Forecasting equity risk premium: A new method based on wavelet de‐noising

Zhifeng Dai, Jie Kang and Hua Yin

International Journal of Finance & Economics, 2023, vol. 28, issue 4, 4331-4352

Abstract: Forecasting equity risk premium is notoriously difficult due to a mass of data noise in the raw series and the absence of clear tendency. Using the monthly S&P 500 excess returns from 1927:01 to 2018:12, we first de‐noise the in‐sample original returns series via wavelet method to capture the basic trend of equity risk premium, and then propose forecasting models to obtain one‐step forward out‐of‐sample predicted values based on the de‐noised returns. Our new models can provide substantially superior out‐of‐sample performance compared with other competing models and the historical average. Sizeable economic gains can be realized by a mean–variance investor if they allocate their asset through the new approach. Our findings are robust under different settings from both statistical and economic perspectives.

Date: 2023
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