Ambiguity and Cross Section of Stock Returns

Abstract
Study examines the effect of ambiguity exposure on the cross-section of stock returns in the US equity market. In order to quantify ambiguity, they use the methodology offered by Brenner and Izhakian (2018), who measure ambiguity by probability perturbations (uncertain probabilities) and aversion to ambiguity by aversion to mean-preserving spreads in these probabilities. They find that there is a left-skewed U-shape association between ambiguity exposure and expected returns. More specifically, results show that expected returns increase as absolute ambiguity exposure increases but the absolute effect of the positive exposure is larger than the absolute effect of negative exposure. U-shape trend is essentially the same when controlling for widely known cross-sectional predictors, other ambiguity proxies, different holding and formation periods, and different states of the economy and financial markets. Overall, results of the study provide substantial empirical evidence that indicates that ambiguity is priced in stock returns. Further tests show that fundamental features like cash flow variance, intangible returns, ad expenses among others might be the channel of influence shaping the stock returns’ relationship with the uncertainty in the market.