Application of neural networks to an emerging financial market: Forecasting and trading the Taiwan stock index

In this study, we attempt to model and predict the direction of return on market index of the Taiwan Stock Exchange, one of the fastest growing financial exchanges in developing Asian countries. Our motivation is based on the notion that trading strategies guided by forecasts of the direction of price movement may be more effective and lead to higher profits. The probabilistic neural network (PNN) is used to forecast the direction of index return after it is trained by historical data. Statistical performance of the PNN forecasts are measured and compared with that of the generalized methods of moments (GMM) with Kalman filter. Moreover, the forecasts are applied to various index trading strategies, of which the performances are compared with those generated by the buy-and-hold strategy as well as the investment strategies guided by forecasts estimated by the random walk model and the parametric GMM models. Empirical results show that the PNN-based investment strategies obtain higher returns than other investment strategies examined in this study. Influences of length of investment horizon and commission rate are also considered.