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Predictability in International Asset Returns: A Reexamination

Published online by Cambridge University Press:  06 April 2009

Christopher J. Neely  and
Paul Weller
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Abstract

This paper argues that inferring long-horizon asset return predictability from the properties of vector autoregressive (VAR) models on relatively short spans of data is potentially unreliable. We illustrate the problems that can arise by reexamining the findings of Bekaert and Hodrick(1992), who detected evidence of in-sample predictability in international equity and foreign exchange markets using VAR methodology for a variety of countries from 1981–1989. The VAR predictions are significantly biased in most out-of-sample forecasts and are conclusively outperformed by a simple benchmark model at horizons of up to six months. This remains true even after corrections for small sample bias and the introduction Bayesian parameter restrictions. A Monte Carlo analysis indicates that the data are unlikely to have been generated by a stable VAR. This conclusion is supported by an examination of structural break statistics. We show that implied long-horizon statistics calculated from the VAR parameter estimates are very unreliable.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 35 , Issue 4 , December 2000 , pp. 601 - 620
Copyright
Copyright © School of Business Administration, University of Washington 2000

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Footnotes

*

Research Department, Federal Reserve Bank of St. Louis. St. Louis, MO 63011, and Department of Finance, College of Business Administration, University of lowa, lowa city, IA 52240, resepectively. The views expressed are those of the authors and do not necessarily reflect official positions of the federal Reserve Bank of St. Louis or the Federal Reserve System. The authors thank Robert Hodrick for supplying the data used in Bekaert and Hodrick (1992), Morgan Stanley for providing additional financial data, and Kent Koch for excellent research assistance. We also thank Chuck Whiteman, Dick Anderson, Bob Rache, Gene Savin, Dan Thornton, and Guofu Zhou (associate editor and referee) for helpful comments. We acknowledge Robert Hodrick and Paul Sengmuller both for helpful comments and for pointing out a program error. Weller thanks the Research Department of the Federal Reserve Bank of St. Louis for its hospitality during his stay as a Visiting Scholar, when this work was initiated.

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