BFS 2002

Contributed Talk

A Simple Theory of Asset Pricing Under Model Uncertainty

Tan Wang, Leonid Kogan

The focus of our paper is on the implications of model uncertainty for the cross-sectional properties of returns. We perform our analysis in the context of a tractable single-period mean-variance framework. We show that there is an uncertainty premium in equilibrium expected returns on financial assets and study how the premium varies across the assets. In particular, the cross-sectional distribution of expected returns can be formally described by a two-factor model, where expected returns are derived as compensation for the asset's contribution to the equilibrium risk and uncertainty of the market portfolio. In light of the large empirical literature on the cross-sectional characteristics of asset returns, understanding the implications of model uncertainty even in such a simple setting would be of significant value. By characterizing the cross-section of returns we are also able to address some of the observational equivalence issues raised in the literature. That is, whether model uncertainty in financial markets can be distinguished from risk, and whether uncertainty aversion at an individual level can be distinguished from risk aversion.