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What causes the forecasting failure of Markov-switching models ? A Monte Carlo study.

By Othman Bouabdallah and Marie Bessec

Abstract

This paper explores the forecasting abilities of Markov-Switching models. Although MS models generally display a superior in-sample fit relative to linear models, the gain in prediction remains small. We confirm this result using simulated data for a wide range of specifications. In order to explain this poor performance, we use a forecasting error decomposition. We identify four components and derive their analytical expressions in different MS specifications. The relative contribution of each source is assessed through Monte Carlo simulations. We find that the main source of error is due to the misclassification of future regimes.Markov Switching; Regime Shifts; Forecasting;

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