Can policy and financial risk predict stock markets?

Abstract

Since higher risk should be rewarded with higher expected returns, more risky time periods are expected to predict rising stock markets. This paper focuses on implied volatility as a measure of financial risk and economic policy uncertainty (EPU) which includes also regulatory risk. We analyze twelve stock markets for which EPU indices exist and find that even though there is no concurrent relationship between EPU and market movements, high EPU indeed predicts subsequent stock market growth. On the other hand, implied volatility is high when markets are falling but is less informative about future market movements. The economic significance of our results is illustrated by a highly profitable trading strategy, which yields abnormal returns of 15% per year on average across countries.