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How Risk & Uncertainty Affect Returns

Asset pricing models imply that equity portfolios’ time-varying exposure to the market risk and uncertainty factors carries with it positive risk premiums. Turan Bali and Hao Zhou contribute to the body of literature on this topic through the study “Risk, Uncertainty, and Expected Returns,” which appeared in the June 2016 issue of the Journal of Financial and Quantitative Analysis.

Their study seeks to investigate whether the market price of risk and the market price of uncertainty are significantly positive, and whether they may help explain the cross-sectional and time-series variation in stock returns. According to the authors’ model, the premium on equity is made up of two separate terms. The first term compensates for standard market risk. The second term represents an additional premium for variance risk.

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