Diffusion Indices for Capital Markets
نویسندگان
چکیده
Recent advances in dynamic factor modelling allow for automated construction of diffusion indices based on large numbers of explanatory variables. We use the methodology proposed by Stock and Watson (1998) to test if such diffusion indices can be used for asset market applications where predictability is expected to be small or nonexistent. Results show that for portfolios formed using the largest 8 developed equity markets diffusion forecasts can result in statistically significant gains, both in terms of forecasting performance as well as portfolio performance, when compared with the benchmark sample-mean forecasts. The results are sensitive to model choice procedures, with data-driven information criteria performing consistently well in comparison with standard methods.
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