Equity Risk Premium Predictability from Cross-Sectoral Downturns

We use a time-varying endogenous sectoral disaster-risk consumption-based asset pricing model to explain a substantial portion of the equity-risk premium. This model illustrates the crucial role of left cross-sectoral... [ view full abstract ]

We use a time-varying endogenous sectoral disaster-risk consumption-based asset pricing model to explain a substantial portion of the equity-risk premium. This model illustrates the crucial role of left cross-sectoral bivariate tail dependence, which endogenously incorporates shocks that are imperceptible at the aggregate level. We proxy left tail dependence by the average of pairwise left tail dependency among major equity sectors, and we confirm that this significantly predicts the equity risk premium in- and out-of-sample and that this information is crucial for improving other predictors’ forecasts.