Finance Research Letters 54 (2023) 103720

Contents lists available at ScienceDirect

Finance Research Letters

journal homepage: www.elsevier.com/locate/frl

EU Climate Change News Index: Forecasting EU ETS prices with

online news
Áron Dénes Hartvig a ,∗, Áron Pap b , Péter Pálos b
a
Corvinus University of Budapest, Cambridge Econometrics, Fővám square 8, Budapest, 1093, Hungary
b
Independent scholar, Budapest, Hungary

ARTICLE INFO ABSTRACT

JEL classification: Carbon prices have been rapidly increasing in the EU since 2018 and accurate forecasting of
C80 EU Emissions Trading System (ETS) prices has become essential. This paper proposes a novel
Q48 method to generate alternative predictors for daily ETS price returns using relevant online news
Q54
information. We devise the EU Climate Change News Index by calculating the term frequency–
Q58
inverse document frequency (TF–IDF) feature for climate change-related keywords. The index
Keywords: is capable of tracking the ongoing debate about climate change in the EU. Finally, we show
Emissions trading system that incorporating the index in a simple predictive model significantly improves forecasts of
Carbon price prediction
ETS price returns.
Online news
TF–IDF
Climate change
Market index

1. Introduction

Carbon pricing is an economically efficient instrument in the policy toolkit to signal emissions’ actual cost and stimulate
investments in low-carbon technological innovations. Emissions trading systems are market-based mechanisms where a cap is set
on certain sectors’ emissions and the entities covered are allowed to trade emissions allowances. In theory, trading ensures that
emissions are reduced where abatement costs are the lowest. The world’s first international carbon market, the EU Emissions Trading
System (ETS), was implemented in 2005 covering power generators and energy-intensive industries. ETS prices stayed low for a long
time but finally started to rise in 2017. The ETS allowance prices skyrocketed in 2021, reaching almost e100 in February 2022.
Nevertheless, prices dropped below e60 in early-March after the disruptions caused by the Russian invasion of Ukraine.
The current price range and the peak price of almost e100 have caught the eyes of investors. However, volatility of the allowance
prices and policy uncertainty around the future of the ETS increases risks associated with low-carbon technology investments.
Furthermore, most companies covered by the ETS are risk averse in terms of trading with allowances (Haita-Falah, 2016) and
volatile carbon prices increase the uncertainty of their production costs since they purchase allowances as they emit.
Our contribution to the literature on carbon pricing is twofold. First, we propose a new EU Climate Change News Index (ECCNI)
that tracks the ongoing discussion in the EU about climate change using global media sources. Although some articles have already
incorporated news information into the forecasting of ETS prices (Ye and Xue, 2021; Zhang and Xia, 2022), no meaningful feature
has been created that captures the media’s climate policy-related discussions. We apply term frequency–inverse document frequency

∗ Corresponding author.
E-mail addresses: aron.hartvig@stud.uni-corvinus.hu (Á.D. Hartvig), aron.pap@barcelonagse.eu (Á. Pap), peterpalos@edu.bme.hu (P. Pálos).

https://doi.org/10.1016/j.frl.2023.103720
Received 5 November 2022; Received in revised form 22 January 2023; Accepted 19 February 2023
Available online 23 February 2023
1544-6123/© 2023 The Authors. Published by Elsevier Inc. This is an open access article under the CC BY-NC-ND license
(http://creativecommons.org/licenses/by-nc-nd/4.0/).
Á.D. Hartvig et al. Finance Research Letters 54 (2023) 103720

