Board of Governors of the Federal Reserve System

January 2012

Risk, Uncertainty, and Expected Returns

Turan G. Bali and Hao Zhou

Abstract:

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 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.

Keywords: Consumption-based asset pricing model, time-series and cross-sectional stock returns, variance risk premium, ICAPM, risk, uncertainty, expected returns

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