In-Sample Inference and Forecasting in Misspecified Factor Models

58 Pages Posted: 18 Jul 2016

See all articles by Marine Carrasco

Marine Carrasco

University of Montreal - Departement de Ciences Economiques

Barbara Rossi

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI); Barcelona Graduate School of Economics

Date Written: July 2016

Abstract

This paper considers in-sample prediction and out-of-sample forecasting in regressions with many exogenous predictors. We consider four dimension reduction devices: principal compo- nents, Ridge, Landweber Fridman, and Partial Least Squares. We derive rates of convergence for two representative models: an ill-posed model and an approximate factor model. The theory is developed for a large cross-section and a large time-series. As all these methods depend on a tuning parameter to be selected, we also propose data-driven selection methods based on cross- validation and establish their optimality. Monte Carlo simulations and an empirical application to forecasting inflation and output growth in the U.S. show that data-reduction methods out- perform conventional methods in several relevant settings, and might effectively guard against instabilities in predictors' forecasting ability.

Keywords: factor models, Forecasting, GDP forecasts, large datasets, partial least squares, principal components, regularization methods, Ridge, sparsity, variable selection

JEL Classification: C22, C52, C53

Suggested Citation

Carrasco, Marine and Rossi, Barbara, In-Sample Inference and Forecasting in Misspecified Factor Models (July 2016). CEPR Discussion Paper No. DP11388, Available at SSRN: https://ssrn.com/abstract=2811083

Marine Carrasco (Contact Author)

University of Montreal - Departement de Ciences Economiques ( email )

C.P. 6128, succursale Centre-Ville
Montreal, Quebec H3C 3J7
Canada
(514) 343-2394 (Phone)

HOME PAGE: http://www.sceco.umontreal.ca/liste_personnel/carrasco/index.htm

Barbara Rossi

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI) ( email )

Ramon Trias Fargas, 25-27
Barcelona, 08005
Spain

Barcelona Graduate School of Economics ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
0
Abstract Views
287
PlumX Metrics