Premium for Heightened Uncertainty: Solving the FOMC Puzzle
NBER Working Paper No. 25817
Lucca and Moench (2015) document that prior to the announcement from FOMC meetings, the stock market yields substantial returns without major increase in conventional measures of risk. This presents a “puzzle” to the simple risk-return connection in most (static) asset pricing models. We hypothesize that the arrival of macroeconomic news, with FOMC announcements at the top of the list, brings heightened uncertainty to the market, as investors cautiously await and assess the outcome. While this heightened uncertainty may not be accurately captured by conventional risk measures, its dissolution occurs during a short time window, mostly prior to the announcement, bringing a significant price appreciation. This hypothesis leads to two testable implications: First, we should see similar return patterns for other pre-scheduled macroeconomic announcements. Second, to the extent that we can find other proxies for heightened uncertainty, we should also observe abnormal returns accompanying its dissolution. Indeed, we find large pre-announcement returns prior to the releases of Nonfarm Payroll, GDP and ISM index. Using CBOE VIX index as a primitive gauge for market uncertainty, we find disproportionately large returns on days following large spike-ups in VIX. Akin to the FOMC result, such heightened-uncertainty days occur on average only eight times per year, but account for more than 30% of the average annual return on the S&P 500 index. Inspired by the VIX result, we search for direct evidence of heightened uncertainty using VIX as a proxy and find a gradual but significant build-up in VIX over a window of up to six business days prior to the FOMC announcements.
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Document Object Identifier (DOI): 10.3386/w25817