Financial Stress and Forecasting UK Equity Risk Premiums

104 Pages Posted: 21 Apr 2022

See all articles by William Berry

William Berry

University of Newcastle - Newcastle University Business School

Diemo Dietrich

Newcastle University Business School

Robert Sollis

University of Newcastle - Newcastle University Business School

Date Written: May 25, 2021

Abstract

We study the predictability of equity risk premiums for UK equity indexes, in particular whether stylized facts found for the US stock market also apply to the UK market. We compare the performance of economic and technical indicators with a particular focus on the time-varying nature of predictability. Some economic variables are viable and consistent predictors, both in and out of sample. Technical indicators cannot, in general, predict equity premiums. Interestingly, while there is a high degree of time-variability in predictability, the UK business cycle does not account well for it. We thus construct a UK Financial Stress Index to test whether predictability depends on financial stress. In-sample, predictability is indeed highest during financially stressful periods for almost all of the indicators. Out-of-sample, predictability is also highly concentrated around financial stress periods, especially for technical indicators. Our findings suggest that, while the predictability of equity risk premiums appears to be time varying, it is stress in the financial system rather than the business cycle that matters.

Keywords: Equity risk premium predictability, financial stress, macroeconomic variables, technical indicators, out-of-sample forecast, business cycle

JEL Classification: E32, G11, G12, G17

Suggested Citation

Berry, William and Dietrich, Diemo and Sollis, Robert, Financial Stress and Forecasting UK Equity Risk Premiums (May 25, 2021). Available at SSRN: https://ssrn.com/abstract=4053405 or http://dx.doi.org/10.2139/ssrn.4053405

William Berry

University of Newcastle - Newcastle University Business School

5 Barrack Road
Devonshire Building
NEWCASTLE UPON TYNE, NE1 7RU
United Kingdom

Diemo Dietrich (Contact Author)

Newcastle University Business School ( email )

5 Barrack Road
Newcastle-upon-Tyne NE1 7RU, NE1 4SE
United Kingdom

HOME PAGE: http://www.ncl.ac.uk/business-school/staff/profile/diemodietrich.html

Robert Sollis

University of Newcastle - Newcastle University Business School ( email )

5 Barrack Road
Devonshire Building
NEWCASTLE UPON TYNE, NE1 7RU
United Kingdom

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