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Volatility, The Macroeconomy and Asset Prices

Ivan Shaliastovich, Wharton

12th Aug 2011  11:30 am - 12:30 pm Room 214/215 H69

In this paper we show that volatility news is essential for a coherent economic interpretation and measurement of the underlying risks in the economy, and that ignoring validity can lead to substantial biases in the stochastic discount factor (SDF). We quantify and show that ignoring volatility can have first-order implications for the implied consumption innovations, the SDF, and asset returns. Furthermore, using a VAR based approach we document that accounting for volatility leads to a positive correlation between the return to human capital and the market, while this correlation is negative when volatility is ignored. Our volatility based asset pricing model captures well the levels and differences in the risk premia across value and size portfolios. We further show that accounting for volatility risks is important for correct economic interpretation of the assets┬┐ exposure to the underlying sources of risks.