Rolling Window Selection in FAR Models with Structural Instabilities

Abstract: The paper develops a theory for selecting the rolling window when generating out-of-sample forecasts with factor-augmented regression (FAR) models in the presence of structural instabilities. It shows how to select a rolling window by minimizing the conditional mean squared forecast error (MSFE) while accounting for uncertainty in factor estimation. Because the conditional MSFE is unobserved and the factors are latent, this paper proposes a feasible version of the criterion and derives conditions under which the new method is asymptotically loss-efficient. A simulation experiment documents the procedure's performance.