Forecasting volatility with neural regression: A contribution to model adequacy

Abstract

Neural nets' usefulness for forecasting is limited by problems of overfitting and the lack of rigorous procedures for model identification, selection and adequacy testing. This paper describes a methodology for neural model misspecification testing. We introduce a generalization of the Durbin-Watson statistic for neural regression and discuss the general issues of misspecification testing using residual analysis. We derive a generalized influence matrix for neural estimators which enables us to evaluate the distribution of the statistic. We deploy Monte Carlo simulation to compare the power of the test for neural and linear regressors. While residual testing is not a sufficient condition for model adequacy, it is nevertheless a necessary condition to demonstrate that the model is a good approximation to the data generating process, particularly as neural-network estimation procedures are susceptible to partial convergence. The work is also an important step toward developing rigorous procedures for neural model identification, selection and adequacy testing which have started to appear in the literature. We demonstrate its applicability in the nontrivial problem of forecasting implied volatility innovations using high-frequency stock index options. Each step of the model building process is validated using statistical tests to verify variable significance and model adequacy with the results confirming the presence of nonlinear relationships in implied volatility innovations.