Forecasting with Factor Models: A Bayesian Model Averaging Perspective

Dimitris, Korobilis (2013): Forecasting with Factor Models: A Bayesian Model Averaging Perspective.

Abstract

We use Bayesian factor regression models to construct a financial conditions index (FCI) for the U.S. Within this context we develop Bayesian model averaging methods that allow the data to select which variables should be included in the FCI or not. We also examine the importance of different sources of instability in the factors, such as stochastic volatility and structural breaks. Our results indicate that ignoring structural breaks in the loadings can be quite costly in terms of the forecasting performance of the FCI. Additionally, Bayesian model averaging can improve in specific cases the performance of the FCI, by means of discarding irrelevant financial variables during the estimation of the factor.

• Item Type: MPRA Paper
• Language: English
• Keywords: financial stress; stochastic search variable selection; early-warning system; forecasting
• Subjects: C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C11 - Bayesian Analysis: General; C - Mathematical and Quantitative Methods > C2 - Single Equation Models ; Single Variables > C22 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C52 - Model Evaluation, Validation, and Selection; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C53 - Forecasting and Prediction Methods ; Simulation Methods; C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C63 - Computational Techniques ; Simulation Modeling; E - Macroeconomics and Monetary Economics > E1 - General Aggregative Models > E17 - Forecasting and Simulation: Models and Applications; G - Financial Economics > G0 - General > G01 - Financial Crises; G - Financial Economics > G1 - General Financial Markets > G17 - Financial Forecasting and Simulation

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