News may lead to volatility and disaster uncertainty - a priced variance premium

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News headlines will impact market returns and volatility. Headlines often represents uncertainty and can increase the fear or probability of rare disasters.  More news headlines that generate investor uncertainty will lead to higher price volatility. 

Headlines will change return expectations and cause investors to switch their views on the chance of markets being in a good or bad state. This will lead to greater deviations in prices. An increase in volatility will mean that return premium have to increase to compensate investors for the added risk from uncertainty. The short-term impact between risk and return can be complex, but longer-term links between news implied volatility and return is actually well-defined. 

This link is especially the case when the news is focused on low probability potential disasters. There has been strong research work that when the probability of a rare disaster or left-hand tail event increases, returns will have to also increase to compensate for risk. Rare disaster risk has been used as an explanation for the excess return premium in equities.

Asaf Manela and Alan Moreira in their paper, "News Implied Volatility and Disaster Concerns" focus on key headline risk using machine learning to tease out text-based measures of uncertainty in newspaper headlines. Their focus is not on stock volatility but changes the chance of a rare disaster. 

Their research work finds a positive link between their news implied volatility index and return patterns. There is a variance premium with respect to their news measures. Of course, this does not mean that you should just ride the wave of negative news with a passive portfolio. Investors will be harmed by disaster shocks or changes in disaster expectations, but returns will then rise in the future to offset this risk. The behavior of the markets in response to war, government redistribution changes, or financial crises is well-defined and linear. Higher news uncertainty will mean future higher returns. 

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