Efficient Prediction of Excess Returns

Jon Faust, Jonathan H. Wright

NBER Working Paper No. 14169
Issued in July 2008
NBER Program(s):   AP   ME

It is well known that augmenting a standard linear regression model with variables that are correlated with the error term but uncorrelated with the original regressors will increase asymptotic efficiency of the original coefficients. We argue that in the context of predicting excess returns, valid augmenting variables exist and are likely to yield substantial gains in estimation efficiency and, hence, predictive accuracy. The proposed augmenting variables are ex post measures of an unforecastable component of excess returns: ex post errors from macroeconomic survey forecasts and the surprise components of asset price movements around macroeconomic news announcements. These "surprises" cannot be used directly in forecasting--they are not observed at the time that the forecast is made--but can nonetheless improve forecasting accuracy by reducing parameter estimation uncertainty. We derive formal results about the benefits and limits of this approach and apply it to standard examples of forecasting excess bond and equity returns. We find substantial improvements in out-of-sample forecast accuracy for standard excess bond return regressions; gains for forecasting excess stock returns are much smaller.

download in pdf format
   (305 K)

email paper

This paper is available as PDF (305 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w14169

Published: May 2011, Vol. 93, No. 2, Pages 647-659 Posted Online April 26, 2011. (doi:10.1162/REST_a_00092) © 2011 The President and Fellows of Harvard College and the Massachusetts Institute of Technology Efficient Prediction of Excess Returns Jon Faust Johns Hopkins University Jonathan H. Wright Johns Hopkins University

Users who downloaded this paper also downloaded these:
Campbell and Yogo w10026 Efficient Tests of Stock Return Predictability
Cochrane and Piazzesi w9178 Bond Risk Premia
Goyal and Welch w8788 Predicting the Equity Premium With Dividend Ratios
Case and Shiller w3368 Forecasting Prices and Excess Returns in the Housing Market
Ang and Bekaert w8207 Stock Return Predictability: Is it There?
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us