Financial Market Risk Perceptions and the Macroeconomy

We propose a novel measure of risk perceptions: the price of volatile stocks (PVSt), defined as the book-to-market ratio of low-volatility stocks minus the book-to-market ratio of high-volatility stocks. PVSt is high when perceived risk directly measured from surveys and option prices is low. When perceived risk is high according to our measure, safe asset prices are high, risky asset prices are low, the cost of capital for risky firms is high, and real investment is forecast to decline. Perceived risk as measured by PVSt falls after positive macroeconomic news. These declines are predictably followed by upward revisions in investor risk perceptions. Our results suggest that risk perceptions embedded in stock prices are an important driver of the business cycle and are not fully rational.

Keywords: risk-centric business cycles, cross-section of equities, real risk-free rate, real investment

JEL Classification: E120, E220, E430, E440, G120, G400

Suggested Citation: Suggested Citation

Pflueger, Carolin E. and Pflueger, Carolin E. and Siriwardane, Emil and Sunderam, Adi, Financial Market Risk Perceptions and the Macroeconomy (September 4, 2019). Harvard Business School Finance Working Paper No. 17-040, Available at SSRN: https://ssrn.com/abstract=2873688 or http://dx.doi.org/10.2139/ssrn.2873688