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A Simple Out-of-Sample Test of Predictability against the Random Walk Benchmark

Author

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  • Pablo Pincheira

    (School of Business, Universidad Adolfo Ibáñez, Peñalolén 8380629, Chile)

  • Nicolas Hardy

    (Facultad de Economía y Empresa, Universidad Diego Portales, Huechuraba 8370179, Chile)

  • Andrea Bentancor

    (Facultad de Economía y Negocios, Universidad de Talca, Talca 3460000, Chile)

Abstract

We show that a straightforward modification of a trading-based test for predictability displays interesting advantages over the Excess Profitability (EP) test proposed by Anatolyev and Gerco when testing the Driftless Random Walk Hypothesis. Our statistic is called the Straightforward Excess Profitability (SEP) test, and it avoids the calculation of a term that under the null of no predictability should be zero but in practice may be sizable. In addition, our test does not require the strong assumption of independence used to derive the EP test. We claim that dependence is the rule and not the exception. We show via Monte Carlo simulations that the SEP test outperforms the EP test in terms of size and power. Finally, we illustrate the use of our test in an empirical application within the context of the commodity-currencies literature.

Suggested Citation

  • Pablo Pincheira & Nicolas Hardy & Andrea Bentancor, 2022. "A Simple Out-of-Sample Test of Predictability against the Random Walk Benchmark," Mathematics, MDPI, vol. 10(2), pages 1-20, January.
    • Handle: RePEc:gam:jmathe:v:10:y:2022:i:2:p:228-:d:722904
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    References listed on IDEAS

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    1. Clark, Todd E. & West, Kenneth D., 2006. "Using out-of-sample mean squared prediction errors to test the martingale difference hypothesis," Journal of Econometrics, Elsevier, vol. 135(1-2), pages 155-186.
    2. Barbara Rossi, 2013. "Exchange Rate Predictability," Journal of Economic Literature, American Economic Association, vol. 51(4), pages 1063-1119, December.
    3. Yu-Chin Chen & Kenneth S. Rogoff & Barbara Rossi, 2010. "Can Exchange Rates Forecast Commodity Prices?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 125(3), pages 1145-1194.
    4. Pincheira Brown, Pablo & Hardy, Nicolás, 2019. "Forecasting base metal prices with the Chilean exchange rate," Resources Policy, Elsevier, vol. 62(C), pages 256-281.
    5. Pablo Pincheira Brown & Nicolás Hardy, 2024. "The mean squared prediction error paradox," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 43(6), pages 2298-2321, September.
    6. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
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    Cited by:

    1. Guo, Honggang & Wang, Jianzhou & Li, Zhiwu & Lu, Haiyan & Zhang, Linyue, 2022. "A non-ferrous metal price ensemble prediction system based on innovative combined kernel extreme learning machine and chaos theory," Resources Policy, Elsevier, vol. 79(C).
    2. Nicolás Magner & Nicolás Hardy, 2022. "Cryptocurrency Forecasting: More Evidence of the Meese-Rogoff Puzzle," Mathematics, MDPI, vol. 10(13), pages 1-27, July.
    3. Hardy, Nicolás & Ferreira, Tiago & Quinteros, Maria J. & Magner, Nicolás S., 2023. "“Watch your tone!”: Forecasting mining industry commodity prices with financial report tone," Resources Policy, Elsevier, vol. 86(PA).

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