Does Ambiguity about Volatility Matter Empirically?

Abstract

It does. Depending on the forecast horizon, a one standard deviation increase in our measure for ambiguity about consumption volatility predicts a significant increase in average excess equity returns varying between 200 and 600 basis points annualized. The ambiguity measure we propose is easily obtained from the cross-section of analysts' forecasts for aggregate output growth. We estimate a version of the long-run risk model, where the investor is concerned about a potential misspecification of the variance dynamics. The measures we construct from survey data can be interpreted as proxies of the usually latent state variables in the model, so that we can perform the estimation without the use of asset pricing information. The model produces unconditional moments and return predictability patterns via the variance premium in line with the data.

Keywords: Ambiguity, ambiguous volatility, asset pricing, long-run risks

JEL Classification: G12, E44, D81