Working Paper

Better the Devil You Know: Improved Forecasts from Imperfect Models

Abstract: Many important economic decisions are based on a parametric forecasting model that is known to be good but imperfect. We propose methods to improve out-of-sample forecasts from a mis- speci…ed model by estimating its parameters using a form of local M estimation (thereby nesting local OLS and local MLE), drawing on information from a state variable that is correlated with the misspeci…cation of the model. We theoretically consider the forecast environments in which our approach is likely to o¤er improvements over standard methods, and we …nd signi…cant fore- cast improvements from applying the proposed method across distinct empirical analyses including volatility forecasting, risk management, and yield curve forecasting.

Keywords: Model misspecification; Local maximum likelihood; Volatility forecasting; Value-at-risk and expected shortfall forecasting; Yield curve forecasting;

JEL Classification: C53; C51; C58; C14;

https://doi.org/10.17016/FEDS.2021.071

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2021-11-05

Number: 2021-071