Incorporating Forward-Looking Economic Information into Financial Downside Risk Prediction: A State-Dependent Approach

Posted: 21 Jun 2016

See all articles by Lei Jiao

Lei Jiao

Xi'an Jiaotong University (XJTU) - Jinhe Center for Economic Research

Qing Zhou

Department of Applied Finance and Actuarial Studies, Macquarie University

Yin Liao

Queensland University of Technology; Australian National University - The Centre for Applied Macroeconomic Analysis (CAMA)

Robert W. Faff

University of Queensland

Date Written: January 10, 2015

Abstract

This paper devises and tests a state-dependent approach to forecasting the downside risk of financial assets. The approach has three merits. First, it proposes downside risk prediction conditional on the state of the real economy to recognize the countercyclical nature of financial risk. Second, while integrating macroeconomic information into the modeling of asset returns, it incorporates forward-looking economic information into financial downside risk prediction. Third, it can be easily adapted to a majority of forecasting methods for downside risk, including parametric and non-parametric methods. Our empirical results show that the state-dependent approach outperforms the existing benchmark methods. We demonstrate that the significant economic gain coming from the proposed method arises from the economic fact that the risk profile of an asset varies across economic states.

Keywords: state-dependent, forward-looking, economic state, risk

JEL Classification: G21, G32, G17

Suggested Citation

Jiao, Lei and Zhou, Qing and Liao, Yin and Faff, Robert W., Incorporating Forward-Looking Economic Information into Financial Downside Risk Prediction: A State-Dependent Approach (January 10, 2015). Available at SSRN: https://ssrn.com/abstract=2798451

Lei Jiao

Xi'an Jiaotong University (XJTU) - Jinhe Center for Economic Research ( email )

China

Qing Zhou (Contact Author)

Department of Applied Finance and Actuarial Studies, Macquarie University ( email )

Sydney, NSW
Australia

Yin Liao

Queensland University of Technology ( email )

2 George Street
Brisbane, Queensland 4000
Australia

Australian National University - The Centre for Applied Macroeconomic Analysis (CAMA) ( email )

Canberra, Australian Capital Territory 2601
Australia

Robert W. Faff

University of Queensland ( email )

St Lucia
Brisbane, Queensland 4072
Australia

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