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The Equity Risk Premium and the Low Frequency of the Term Spread

38 Pages Posted: 6 Sep 2017  

Gonçalo Faria

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

Fabio Verona

Bank of Finland - Research

Date Written: September 1, 2017

Abstract

The term spread has long been of interest to monetary policymakers and to financial markets participants. Despite being a strong business cycle leading indicator, it is known to be a poor out-of-sample predictor of the equity risk premium. In this paper we show that its low-frequency component, when properly extracted from the data, is effectively a very strong equity risk premium out-of-sample predictor. The economic source of this predictability power is found to come from the discount rate channel. The out performance of the low-frequency component of the term spread (versus the historical mean benchmark) is surprisingly very strong at one-month horizon, increases with the forecasting horizon and is consistently stable throughout an out-of-sample period comprising more than 20 years of monthly data. Remarkably, it also forecasts well in expansions. It outperforms several predictors that have recently been proposed in the literature.

Keywords: equity risk premium, term spread, predictability, frequency domain

JEL Classification: C58, G11, G12, G17

Suggested Citation

Faria, Gonçalo and Verona, Fabio, The Equity Risk Premium and the Low Frequency of the Term Spread (September 1, 2017). Available at SSRN: https://ssrn.com/abstract=3030760

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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