From Economic Policy Uncertainty to Implied Market Volatility: Nothing to Fear?

Abstract

This paper investigates the interdependence between economic policy uncertainty (EPU) and implied market volatility using a Bayesian copula network. The results indicate that market-implied volatilities serve as more reliable forward-looking indicators of uncertainty compared to newspaper-based EPU. Through a complex partial wavelet coherence approach, the study further explores the dynamic interdependence between these variables, revealing the specific time-domain patterns of their effects on economic uncertainty and the conditions under which they can be distinguished as measures of risk aversion and ambiguity aversion. Notably, the findings suggest that, in the short time scales, the media tends to generate ambiguity, contributing to belief divergence among market participants. However, over longer time scales, EPU increasingly reflects economic uncertainty. These insights are valuable for gaining a deeper understanding of the media's role in conveying information and the behavioral traits influencing economic decision-making.