How Costly is it to Ignore Breaks When Forecasting the Direction of a Time Series?

39 Pages Posted: 10 Mar 2003

See all articles by M. Hashem Pesaran

M. Hashem Pesaran

University of Southern California - Department of Economics

Allan Timmermann

UCSD ; Centre for Economic Policy Research (CEPR)

Date Written: February 2003

Abstract

Empirical evidence suggests that many macroeconomic and financial time series are subject to occasional structural breaks. In this paper we present analytical results quantifying the effects of such breaks on the correlation between the forecast and the realization and on the ability to forecast the sign or direction of a time-series that is subject to breaks. Our results suggest that it can be very costly to ignore breaks. Forecasting approaches that condition on the most recent break are likely to perform better over unconditional approaches that use expanding or rolling estimation windows provided that the break is reasonably large.

Keywords: Sign Prediction, Estimation Window, Structural Breaks

JEL Classification: C22, G10

Suggested Citation

Pesaran, M. Hashem and Timmermann, Allan, How Costly is it to Ignore Breaks When Forecasting the Direction of a Time Series? (February 2003). Available at SSRN: https://ssrn.com/abstract=385740

M. Hashem Pesaran (Contact Author)

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

Allan Timmermann

UCSD ( email )

9500 Gilman Drive
La Jolla, CA 92093-0553
United States
858-534-0894 (Phone)

HOME PAGE: http://rady.ucsd.edu/people/faculty/timmermann/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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