Macro Tail Risk and Market Risk Premium
50 Pages Posted: 13 Sep 2022 Last revised: 7 Oct 2023
Date Written: September 1, 2022
Abstract
This study proposes a new index of aggregate macro tail risk based on the forecasts of future macroeconomic fundamentals. Using this index, we find that a positive market risk premium compensates for the economic tail risk; a high tail risk predicts a subsequent high return. This predictability exists both in- and out-of-sample, and cannot be explained by extant stock tail risk and economic uncertainty measures. We exploit the underlying economic mechanism and demonstrate that macro tail risk contains information about the future economic conditions and influences stock returns primarily through both cash flow and discount rate channels.
Keywords: Macro Tail Risk, Return Predictability, Out-of-sample, Partial Least Squares (PLS)
JEL Classification: C22, C53, G12, G17
Suggested Citation: Suggested Citation