Essays on the Cross-section of Returns

This dissertation examines what factors determine the cross-section of returns.It contains three chapters.Chapter 1 investigates whether uncertainty shocks can explain the value premium puzzle.Intuitively, the value of growth options increases when uncertainty is high.As a result, growth stocks hedge against uncertainty risk and earn lower risk premiums than value stocks.An investment-based asset pricing model augmented with timevarying uncertainty accounts for both the value premium and the empirical failure of the capital asset pricing model (CAPM).This study also shows that uncertainty shocks influence cross-sectional investment.Uncertainty has a negative impact on the investment of value firms, while it has a positive impact on the investment of growth firms.Chapter 2 shows that uncertainty shocks can explain the negative relation between idiosyncratic volatility and expected returns in Ang, Hodrick, Xing and Zhang (2006, 2009).The main intuition is that idiosyncratic volatility amplifies the positive impact of uncertainty shocks on the value of growth options.Therefore, everything else being equal, growth stocks with higher idiosyncratic volatilities perform better than growth stocks with lower idiosyncratic volatilities when uncertainty is high, and consequently have lower expected returns.Using an investment-based asset pricing model with time-varying uncertainty, I show that the idiosyncratic volatility puzzle