Equity Risk Premium Predictability from Cross-Sectoral Downturns
62 Pages Posted: 12 Jun 2015 Last revised: 11 Aug 2019
Date Written: July 1, 2019
We illustrate the role of left tail dependence measures, 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 the variance risk premium (VRP), significantly predict the ERP in- and out-of-sample, which is not the case with the other commonly used predictors. We find 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
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