A Simple Out-of-Sample Test for the Martingale Difference Hypothesis

29 Pages Posted: 10 Jul 2013

See all articles by Pablo M. Pincheira

Pablo M. Pincheira

Adolfo Ibanez University - School of Business

Date Written: May 2013

Abstract

We show that a straightforward modification of a trading based test for predictability displays interesting advantages over the Excess Profitability (EP) test (proposed by Anatolyev and Gerco) when testing the Martingale Difference Hypothesis. Our statistic is called Straightforward Excess Profitability (SEP) and avoids the calculation of a term that under the null of no predictability should be zero, but in practice may be sizable. In addition, our test does not require the strong assumption of independency used to derive the EP test. We claim that dependency is the rule and not the exception. We show via Monte Carlo simulations that the SEP test outperforms the EP test in terms of size and power. Finally, we illustrate the use of these tests in an empirical application within the context of the exchange rate literature.

Keywords: Forecast Evaluation, Hypothesis Testing, Martingale Difference, Exchange Rate, Asset Returns

JEL Classification: C12, C22, C32, C52, C53, F37

Suggested Citation

Pincheira, Pablo M., A Simple Out-of-Sample Test for the Martingale Difference Hypothesis (May 2013). Available at SSRN: https://ssrn.com/abstract=2291192 or http://dx.doi.org/10.2139/ssrn.2291192

Pablo M. Pincheira (Contact Author)

Adolfo Ibanez University - School of Business ( email )

Diagonal Las Torres 2640
Peñalolén
Santiago
Chile

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