Equity Risk Premium Predictability from Cross-Sectoral Downturns

International asset allocation with regime shifts

Jose Faias and Juan Arismendi Zambrano ()

The Review of Asset Pricing Studies, 2022, vol. 12, issue 3, 808-842

Abstract: We illustrate the role of left tail dependence—left tail mean (LTM)—in equity risk premium (ERP) predictability. LTM measures the average of pairwise left tail dependency among major equity sectors incorporating shocks imperceptible at the aggregate level. LTM, as well as the variance risk premium, significantly predicts the ERP in and out of sample, which is not the case with commonly used predictors. We find this predictability is the result of procyclical shocks’ reversals in a stable business cycle. This paper contributes to the ongoing debate on ERP predictability. (JEL G10, G12, G14)

Date: 2022
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