Ambiguity Aversion, Risk Aversion, and Asset Pricing

Abstract

I study the effects of aversion to risk and ambiguity (uncertainty in the sense of Knight (1921)) on the value of the market portfolio when investors receive information that they find difficult to link to fundamentals and hence treat as ambiguous. Investors consider a set of models that consists of a single normally distributed marginal for fundamentals and a family of normally distributed conditionals that relate information to fundamentals. Hence, they neither know the posterior mean nor the posterior variance of fundamentals. I show that when investors receive ambiguous information, then the interpretation of this information can drastically change. This leads to a discontinuity in the equilibrium price of the market portfolio, excess volatility, negative skewness, and excess kurtosis of stock market returns. Moreover, a higher signal value does not always lead to a higher price.