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Can unpredictable risk exposure be priced?

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  • Barahona, Ricardo
  • Driessen, Joost
  • Frehen, Rik

Abstract

We study the link between beta predictability and the price of risk. An investor who desires exposure to a certain risk factor needs to predict what next period’s beta will be. We use a simple model to show that an ambiguity averse agent’s demand is lower when betas are hard to predict, leading to a reduction in risk premiums. We test the implications for downside betas and VIX betas. We find that they have economically and statistically small prices of risk once we account for the fact that an investor cannot observe ex-post realized betas when determining asset demand.

Suggested Citation

  • Barahona, Ricardo & Driessen, Joost & Frehen, Rik, 2021. "Can unpredictable risk exposure be priced?," Journal of Financial Economics, Elsevier, vol. 139(2), pages 522-544.
  • Handle: RePEc:eee:jfinec:v:139:y:2021:i:2:p:522-544
    DOI: 10.1016/j.jfineco.2020.08.006
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    References listed on IDEAS

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    Cited by:

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    2. Tong Wang, 2023. "Bear Beta or Speculative Beta?—Reconciling the Evidence on Downside Risk Premium," Review of Finance, European Finance Association, vol. 27(1), pages 325-367.
    3. Hollstein, Fabian & Prokopczuk, Marcel, 2022. "Testing Factor Models in the Cross-Section," Journal of Banking & Finance, Elsevier, vol. 145(C).
    4. Gertsman, Gleb & Frehen, Rik & Werker, Bas J.M., 2019. "Would Ambiguity Averse Investors Hedge Risk in Equity Markets?," Other publications TiSEM bd3eb3e5-517e-40d4-aab9-e, Tilburg University, School of Economics and Management.
    5. Venturini, Alessio, 2022. "Climate change, risk factors and stock returns: A review of the literature," International Review of Financial Analysis, Elsevier, vol. 79(C).

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    More about this item

    Keywords

    Ambiguity aversion; Beta uncertainty; Hedging demand; Price of risk;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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