Factor Augmented Artificial Neural Network Model

This paper brings together two important developments in forecasting literature; the artificial neural networks and factor models. The paper introduces the factor augmented artificial neural network (FAANN) hybrid model in order to produce a more accurate forecasting. Theoretical and empirical findings have indicated that integration of various models can be an effective way of improving on their predictive performance, especially when the models in the ensemble are quite different. The proposed model is used to forecast three time series variables using large South African monthly panel, namely, deposit rate, gold mining share prices and Long term interest rate, using monthly data over the in-sample period (training set) 1992:1-2006:12. The variables are used to compute out-of-sample (testing set) results for 3, 6 and 12 month-ahead forecasts for the period of 2007:1-2011:12. The out-of-sample root mean square error findings show that the FAANN model yields substantial improvements over the autoregressive AR benchmark model and standard dynamic factor model (DFM). The Diebold-Mariano test results also further confirm the superiority of the FAANN model forecast performance over the AR benchmark model and the DFM model forecasts. The superiority of the FAANN model is due to the ANN flexibility to account for potentially complex nonlinear relationships that are not easily captured by linear models.