Uncertainty Risk and the Cross-sectional Returns: Theory and Evidence

In this paper we develop a continuous-time general equilibrium model in a representative exchange economy with incomplete information. We show, in a multiple assets setting, that state uncertainty risk is priced and commands additional (state-dependent) premium. It is affected by both the investor’s estimate of the state of the economy, as well as the uncertainty about her estimation. Moreover, noisier stocks/firms respond more strongly to uncertainty shocks, which may help rationalize Fama-French size and book-tomarket factors. We formally test our model using the ASA-NBER survey of professional forecasters, GDP growth rate data, and Fama-French size and book-to-market portfolios. The empirical evidence is largely consistent with the model’s predictions. The estimated uncertainty risk premium is both statistically and economically significant (4.1% per year), and the Fama-French factors lose explanatory power for the cross-sectional returns after controlling for the uncertainty risk.