(TF–IDF) feature extraction to the GDELT1 news database to measure the frequency of climate change-related keywords in the news
associated with the EU. The TF–IDF features help to quantify the intensity of the discussion about climate change in the EU and to
incorporate policy context in the analysis of carbon prices.
Second, we apply the news index to predict the next day’s ETS allowance price returns. We test the forecast accuracy of the
ECCNI against a set of standard predictors taken from the literature. Our results suggest that the integration of the occurrence of
climate change-related keywords in the most reliable news sites improves the forecasts of the ETS price returns.
Several quantitative methods have already been developed in academic literature to forecast carbon prices. Zhao et al. (2018)
categorizes these papers into two groups: (1) forecasting based on time-series data using carbon price only; (2) forecasting via
using both carbon prices and information that is contained in economic and energy data. The carbon price-only methods mostly
include ARIMA models; however, they can only capture linear relationships (Zhu and Chevallier, 2017). Therefore, more advanced
frameworks have been applied to carbon prices, like different varieties of generalized autoregressive conditional heteroscedasticity
(GARCH) models (Arouri et al., 2012; Benschopa and López Cabreraa, 2014; Byun and Cho, 2013) and vector autoregressive (VAR)
models (Arouri et al., 2012).
Nevertheless, carbon price-only methods do not incorporate all available information in the market. Various articles that aim
to forecast carbon prices use economic and energy-related variables proxying the demand for CO2 allowances (Arouri et al., 2012;
Guðbrandsdóttir and Haraldsson, 2011; Zhao et al., 2018). Recently, alternative predictors, e.g., news data through natural language
processing (NLP), have also been used to forecast ETS prices. Ye and Xue (2021) created a carbon tone index reflecting sentiment
in news articles and showed that it has strong predictive power on carbon prices. Zhang and Xia (2022) used online news data
and Google trends to improve the forecast of ETS prices. However, they only included the headlines and titles of online news from
limited sources and consequently could only examine carbon prices with a weekly frequency. Furthermore, their word embedding
algorithm is not directly interpretable and lacks transparency. To shed more light on the impact of news on daily ETS prices, we
create features by applying the TF–IDF method to the GDELT news dataset. TF–IDF has been widely used to improve the forecast
accuracy of stock prices (Coyne et al., 2017; Lubis et al., 2021; Mittermayer, 2004; Nikfarjam et al., 2010).
The remainder of this paper is organized as follows. Section 2 provides a short description of our dataset, while Section 3 outlines
the methods used to analyze it. This leads into Section 4, where we discuss the generated ECCNI and the forecasting performance
of the models that incorporate news information. Finally, Sections 5 and 6 summarize our conclusions and ideas for future work.

2. Data

The main contribution of this study is the conversion of online news articles to meaningful variables that enhances our
understanding of ETS. Therefore, we use GDELT, a free open platform covering global news from numerous countries in over 100
languages with daily frequency. The database includes, along with others, the actors, locations, organizations, themes, and sources
of the news items (Leetaru and Schrodt, 2013). GDELT has been used in various articles that apply NLP to extract alternative
information from the news (Alamro et al., 2019; Galla and Burke, 2018; Guidolin and Pedio, 2021).
We take the daily returns of futures closing prices of the European Union Allowance (EUA) (e/ton) from ember-climate.org as
the dependent variable since that is the underlying carbon price of ETS. Besides news data, we include the most fundamental drivers
of ETS prices (Ye and Xue, 2021) in our analysis to serve as standard predictors:

• Gas: NBP Natural Gas Futures (NGLNMc1)

• Electricity: Electricity Yearly Futures (ELCBASYc1)
• Coal: Rotterdam Coal Futures (ATWMc1)
• Oil: Brent Oil Futures (LCOF3)
• Stocks: Europe 600 Index (STOXX).

The data was collected from Investing.com between January 2, 2018 and November 30, 2021, with 1011 daily observations in
total. The availability of standard predictors gave the starting date, and the end was determined to avoid the possible distorting
effect of the Russian–Ukrainian conflict.

3. Methodology

This study suggests creating the ECCNI and incorporating this index into the forecasts of ETS price returns. The following
subsection outlines the methodology of the index construction.

1 The Global Database of Events, Language, and Tone (GDELT) Project is a real-time network diagram and database of global human society for open research

that monitors the world’s broadcast, print, and web news in over 100 languages. For more information, see: https://www.gdeltproject.org/, accessed: 2022-10-21.

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Á.D. Hartvig et al. Finance Research Letters 54 (2023) 103720

3.1. Article collection

Our ECCNI relies on the GDELT database that gathers a wide range of online news with daily frequency. Thus, to focus our
analysis, we restricted the dataset to the articles where the actor2 is European Union or EU and extracted their URL-s. We chose to
filter on the actor to focus on issues and policies that are dealt with by the EU. Moreover, carbon prices are also affected by global
trends; consequently, filtering based on geography would not be adequate.
Furthermore, we removed the articles from the database that were coming from unreliable sources. For this purpose, we used
one of the most cited media bias resources, Media Bias Fact Check (MBFC) (MBFC, 2022). We removed the articles from the data
that appeared on ‘questionable’ websites according to the ‘Factual/Sourcing’ category of MBFC.3
After the filtering, the overall number of news sites was reduced from 9497 to 719, from which our web scraper collected 27,777
articles.

