DP4649 Optimal Forecast Combination Under Regime Switching

Author(s): Graham Elliott, Allan Timmermann
Publication Date: October 2004
Keyword(s): forecast combination, Markov switching, survey data, time-varying combination weights
JEL(s): C53
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4649

This Paper proposes a new forecast combination method that lets the combination weights be driven by regime switching in a latent state variable. An empirical application that combines forecasts from survey data and time series models finds that the proposed regime switching combination scheme performs well for a variety of macroeconomic variables. Monte Carlo simulations shed light on the type of data generating processes for which the proposed combination method can be expected to perform better than a range of alternative combination schemes. Finally, we show how time-variations in the combination weights arise when the target variable and the predictors share a common factor structure driven by a hidden Markov process.