Selection of estimation window in the presence of breaks

In situations where a regression model is subject to one or more breaks it is shown that it can be optimal to use pre-break data to estimate the parameters of the model used to compute out-of-sample forecasts. The issue of how best to exploit the trade-off that might exist between bias and forecast error variance is explored and illustrated for the multivariate regression model under the assumption of strictly exogenous regressors. In practice when this assumption cannot be maintained and both the time and size of the breaks are unknown, the optimal choice of the observation window will be subject to further uncertainties that make exploiting the bias-variance trade-off difficult. To that end we propose a new set of cross-validation methods for selection of a single estimation window and weighting or pooling methods for combination of forecasts based on estimation windows of different lengths. Monte Carlo simulations are used to show when these procedures work well compared with methods that ignore the presence of breaks. (c) 2006 Elsevier B.V. All rights reserved.