3.2. Feature generation workflow

We performed basic string pre-processing steps on the raw texts using the Natural Language Toolkit (NLTK) package (Bird et al.,
2009). This package was also used to lemmatize words with WordNetLemmatizer, a more advanced solution than standard stemming
because of the addition of morphological analysis. Since our keyword collection contains several multi-word elements, bigrams and
trigrams were also formed with the lemmatizer to create the Term Frequency–Inverse Document Frequency (TF–IDF) matrix, which
is one of the most commonly used methods for NLP (more details in Appendix A). The TF–IDF method is an adequate tool to
transform alternative information from text documents to numerical variables which can be incorporated into forecasting models
of financial time series (Coyne et al., 2017; Lubis et al., 2021; Mittermayer, 2004; Nikfarjam et al., 2010). It is generally accepted
that the normalized form of TF–IDF is more effective than Bag-of-words methods in terms of ignoring common words, and it is also
able to highlight rare terms.
The rows of our calculated TF–IDF matrix represent the individual articles, and its columns are the elements of the partially
external, partially custom-defined keyword list. We gathered our keywords around five main groups: fossil fuels, renewable energy
carriers, energy policy, emissions and gas as an independent topic. We used keyword suggestions from Google Trends and our
intuition to expand the mentioned groups. The complete list of keywords is shown in Table A.1. We calculated the score for each
keyword so it can also be used for further detailed analysis. Still, due to the high variance of the occurrences and the strong
correlation between the keyword groups (shown in Fig. A.1), we created the EU Climate Change News Index as the aggregated
TF–IDF score of the groups.4

3.3. Forecasting models

We use simple ARIMAX models to test whether the ECCNI can provide additional predictive power to standard ETS price return
forecasts. The first (TF–IDF ) model includes the lags of the ETS price returns5 (𝑟𝑡 ) and the 30-day moving average deviation6 of the
ECCNI (𝑀𝐴𝐷(𝐸𝐶𝐶𝑁𝐼𝑡 )) as measure of ‘‘abnormal attention’’ to serve as predictors7 :
𝑘 (
∑ )
𝑟𝑡 = 𝑐 + 𝜙𝑖 𝑟𝑡−𝑖 + 𝜃𝑖 𝑀𝐴𝐷(𝐸𝐶𝐶𝑁𝐼𝑡−𝑖 ) . (1)
𝑖=1

While the second model, called Baseline, serves as a benchmark model which considers the lags of the ETS price returns and the
fundamental driving factors of carbon prices based on academic literature (lags of gas, electricity, coal, oil and stock price returns
represented by vector 𝑥𝑡 for period t ):
𝑘 (
∑ )
𝑟𝑡 = 𝑐 + 𝜙𝑖 𝑟𝑡−𝑖 + 𝛽𝑖𝑇 𝑥𝑡−𝑖 . (2)
𝑖=1

The final, Full model includes all predictors: the lags of the ETS price returns, the standard predictors’ price returns and the
30-day moving average deviation of the ECCNI:
𝑘 (
∑ )
𝑟𝑡 = 𝑐 + 𝜙𝑖 𝑟𝑡−𝑖 + 𝛽𝑖𝑇 𝑥𝑡−𝑖 + 𝜃𝑖 𝑀𝐴𝐷(𝐸𝐶𝐶𝑁𝐼𝑡−𝑖 ) . (3)
𝑖=1

We use OLS regression and ElasticNet shrinkage method8 to estimate the models.

2 Actor describes characteristics of the two actors involved in the event. This may include its proper name, geographic, ethnic, and religious affiliation and

the actor’s role in the environment.

3 We are grateful to Courtney Pitcher who fetched the data from MBFC and published an organized dataset on her blog (Pitcher, 2019).
4 The TF–IDF scores of the EU Climate Change News Index and the keyword groups is available on the EU ETS news tracker dashboard.
5 By price return of variable 𝑝 we mean the log return: 𝛥𝑙𝑜𝑔(𝑝 ) = 𝑙𝑜𝑔( 𝑝𝑡 ).
𝑡 𝑝 𝑡−1 ∑30
6 𝑝𝑡−𝑖
By 30-day moving average deviation we mean the distance between the asset’s current price and its 30-day moving average: 𝑀𝐴𝐷(𝑝𝑡 ) = 𝑝𝑡 − 𝑖=1
30
.
7 We would like to thank the anonymous reviewer for their suggestion.
8 We used the following hyperparameters for grid search: 𝐿1 = [0, 0.01, 0.05, 0.1, 0.3, 0.5, 0.7, 0.9, 0.95, 0.99, 1] and 𝛼 = [0, 0.001, 0.003, 0.005, 0.007, 0.009,

0.0095, 0.01, 0.1, 0.3, 0.5, 0.7, 0.9, 0.95, 0.99, 0.999, 1].

