Forecasting stock market volatility under parameter and model uncertainty

Zhao-Chen Li, Chi Xie, Gang-Jin Wang, You Zhu, Jian-You Long and Yang Zhou

Research in International Business and Finance, 2023, vol. 66, issue C

Abstract: We forecast monthly stock market volatility under parameter and model uncertainty. Using a long economic dataset spanning almost a century, we prove that model uncertainty plays a more crucial role than parameter uncertainty in improving volatility predictability. The combination models with model uncertainty, especially dynamic model averaging (DMA), provide very competitive improvements in forecasting accuracy, whose superiority is also reflected in asset allocation and risk hedging. We find two empirical properties of forecast combination: (i) it incorporates information from numerous predictors, helping reduce both the forecast bias and forecast error variance; and (ii) the economic links of the forecasts based on it are significant, and the predictive gains are concentrated in poor economic conditions. Overall, we highlight the importance of considering model uncertainty via forecast combination when investigating the expected stock market volatility.

Keywords: Stock market volatility; Parameter uncertainty; Model uncertainty; Forecast combination; Dynamic model averaging (search for similar items in EconPapers)
JEL-codes: C52 C53 C58 G17 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:riibaf:v:66:y:2023:i:c:s0275531923002106

DOI: 10.1016/j.ribaf.2023.102084

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