Letter from the Editor-in-Chief

For readers of this journal who wish to set up a business selling financial forecasts, a word of caution is in order. Your clients will be active managers. These people are paid a fee by pension funds and so forth to come up with active management services. The single biggest component of these services is forecasts or alphas. In fact, Grinold and Kahn reduce an active manager down to a vector of alphas that are independently and identically distributed, standardized Gaussian random variables; a view that I would endorse with the possible addition of an implementation function as well. However ...

Issue: Volume 1/ Number 2, Fall 2007

Research Papers

Direction-of-change forecasts based on conditional variance, skewness and kurtosis dynamics: international evidence

Recent theoretical work has revealed a direct connection between asset return volatility forecastability and asset return sign forecastability. This suggests that the pervasive volatility forecastability in equity returns could, through induced sign forecastability, be used to produce direction-ofchange forecasts useful for market timing. We attempt to do so in an international sample of developed equity markets, with some success, as assessed by formal probability forecast scoring rules such as the Brier score. An important ingredient is our conditioning not only on conditional mean an ...

Issue: Volume 1/ Number 2, Fall 2007

Research Papers

Multiyear risk of credit losses in SME portfolios

We model multiyear loss distributions based on credit scores and macroeconomic risk drivers. In a two-step approach, we first model future default probabilities as functions of these risk factors and, second, model processes for the risk factors themselves. As an essential extension to one-year forecasts – used, eg, for calculating a bank’s regulatory capital charges under Basel II – we explicitly consider forecasting errors. These errors are introduced by forecasting future paths of the risk factors. We distinguish between idiosyncratic and systematic forecasting errors and show their effects ...

Issue: Volume 1/ Number 2, Fall 2007

Research Papers

Can sentiment be predicted to have cross-sectional effects?

Previous research suggests that sentiment has incremental explanatory power for returns and conditional volatility of stocks. When sentimentbased demands vary across stocks, to what extent then is sentiment responsible for the observed cross-sectional patterns in stock returns? Assuming that sentiment correlates with contemporaneous returns of particular categories of stocks, subsequent cross-sectional variation in stock returns is assumed to represent corrections of the initial mispricing. Therefore, this paper investigates whether sentiment can be predicted to have crosssectional effects. We ...

Issue: Volume 1/ Number 2, Fall 2007

Research Papers

The yield curve and macro fundamentals in forecasting exchange rates

This paper presents a vector error-correction model that facilitates the generation of long-term projections for exchange rates conditional upon yield curve movements, inflation and output gap. Our modeling framework draws on information from the whole yield curve, as represented by the yield curve’s level, slope and curvature. Using data from the US, the Eurozone and Japan, covering the period from 1973 to 2006, it is shown that the model generates superior exchange rate forecasts compared with the random walk and other alternative forecasting models. ...