Predicting Future Market Returns


Title of the Article : Tail Risk Premia and Return Predictability

Author Information : Lai Xu (Whitman School of Management, Syracuse University)
Tim Bollerslev (Fuqua School of Business, Duke University)
Viktor Todorov (Kellogg School of Business, Northwestern University)

Year of Publication : Journal of Financial Economics (2015)

Summary of Findings : Market fears play an important role in understanding the stock return predictability.

Research Questions : 1. How to decompose the equity risk premium into separate diffusive risk and jump risk components?

2. Where is the inherent market return predictability coming from?

3. How does it plays out over different horizons and for different portfolios with different risk exposures?

What we know : The genuine fear component of the index provides a much better guide for making a "good" investment decision.

Novel Findings : Most of the predictability for the aggregate market portfolio previously ascribed to the variance risk premium stems from the jump tail risk component.

For size, value, and momentum portfolios, we document even greater increases in the degree of return predictability by separately considering the two variance risk premium components.

Novel Methodology : This research used a nonparametric decomposition of the variance risk premium.

Implications for Practice : Our new jump tail risk measure is obviously related to the pricing of tail risk in the economy and investors' attitude toward risk more generally.

Full Citations : T. Bollerslev et al., Tail risk premia and return predictability, Journal of Financial Economics, 118 (2015) 113–134.

Abstract : The variance risk premium, defined as the difference between the actual and risk-neutral expectations of the forward aggregate market variation, helps predict future market returns. Relying on new essentially model-free estimation procedure, we show that much of this predictability may be attributed to time variation in the part of the variance risk premium associated with the special compensation demanded by investors for bearing jump tail risk, consistent with idea that market fears play an important role in understanding the return predictability.

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Market fears play an important role in understanding the stock return predictability.

Lai Xu

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