When uncertainty and volatility are disconnected: Implications for asset pricing and portfolio performance

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.