The Effect of Uncertainty on Volatility and Correlation

Abstract

We use an extension of the heterogeneous autoregressive model to investigate the influence of time-varying risk aversion and a number of macroeconomic, financial, and economic-policy uncertainty measures on stock-return volatility and correlations. Our results indicate strong in-sample and out-of-sample predictive ability of risk aversion and economic uncertainty constructed from financial information for the realized volatility. In contrast, economic-policy uncertainty, the TED spread, the leading indicator, and industrial production do not provide useful information once we account for risk aversion and economic uncertainty. We also provide evidence on the strong forecasting ability and considerable economic value of risk aversion and economic uncertainty for international-portfolio analysis.

Keywords: economic uncertainty; HAR-RV-X model; international-portfolio analysis; stock market correlation; stock market volatility

JEL Classification: C32; G11; G15; G17