Predictive ability tests with possibly overlapping models

Abstract

This paper provides novel tests for comparing out-of-sample predictive ability of two or more competing models that are possibly overlapping. The tests do not require pre-testing, they allow for dynamic misspecification and are valid under different estimation schemes and loss functions. In pairwise model comparisons, the test is constructed by adding a random perturbation to both the numerator and denominator of a standard Diebold–Mariano test statistic. This prevents degeneracy in the presence of overlapping models but becomes asymptotically negligible otherwise. The test is shown to control the Type I error probability asymptotically at the nominal level, uniformly over all null data generating processes. A similar idea is used to develop a superior predictive ability test for the comparison of multiple models against a benchmark. Monte Carlo simulations demonstrate that our tests exhibit very good size control in finite samples reducing both over- and under-rejection relative to its competitors. Finally, an application to forecasting U.S. excess bond returns provides evidence in favour of models using macroeconomic factors.