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Forecasting the Equity Risk Premium with Frequency-Decomposed Predictors

42 Pages Posted: 14 Feb 2017  

Gonçalo Faria

Catholic University of Portugal (UCP) - School of Economics and Management and CEGE

Fabio Verona

Bank of Finland - Research

Date Written: January 3, 2017

Abstract

We show that the out-of-sample forecast of the equity risk premium can be significantly improved by taking into account the frequency-domain relationship between the equity risk premium and several potential predictors. We consider fifteen predictors from the existing literature, for the out-of-sample forecasting period from January 1990 to December 2014. The best result achieved for individual predictors is a monthly out-of-sample R2 of 2.98% and utility gains of 549 basis points per year for a mean-variance investor. This performance is improved even further when the individual forecasts from the frequency-decomposed predictors are combined. These results are robust for different subsamples, including the Great Moderation period, the Great Financial Crisis period and, more generically, periods of bad, normal and good economic growth. The strong and robust performance of this method comes from its ability to disentangle the information aggregated in the original time series of each variable, which allows to isolate the frequencies of the predictors with the highest predictive power from the noisy parts.

Keywords: predictability, equity risk premium, frequency domain, discrete wavelets

JEL Classification: C58, G11, G12, G17

Suggested Citation

Faria, Gonçalo and Verona, Fabio, Forecasting the Equity Risk Premium with Frequency-Decomposed Predictors (January 3, 2017). Bank of Finland Research Discussion Paper No. 1/2017. Available at SSRN: https://ssrn.com/abstract=2914027

Gonçalo Faria (Contact Author)

Catholic University of Portugal (UCP) - School of Economics and Management and CEGE ( email )

Universidade Católica Portuguesa
Rua Diogo Botelho 1327
Porto, 4169-005
Portugal

Fabio Verona

Bank of Finland - Research ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland

HOME PAGE: http://bofcris.solenovo.fi/crisyp/disp/_/en/cr_redir_all/fet/fet/sea?direction=3&id=3827426

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