Abstract:
Research in asset pricing has, until recently, side-stepped the high dimensionality problem by focusing on low-dimensional models. Work on cross-sectional stock return prediction, for example, has focused on regressions with a small number of characteristics. Given the background of an enormously large number of variables that could potentially be relevant for predicting returns, focusing on such a small number of factors effectively means that the researchers are imposing a very high degree of sparsity on these models. This research studies the use of the recurrent neural network (RNN) method to deal with the “curse of dimensionality” challenge in the cross-section of stock returns. The purpose is to predict the daily stock returns. Compared with the traditional method of returns, namely the CAPM model, the focus will be on using the LSTM model to do the prediction. LSTM is very powerful in sequence prediction problems because they’re able to store past information. Thus, we compare the forecast of returns from the LSTM model with the traditional CAPM model. The comparison will be made using the out-of-sample R2 along with the Sharpe Ratio and Sortino Ratio. Finally, we conclude with the further improvements that need to be made for models trained by LSTMs to have any notable predictive ability in the area of stock returns.
