The Impact of Risk and Uncertainty on Expected Returns

Abstract

We study asset pricing when agents face model uncertainty and empirically demonstrate that model uncertainty matters for asset pricing. We measure the amount of model uncertainty in the economy with the disagreement of professional forecasters, attributing different weights to each professional forecaster. The weighting scheme is estimated via a method that is inspired by recent work on MIDAS regressions. We run regressions representing the typical risk-return trade-off, where risk is represented by conditional volatility and augment these regressions with a measure of model uncertainty. We nd stronger empirical evidence for a model uncertainty-return trade-off than for the traditional risk-return trade-off.

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