Good and Bad Uncertainty: Macroeconomic and Financial Market Implications
Jacobs Levy Equity Management Center for Quantitative Financial Research Paper
Journal of Financial Economics (JFE), Vol. 117, No. 2, 2015
Kenan Institute of Private Enterprise Research Paper No. 20-08
69 Pages Posted: 1 Dec 2015
Date Written: 2015
Does macroeconomic uncertainty increase or decrease aggregate growth and asset prices? To address this question, we decompose aggregate uncertainty into ‘good’ and ‘bad’ volatility components, associated with positive and negative innovations to macroeconomic growth. We document that in line with our theoretical framework, these two uncertainties have opposite impact on aggregate growth and asset prices. Good uncertainty predicts an increase in future economic activity, such as consumption, output, and investment, and is positively related to valuation ratios, while bad uncertainty forecasts a decline in economic growth and depresses asset prices. Further, the market price of risk and equity beta of good uncertainty are positive, while negative for bad uncertainty. Hence, both uncertainty risks contribute positively to risk premia, and help explain the cross-section of expected returns beyond cash flow risk.
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