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Á.D. Hartvig et al. Finance Research Letters 54 (2023) 103720

Fig. 1. EU Climate Change News Index between January 2, 2018 and November 30, 2021.

4. Results

In this section, we present the ECCNI, the index constructed from the TF–IDF features that are derived using our methodology
described in Section 3. First, we assess the evolution of the index qualitatively by walking through the most important events related
to climate change in the EU since 2020. We then use OLS and ElasticNet models to test the forecasting ability of the index.

4.1. EU climate change news index

Since policy uncertainty is substantial around the ETS system, measuring the intensity of debate around it is crucial. One of
the key drivers of the ETS prices is the EU’s ever-increasing emissions reduction targets, which set a cap on the number of ETS
allowances. Nevertheless, various other policy measures also impact carbon prices as sectoral policies, like green energy mandates.
We present the evolution of the ECCNI between January 2, 2018, and November 30, 2021, in Fig. 1. The index is highly volatile,
but several cycles are outlined in the 30-days moving average. In the followings, we concentrate on the events influencing the index
starting from 2020. In January and February 2020, the index reached a relatively high and stable level due to the recent presentation
of the EU Green Deal. Then, in March 2020, the index started to decrease steadily as the COVID-19 pandemic overtook the public
discourse in the EU. However, the concept of ‘green recovery’ soon emerged, and climate change keywords again started trending.
In October 2020, COVID-19 cases soared again, pushing down the index. The European Council endorsed a binding EU target of
a net domestic reduction of greenhouse gas emissions by at least 55% by 2030 (compared to 1990 levels), leading to a local peak
at the end of the year. The proceeding period was less volatile; however, in June 2021, the index jumped to a higher level as the
European Council endorsed the new Renovation Wave strategy, and in July, the ‘Fit for 55’ package was presented. Finally, the
climate change news index peaked in November 2021 as the 26th Conference of the Parties (COP26) was held between October 31
and November 13 in Scotland.

4.2. Forecasting performance

We argue that the EU Climate Change News Index can track the ongoing discussion about the ETS. Since ETS prices are strongly
dependent on the policy environment and the measures introduced, the index could potentially help to better predict the evolution of
carbon prices in the EU. Therefore, in the followings, we test the forecasting performance of the index. In our analysis, we compare
three models to measure the forecasting performance of the ECCNI. Only the lagged values of the predictors are included in the
models to produce forecasts that rely entirely on historical information. We run the models with 𝑘 = 1, 2, 3, 4, 5 lags for robustness
purposes but only report the results from the best-performing models. We statically estimated the models on three different train-test
splits of the sample using the last 𝑛 ∈ [50, 75, 100] days for the out-of-sample testing to examine the performance of the models on
the most recent data.9 Table 1 summarizes the out-of-sample 1-day ahead forecast results (𝑀𝐴𝐸 and 𝑅𝑀𝑆𝐸) of the TF–IDF, Baseline
and Full models for carbon price returns.

9 We cut the last 𝑛 days from the 1011 days included in the analysis and use them as a test window while train the models on the first 1011 − 𝑛 days.

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Table 1
Forecast performance comparison of different models with static estimation method.
Test window Measure Model TF–IDF Baseline Full
Valuea Lags Valuea Lags Valuea Lags
MAE OLS 20.256 2 18.878 1 18.679 1
ElasticNet 20.827 1 20.220 3 20.038 3
50
RMSE OLS 0.7651 4 0.6903 1 0.6867 1
ElasticNet 0.7976 1 0.7430 3 0.7358 3
MAE OLS 18.204 4 17.222 1 17.062 1
ElasticNet 18.647 1 17.931 3 17.844 3
75
RMSE OLS 0.6440 4 0.6028 1 0.6002 1
ElasticNet 0.6705 1 0.6251 3 0.6217 3
MAE OLS 17.419 1 16.641 1 16.507 1
ElasticNet 17.726 2 17.305 3 17.314 3
100
RMSE OLS 0.5824 1 0.5400 1 0.5382 1
ElasticNet 0.5944 2 0.5567 3 0.5578 3
a 10−3

