Foreign Exchange Market and Equity Risk Premium Forecasting

Numerous academic studies examine equity risk premium predictability based on various macroeconomic variables and price and volume based variables from stock market. In this article, we extend the frontier of the set of predictors from macroeconomic variables and stock market variables to foreign exchange market variables due to various reasons. Firstly, foreign exchange market reflects various economic fundamentals potentially useful for predicting equity risk premium, though may not be fully reflected by available macroeconomic variables used in the literature for forecasting equity risk premium. Moreover, given that technical rules have been documented to work well in offering predicting power at foreign exchange market, price-based variables from foreign exchange market may provide useful information on predicting equity risk premium as well through the connections between foreign exchange market and stock market. We find that on top of using price and volume based variables from stock market and macroeconomic variables, incorporating price-based variables from foreign exchange market as well can not only improve the overall forecasting performance but also produce significant certainty equivalent return gain from an investment perspective. JEL classifications: C53, C58, G11, G12, G17