The Influence of Yield Curve Factors on the Conditional Distribution of Equity Risk Premia

Abstract

This paper examines the efficacy of how certain yield curve factors, namely the level, slope, and curvature, can predict the shape of cumulative return distributions in equity markets. We utilise the GAMLSS framework to analyse distributional characteristics and examine the impact yield curve factors have on equity returns. Our findings indicate that the slope of the yield curve is the most influential factor affecting the shape of the return distribution, compared to other factors such as level and curvature. Specifically, as the slope becomes increasingly upward-sloping, the return distribution approaches symmetry, while a lower slope leads to the distribution becoming more negatively skewed. The results highlight the importance of accurate distributional assumptions in estimating risk metrics for making informed investment decisions. This is demonstrated by comparing several models based on different distribution families and incorporating more complexity to capture the characteristics in financial time series. Additionally, the predictive power of the slope on the shape of the distribution diminishes in US markets after the mid-1980s, consistent with existing academic literature that suggests a diminished effect in the slope’s ability to forecast output growth after the mid-1980s. However, we report evidence suggesting that the slope remains relevant for predicting the shape of the distribution in other developed markets.