High policy uncertainty and low market volatility – an academic puzzle?

Xiaopeng Wei    Xiaopeng Wei, Jedrzej Bialkowski, Huong Dang
25 Nov 2018
Categories: Derivatives, Behavioral Finance

Country or region: New Zealand

Summary:
The paper attempts to explain the puzzle of low market volatility, as measured by VIX, while the policy uncertainty was high in 2017, by analyzing potential factors that could affect the relationship between the market volatility and policy uncertainty.


Abstract

Motivated by the extremely low level of the CBOE VIX accompanied by the high level of U.S. economic policy uncertainty in the period of late 2016 to the end of 2017, we examine the factors affecting the relationship between those two realities. Our analysis shows that the quality of political/economic signals, the divergence of investors’ opinions, and representativeness bias influence the link between the fear gauge and economic policy uncertainty. Specifically, representativeness bias caused by recent low realized volatility weakens the positive relationship between the VIX and policy uncertainty consistently, while the impacts of the quality of political/economic signals and investors’ divergence of opinion depend on the overall level of economic policy uncertainty. Given the level of policy uncertainty, our results allow us to explain the record-low VIX level post the 2016 presidential election.  



Date of original publication:

11/21/2018


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