High order smooth ambiguity preferences and asset prices

Abstract

This paper extends the recursive smooth ambiguity decision model developed in Klibanoff, Marinacci, and Mukerji (2005, 2009) by relaxing the uniformity imposed on higher order acts. This generalization permits a separation of intertemporal substitution, risk attitude, and attitudes towards different sources of uncertainty. Our decision model is suited in situations where subjects may treat several kinds of uncertainty in different manners. We apply our preference specification to a consumption-based asset pricing model with long run risks and assess the impact of ambiguity on asset prices and predictability patterns. We find that modeling attitudes towards uncertainty through high order smooth ambiguity preferences has important implications for asset prices. Our model generates a highly volatile price-dividend ratio and predictability patterns in line with the data.