Cyclicality is a well established behaviour of volatility and has been widely used in its modelling. In particular, it is well documented that market volatility can be characterised by a two-factor process, one with a slowly varying long run component called the core volatility, and another strongly mean-reverting short run component commonly referred to as the transitory volatility.
In a paper put forth by the Bank of England (BoE), they have studied the relationship of the two volatility components towards some macroeconomical fundamentals of the U.S economy. The aim is to investigate whether there exist any relationships in how macroeconomical shocks impact the different volatility components as well as how changes in volatility effect the macroeconomy. Using data between 2001 and 2015, a structural vector autoregression (SVAR) model has been used where the core and transitory volatility have been fitted to a series of macroeconomical measures including; industrial production growth rate, inflation rate, short-term interest rate as well as the Shiller’s crash confidence index −− a proxy for investor sentiment.
The result of the study highlights three structural shocks related to aggregate demand, aggregate supply and monetary policy. With respect to supply and demand, the study shows that both a shock to adverse aggregate demand and aggregate supply create a significant and sustained increase in both the core and total volatility with the former peaking later and staying significant for a considerably longer period. For the transitory component on the other hand, the impact of changes in supply and demand is found to be insignificant. Moreover, the study shows that a change in core volatility carries a deeper recessionary impact on the market than what is observed from shocks in transitory or total volatility. In particular, an equal shock towards the core volatility and total volatility resulted in a more sustained rise in volatility and a deeper contraction in industrial production growth and inflation rate for the core volatility in every case. In contrast, the transitory component were found to have a much weaker relationship to the real economy but instead a more pronounced effect on investor sentiment.
In conclusion it is apparent based on the study presented by BoE that the choice of volatility component is an important factor in the study of how volatility interacts with the macroeconomy and a practitioner might therefore want to choose a measure of volatility most suitable for their need. If the intention behind the study is to understand how volatility impacts the macroeconomy, core volatility should be considered. On the other hand, if they are more interested in studying the relationship between investor sentiment and volatility, transitory volatility may be the more suitable component to consider.
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