November 2020 - Chicago Global

November 3, 20200

The Asset-Pricing Implications of Government Economic Policy Uncertainty

Uncertainty about the future undoubtedly impacts market participant behavior and thus could influence how assets are priced. Government policy makers not only affect the policies themselves, but also the uncertainty regarding future monetary, fiscal, and regulatory policies collectively referred to as Economic Policy Uncertainty (EPU). Because government economic policies have wide-ranging impacts on firms in all sectors, this type of uncertainty is a type of non-diversifiable (also known as systematic) risk.


In traditional financial economic theory, investors are compensated for bearing systematic market risk with higher expected returns. In other words, investors have a higher demand for assets that hedge against downturn in adverse changes to the overall market, thereby raising prices of these assets and lowering expected returns. Pástor and Veronesi (2013), both professors of finance at the Chicago Booth School of Business, suggest that economic policy uncertainty raises the equity risk premium and is a variable that affects the future investment opportunities. This implies that changes in EPU, like volatility, carries a negative price of risk. In other words, investors are willing to pay (by tolerating lower returns) on portfolios which hedge such risks.

Research Setting

To study whether such an empirical pattern exists, Brogaard and Detzel (2015) provide empirical evidence that economic policy uncertainty impacts equity returns through a time-series as well as cross-sectional analyses. Prior to this research, most extant studies relied on event studies around a particular policy change or an election; it has the advantage of being well documented with a timeline but does not provide a holistic view of EPU as a risk premium. Broggard and Detzel use a news-based measure of policy uncertainty extracted from influential news outlets (Baker et al. (2016)), a measure that allows for a continuous tracking of policy risk. This EPU index is computed by taking the weighted average of three measures of EPU which comprises a news-based measure (given the largest weight), expiring tax provisions, and forecaster disagreement about government purchases and inflation.

They found the estimated relation between economic policy uncertainty and returns for two, three, and six months in the future to be positive and statistically significant, meaning that EPU positively predicts expected excess returns and does in fact raise the equity risk premium. For quarterly returns, a one-standard deviation increase in EPU raises the expected excess quarterly returns by 6.12% annualized. These time series analyses contain a variety of time-series forecasting regressions, regressing market log excess returns (for different time periods) against EPU while controlling for variables such as monthly historical volatility, monthly implied volatility, 10-year treasury yield and several other macroeconomic variables to emphasize the incremental statistical power from EPU. The results suggest that compared to existing measures of uncertainty, EPU is different and carries additional information not contained in measures like the VIX, the forward looking 90-day volatility of the S&P 500 index which is also referred to the “fear index” and used to proxy for the general uncertainty within the market.

The paper also found that EPU affected cross-sectional returns of stocks, even when accounting for standard Fama-French and liquidity exposures. Portfolios positively correlated with EPU rise in value with EPU rises. Therefore, investors will be willing to pay a higher price (and tolerate lower returns) for portfolios that are more positively correlated with EPU. The paper shows that within the Fama-French 25 independently sorted size and momentum, shorting the portfolio with the highest exposure to EPU and going long the one with the lowest exposure to EPU delivers an average of 5.53% annual alpha relative to standard risk factors.

What does that mean for investors?

Following periods of higher economic policy uncertainty, equity market returns tend to generate higher returns. Investors who can tolerate such risks will tend to be rewarded for staying in the market during periods of heightened economic policy risks. In addition, portfolios that serve to hedge these risks tend to have lower returns. Although not every risk is compensated for with more average returns, economic policy uncertainty appears to be a relevant priced risk factor.

Investors should be mindful of the levels of economic policy uncertainty risks they are willing to tolerate. Portfolios that tend to lose value with EPU rises tend to have higher average returns on average for bearing the EPU risk. However, an optimal investment portfolio should be tailored to the risk tolerance of the investors rather than simply aiming to maximize returns at any costs. One way to manage EPU risk is to blend the portfolio exposure to other imperfectly correlated sources of returns, allowing diversification across return drivers to reduce the overall portfolio risk to help investors remain patient and disciplined even during times when economic policy uncertainty is high.

To see how the Chicago Global’s portfolio performs during periods of higher economic policy uncertainty and how the EPU risk exposures compares with the global market benchmark, login to read our research note.


Baker, Scott R, Nicholas Bloom, and Steven J Davis. 2016. “Measuring Economic Policy Uncertainty.” The Quarterly Journal of Economics 131 (4): 1593–1636. doi:10.1093/qje/qjw024.Advance.

Brogaard, Jonathan, and Andrew Detzel. 2015. “Policy Uncertainty The Asset-Pricing Implications of Government Economic Policy Uncertainty.” Management Science 61 (1): 3–18.

Pástor, Luboš, and Pietro Veronesi. 2013. “Political Uncertainty and Risk Premia.” Journal of Financial Economics 110 (3): 520–45. doi:10.1016/j.jfineco.2013.08.007.