Understanding the effects of uncertainty on the macroeconomy and financial markets

Abstract

Theoretical works have illustrated distinct roles of risk and uncertainty in financial markets. However, there is no consensus on measurement of uncertainty. Financial uncertainty and macroeconomic uncertainty are commonly proxied separately by the volatility of stock returns or key macroeconomic variables, respectively. This thesis first proposes a portfolio-based uncertainty measure PBMEU that aims to capture aggregate uncertainty in both financial markets and the macroeconomy. When there are significant and persistent economy-wide shocks, the PBMEU produces higher level of uncertainty than the sum of financial and macroeconomic uncertainties, and is associated more significantly with shocks to the macroeconomy. This asymmetric effect cannot be achieved through commonly used proxies of uncertainty.

Using the proposed measure of uncertainty, this thesis revisits the negative premium documented for different uncertainty proxies and finds that its significance is sensitive to the control of risk factors. When the macro factors are controlled in examining the stock returns' exposure to uncertainty, the negative premium is weakened significantly for some of the uncertainty proxies. Overall, the premium is largely dependent on what uncertainty proxy measures, e.g. risk, differences in opinion, individual or aggregate level, and real-time or historical uncertainties. This raises concerns of the choice of uncertainty proxies and control variables used to examine the uncertainty premium.

Finally, this thesis provides new evidence on distinct roles of risk and uncertainty in financial markets through examining trading activity around the U.S. macro news releases. It documents a sustained increase in stock and option trading activity coupled with a rise in risk and dramatic drop in uncertainty after the release of Federal Open Market Committee (FOMC) statements. Following the non-FOMC macro news, equity trading activity increases moderately as does risk, while uncertainty remains stable. Comparing the trading activity prior to news release with those in non-event days, a significant reduction in both stock and option trades for FOMC news is demonstrated. Meanwhile, a surge in option trades is found before non-FOMC macro news. The results suggest that FOMC news help resolve uncertainty, resolution of uncertainty encourages more trading activity than a rise in risk, and investors actively exploit their insights when there is little change in uncertainty.