Ambiguity-averse Investors Research Articles

Endogenous Aggregate Beliefs: Equity Trading under Heterogeneity in Ambiguity Aversion

We build a simple and tractable model of consumer heterogeneity in ambiguity aversion and use it to illustrate how asymmetric beliefs in the asset markets affect the dynamics of asset pricing, portfolio allocation, and the wealth distribution. The model is an otherwise canonical exchange-economy setting with two aggregate states of nature and two assets. The key focus is on how asset prices, when subjected to ambiguity, behave very differently in the short run than in the long run. In the short run, heterogeneity plays an important role. In the long run, belief heterogeneity persists, but the wealth distribution has evolved so that only the least ambiguity-averse investors matter for prices. As part of the short-run dynamics, the model can generate endogenous aggregate movements in non-participation—a drastic form of trading less—in response to ambiguity, with strong depressing effects on asset prices.

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

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.

Robust Portfolio Optimization with Environmental, Social, and Corporate Governance Preference

This study addresses the crucial but under-explored topic of ambiguity aversion, i.e., model misspecification, in the area of environmental, social, and corporate governance (ESG) within portfolio decisions. It considers a risk- and ambiguity-averse investor allocating resources to a risk-free asset, a market index, a green stock, and a brown stock. The study employs a robust control approach rooted in relative entropy to account for model misspecification and derive closed-form optimal investment strategies. The key contribution of this study includes demonstrating, using two sets of empirical data on asset returns and ESG ratings, the substantial influence of ambiguity on optimal trading strategies, particularly highlighting the differential effects of market, green, and brown ambiguities. As a by-product of our analytical solutions, the study contrasts ambiguity-averse investors with their non-ambiguity counterparts, revealing more cautious risk exposures with a reduction in short-selling positions for the former. Furthermore, three types of investors who employ popular suboptimal strategies are identified, together with two loss measures used to quantify their performance. The findings reveal that popular strategies, not accounting for ESG and misspecification in the model, could lead to significant financial costs, with the extent of loss varying depending on those two factors: investors’ ambiguity aversion profiles and ESG preferences.

Loss Aversion Robust Optimization Model Under Distribution and Mean Return Ambiguity

From the aspect of behavioral finance, which is an emerging area integrating human behavior into finance, this work studies a robust portfolio problem for loss-averse investors under distribution and mean return ambiguity. A loss-aversion distributionally-robust optimization model is constructed if the return distribution of risky assets is unknown. Then, under the premise that the mean returns of risky assets belong to an ellipsoidal uncertainty set, a model under joint ambiguity in distribution and mean returns is constructed. This study solves both robust models and derives their analytical solutions, respectively. Moreover, the effect of ambiguity aversion and loss aversion on robust optimal portfolio returns is studied. The results show that ambiguity-neutral investors who do not know the return distribution obtain more robust optimal portfolio returns than ambiguity-averse investors who are unaware of both the distribution and mean return. The difference between them decreases with the increase of loss aversion coefficients and increases with ambiguity aversion coefficients. Both loss aversion and ambiguity aversion play important roles in investors’ behavioral portfolio selection.

Correlation uncertainty, limited participation, and flight to quality

This study extends the multi-asset model of Huang et al. (2017), who examine only two types of investors, by adding a new investor type with partial information on the correlation coefficient and re-explores the limited participation phenomenon under correlation ambiguity. We investigate whether asset allocations depend on incomplete information under market equilibrium—specifically, whether investors with less information might hold greater equilibrium positions than investors with more information. We find that, as the true correlation coefficient (and the maximum correlation coefficient for ambiguity-averse investors) increases and asset quality increases, investors with less information escape from low- to high-quality assets, thus exhibiting a flight-to-quality trading pattern in equilibrium.

