Uncertainty and risk premium

Uncertainty can be described as a situation of missing or unknown information but is having a direct impact on the decision-making process. Particularly recently, during the last periods of turmoil, we were able to experience how uncertainty matters for economic decision-making and their impact on the financial market. The literature has proposed three main channels through which uncertainty potentially affects the real economy. This study focuses on the second channel that goes through the risk premium, as investors are likely to demand a higher risk premium. Using MIDAS approach, the relationship between one of the uncertainty measure the fear index VIX and the risk premium is studied. The data refers to the United States, as the country which has the most highly developed capital markets in the world. Its assumed that forecasting process is important for policymakers, especially during the period with a high level of uncertainty. This paper demonstrates that the forecasting process could improve by using the mixed-frequency sampling approach and by introducing uncertainty into the model using the fear index