Market Ambiguity Attitude Restores the Risk-Return Trade-Off

A positive relation between the conditional mean and conditional volatility of aggregate stock returns, although viewed as a fundamental law of finance, has been challenging to find empirically. We consider a representative agent asset pricing model with Knightian uncertainty and demonstrate that this risk-return trade-off depends on the agent’s ambiguity attitude (reflecting the agent’s degree of optimism or pessimism). The model predicts that the conditional equity premium is increasing in market volatility, but its slope flattens as market optimism rises. We develop a methodology to extract the representative agent’s ambiguity attitude from our asset pricing model. Results validate our model predictions. We document the significant in-sample and out-of-sample explanatory power of ambiguity attitude in explaining the risk-return trade-off. In our sample, market volatility is not significant in forecasting returns. However, including the market ambiguity attitude leads to a significant positive relationship between volatility and future returns. Hence, our model and results identify market ambiguity attitude as a missing state variable that can explain why the literature has found it difficult to empirically validate the risk-return trade-off. This paper was accepted by Manel Baucells, behavioral economics and decision analysis. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2023.03595 .