Working Paper: NBER ID: w29195
Authors: Yacine Atsahalia; Felix Matthys; Emilio Osambela; Ronnie Sircar
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: asset pricing; portfolio performance; uncertainty; volatility; equity premium
JEL Codes: G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Uncertainty (D89) | Equity Premium (G19) |
| Disconnect of Uncertainty and Volatility (D80) | Equity Premium (G19) |
| High Uncertainty & Low Volatility (D89) | Higher Equity Premium (G19) |
| High Volatility & Low Uncertainty (D89) | Lower Equity Premium (G19) |
| Return Volatility (G17) | Stock Returns (G12) |
| Uncertainty (D89) | Stock Returns (G12) |