Market power, ambiguity, and market participation

We investigate how market power or price impact of market makers affects the participation decisions of investors with ambiguity aversion. Limited participation exists because some investors are ambiguous about the asset fundamental, but the market power of market makers mitigates limited participation. As a result, when market makers become less competitive, the non-participation range decreases, while return volatility increases; thus, market makers and ambiguity-averse investors are better off, but investors with liquidity needs are worse off. However, the non-participation range and uninformed investors’ welfare can increase or decrease when information is more asymmetric, depending on the importance of liquidity demand.

Ambiguity, ambiguity aversion and foreign bias: New evidence from international panel data

This paper provides novel empirical evidence on the relationship between ambiguity, ambiguity aversion and foreign bias in equities. We show that, after an increase in the level of domestic ambiguity relative to the level of foreign ambiguity, more ambiguity averse investors see a larger fall in foreign bias than less ambiguity investors. This finding is consistent with ambiguity operating through an information quality channel but at odds with interpretations based on familiarity. We proxy for the level of ambiguity using the prediction errors around variance forecasts based on state-of-the-art volatility models for 23 developing and emerging markets. Our measure of ambiguity aversion comes from an international survey and is based on an Ellsberg-type urn experiment. Cross-sectional regressions show that home country ambiguity aversion correlates positively with foreign bias. The results are robust to the inclusion of a broad set of control variables, changes in sample size and different ways of computing variance forecasts and the level of ambiguity. However, the results suggest that this fall in foreign bias is not associated with an improvement of international diversification.

Welfare implications of mitigating investment uncertainty

This study explores the welfare implications of mitigating investment uncertainty in the context of Easley and O’Hara (Rev Financ Stud 22:1817–1843, 2009) While one may expect welfare gains by encouraging participation in financial markets by ambiguity-averse investors, we formally show that it hurts other investors and thus is not Pareto-improving without appropriate income transfers. We also examine the welfare effects of income redistribution among heterogeneous investors and government spending on investor education.

Ambiguity about volatility and investor behavior

We relate time-varying aggregate ambiguity about volatility (V-VSTOXX) to individual investor trading. We use the trading records of more than 100,000 individual investors from a large German online brokerage from March 2010 to December 2015. We find that an increase in ambiguity is associated with increased investor activity. It also leads to a reduction in risk-taking, which does not reverse over the following days. Ambiguity averse investors are more prone to ambiguity shocks. These results replicate when using the dispersion of professional forecasters as a long-term measure of ambiguity and are robust when controlling for newspaper- or market-based ambiguity measures.

Life-cycle asset allocation and the peso problem: does ambiguity aversion matter?

PurposeThe study aims to show that ambiguity aversion exerts a non-negligible effect on the investors' decisions, especially due to the possibility of sharp declines in stock prices.Design/methodology/approachThe vast majority of previous studies on life-cycle consumption and asset allocation assume that the equity premium is constant. This study evaluates the impact of rare disasters that shift the stock market to a low return state on investors' consumption and portfolio decisions. The author assumes that investors are averse to ambiguity relative to the current state of the economy and must incur a per period cost to participate in the stock market and solve their optimal consumption and asset allocation problem using dynamic programming.FindingsThe results show that most young investors choose not to invest in stocks because they have low accumulated wealth and the potential return from their stock market investments would not cover the participation costs. Furthermore, ambiguity-averse investors hold considerably fewer stocks throughout their lifetime than ambiguity-neutral ones. The fraction of wealth invested in stocks over the typical consumer's life is hump-shaped: it is low for a young individual, peaks at his early 30s and then decreases until his retirement age.Originality/valueTo the best of the author’s knowledge, this is the first study that assesses the impact of negative stock price jumps on the optimal portfolio of an ambiguity-averse investor.

Ambiguity and Retained Earnings

We investigate the implications of ambiguity aversion for retained earnings. We show that firms can eliminate distortions such as underinvestment by paying out earnings that maximizes shareholder wealth. We show that there is a negative relationship between ambiguity and retained earnings and argue that it is different from the positive relationship between retained earnings and volatility obtained in the literature. Firms pay out part of their earnings to attract ambiguity averse investors to their equity markets. We test our results and find strong and robust empirical support.

