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Backtesting in Excel
Fayez
October 21, 2020 23:34
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Backtesting in modeling refers to a predictive model's testing using historical data.

The article is about how to do so in Microsoft Excel, not about the theoretical
background of backtesting.

How do we conduct backtesting? We rewind the time to the beginning of our time
series, calibrate the subject-model parameters using available data up to that
instance of time, and conduct a prediction (i.e., forecast) for the next period. Next,
we advance the time, recalibrate the parameters' values and perform another
projection, and so on. At the end of our exercise, we'd have a set of predictions.

Note that at each point, the only assumption we make is the general model
definition (e.g., ARMA(1,1)). Still, we'd calibrate the parameters' values using only
the information available up to that instance of time.

This approach is consistent with real-life practices: first, we start with an initial
model and conduct a forecast for the following period. Time moves on. A new
period occurred, so we append the new data-point to the current input data set,
recalibrate the parameters, conduct a forecast for the following period, and repeat.

Why should I care?

This article will take you through the steps in Microsoft Excel needed to conduct
backtesting We will mainly use two powerful excel built-in functions: INDEX(.) and
SEQUENCE(.), and leverage Excel's "Data table" mechanism to run the different
scenarios.
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The backtesting generates what would-have-been forecasting errors so you can

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The backtesting generates what would have been forecasting errors, so you can
closely examine the prediction error time series for serial correlation, distributions,
outliers, and others, to better understand the model's accuracy and performance.

Let's dig in!

For this issue, we are using a synthetic stationary data set of 200 observations. The
data set follows an ARMA(1,1) process, as shown next.

The proposed model is ARMA(1,1)

Backtesting Procedure
For every iteration, we need to do the following: (1) define the input data set (as sub-
set of the original time series), (2) using the data set in (1), calibrate the parameters'
values of the ARMA(1,1) model, (3) Using the model in (2) and the dataset in (1),
calculate a forecast for one-period ahead.

1. Input data set

To fully describe the input data set, we require two indices: start and finish, then,
using the SEQUENCE(.) function, we generate a set of indices between the start and
finish. Now, we use the INDEX(.) function to return all cell-range in the original data
set with row-indices in the sequence set.

Example:

The original input data set is A3:A202. To select the cells between indices 1 and
50.

=INDEX(
Chat A3:A202,SEQUENCE(50,1,1,1),1)

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Note that you can define a name for your input data and reference this name in
place of the input cell range.

2. Calibrate the Model

We will use the NumXL ARMA_PARAM(.) function and specify return type=2 for
calibrated parameters.

Note that ARMA_PARAM(.) returns a compact form of the model's parameters, so in

the figure above, the ARMA process is:

Xt = 1.485 + 0.401Xt−1 + 0.734a t−1 + a t

a t ∼ N (0, 1.14)

3. Forecasting

Using the ARMA_FORE(.), data set in (1), and the model parameters calculated in 2,
we can calculate the forecast values for the 1-period ahead.

Note that I generated the mean forecast, forecast error, and confidence interval.

Data Table

Now, we have just completed the calculation of one step. We will use Excel's "Data
table" feature to do the same math for the remaining periods up to step 200.

First, we need to prepare the output table:

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Now, select the whole data table, starting with the output row and including the
finish index column, as shown below:

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Next, switch to the "Data" Toolbar and locate the "Data Table" item under "What-if
Scenario."

The "Data Table" dialog pops up. Locate the "column input cell," enter a reference to
the "finish" index of the data set, and click the OK button.

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The data table will substitute the finish index's value with the ones in our data table
and store the outputs.

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Note that "Std. Error" is generated by the ARMA_FORE(.) function, while the right-
most column ("Error") is the error between forecast and actual realized value.

Back-Testing Analysis
First, Let's examine the backtesting forecast outputs visually to actual realized
values, and then we will delve deeper into the statistical properties.

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The shaded area in the plot corresponds to the 95% forecast confidence interval.

The plot exhibits a good model fit and, thus, forecast accuracy.

Next, let's examine the forecast error (Forecast – Actual) statistical properties using
summary statistics in the NumXL toolbar.

The summary statistics table indicates that forecast error is Gaussian noise with
zero mean and standard deviation of 1.0

In conclusion, the ARMA(1,1) is a suitable predictive model for the given data set.

What is next?

By now, you are probably wondering about the values of the model's parameters?
Are they stable?

First, we construct a second "Data Table," but in the output row are the model
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parameters' values, and run the data table just like we did earlier.

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Now, analyze the values of every parameter as we did with the forecast error.

The values of the parameters (except theta) exhibit stability and a trend toward a
constant value. The theta (MA coefficient) values are more volatile but bound
between 0.6 and 0.9.

Next, we should examine the descriptive statistics and the underlying distributions
of the parameters' values, but we will leave this exercise to you.

Please, refer to the attached spreadsheet for the data set and analysis.

Conclusion
This article demonstrated the steps to conduct backtesting for a predictive model
with minimal or no intermediate calculation. We have used Excel's built-in functions:
INDEX(.) and SEQUENCE(.) and leveraged the "Data Table" feature to run the
Chat for all pre-defined indices.
calculation

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Once we had the backtesting results, we turn our heads to statistical analysis and
evaluate their properties and distribution to uncover any biases (e.g., serial
correlation) in the output.

  Attachments
 
Backtesting Workbook.xlsx (200 KB)

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