Incorporating Forward-Looking Economic Information into Financial Downside Risk Prediction : A State-Dependent Approach

This paper devises and tests a state-dependent approach to forecasting the downside risk of financial assets. The approach has three merits. First, it proposes downside risk prediction conditional on the state of the real economy to recognize the countercyclical nature of financial risk. Second, while integrating macroeconomic information into the modeling of asset returns, it incorporates forward-looking economic information into financial downside risk prediction. Third, it can be easily adapted to a majority of forecasting methods for downside risk, including parametric and non-parametric methods. Our empirical results show that the state-dependent approach outperforms the existing benchmark methods. We demonstrate that the significant economic gain coming from the proposed method arises from the economic fact that the risk profile of an asset varies across economic states