Unspanned Risk and Risk-Return Tradeoff

Abstract

We show that the conditional risk estimation in the ICAPM model (Merton, 1973) should contain the unspanned uncertainty beyond stock market if the interest rate is not sufficient to describe the dynamic investment state. Borrowing an aggregated uncertainty measure that captures unspanned uncertainty beyond financial markets from Baker, Bloom, and Davis (2016), we detect a significant risk-return tradeoff in both aggregated market and stock cross-section, in both short and long run, and both in and out of sample. We find that about 80% of this tradeoff can be attributed to unspanned uncertainty. A zero-investment portfolio buying stocks in the top unspanned risk decile and selling stocks in the bottom decile can generate a Fama-French-Carhart alpha of 0.61% in the subsequent month and 8.4% in the next 12 months. Further analysis suggests that the unspanned uncertainty comes mainly from economic policy, fiscal policy, healthcare, government-entitled programs, national security, and non-financial regulations. This significant unspanned uncertainty−return tradeoff exists in seven Europe markets as well. Overall, our study suggests that uncertainty unspanned by capital market risks plays a key role in the positive risk–return tradeoff relationship.

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

JEL Classification: G00, G10