How to Understand Market Volatility
November 12, 2013
Predicting markets and understanding financial volatility can be overwhelming for many.
Professor Ravi Bansal has researched this topic, and offers a unique model to understand the complexities of markets.His 2004 paper "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles" (co-authored with Amir Yaron) - was discussed as being "influential" in the Economic Sciences Nobel Prize Committee of the Royal Swedish Academy of Sciences paper on understanding asset prices.
He explains why in the following in a Fuqua Q and A.
What is your reaction to the three 2013 Nobel Prize winners in Economics?
The three Nobel Prize winners --- Eugene Fama, Lars Hansen, and Robert Shiller --- are outstanding economists who have revolutionized financial economics over the last four decades. I am absolutely delighted to see them receive this high honor.
What is the key takeaway from your paper, "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles"?
Investors receive information about short, medium and long run prospects of the economy. All these risks determine asset prices and expected returns. However, information about the long run and the uncertainty associated with it has the most impact on prices. For example, concerns about whether the economy is going to have a long-term growth reduction (as was the case recently in Japan) is a more important determinant of asset prices than a transitory reduction in expected growth, say, for the next quarter or two. Similarly, any change in long run economic uncertainty significantly affects assets prices.
The Long-Run Risks (LRR) paper models the behavior of investors and quantifies the magnitude of long-run growth and uncertainty risk using macroeconomic data. Using this set-up the paper provides a fundamental explanation for observed market volatility and returns. The follow-up papers that use the LRR set-up find that it can also account for bond yields, cross-section of equity returns, foreign exchange rates, option returns, and other important asset prices.
What is unique about the Long Run Risk Model?
The paper provides a dynamic CAPM (Capital Asset Pricing Model) in which betas (i.e., risk exposures) related to aggregate long term growth and volatility play an important role in explaining differences in expected returns on equities, bonds, and assets in general. The model predicts that equities have low realized returns in periods of high uncertainty and low growth, while bonds have high returns in these "bad" economic periods. These differences in returns are reflected in asset betas and therefore in their expected returns. The Long Run Risk Model highlighted the importance of the long-run fluctuations, which is distinct and unique relative to all the previous literature which focused predominantly on shorter-term risks. Follow-up empirical research finds considerable support for the channels highlighted in the LRR model.
What advice would you give to financial professionals on how they can understand market volatility?
Day to day market volatility is driven by various short term events and therefore the noise in these fluctuations is large. However, longer term market volatility is driven by changes in investor expectations about macroeconomic uncertainty and growth. Periods of high uncertainty and low expected growth, something that we saw not too long ago in the U.S., are associated with low equity prices. At the same time, demand for safe assets rise during these periods causing bond prices to rise. The opposite is true during periods of low economic uncertainty and high growth. These ebbs and flows lead to market volatility.
Why do you think that your paper is being discussed as "influential" in the Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences paper?
The paper has changed the way people think about the key drivers of financial market prices and their expected returns. The literature on the Long-Run Risks model is quite large, and has provided us with new theoretical and empirical insights about the role of long-run economic risks in determining asset price volatility and return.