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Forecasting dynamic return distributions based on ordered binary choice

Publication |
2019

Abstract

We present a simple approach to the forecasting of conditional probability distributions of asset returns. We work with a parsimonious specification of ordered binary choice regressions that imposes a connection on sign predictability across different quantiles.

The model forecasts the future conditional probability distributions of returns quite precisely when using a past indicator and a past volatility proxy as predictors. The direct benefits of the model are revealed in an empirical application to the 29 most liquid U.S. stocks.

The forecast probability distribution is translated to significant economic gains in a simple trading strategy. Our approach can also be useful in many other applications in which conditional distribution forecasts are desired. (C) 2019 International Institute of Forecasters.

Published by Elsevier B.V. All rights reserved.