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Economic Value of Stock and Interest Rate Predictability in the UK

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Listed:
  • Stephen Hall
  • Kavita Sirichand

Abstract

In this paper, we evaluate the forecast performance of a range of atheoretic and theory informed models of bond and stock returns. The decision making environment is fully described for an investor who would like to optimally allocate his portfolio between bonds and stocks, over an investment horizon of up to two years. We use a weekly dataset on UK Treasury Bill rates and the FTSE All-Share Index over the period 1997 to 2007, to examine the impact parameter uncertainty and predictability in returns have on how the investor optimally allocates his portfolio. The methods by which the forecasts should be computed and used in this context are described. Both statistical and decision based criteria are used to evaluate the out-of-sample forecasting performance of the models. Our results suggest that in the context of investment decision making under an economic value criterion, the investor gains from not only assuming predictability but by modelling the bond and stock returns together.

Suggested Citation

  • Stephen Hall & Kavita Sirichand, 2010. "Economic Value of Stock and Interest Rate Predictability in the UK," Discussion Papers in Economics 10/13, Division of Economics, School of Business, University of Leicester.
    • Handle: RePEc:lec:leecon:10/13
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    File URL: https://www.le.ac.uk/economics/research/RePEc/lec/leecon/dp10-13.pdf
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    References listed on IDEAS

    as
    1. Della Corte, Pasquale & Sarno, Lucio & Thornton, Daniel L., 2008. "The expectation hypothesis of the term structure of very short-term rates: Statistical tests and economic value," Journal of Financial Economics, Elsevier, vol. 89(1), pages 158-174, July.
    2. Sarno, Lucio & Thornton, Daniel L. & Valente, Giorgio, 2007. "The Empirical Failure of the Expectations Hypothesis of the Term Structure of Bond Yields," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(1), pages 81-100, March.
    3. Yihong Xia, 2001. "Learning about Predictability: The Effects of Parameter Uncertainty on Dynamic Asset Allocation," Journal of Finance, American Finance Association, vol. 56(1), pages 205-246, February.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Density Forecasting; Decision-based Forecast Evaluation; Interest Rate and Stock Return Models; Predictability and Parameter Uncertainty;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications

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