Economic Uncertainty : Mispricing and Ambiguity Premium

We study the effect of economic uncertainty exposure (EUE) on cross-sectional return differentiating the mispricing from ambiguity-premium effects. Conditional on a common mispricing index, we find that EUE induces disagreement which amplifies mispricing. The highest EUE quintile produces an annualized mispricing alpha of 9%, more than double the unconditional mispricing effect. An ambiguity premium of 4.2% alpha is documented in the “non-mispricing” quintile. The EUE induced mispricing effect is different from existing limits of arbitrage explanations, such as idiosyncratic risk. The ambiguity premium is a new source of the risk premium that is robust to the latest risk models