Open AccessWhen Uncertainty and Volatility Are Disconnected: Implications for Asset Pricing and Portfolio Performance
Author(s) -
Yacine Aı̈t-Sahalia,
Felix Matthys,
Emilio Osambela,
Ronnie Sircar
Publication year - 2021
Publication title -
finance and economics discussion series
Language(s) - English
Resource type - Journals
eISSN - 2767-3898
pISSN - 1936-2854
DOI - 10.17016/feds.2021.063
Subject(s) - volatility (finance) , volatility swap , volatility risk premium , economics , implied volatility , volatility smile , forward volatility , portfolio , financial economics , econometrics , stochastic volatility , capital asset pricing model , equity (law) , political science , law
We analyze an environment where the uncertainty in the equity market return and its volatility are both stochastic and may be potentially disconnected. We solve a representative investor's optimal asset allocation and derive the resulting conditional equity premium and risk-free rate in equilibrium. Our empirical analysis shows that the equity premium appears to be earned for facing uncertainty, especially high uncertainty that is disconnected from lower volatility, rather than for facing volatility as traditionally assumed. Incorporating the possibility of a disconnect between volatility and uncertainty significantly improves portfolio performance, over and above the performance obtained by conditioning on volatility only.