Prediction in Econometrics: Towards Mathematical Justification of Simple (and Successful) Heuristics

Many heuristic and semi-heuristic methods have been proposed to predict economic and financial processes. Some of these heuristic processes are intuitively reasonable, some seemingly contradict to our intuition. The success of these heuristics leads to a reasonable conjecture that these heuristic methods must have a more fundamental justification. In this paper, we provide such a justification for two simple (and successful) prediction heuristics: of an intuitive exponential smoothing that provides a reasonable prediction for slowly changing processes, and of a seemingly counter-intuitive idea of an increase in volatility as a predictor of trend reversal. As a possible application of these ideas, we consider a new explanation of the price transmission phenomenon.