Model Averaging and Value-at-Risk Based Evaluation of Large Multi-Asset Volatility Models for Risk Management

30 Pages Posted: 18 Nov 2005

See all articles by M. Hashem Pesaran

M. Hashem Pesaran

University of Southern California - Department of Economics; University of Cambridge - Trinity College (Cambridge)

P. Zaffaroni

Imperial College London; Bank of Italy

Multiple version iconThere are 2 versions of this paper

Date Written: October 2005

Abstract

This paper considers the problem of model uncertainty in the case of multi-asset volatility models and discusses the use of model averaging techniques as a way of dealing with the risk of inadvertently using false models in portfolio management. Evaluation of volatility models is then considered and a simple Value-at-Risk (VaR) diagnostic test is proposed for individual as well as 'average' models. The asymptotic as well as the exact finite-sample distribution of the test statistic, dealing with the possibility of parameter uncertainty, are established. The model averaging idea and the VaR diagnostic tests are illustrated by an application to portfolios of daily returns based on 22 of Standard & Poor's 500 industry group indices over the period 1995-2003. We find strong evidence in support of 'thick' modelling proposed in the forecasting literature by Granger and Jeon (2004).

Keywords: Model averaging, value-at-risk, decision-based evaluations

JEL Classification: C32, C52, C53, G11

Suggested Citation

Pesaran, M. Hashem and Zaffaroni, P., Model Averaging and Value-at-Risk Based Evaluation of Large Multi-Asset Volatility Models for Risk Management (October 2005). CEPR Discussion Paper No. 5279, Available at SSRN: https://ssrn.com/abstract=851229

M. Hashem Pesaran (Contact Author)

University of Southern California - Department of Economics

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

University of Cambridge - Trinity College (Cambridge) ( email )

United Kingdom

P. Zaffaroni

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

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