Density Forecast of Financial Returns Using Decomposition and Maximum Entropy

Tae Hwy Lee, He Wang (), Zhou Xi () and Ru Zhang ()
Additional contact information
He Wang: University of International Business and Economics, Beijing
Zhou Xi: Citigroup
Ru Zhang: JP Morgan Chase

No 202115, Working Papers from University of California at Riverside, Department of Economics

Abstract: We consider a multiplicative decomposition of the financial returns to improve the density forecasts of financial returns. The multiplicative decomposition is based on the identity that financial return is the product of its absolute value and its sign. Advantages of modeling the two components are discussed. To reduce the effect of the estimation error due to the multiplicative decomposition in estimation of the density forecast model, we impose a moment constraint that the conditional mean forecast is set to match with the sample mean. Imposing such a moment constraint operates a shrinkage and tilts the density forecast of the decomposition model to produce the improved maximum entropy density forecast. An empirical application to forecasting density of the daily stock returns demonstrates the benefits of using the decomposition and imposing the moment constraint to obtain the improved density forecast. We evaluate the density forecast by comparing the logarithmic score, the quantile score, and the continuous ranked probability score. We contribute to the literature on the density forecast and the decomposition models by showing that the density forecast of the decomposition model can be improved by imposing a sensible constraint in the maximum entropy framework.

Keywords: Decomposition; Copula; Moment constraint; Maximum entropy; Density forecast; Logarithmic score; Quantile score; VaR; Continuous ranked probability score. (search for similar items in EconPapers)
JEL-codes: C1 C3 C5 (search for similar items in EconPapers)
Pages: 43 Pages
Date: 2021-11
New Economics Papers: this item is included in nep-ecm, nep-for, nep-ore and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
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Forthcoming in Journal of Econometric Methods

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https://economics.ucr.edu/repec/ucr/wpaper/202115.pdf First version, 2021 (application/pdf)

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Journal Article: Density Forecast of Financial Returns Using Decomposition and Maximum Entropy (2023)
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