LUCIO SARNO AND GIORGIO VALENTE

SUMMARY
This paper proposes a vector equilibrium correction model of stock returns that exploits the information in
the futures market, while allowing for both regime-switching behaviour and international spillovers across
stock market indices. Using data for three major stock market indices since 1989, we find that: (i) in sample,
our model outperforms several alternative models on the basis of standard statistical criteria; (ii) in out-ofsample
forecasting, our model does not produce significant gains in terms of point forecasts relative to more
parsimonious alternative specifications, but it does so both in terms of market timing ability and in density
forecasting performance. The economic value of the density forecasts is illustrated with an application to a
simple risk management exercise. Copyright  2005 John Wiley & Sons, Ltd.