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Financial Asset Returns, Direction-of-Change Forecasting, and Volatility Dynamics

Faculty of Management, McGill University, 1001 Sherbrooke Street West, Montreal, Quebec, Canada H3A 1G5 and Centre for Interuniversity Research and Analysis on Organizations (CIRANO), Montreal, Quebec, Canada
Department of Economics, University of Pennsylvania, 3718 Locust Walk, Philadelphia, Pennsylvania 19104-6297 and National Bureau of Economic Research, Cambridge, Massachusetts
peter.christoffersen{at}mcgill.ca
fdiebold{at}wharton.upenn.edu

We consider three sets of phenomena that feature prominently in the financial economics literature: (1) conditional mean dependence (or lack thereof) in asset returns, (2) dependence (and hence forecastability) in asset return signs, and (3) dependence (and hence forecastability) in asset return volatilities. We show that they are very much interrelated and explore the relationships in detail. Among other things, we show that (1) volatility dependence produces sign dependence, so long as expected returns are nonzero, so that one should expect sign dependence, given the overwhelming evidence of volatility dependence; (2) it is statistically possible to have sign dependence without conditional mean dependence; (3) sign dependence is not likely to be found via analysis of sign autocorrelations, runs tests, or traditional market timing tests because of the special nonlinear nature of sign dependence, so that traditional market timing tests are best viewed as tests for sign dependence arising from variation in expected returns rather than from variation in volatility or higher moments; (4) sign dependence is not likely to be found in very high-frequency (e.g., daily) or very low-frequency (e.g., annual) returns; instead, it is more likely to be found at intermediate return horizons; and (5) the link between volatility dependence and sign dependence remains intact in conditionally non-Gaussian environments, for example, with time-varying conditional skewness and/or kurtosis.

Key Words: return sign dependence; market timing; prediction
History: Received: February 25, 2004;