Bayesian Model Averaging in the Presence of Structural Breaks

43 Pages Posted: 1 Apr 2007  

Francesco Ravazzolo

Free University of Bolzano

Dick J. C. van Dijk

Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute; ERIM

Philip Hans Franses

Erasmus University Rotterdam (EUR) - Department of Econometrics

Date Written: February 16, 2007

Abstract

This paper develops a return forecasting methodology that allows for instability in the relationship between stock returns and predictor variables, for model uncertainty, and for parameter estimation uncertainty. The predictive regression specification that is put forward allows for occasional structural breaks of random magnitude in the regression parameters, and for uncertainty about the inclusion of forecasting variables, and about the parameter values by employing Bayesian Model Averaging. The implications of these three sources of uncertainty, and their relative importance, are investigated from an active investment management perspective. It is found that the economic value of incorporating all three sources of uncertainty is considerable. A typical in vestor would be willing to pay up to several hundreds of basis points annually to switch from a passive buy-and-hold strategy to an active strategy based on a return forecasting model that allows for model and parameter uncertainty as well as structural breaks in the regression parameters.

Keywords: Stock return predictability, model uncertainty, Bayesian model averaging, structural breaks, portfolio selection

JEL Classification: G11, G12, C11

Suggested Citation

Ravazzolo, Francesco and van Dijk, Dick J. C. and Franses, Philip Hans, Bayesian Model Averaging in the Presence of Structural Breaks (February 16, 2007). Available at SSRN: https://ssrn.com/abstract=977507 or http://dx.doi.org/10.2139/ssrn.977507

Francesco Ravazzolo (Contact Author)

Free University of Bolzano ( email )

Bolzano
Italy

Dick J.C. Van Dijk

Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute

P.O. Box 1738
3000 DR Rotterdam
Netherlands

ERIM ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands
+31 10 408 1263 (Phone)
+31 10 4089162 (Fax)

HOME PAGE: http://people.few.eur.nl/djvandijk

Philip Hans Franses

Erasmus University Rotterdam (EUR) - Department of Econometrics ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands
+31 10 408 1278 (Phone)
+31 10 408 9162 (Fax)

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