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September 26, 2025Open Access

Measuring Political Risk in the Stock Market : An Empirical Study of Economic Policy Uncertainty and the Volatility Index

Key Points

A positive shock to the volatility index initially has a muted impact on economic policy uncertainty, but this effect increases over time.
Variance-decomposition analysis shows that fluctuations in the volatility index contribute to the forecast-error variance in economic policy uncertainty.
Using a vector error correction model allows the quantification of the long-term relationship and dynamics between economic policy uncertainty and volatility index.
Findings indicate the interconnectedness of policy uncertainty and market dynamics, providing crucial insights for investors and policymakers.

Abstract

This paper investigates how Economic Policy Uncertainty (EPU) and the Volatility Index (VIX) in financial markets relate in both the long and short term. After examining the stability, causality, and long-term equilibrium between these two variables, a vector error correction model is constructed to quantify their dynamics. Impulse-response functions indicate that a positive shock to VIX initially has a muted impact on EPU, but the effect strengthens over time and eventually stabilizes, and variance-decomposition analysis suggests that shocks of VIX attributes to the forecast-error variance in EPU to some extent after several periods. As for robustness check, VIX is supplanted by Geopolitical Risk (GPR), and the results corroborate previous findings: the cointegrating relationship persists, and the VECM again produces significant error-correction coefficients. The findings contributes to understand how economic policy uncertainty influences market dynamics, and also provides practical insights for policymakers and investors to better handle risks linked to policy uncertainty.

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