Unspanned Risk and Risk-Return Tradeoff

77 Pages Posted: 6 Feb 2023 Last revised: 29 Jan 2024

See all articles by Huacheng Zhang

Huacheng Zhang

University of Edinburgh Business School

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School

Date Written: January 1, 2023

Abstract

A major tenet of modern finance is the risk-return tradeoff, and yet there is a lack of empirical evidence supporting it. We provide an unspanned risk explanation, which, measured as uncertainty beyond financial markets, is well approximated by the macro uncertainty index of Baker, Bloom, and Davis (2016), 90% of which can be attributed to unspanned uncertainty. We find the first out-of-sample evidence that there is a positive risk-return tradeoff after all. In addition, we find that the unspanned risk matters at stock level too: a high-minus-low unspanned risk portfolio can generate an annualized return of 3.5%.

Keywords: ICAPM, Conditional risk, Unspanned Risk, Tradeoff, Knightian Uncertainty, Policy Uncertainty

JEL Classification: G00, G10

Suggested Citation

Zhang, Huacheng and Zhou, Guofu, Unspanned Risk and Risk-Return Tradeoff (January 1, 2023). Available at SSRN: https://ssrn.com/abstract=4344929 or http://dx.doi.org/10.2139/ssrn.4344929

Huacheng Zhang

University of Edinburgh Business School ( email )

EH8 9JS (Fax)

HOME PAGE: http://https://www.business-school.ed.ac.uk/

Guofu Zhou (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

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