Finance and Economics Discussion Series (FEDS)
Better the Devil You Know: Improved Forecasts from Imperfect Models
Dong Hwan Oh and Andrew J. Patton
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.
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