DP4380 Asset Prices and International Spillovers: An Empirical Investigation

Author(s): Lucio Sarno , Giorgio Valente

Publication Date: May 2004

Keyword(s): asset prices , international spillovers , forecasting , non-linearity

JEL(s): F31 , G10 , G13

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4380.asp

This Paper proposes a vector equilibrium correction model of stock returns that exploits the information in the futures market, while allowing for both regime-switching behaviour and international spillovers across stock market indices. Using data for three major stock market indices since 1989, we find that: (i) in sample, our model outperforms several alternative models on the basis of standard statistical criteria; (ii) in out-of-sample forecasting, our model does not produce significant gains in terms of point forecasts relative to more parsimonious alternative specifications, but it does so both in terms of market timing ability and in density forecasting performance. The economic value of the density forecasts is illustrated with an application to a simple risk management exercise.