Asset pricing models imply that equity portfolios’ time-varying exposure to the market risk and uncertainty factors carries with it positive risk premiums. Turan Bali and Hao Zhou contribute to the body of literature on this topic through the study “Risk, Uncertainty, and Expected Returns,” which appeared in the June 2016 issue of the Journal of Financial and Quantitative Analysis.
Their study seeks to investigate whether the market price of risk and the market price of uncertainty are significantly positive, and whether they may help explain the cross-sectional and time-series variation in stock returns. According to the authors’ model, the premium on equity is made up of two separate terms. The first term compensates for standard market risk. The second term represents an additional premium for variance risk.
Measures Of Uncertainty
Economic uncertainty is proxied by the variance risk premium (the price of volatility insurance as implied in options prices) in the U.S. equity market. The second set of uncertainty measures that they use is based on the extreme downside risk of financial institutions and is obtained from the left tail of the time-series and cross-sectional distribution of financial firms' returns.
The third uncertainty variable is related to the general health of the financial sector, and is proxied by the credit default swap index. The final uncertainty variable originates from the aggregate measure of investors' disagreement about the individual stocks trading at the NYSE, AMEX and Nasdaq. The dispersion in analysts' earnings forecasts acts as a proxy for the divergence of opinion.
Bali and Zhou’s study covers the period January 1990 to December 2012. Following is a summary of their findings, all of which are intuitive:
