Risk, Uncertainty, and Expected Returns

Turan G. Bali, Hao Zhou
2011 Social Science Research Network  
A consumption-based asset pricing model with risk and uncertainty implies that the time-varying exposures of equity portfolios to the market and uncertainty factors carry positive risk premiums. The empirical results from the size, book-to-market, and industry portfolios as well as individual stocks indicate that the conditional covariances of equity portfolios (individual stocks) with market and uncertainty predict the timeseries and cross-sectional variation in stock returns. We find that
more » ... s. We find that equity portfolios that are highly correlated with economic uncertainty proxied by the variance risk premium (VRP) carry a significant premium relative to portfolios that are uncorrelated or lowly correlated with VRP. The insignificant alpha estimates indicate that the conditional asset pricing model proposed in the paper also explains the industry, size, and value premiums. JEL classification: G10, G11, C13. Abstract A consumption-based asset pricing model with risk and uncertainty implies that the timevarying exposures of equity portfolios to the market and uncertainty factors carry positive risk premiums. The empirical results from the size, book-to-market, and industry portfolios as well as individual stocks indicate that the conditional covariances of equity portfolios (individual stocks) with market and uncertainty predict the time-series and cross-sectional variation in stock returns. We find that equity portfolios that are highly correlated with economic uncertainty proxied by the variance risk premium (VRP) carry a significant premium relative to portfolios that are uncorrelated or lowly correlated with VRP. The insignificant alpha estimates indicate that the conditional asset pricing model proposed in the paper also explains the industry, size, and value premiums. JEL classification: G10, G11, C13.
doi:10.2139/ssrn.1993304 fatcat:7thyduoe6zfznehj5qal4dyile