Table 2
Clark and West test results for the full and baseline models.
Test window Model Baseline Full CW
Lags Lags p-value
OLS 1 1 0.088
50
ElasticNet 3 3 0.046
OLS 1 1 0.050
75
ElasticNet 3 3 0.141
OLS 1 1 0.055
100
ElasticNet 3 3 0.398

Based on the results, the Full model outperforms the others for most of the test windows, evaluation metrics and estimation
methods, while the TF–IDF model produces the largest errors. The inclusion of the 30-day moving average deviation of the ECCNI
notably decreases both the MAE and the RMSE values except for the ElasticNet models with 100-day test window. To test whether
the forecasting accuracy of our Full model is significantly different from the Baseline model’s, we carry out the Clark and West (CW)
test (Clark and West, 2007) for equal predictive accuracy in nested models. The test results are shown in Table 2.10
The results of the CW tests indicate that adding the ECCNI to the Baseline model significantly improves the model’s forecast
accuracy in four out of six cases (at 10% significance level). The Full model performs especially well on the last 50 days of the
sample when the COP26 conference was taken place and the ETS prices were soaring (see the evolution of ETS price on Fig. A.2 in
the Appendix A).
We further tested the predictive ability of the models by dynamically estimating them using different rolling windows. Results
for 50-day and 500-day rolling windows are shown in Table A.2 in the Appendix A. Using a 50-day rolling window and the
ElasticNet shrinkage method, which is more appropriate than the OLS method with such a short window, we find that the Full model
significantly outperforms the Baseline model. Furthermore, significant differences can be observed between the two models even with
a 500-day rolling window. We also investigated whether the predictive ability of ECCNI could be used in trading strategies. The
historical backtests suggest that the index could be utilized for such purposes, the details of this analysis can be found in Appendix B.
We conclude that ECCNI can provide additional predictive power to ETS price return forecasting; however, more sophisticated
models are required to fully exploit. These outcomes are in line with the literature exploring the effectiveness of additional textual
information in carbon price prediction (Ye and Xue, 2021; Zhang and Xia, 2022). News information alone cannot outperform the
standard predictors, but extending the standard driving factors with the ECCNI can improve forecast performance. The ECCNI
captures policy uncertainty and is able to track the discussion about climate change in the EU.

5. Conclusions

In this paper we first aggregated textual information from online news articles representing a novel data source for carbon
price prediction. We produced TF–IDF features tracking the relative occurrences of climate change-related keywords in online news
related to the EU. Then, we derived the EU Climate Change News Index as the aggregated TF–IDF score of the keywords. The index
accurately reflects the ongoing discussion about climate change in the EU. It outlines the most influential events in the topic like

10 Note that here we consider one-sided tests since we are comparing forecasts from nested models. The alternative hypothesis is that our Full (the larger)

model has smaller forecasting error than the Baseline model.

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Á.D. Hartvig et al. Finance Research Letters 54 (2023) 103720

the annual United Nations Climate Change Conferences or the endorsement of the EU’s emissions reduction target of at least 55%
by 2030 below 1990 levels. Finally, we showed that the index brings valuable additional information and predictive power to ETS
price return forecasting compared to a baseline model where the traditional predictors of carbon prices are included.
The increasing ambition of the EU climate targets brings significant uncertainty to carbon prices. The market is subject to frequent
adjustments in the supply and demand of allowances. This means that market participants must constantly adjust their strategies
to keep up with the changing market conditions. Hence, news articles about EU climate issues are highly relevant to their market
expectations. Therefore, the proposed ECCNI could also help to manage volatility in the EU ETS. By integrating the index into
forecasting models, companies can predict ETS prices more accurately.

6. Further research

The NLP method applied in our study offers a great variety of further research ideas. First, ECCNI could be incorporated into
more sophisticated forecasting models. Second, in this study, we presented the aggregated time series of the climate keywords.
Other groupings or individual TF–IDF time series can be further used in other analyses, like forecasting natural gas prices. Also, our
current models assume that the impact of the different variables always has the same direction; however, this assumption could be
relaxed and explored with Markov-switching models, as in Guidolin et al. (2018). It would be interesting to use their test procedure
and statistical model set to compare the predictive performance of our news coverage-based method to their Google Trends-based
models. Furthermore, the TF–IDF matrices, including the frequency of the keywords by article, could provide the basis for any
news network analysis where the nodes are keywords, and the edges are the number of articles in which both keywords appear.
This analysis could help to better understand the interconnections between climate change topics in the media. Finally, other NLP
methods could be explored with larger datasets, for example word embeddings models to improve the representation of contextual
information from the news articles.

