Equity Risk Premium Predictability from Cross-Sectoral Downturns

Abstract

We illustrate the role of left tail dependence variables – left exceedance correlation (LEC ) and
left tail mean (LTM ) – in equity risk premium (ERP) predictability. LEC and LTM measure
the average of pairwise left tail dependency among major equity sectors incorporating shocks
that are imperceptible at the aggregate level. LEC and LTM, as well as the variance risk
premium, significantly predict the ERP in- and out-of-sample, which is not the case with
commonly used predictors. We find this predictability is the result of pro-cyclical shocks in
a stable business cycle. This paper contributes to the ongoing debate on ERP predictability.

Keywords: predictability, left tail dependence, asset pricing model

JEL Classification: G10, G12, G14