Financial applications of a Tabu search variable selection model

We illustrate how a comparatively new technique, a Tabu search variable selection model [Drezner, Marcoulides and Salhi (1999)], can be applied efficiently within finance when the researcher must select a subset of variables from among the whole set of explanatory variables under consideration. Several types of problems in finance, including corporate and personal bankruptcy prediction, mortgage and credit scoring, and the selection of variables for the Arbitrage Pricing Model, require the researcher to select a subset of variables from a larger set. In order to demonstrate the usefulness of the Tabu search variable selection model, we: (1) illustrate its efficiency in comparison to the main alternative search procedures, such as stepwise regression and the Maximum R2 procedure, and (2) show how a version of the Tabu search procedure may be implemented when attempting to predict corporate bankruptcy. We accomplish (2) by indicating that a Tabu Search procedure increases the predictability of corporate bankruptcy by up to 10 percentage points in comparison to Altman’s (1968) Z-Score model.