Bouts of increased uncertainty are associated with lower growth rates across western countries and therefore play a pivotal role in formation of an “observed equity premium and risk-free rate” in those countries, says the latest paper by three Columbia professors.
“Uncertainty shocks play an important role in generating movements in asset prices in our model. Shocks that raise expected future uncertainty lead stock prices to fall. And expected returns are predictably high following stock market declines provoked by such uncertainty shocks,” say authors Emi Nakamura, Dmitriy Sergeyev, Jon Steinsson in Growth-Rate and Uncertainty Shocks in Consumption: Cross-Country Evidence published in May.
For traders using volatility hedges like VIX, these presumptions maybe nothing new but, in the world of economics, where stylized models often clash with data, a model presented in this paper presents significant improvements in the research world while giving a glimpse as to where we may be in the longer set of financial trends.
For the research world, where uncertainty is sometimes an appendage to the end of an equation (stochastic variable) in order to make the model work, these authors link economic growth with uncertainty and convincingly show that there is a significant and negative correlation between the two.
“For the same utility function parameters, the model without growth-rate and uncertainty shocks generates an equity premium that is more than an order of magnitude smaller,” say the authors, meaning that absence of uncertainty in asset pricing models improperly prices those assets.
By using consumption-based asset pricing, the model authors develop pretty much corresponds to the bullish periods in the stock market: just replace (paragraph below) higher stock prices for every period where volatility has been calculated to have fallen.
“We estimate that world volatility was high in the early post-WWII period and has been on an uneven downward trend since then. World volatility fell a great deal in the 1960′s, but was high again in the 1970′s and early 1980′s. It fell sharply in the mid-to-late 1980′s but was relatively high in the early 1990′s | likely due to the ERM crisis in Europe. From 1995 to 2007 the world experienced a long period of relative tranquility with volatility falling sharply towards the end of this period to record lows. At the end of our sample period, world volatility rose sharply once again,” write the authors (graph above).
Model’s high conformity to reality has an additional interesting feature – the “sensitivity to the world growth-rate process”.
For example, by setting the sensitivity index of the US to 1, the current culprits of global financial troubles – Spain, Italy, Portugal and Belgium – have a visible high mean sensitivity index along with higher swings (standard deviation) in it (Table A.1).
If a person was to pick out the trouble spots just by looking at those numbers, absent any knowledge of the news, the countries listed in the table on the left clearly stand out. Of particular interest, at least in this exercise, would be Finland and The Netherlands, both considered to be part of the EU “core” and largely immune to the ongoing financial crisis… but are they?
Paper available here.