City Research Online

Combining Nearest Neighbor Predictions and Model-Based Predictions of Realized Variance: Does it Pay?

Andrada-Felix, J., Fernandez-Rodriguez, F. & Fuertes, A-M. ORCID: 0000-0001-6468-9845 (2016). Combining Nearest Neighbor Predictions and Model-Based Predictions of Realized Variance: Does it Pay?. International Journal of Forecasting, 32(3), pp. 695-715. doi: 10.1016/j.ijforecast.2015.10.004


The increasing availability of intraday financial data has led to improvements in daily volatility forecasting through long-memory models of realized volatility. This paper demonstrates the merit of the non-parametric Nearest Neighbor (NN) approach for S&P 100 realized variance forecasting. A priori the NN approach is appealing because it can reproduce complex dynamic dependencies while largely avoiding misspecification and parameter estimation uncertainty, unlike model-based methods. We evaluate the forecasts through straddle trading profitability metrics and using conventional statistical accuracy criteria. The ranking of individual forecasts confirms that statistical accuracy does not have a one-to-one mapping into profitability. In turbulent markets, the NN forecasts lead to higher risk-adjusted profitability even though the model-based forecasts are statistically superior. In both calm and turbulent market conditions, the directional combination of NN and model-based forecasts is more profitable than any of the individual forecasts.

Publication Type: Article
Additional Information: © 2015, Elsevier. Licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International
Publisher Keywords: Realized Volatility; Volatility Forecasting; Non-parametric Forecasts; Nearest Neighbor; Long-Memory Models; Forecast Combination; Straddles; Options Trading
Subjects: H Social Sciences > HG Finance
Q Science > QA Mathematics
Departments: Bayes Business School > Finance
SWORD Depositor:
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