Ambiguity and the Cross-Section of Stock Returns

Posted: 15 Mar 2012

See all articles by Antoine Giannetti

Antoine Giannetti

Florida Atlantic University

Ariel M. Viale

Florida Atlantic University

Date Written: December 1, 2011

Abstract

We derive a simple capital asset pricing model under Knightian uncertainty or model ambiguity by solving a static constrained robust control problem. We show that under the reference or approximating model the resulting “Beta form” regression displays intercepts (or alphas) that reflect each asset’s relative ambiguity (with respect to the market). Under the “worst-case” scenario however, the usual CAPM obtains. Consistent with this view and the well-known fact that the empirical test of the CAPM is an ill-posed problem, we introduce a novel estimation method based on “entropy” as proxy of investors’ state of knowledge. We show that the “ambiguity” component of the equity premium is statistically and economically significant with an average size commensurable with the usual risk premium. The results are robust to different time periods, rolling regression windows, and sample of test assets. Finally, we discuss the role of book-to-market and size as proxies of investors’ concern to model ambiguity in the stock market.

Keywords: Ambiguity, Cross section of stock returns, Maximum entropy

JEL Classification: G12, C5

Suggested Citation

Giannetti, Antoine and Viale, Ariel M., Ambiguity and the Cross-Section of Stock Returns (December 1, 2011). Available at SSRN: https://ssrn.com/abstract=2021948 or http://dx.doi.org/10.2139/ssrn.2021948

Antoine Giannetti

Florida Atlantic University ( email )

777 Glades Road
Boca Raton, FL 33431
United States
561-297-3192 (Phone)
561-297-2956 (Fax)

Ariel M. Viale (Contact Author)

Florida Atlantic University ( email )

777 Glades Road
Boca Raton, FL 33431
United States
561-2972914 (Phone)
561-2972189 (Fax)

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