Pricing ambiguity and ambiguity aversion in the cross-section of stocks

Based on a theoretical model that relies on the theory of smooth ambiguity aver- sion, this thesis empirically investigates whether ambiguity and aversion towards it is priced in the cross-section of stocks and tests whether the model has explanatory power for resolving some of the cross sectional stock anomalies. The literature inves- tigating whether ambiguity is priced in stock returns typically studies the research question at the aggregate market level. The main finding in the thesis is that am- biguity is priced in the cross section of stocks. Abnormal excess returns of stocks (i.e. CAPM alphas) in the cross section are shown to increase with stocks' ambi- guity exposure which is defined as the difference between the ambiguity beta of a stock and its CAPM beta, where ambiguity beta is the stock's exposure to market portfolio ambiguity. In order to estimate stocks' ambiguity betas, macroeconomic uncertainty index of Jurado, Ludvigson and Ng (2015) is employed as a proxy for market portfolio ambiguity. The thesis shows when stocks are ranked into quintile portfolios according to their ambiguity exposure and ambiguity exposure is controlled for in the CAPM regression as a separate factor, alpha of the high-minus-low quintile as well as the alphas of the individual quintiles disappear. The thesis also shows that ambiguity and ambiguity aversion fully explain the beta anomaly, while providing partial explanations to operating profitability and momentum anomalies.