Economic Uncertainty: Mispricing and Ambiguity Premium

60 Pages Posted: 25 Aug 2020 Last revised: 1 Jul 2021

See all articles by Semih Kerestecioglu

Semih Kerestecioglu

University of Liverpool Management School

Xi Fu

University of Liverpool

Charlie X. Cai

University of Liverpool Management School

Date Written: June 23, 2021

Abstract

We study the effect of economic uncertainty exposure (EUE) on cross-sectional return differentiating the mispricing from ambiguity-premium effects. Conditional on a common mispricing index, we find that EUE induces disagreement which amplifies mispricing. The highest EUE quintile produces an annualized mispricing alpha of 9%, more than double the unconditional mispricing effect. An ambiguity premium of 4.2% alpha is documented in the “non-mispricing” quintile. The EUE induced mispricing effect is different from existing limits of arbitrage explanations, such as idiosyncratic risk. The ambiguity premium is a new source of the risk premium that is robust to the latest risk models.

Keywords: Economic Uncertainty, Ambiguity Aversion, Risk Premium, Mis-Pricing, Cross-Section of Stock Returns, Return Predictability

JEL Classification: G11, G12, E30, C13

Suggested Citation

Kerestecioglu, Semih and Fu, Xi and Cai, Charlie Xiaowu, Economic Uncertainty: Mispricing and Ambiguity Premium (June 23, 2021). Available at SSRN: https://ssrn.com/abstract=3655670 or http://dx.doi.org/10.2139/ssrn.3655670

Semih Kerestecioglu

University of Liverpool Management School ( email )

Xi Fu

University of Liverpool ( email )

Chatham Street
Liverpool, L69 7ZA
United Kingdom

Charlie Xiaowu Cai (Contact Author)

University of Liverpool Management School ( email )

University of Liverpool
Liverpool, L69 7ZA
United Kingdom

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