CRediT authorship contribution statement

Áron Dénes Hartvig: Conceptualization, Methodology, Validation, Writing – original draft, Writing – review & editing. Áron
Pap: Conceptualization, Methodology, Software, Validation, Writing – original draft, Visualization. Péter Pálos: Conceptualization,
Methodology, Software, Validation, Writing – original draft.

Declaration of competing interest

The authors declare that they have no known competing financial interests or personal relationships that could have appeared
to influence the work reported in this paper.

Data availability

Data will be made available on request.

Acknowledgments and funding information

This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.

Statement of exclusive submission

This paper has not been submitted elsewhere in identical or similar form, nor will it be during the first four months after its
submission to the Publisher.

Appendix A. TF–IDF methodology

TF–IDF measures the importance of a term to a document in a corpus with the formula below:

( )
( ) 𝑁
𝑙𝑜𝑔 1 + 𝑓𝑡,𝑑 ⋅ 𝑙𝑜𝑔 1 + , (A.1)
𝑛𝑡
where

𝑓𝑡,𝑑 = raw count of term 𝑡 in document 𝑑,

𝑁 = total number of documents in the corpus,
𝑛𝑡 = number of documents containing term 𝑡.

For our aggregated and group-level TF–IDF scores we count the appearances of any of the elements in the keyword list or keyword
groups (and not just a single term).

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Fig. A.1. Correlation matrix of TF–IDF group scores.

Table A.1
TF–IDF keyword list.
Group Keywords
Emissions Carbon dioxide, CO2 , green deal, greenhouse gas, ghg
Fossil fuels Coal, oil, crude, gasoline, diesel, petrol, fuel
Gas gas
Policy Climate, sustainability, sustainable, environment, ets
Renewables Renewable, electricity, solar power, solar panel, solar energy, wind power,
wind turbine, wind energy, nuclear power, nuclear plant, nuclear energy,
clean energy, green energy

Table A.2
Forecast performance comparison of Baseline and Full models with rolling window estimation method.
Rolling window Test window Model Baseline Full CW
MAEa RMSEa Lags MAEa RMSEa Lags p-value
OLS 22.131 0.8474 1 22.057 0.8390 1 0.599
50
ElasticNet 21.229 0.8332 4 21.249 0.8099 4 0.024

50 OLS 20.115 0.7437 1 20.159 0.7519 1 0.900

75
ElasticNet 19.024 0.6960 4 18.984 0.6802 4 0.003
OLS 19.966 0.710 1 19.992 0.7228 1 0.970
100
ElasticNet 18.066 0.6155 4 18.036 0.6036 4 0.006
OLS 19.113 0.6986 1 18.750 0.6916 1 0.108
50
ElasticNet 20.311 0.7409 3 19.916 0.7404 3 0.058

500 OLS 17.320 0.6049 1 16.991 0.6002 1 0.067

75
ElasticNet 18.030 0.6254 3 17.948 0.6308 3 0.547
OLS 16.729 0.5403 1 16.429 0.5375 1 0.068
100
ElasticNet 17.337 0.5591 3 17.285 0.5647 3 0.826
a 10−3

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Fig. A.2. EU ETS carbon price dynamics between January 2, 2018 and November 30, 2021. Price on the primary axis, volatility on the secondary axis.

Appendix B. Trading strategy backtesting

In this section we investigate whether the predictive ability of our index could be utilized in trading strategies. We use a simple
approach in which we buy ETS when the forecasted return is positive, while we invest in cash when it is negative, following (Pesaran
and Timmerman, 1995) (Pesaran and Timmermann, 1995). We use the forecasts of the models presented in Table 1. We compare
the results of this active strategy during our out-of-sample prediction windows with: (1) cash (where we assume 10% annual interest
rate); (2) passively investing into ETS. The results are shown in Table B.1. This initial exercise could be made more realistic with
incorporating trading costs (which could be substantial since we are rebalancing the portfolio daily) and by using a more appropriate
benchmark in terms of risk and return characteristics of the proposed active ETS trading strategy.

Table B.1
Trading strategy comparison results.
Test window Model Total return (%) Active return vs. cash (%p) Active return vs. ETS (%p)
OLS 28.24 26.86 5.48
50
ElasticNet 28.18 26.80 5.42
OLS 37.56 35.48 9.20
75
ElasticNet 37.92 35.84 9.56
OLS 51.96 49.19 13.61
100
ElasticNet 41.32 38.54 2.96

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