Decision‐Based Forecast Evaluation of UK Interest Rate Predictability

Abstract

This paper illustrates the importance of density forecasting and forecast evaluation in portfolio decision making. The decision‐making environment is fully described for an investor seeking to optimally allocate her portfolio between long and short Treasury bills, over investment horizons of up to 2 years. We examine the impact of parameter uncertainty and predictability in bond returns on the investor's allocation and we describe how the forecasts are computed and used in this context. Both statistical and decision‐based criteria are used to assess the predictability of returns. Our results show sensitivity to the evaluation criterion used and, in the context of investment decision making under an economic value criterion, we find some potential gain for the investor from assuming predictability. Copyright © 2015 John Wiley & Sons, Ltd.

Forecasting U.S. stock returns

“…Such an evaluation, which is more closely aligned with investors, has often found greater support for predictor variables over the historical mean. For stock markets this includes, for example, Campbell and Thompson (2008) and Maio (2016), while other assets are also examined, including interest rates (e.g., Della Corte et al, 2008;Sirichand and Hall, 2016) and foreign exchange (e.g., Garratt and Lee, 2009;West et al, 1993). Leitch and Tanner (1991) and Pesaran and Skouras (2004) both argue that given forecasts are intended to inform investor decision-…”