An Alternative Methodology for Combining Different Forecasting Models

Many economic and financial time series exhibit heteroskedasticity, where the variability changes are often based on recent past shocks, which cause large or small fluctuations to cluster together. Classical ways of modelling the changing variance include the use of Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models and Neural Networks models. The paper starts with a comparative study of these two models, both in terms of capturing the nonlinear or heteroskedastic structure and forecasting performance. Monthly and daily exchange rates for three different countries are implemented. The paper continues with different methods for combining forecasts of the volatility from the competing models, in order to improve forecasting accuracy. Traditional methods for combining the predicted values from different models, using various weighting schemes are considered, such as the simple average or methods that find the best weights in terms of minimizing the squared forecast error. The main purpose of the paper is, however, to propose an alternative methodology for combining forecasts effectively. The new, hereby-proposed non-linear, non-parametric, kernel-based method, is shown to have the basic advantage of not being affected by outliers, structural breaks or shocks to the system and it does not require a specific functional form for the combination.