Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2014/12: A Likelihood Ratio and Markov Chain Based Method to Evaluate Density Forecasting

Yushu Li () and Jonas Andersson ()
Additional contact information
Yushu Li: Dept. of Business and Management Science, Norwegian School of Economics, Postal: NHH , Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway
Jonas Andersson: Dept. of Business and Management Science, Norwegian School of Economics, Postal: NHH , Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: In this paper, we propose a likelihood ratio and Markov chain based method to evaluate density forecasting. This method can jointly evaluate the unconditional forecasted distribution and dependence of the outcomes. This method is an extension of the widely applied evaluation method for interval forecasting proposed by Christoffersen (1998). It is also a more refined approach than the pure contingency table based density forecasting method in Wallis (2003). We show that our method has very high power against incorrect forecasting distributions and dependence. Moreover, the straightforwardness and ease of application of this joint test provide a high potentiality for further applications in both financial and economical areas.

Keywords: Likelihood ratio test; Markov Chain; Density forecasting

JEL-codes: C14; C53; C61

12 pages, March 25, 2014

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