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Policy Uncertainty and Stock Market Volatility Revisited: The Predictive Role of Signal Quality

Author

Listed:
  • Afees A. Salisu

    (Centre for Econometrics & Applied Research, Ibadan, Nigeria; Department of Economics, University of Pretoria, Private Bag X20, Hatfield 0028, South Africa)

  • Riza Demirer

    (Department of Economics and Finance, Southern Illinois University Edwardsville, Edwardsville, IL 62026-1102, USA)

  • Rangan Gupta

    (Department of Economics, University of Pretoria, Private Bag X20, Hatfield 0028, South Africa)

Abstract

This paper provides novel mixed-frequency insight to the growing literature on the (monthly) economic policy uncertainty-(daily) stock market volatility nexus by examining the out-of-sample predictive ability of the quality of political signals over stock market volatility at various forecast horizons, and whether or not accounting for the signal quality in forecasting models can help achieve economic gains for investors. Both in- and out-of-sample tests, based on a GARCH-MIDAS framework, show that the quality of the policy signal indeed matters when it comes to the predictive role played by policy uncertainty over subsequent stock market volatility. While high EPU is found to predict high volatility, particularly when the signal quality is high, the positive relationship between EPU and volatility breaks down when the signal quality is low. The improved out-of-sample volatility forecasts obtained from the models that account for the quality of policy signals also helps typical mean-variance investors achieve improved economic outcomes captured by higher certainty equivalent returns and Sharpe ratios. Although our results indicate clear distinctions between the U.S. and U.K. stock markets in terms of how policy signals are processed by market participants, they highlight the role of the quality of policy signals as a driver of volatility forecasts with significant economic implications.

Suggested Citation

  • Afees A. Salisu & Riza Demirer & Rangan Gupta, 2022. "Policy Uncertainty and Stock Market Volatility Revisited: The Predictive Role of Signal Quality," Working Papers 202232, University of Pretoria, Department of Economics.
  • Handle: RePEc:pre:wpaper:202232
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    More about this item

    Keywords

    Economic policy uncertainty; Signal quality; Market Volatility; Forecasting;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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