On economic evaluation of directional forecasts

It is commonly accepted that information is helpful if it can be exploited to improve a decision making process. In economics, decisions are often based on forecasts of the upward or downward movements of the variable of interest. We point out that directional forecasts can provide a useful framework for assessing the economic forecast value when loss functions (or success measures) are properly formulated to account for the realized signs and realized magnitudes of directional movements. We discuss a general approach to (directional) forecast evaluation which is based on the loss function proposed by Granger, Pesaran and Skouras. It is simple to implement and provides an economically interpretable loss/success functional framework. We show that, in addition, this loss function is more robust to outlying forecasts than traditional loss functions. As such, the measure of the directional forecast value is a readily available complement to the commonly used squared error loss criterion.