When uncertainty and volatility are disconnected: implications for asset valuation and portfolio performance
Yacine Aït-Sahalia, Félix Matthys,Emilio Osambela, and Ronnie Sircar
We analyze an environment where uncertainty about equity market performance and its volatility are both stochastic and can potentially be disconnected. We solve for the optimal asset allocation of a representative investor and derive the resulting conditional equity premium and risk-free rate at equilibrium. Our empirical analysis shows that the premium on equities appears to be earned to deal with uncertainty, especially high uncertainty that is disconnected from lower volatility, rather than to deal with volatility as traditionally assumed. Integrating the possibility of a disconnection between volatility and uncertainty significantly improves the performance of the portfolio, beyond the performance obtained by conditioning only volatility.
DO I: https://doi.org/10.17016/FEDS.2021.063
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Last updated: September 30, 2021
Board of Governors of the Federal Reserve System published this content on September 30, 2021 and is solely responsible for the information it contains. Distributed by Public, unedited and unmodified, on September 30, 2021 06:21:03 PM UTC.