More Power for Out-Of-Sample Tests of Predictability

37 Pages Posted: 24 Feb 2017

See all articles by Pablo M. Pincheira

Pablo M. Pincheira

Adolfo Ibanez University - School of Business

Date Written: February 22, 2017

Abstract

In this paper we introduce a “power booster factor” for out-of-sample tests of predictability. The relevant econometric environment is one in which the econometrician wants to compare the population Mean Squared Prediction Errors (MSPE) of two models: one big nesting model, and another smaller nested model. Although our factor can be used to improve the power of many out-of-sample tests of predictability, in this paper we focus on boosting the power of the widely used test developed by Clark and West (2006, 2007). Our new test multiplies the Clark and West t-statistic by a factor that should be close to one under the null hypothesis that the short nested model is the true model, but that should be greater than one under the alternative hypothesis that the big nesting model is more adequate. We use Monte Carlo simulations to explore the size and power of our approach. Our simulations reveal that the new test is well sized and powerful. In particular, it tends to be less undersized and more powerful than the test by Clark and West (2006, 2007). Although most of the gains in power are associated to size improvements, we also obtain gains in size-adjusted power. Finally we present an empirical application in which more rejections of the null hypothesis are obtained with our new test.

Keywords: Time-Series, Forecasting, Inference, Inflation, Exchange Rates, Random Walk, Out-Of-Sample

JEL Classification: C22, C52, C53, C58, E17, E27, E37, E47, F37

Suggested Citation

Pincheira, Pablo M., More Power for Out-Of-Sample Tests of Predictability (February 22, 2017). Available at SSRN: https://ssrn.com/abstract=2922238 or http://dx.doi.org/10.2139/ssrn.2922238

Pablo M. Pincheira (Contact Author)

Adolfo Ibanez University - School of Business ( email )

Diagonal Las Torres 2640
Peñalolén
Santiago
Chile

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