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UNIVERSITY OF EDINBURGH
CENTER FOR FINANCIAL MARKETS RESEARCH
WORKING PAPER 2002.04
FORECASTING STOCK MARKET VOLATILITY:
EVIDENCE FROM FOURTEEN COUNTRIES
Abstract
This paper evaluates the out-of-sample forecasting accuracy of eleven models for weekly and
monthly volatility in fourteen stock markets. Volatility is defined as within-week (withinmonth) standard deviation of continuously compounded daily returns on the stock market
index of each country for the ten-year period 1988 to 1997. The first half of the sample is
retained for the estimation of parameters while the second half is for the forecast period. The
following models are employed: a random walk model, a historical mean model, moving
average models, weighted moving average models, exponentially weighted moving average
models, an exponential smoothing model, a regression model, an ARCH model, a GARCH
model, a GJR-GARCH model, and an EGARCH model. We first use the standard
(symmetric) loss functions to evaluate the performance of the competing models: the mean
error, the mean absolute error, the root mean squared error, and the mean absolute percentage
error. According to all of these standard loss functions, the exponential smoothing model
provides superior forecasts of volatility. On the other hand, ARCH-based models generally
prove to be the worst forecasting models. We also employ the asymmetric loss functions to
penalize under/over-prediction. When under-predictions are penalized more heavily ARCHtype models provide the best forecasts while the random walk is worst. However, when overpredictions of volatility are penalized more heavily the exponential smoothing model
performs best while the ARCH-type models are now universally found to be inferior
forecasters.
Key words: Stock market volatility, forecasting, forecast evaluation
JEL Classification: C22, C53, G12, G15
ERCAN BALABAN
School of Economics and Management Studies
University of Edinburgh, Edinburgh EH8 9JY UK
Faculty of Economics and Business Administration
Johann Wolfgang Goethe University, Frankfurt/M. 60325 Germany
[email protected]
ASLI BAYAR
Department of Management, Cankaya University, Ankara 06533 Turkey
[email protected]
ROBERT FAFF
Department of Accounting and Finance
Monash University, Clayton VIC 3800 Australia
[email protected]