Safety First, Robust Dynamic Asset Pricing, and the Cross-Section of Expected Stock Returns

Abstract

We investigate the implications of investors’ aversion to Knightian uncertainty for the cross-section of average stock returns. First, we derive the fundamental dynamic asset pricing equation in beta regression form of a robust investor concerned with Knightian uncertainty. Second, we provide empirical evidence that learning and uncertainty are both risk dimensions of systematic risk priced in the cross-section of stock returns. However, the risk premium component corresponding to uncertainty dominates the one corresponding to learning as investors’ investment horizon increases. Third, we report that a robust version of the intertemporal CAPM (ICAPM) explains average stock returns better than the four-factor model and the standard ICAPM.