Premium for Heightened Uncertainty : Solving the FOMC Puzzle

The substantial stock market return prior to FOMC announcements without major increase in conventional measures of risk, as documented by Lucca and Moench (2015), presents a "puzzle" to the simple notion of risk-return trade off. We hypothesize that the arrival of macroeconomic news, with FOMC announcements leading the list, brings heightened uncertainty to the market as an additional source of risk. While this heightened uncertainty may not be accurately captured by common risk measures, its dissolution occurs mostly during a short time window prior to the announcement and brings a significant price appreciation, reflecting the risk premium associated with it. 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 proxies for heightened uncertainty in the market can be found, 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 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. We further find that there is a gradual but significant build-up in VIX over a window of up to six business days prior to the FOMC announcements