Ambiguity, limited market participation, and the cross-sectional stock return

Abstract

Using expected utility under uncertain probability theory (EUUP, Izhakian, 2017, 2020), we study whether the ambiguity related to individual stocks is priced in the Chinese A-share market and the mechanism behind the ambiguity premium phenomenon. Theoretically, when the asset price is within a specific range, ambiguity-averse investors refrain from participating in trading. As asset ambiguity increases, high ambiguity-averse investors exit the market, with those with lower aversion remaining in the market (limited market participation phenomenon). Investors who remain in the market due to lower ambiguity aversion are willing to accept a low ambiguity premium. Empirically, we measure monthly ambiguity using the volatility of daily stock return distributions within a month and find the following: (1) The equal-weighted average returns of the most ambiguous portfolios (top 20%) are significantly lower than those of the least ambiguous portfolios (bottom 20%). (2) Ambiguity still significantly negatively affects the cross-sectional stock return after controlling for common firm characteristics. (3) The higher the ambiguity, the lower the future trading activity, supporting our theoretical predictions. These findings reveal the mechanism of the negative ambiguity premium in the Chinese A-share market. This study provides new ideas for building a factor-pricing model suitable for the A-share market and a fresh perspective for preventing systemic financial risk.