42 Pages Posted: 13 Jul 1999
Date Written: January 2004
The paper compares the forecasting ability of the most popular volatility forecasting models and develops an alternative. The comparison of existing models focuses on four issues: 1) the relative weighting of recent versus older observations, 2) the estimation criteria, 3) the trade-off in terms of out-of-sample forecasting error between simple and complex models, and 4) the emphasis placed on large shocks. Like previous studies, we find that financial markets have longer memories than reflected in GARCH(1,1) model estimates but find this has little impact on out-of-sample forecasting ability. While more complex models which allow a more flexible weighting pattern than the exponential model forecast better on an in-sample basis, due to the additional estimation error introduced by additional parameters, they forecast poorly out-of-sample. With the exception of GARCH models, we find that models based on absolute return deviations generally forecast volatility better than otherwise equivalent models based on squared return deviations. Among the most popular time series models, we find that GARCH(1,1) generally yields better forecasts than the historical standard deviation and exponentially weighted moving average models though between GARCH and EGARCH there is no clear favorite. However, in terms of forecast accuracy, all are dominated by a new, simple, non-linear least squares model, based on historical absolute return deviations, that we develop and test here.
JEL Classification: C53, G10, G13, E47
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