Download this Paper Open PDF in Browser

Consistent Ranking of Volatility Models

Brown University, Economics Working Paper No. 2003-01

30 Pages Posted: 4 May 2003  

Peter Reinhard Hansen

University of North Carolina (UNC) at Chapel Hill - Department of Economics; University of Aarhus - CREATES

Asger Lunde

University of Aarhus - School of Economics and Management; CREATES

Date Written: April 2004

Abstract

We show that the empirical ranking of volatility models can be inconsistent for the true ranking if the evaluation is based on a proxy for the population measure of volatility. For example, the substitution of a squared return for the conditional variance in the evaluation of ARCH-type models can result in an inferior model being chosen as "best" with a probability that converges to one as the sample size increases. We document the practical relevance of this problem in an empirical application and by simulation experiments. Our results provide an additional argument for using the realized variance in out-of-sample evaluations rather than the squared return. We derive the theoretical results in a general framework that is not specific to the comparison of volatility models. Similar problems can arise in comparisons of forecasting models whenever the predicted variable is a latent variable.

Keywords: Consistent Ranking, Model Comparison, Volatility Models.

JEL Classification: C22, C52, C53

Suggested Citation

Hansen, Peter Reinhard and Lunde, Asger, Consistent Ranking of Volatility Models (April 2004). Brown University, Economics Working Paper No. 2003-01. Available at SSRN: https://ssrn.com/abstract=388600 or http://dx.doi.org/10.2139/ssrn.388600

Peter Hansen (Contact Author)

University of Aarhus - CREATES ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

University of North Carolina (UNC) at Chapel Hill - Department of Economics ( email )

Chapel Hill, NC 27599
United States

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

Asger Lunde

University of Aarhus - School of Economics and Management ( email )

Aarhus
Denmark

CREATES ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Paper statistics

Downloads
674
Rank
31,619
Abstract Views
3,129