- August 03, 2016
- CBR - Finance
Why Markets Need Not Fear Uncertainty
Here’s a chicken-or-egg finance question: Do volatility shocks in equities markets cause business-cycle downturns, or do business-cycle downturns manifest as highly volatile stock prices?
The study covers two types of volatility: realized and expected. Realized volatility is manifest in stock prices, and measures how much prices move around each month. Expected volatility, as measured by options prices, reflects what market participants expect the market’s realized volatility to be in future months. When expected volatility is high or rising, investors expect uncertain times in the future. In these cases, it could be that investors cause downturns through their expectations of volatility—some have argued that fear and uncertainty themselves can cause the economy to contract. For example, companies may delay making investments in times of high uncertainty. If that were to happen, changes in expected volatility could actively cause economic downturns.
This, however, seems not to be the case, according to the researchers. Volatility does not lead to contractions; rather, contractions cause volatility. “The evidence we present favors the view that bad times are volatile times, not that volatility causes bad times,” they write.
The study focuses on S&P 500 index options, with rolling six-month measurements of expected equity-market volatility beginning in 1983. Investors generally price options based on measurements of expected future volatility. Movements in the price of underlying equities, meanwhile, reflects current volatility.
What the study finds, which is at odds with the standard view described above, is that increases in expected volatility actually have no measurable effect on the real economy, after controlling for current volatility. In other words, increases in uncertainty have not historically been associated with future downturns—so fear itself is nothing to fear.
The findings call into question common explanations about uncertainty causing, rather than reflecting, poor economic performance.
More from Chicago Booth Review
We want to demonstrate our commitment to your privacy. Please review Chicago Booth's privacy notice, which provides information explaining how and why we collect particular information when you visit our website.