Interest Rate Uncertainty and Vulnerabilities in Stock Market Valuation
This paper proposes a new method to quantify economic uncertainty using At-The-Money (ATM) and Out-of-The-Money (OTM) options prices. Empirically, cap and floor options are used to gauge interest rate uncertainty-IRU. VAR estimation suggests that IRU is counter-cyclical, precedes bad macroeconomic states, and its increases are associated witha lower stock market valuation. I also examine the conditional distribution of the cyclically adjusted price-to-earnings ratio (CAPE ratio) as a function of economic and uncertainty conditions. Increases in IRU are related to rises in conditional volatility and a fall in the conditional median of CAPE ratio growth. In the third application, I show that stock market indexes worldwide are somewhat influenced by U.S. monetary policy uncertainty