Forecasting Stock Returns Under Economic Constraints

61 Pages Posted: 12 Mar 2013

See all articles by Davide Pettenuzzo

Davide Pettenuzzo

Brandeis University - Department of Economics

Allan Timmermann

UCSD ; Centre for Economic Policy Research (CEPR)

Rossen I. Valkanov

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

Multiple version iconThere are 2 versions of this paper

Date Written: March 2013

Abstract

We propose a new approach to imposing economic constraints on time-series 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 timevarying volatility in the predictive regression framework. Empirically, we find that economic constraints systematically reduce uncertainty about model parameters, reduce the risk of selecting a poor forecasting model, 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: Bayesian analysis, Economic constraints, Sharpe Ratio, Stock return predictability

JEL Classification: C11, C22, G11, G12

Suggested Citation

Pettenuzzo, Davide and Timmermann, Allan and Valkanov, Rossen, Forecasting Stock Returns Under Economic Constraints (March 2013). CEPR Discussion Paper No. DP9377. Available at SSRN: https://ssrn.com/abstract=2231868

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 Timmermann

UCSD ( email )

9500 Gilman Drive
La Jolla, CA 92093-0553
United States
858-534-0894 (Phone)

HOME PAGE: http://rady.ucsd.edu/people/faculty/timmermann/

Centre for Economic Policy Research (CEPR)

London
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)

Register to save articles to
your library

Register

Paper statistics

Downloads
2
Abstract Views
569
PlumX Metrics
!

Under construction: SSRN citations while be offline until July when we will launch a brand new and improved citations service, check here for more details.

For more information