posted: 9 Dec 2012  

Davide Pettenuzzo

Brandeis University - Department of Economics

Allan G. Timmermann

University of California, San Diego (UCSD) - Department of Economics; Centre for Economic Policy Research (CEPR)

Rossen I. Valkanov

University of California, San Diego (UCSD) - Rady School of Management

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Date Written: December 7, 2012

Abstract

We propose a new approach to imposing economic constraints on forecasts of the equity premium. Economic constraints are used to modify the posterior distribution of the parameters of the predictive return regression in a way that better allows the model to learn from the data. We consider two types of constraints: Non-negative equity premia and bounds on the conditional Sharpe ratio, the latter of which incorporates time-varying volatility in the predictive regression framework. Empirically, we Â…find that economic constraints systematically reduce uncertainty about model parameters and improve both statistical and economic measures of out-of-sample forecast performance. The Sharpe ratio constraint, in particular, results in considerable economic gains.

Keywords: Economic constraints, Sharpe ratio, Equity premium predictions, Bayesian analysis

JEL Classification: C11, C22, G11, G12

Suggested Citation

Pettenuzzo, Davide and Timmermann, Allan G. and Valkanov, Rossen I., Forecasting Stock Returns Under Economic Constraints (December 7, 2012). Available at SSRN: https://ssrn.com/abstract=2186574 or http://dx.doi.org/10.2139/ssrn.2186574

Davide Pettenuzzo (Contact Author)

Brandeis University - Department of Economics ( email )

Waltham, MA 02454-9110
United States
781.736.2834 (Phone)
781.736.2269 (Fax)

Allan G. Timmermann

University of California, San Diego (UCSD) - Department of Economics ( email )

9500 Gilman Drive
La Jolla, CA 92093-0508
United States
858-534-4860 (Phone)
858-534-7040 (Fax)

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Rossen Valkanov

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858-534-0898 (Phone)

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