The Impact of Uncertainty Shocks on the Cross-Section of Returns

Abstract

Historically, value stocks earn higher average returns than growth stocks; however, the capital asset pricing model (CAPM) cannot explain this pattern, which is called the value premium puzzle. This study shows that uncertainty shocks can explain the puzzle. Intuitively, the value of growth options increases with uncertainty. As a result, growth stocks provide a hedge against uncertainty risk and earn lower risk premiums than value stocks. An investment-based asset pricing model augmented with time-varying uncertainty accounts for both the value premium and the empirical failure of the CAPM. This study also shows that uncertainty shocks differentially affect corporate investment, depending on the book-to-market ratio. Value firms reduce their investment more severely than growth firms when uncertainty increases.

Keywords: investment-based asset pricing model, uncertainty shocks, volatility, value premium, growth options

JEL Classification: E22, G11, G12