Market Ambiguity and Returns

Using a GARCH-M model, we examine the effect of the level of ambiguity in the stock market on the conditional mean of market returns. Additionally, we investigate the predictive power of the level of ambiguity expected market returns. The results of the GARCH-M estimation indicate the presence of GARCH effects and show a positive risk-return tradeoff. Second, we find that the level of ambiguity, although orthogonal to risk, is correlated with market returns. On dividing our study period into expansion and recession subperiods, we find that there is an inverse relationship between the level of ambiguity and contemporaneous market returns only during recessions. Finally, the results of the forecast models indicate that the level of ambiguity is a strong predictor of future market returns. Specifically, our findings offer the first definite evidence of a positive relationship between the level of ambiguity and future market returns.