Equity Risk Premium Predictability from Cross-Sectoral Downturns
(Accepted for publication in "Review of Asset Pricing Studies")
Abstract
We illustrate the role of left tail dependence variables – left exceedance correlation (LEC ) and left tail mean (LTM ) – in equity risk premium (ERP) predictability. LEC and LTM measure the average of pairwise left tail dependency among major equity sectors incorporating shocks that are imperceptible at the aggregate level. LEC and LTM, as well as the variance risk premium, significantly predict the ERP in- and out-of-sample, which is not the case with commonly used predictors. We find this predictability is the result of pro-cyclical shocks in a stable business cycle. This paper contributes to the ongoing debate on ERP predictability.
Keywords: predictability, left tail dependence, asset pricing model
JEL Classification: G10, G12, G14