Posted: 5 Jan 2001
This paper argues that inferring long-horizon asset-return predictability from the properties of vector autoregressive (VAR) models on relatively short spans of data is potentially unreliable. We illustrate the problems that can arise by re-examining the findings of Bekaert and Hodrick (1992), who detected evidence of in-sample predictability in international equity and foreign exchange markets using VAR methodology for a variety of countries over the period 1981-1989. The VAR predictions are significantly biased in most out-of-sample forecasts and are conclusively outperformed by a simple benchmark model at horizons of up to six months. This remains true even after corrections for small sample bias and the introduction of Bayesian parameter restrictions. A Monte Carlo analysis indicates that the data are unlikely to have been generated by a stable VAR. This conclusion is supported by an examination of structural break statistics. Implied long-horizon statistics calculated from the VAR parameter estimates are shown to be very unreliable.
Keywords: Vector autoregression, asset price, exchange rate, forecasting
JEL Classification: C32, F30
Suggested Citation: Suggested Citation
Neely, Christopher J. and Weller, Paul A., Predictability in International Asset Returns: A Reexamination. Journal of Financial and Quantitative Analysis, Vol. 35, No. 4, December 2000. Available at SSRN: https://ssrn.com/abstract=243587