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

51 Pages Posted: 5 Apr 2018 Last revised: 12 Apr 2018

Gonçalo Faria

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

Fabio Verona

Bank of Finland - Research

Multiple version iconThere are 2 versions of this paper

Date Written: April 3, 2018

Abstract

We extract cycles in the term spread (TMS) and study their role for predicting the equity risk premium (ERP) using linear models. The low frequency component of the TMS is a strong and robust out-of-sample ERP predictor. It obtains out-of-sample R-squares (versus the historical mean benchmark) of 1.98% and 22.1% for monthly and annual data, respectively. It forecasts well also during expansions and outperforms several variables that have been proposed as good ERP predictors. Its predictability power comes exclusively from the discount rate channel. Contrarily, the high and business-cycle frequency components of the TMS are poor out-of-sample ERP predictors.

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 (April 3, 2018). Bank of Finland Research Discussion Paper No. 7/2018. Available at SSRN: https://ssrn.com/abstract=3156193

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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