When Uncertainty and Volatility Are Disconnected: Implications for Asset Pricing and Portfolio Performance

45 Pages Posted: 10 May 2021 Last revised: 20 May 2021

See all articles by Yacine Ait-Sahalia

Yacine Ait-Sahalia

Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Felix Matthys

ITAM

Emilio Osambela

Board of Governors of the Federal Reserve System

Ronnie Sircar

Princeton University - Department of Operations Research and Financial Engineering

Date Written: May 6, 2021

Abstract

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.

Keywords: Volatility and Uncertainty Disconnect, Stochastic Volatility, Stochastic Uncertainty, Risk Aversion, Uncertainty Aversion

JEL Classification: G00, G01, G10, G11, G12

Suggested Citation

Ait-Sahalia, Yacine and Matthys, Felix and Osambela, Emilio and Sircar, Ronnie, When Uncertainty and Volatility Are Disconnected: Implications for Asset Pricing and Portfolio Performance (May 6, 2021). Available at SSRN: https://ssrn.com/abstract=3841103 or http://dx.doi.org/10.2139/ssrn.3841103

Yacine Ait-Sahalia

Princeton University - Department of Economics ( email )

Fisher Hall
Princeton, NJ 08544
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National Bureau of Economic Research (NBER)

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Felix Matthys

ITAM ( email )

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Mexico
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Emilio Osambela (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Ronnie Sircar

Princeton University - Department of Operations Research and Financial Engineering ( email )

Princeton, NJ 08544
United States

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