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Because climate change broadcasts a large aggregate risk to the overall macroeconomy and the global financial system, we investigate how a temperature anomaly and/or its volatility affect the accuracy of forecasts of stock return volatility. To this end, we do not apply only the classical GARCH and GARCHX models, but rather we apply newly proposed model-free prediction methods, and use GARCH-NoVaS and GARCHX-NoVaS models to compute volatility predictions. These two models are based on a normalizing and variance-stabilizing transformation (NoVaS transformation) and are guided by a so-called model-free prediction principle. Applying the new models to data for South Africa, we find that climate-related information is helpful in forecasting stock return volatility. Moreover, the novel model-free prediction method can incorporate such exogenous information better than the classical GARCH approach, as revealed by the the squared prediction errors. More importantly, the forecast comparison test reveals that the advantage of applying exogenous information related to climate risks in prediction of the South African stock return volatility is significant over a century of monthly data (February 1910–February 2023). Our findings have important implications for academics, investors, and policymakers.
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A model-free approach to do long-term volatility forecasting and its variants
Abstract Volatility forecasting is important in financial econometrics and is mainly based on the application of various GARCH-type models. However, it is difficult to choose a specific GARCH model that works uniformly well across datasets, and the traditional methods are unstable when dealing with highly volatile or short-sized datasets. The newly proposed normalizing and variance stabilizing (NoVaS) method is a more robust and accurate prediction technique that can help with such datasets. This model-free method was originally developed by taking advantage of an inverse transformation based on the frame of the ARCH model. In this study, we conduct extensive empirical and simulation analyses to investigate whether it provides higher-quality long-term volatility forecasting than standard GARCH models. Specifically, we found this advantage to be more prominent with short and volatile data. Next, we propose a variant of the NoVaS method that possesses a more complete form and generally outperforms the current state-of-the-art NoVaS method. The uniformly superior performance of NoVaS-type methods encourages their wide application in volatility forecasting. Our analyses also highlight the flexibility of the NoVaS idea that allows the exploration of other model structures to improve existing models or solve specific prediction problems.
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- Award ID(s):
- 2124222
- PAR ID:
- 10399445
- Publisher / Repository:
- Springer Science + Business Media
- Date Published:
- Journal Name:
- Financial Innovation
- Volume:
- 9
- Issue:
- 1
- ISSN:
- 2199-4730
- Format(s):
- Medium: X
- Sponsoring Org:
- National Science Foundation
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