During the fall of 2008, as Lehman Brothers Holdings Inc Plan Trust (OTCMKTS:LEHMQ) was collapsing and emails and text messages were documented to be flying back and forth among professional traders expressing concerns that the banking system might not be able to handle a derivatives event, a high degree of uncertainty gripped the market. Uncertainty is a component of volatility and is almost universally considered a market a market negative. A study from a trio of Wharton researchers says this is not always the case, however.

Good and bad volatility considered as different measures of risk by Wharton researchers

There are two categories of uncertainty, Wharton finance professor Ivan Shaliastovich along with researchers Gill Segal and Amir Yaron observe. Previously all research on volatility has categorized uncertainty into one category.

The paper, titled "Good and Bad Uncertainty: Macroeconomic and Financial Market Implications," places uncertainty into a “good” and “bad” camp and notes that some uncertainty is associated with positive and negative stock price appreciation.

“These two uncertainties have opposite impact on aggregate growth and asset prices,” the report said. Good uncertainty projects an increase in future economic activity, consumption, output, and investment among them, and is positively related to valuation ratios. Bad uncertainty, on the other hand, forecasts a decline in economic growth and depresses asset prices.

Net impact of uncertainty higher than previously thought, as volatility in a stock market environment is also correlated with "surprise"

The net impact of uncertainty is higher than previous studies have indicated, the report observed. Trading practitioners have long known that when a potential future negative event is known and discussed, even on a behind the scenes level, such discussion and public acknowledgement of a risk issue has been known to reduce market volatility.

Volatile events with damaging impacts are often associated with market surprise, while manageable and relatively orderly price declines can be associated with a potential volatile event being discussed in public.

Offsetting volatility types

At times both positive and negative uncertainty can cancel each other out.   The report observed that an implication of offsetting responses to good and bad uncertainty is that the measured responses to overall uncertainty are going to be muted. This can be seen at times when a company knows negative news is forthcoming they will often announce something positive to offset the reaction.

“The response to total uncertainty is significantly weaker than that to bad uncertainty, which underscores the potential importance of decomposing uncertainty into good and bad components,” the report noted.

Stocks respond more to bad volatility than good, impact on risk premia

Stock prices respond more to bad than to good uncertainty, the report noted, observing that for prices to rise in response to a good uncertainty shock there has to be an explicit positive link between good uncertainty and future growth prospects.

Quantitatively, the study observed the impact uncertainty has on large macro variables. Giving the example of private GDP growth increasing by nearly 2.5 percent in one year after a one standard deviation shock to good uncertainty, such a positive effect has a persistence to it that can last for the next three years. Considering the opposite side of the equation, the report noted bad uncertainty shocks decrease output growth by about “1.3 percent one year after and their effects remain negative for several years.”

The responses of investment and R&D to these shocks are even stronger and impact both good and bad uncertainty.  Both capital and R&D investment significantly increase with good uncertainty and remain positive five years out, while they significantly drop with a shock to bad uncertainty, the researchers concluded.

“We show that the equity prices decline with bad uncertainty and rise with good uncertainty, provided there is a sufficiently large feedback from good uncertainty to future growth.” The research also demonstrated the market price of risk and equity beta are both positive for good uncertainty, while they are both negative for bad uncertainty. “This implies that both good and bad uncertainty risks contribute positively to the risk premia.”

Other studies that differentiate between positive and negative volatility do so for the purpose of evaluating hedge funds and other volatile investments

Research done in managed futures algorithmic trading, some of it particularly critical of the Sharp Ratio, has noted that there is a different risk categorization for upside deviation (positive returns) as there is downside deviation (negative returns). This division of risk into positive and negative volatility is key to evaluating various hedge fund investments. Further, the study noted that combining various noncorrelated volatility types into a single investment actually reduced overall volatility.

Read the full study below.