The equity risk premium and the low frequency of the term spread

Gonçalo Faria and Fabio Verona

No 7/2018, Bank of Finland Research Discussion Papers from Bank of Finland

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.

JEL-codes: C58 G11 G12 G17 (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (1)

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