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

49 Pages Posted: 19 Oct 2021

See all articles by Yacine Ait-Sahalia

Yacine Ait-Sahalia

Princeton University - Department of Economics

Felix Matthys

ITAM

Emilio Osambela

Board of Governors of the Federal Reserve System

Ronnie Sircar

Princeton University - Department of Operations Research and Financial Engineering

Multiple version iconThere are 3 versions of this paper

Date Written: September, 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: Risk Aversion, Stochastic Uncertainty, Stochastic Volatility, Uncertainty Aversion, Volatility and Uncertainty Disconnect

JEL Classification: 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 (September, 2021). FEDS Working Paper No. 2021-63, Available at SSRN: https://ssrn.com/abstract=3945259 or http://dx.doi.org/10.17016/FEDS.2021.063

Yacine Ait-Sahalia (Contact Author)

Princeton University - Department of Economics ( email )

Fisher Hall
Princeton, NJ 08544
United States
609-258-4015 (Phone)
609-258-5398 (Fax)

Felix Matthys

ITAM ( email )

Av. Camino a Sta. Teresa 930
Col. Héroes de Padierna
Mexico City, D.F. 01000, Federal District 01080
Mexico
+52 155 1394 6562 (Phone)

Emilio Osambela

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

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
138
Abstract Views
504
rank
65,093
PlumX Metrics