Improving Forecast Accuracy of Financial Vulnerability: Partial Least Squares Factor Model Approach

44 Pages Posted: 4 May 2017

See all articles by Hyeongwoo Kim

Hyeongwoo Kim

Auburn University

Kyunghwan Ko

Economic Research Team, Jeju Branch, The Bank ok Korea

Date Written: May 2, 2017

Abstract

We present a factor augmented forecasting model for assessing the financial vulnerability in Korea. Dynamic factor models often extract latent common factors from a large panel of time series data via the method of the principal components (PC). Instead, we employ the partial least squares (PLS) method that estimates target specific common factors, utilizing covariances between predictors and the target variable. Applying PLS to 198 monthly frequency macroeconomic time series variables and the Bank of Korea's Financial Stress Index (KFSTI), our PLS factor augmented forecasting models consistently outperformed the random walk benchmark model in out-of-sample prediction exercises in all forecast horizons we considered. Our models also outperformed the autoregressive benchmark model in short-term forecast horizons. We expect our models would provide useful early warning signs of the emergence of systemic risks in Korea's financial markets.

Keywords: Partial Least Squares, Principal Component Analysis, Financial Stress Index, Out-Of-Sample Forecast, RRMSPE, DMW Statistics

JEL Classification: C38, C53, C55, E44, E47, G01, G17

Suggested Citation

Kim, Hyeongwoo and Ko, Kyunghwan, Improving Forecast Accuracy of Financial Vulnerability: Partial Least Squares Factor Model Approach (May 2, 2017). Bank of Korea WP 2017-14. Available at SSRN: https://ssrn.com/abstract=2962775 or http://dx.doi.org/10.2139/ssrn.2962775

Hyeongwoo Kim (Contact Author)

Auburn University ( email )

Department of Economics
Auburn, AL 36849
United States
+1-334-844-2928 (Phone)

HOME PAGE: http://https://sites.google.com/site/hkimphd/

Kyunghwan Ko

Economic Research Team, Jeju Branch, The Bank ok Korea ( email )

39, Namdaemun-ro, Jung-gu
Seoul, 04531
Korea, Republic of (South Korea)

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