The Ambiguity of Earnings Announcements

We study the consequences of misreporting in settings where ambiguity-averse investors face uncertainty about two aspects of the firm: its productivity and the weakness of its reporting system. We show that the joint presence of these two sources of uncertainty distorts the firm’s investment choices in opposing ways, leading to overinvestment by large firms (to signal productivity) and underinvestment by small firms (to signal that the reporting system is not weak). Our analysis suggests that uncertainty regarding reporting weakness affects both the level of the market-to-book ratio and its association with firm size. In addition, we show that, under plausible circumstances, reductions in uncertainty can be detrimental to social welfare: lower information asymmetry about reporting weakness always encourages more aggressive misreporting and boosts investment, thereby exacerbating the possible overinvestment problem faced by some firms. This paper was accepted by Suraj Srinivasan, accounting.

Would Ambiguity Averse Investors Hedge Risk in Equity Markets?

This paper studies the conjecture that investors prefer derivative markets over the equity market when hedging risks. An investor who wants to hedge, say inflation or crash risk, generally faces substantially more beta uncertainty in the stock market than in the derivatives market. We show that an investor with smooth ambiguity aversion preferences avoids a hedge portfolio consisting of stocks, which is typically subject to large beta uncertainty. The ambiguity averse investor prefers to hedge using derivatives (TIPS and options) which are not subject to beta uncertainty. More specifically, we show that equilibrium risk premiums for assets with large beta uncertainty (long-short portfolio of stocks) decline once derivatives with less beta uncertainty (TIPS and options) are introduced. In line with this theory, we find that the inflation risk premium decreases significantly, in absolute terms, when TIPS are introduced.

Ambiguity in securitization markets

Abstract During the financial crisis of 2008, origination and trading in asset-backed securities markets dropped dramatically. I present a model with ambiguity-averse investors to explain how such a market freeze could occur and to investigate how ambiguity affects origination and securitization decisions. The model shows how non-fundamental factors such as ambiguity can lead to market freezes and fire sales, as well as reductions in real economic activity. I consider the differing implications of a non-fundamental shock, such as ambiguity, and fundamental shocks, such as changes in risk or a deterioration of expected value. Market outcomes can change more abruptly under ambiguity than under either fundamental deterioration or risk alone. Additionally, ambiguity leads to different policy implications than fundamental shocks do.

Ambiguity in Securitization Markets

Abstract During the financial crisis of 2008, origination and trading in asset-backed securities markets dropped dramatically. I present a model with ambiguity-averse investors to explain how such a market freeze could occur and to investigate how ambiguity affects origination and securitization decisions. The model shows how non-fundamental factors such as ambiguity can lead to market freezes and fire sales, as well as reductions in real economic activity. I consider the differing implications of a non-fundamental shock, such as ambiguity, and fundamental shocks, such as changes in risk or a deterioration of expected value. Market outcomes can change more abruptly under ambiguity than under either fundamental deterioration or risk alone. Additionally, ambiguity leads to different policy implications than fundamental shocks do.

Trading Ambiguity: A Tale of Two Heterogeneities

We consider financial markets with heterogeneously ambiguous assets and heterogeneously ambiguity averse investors. Investors' preferences, a version of the smooth ambiguity model, are a parsimonious extension of the standard mean-variance framework. We consider, in a unified setting, portfolio choice, and trade upon arrival of public information, and show, in both cases, there are systematic departures from the predictions of standard theory. These departures are of significance as they occur in the direction of empirical regularities that belie the standard theory. In particular, our theory speaks to several puzzling phenomena in a unified fashion: the asset allocation puzzle, the observation that earnings announcements are often followed by significant trading volume with small price change, and that increases in uncertainty are positively associated with increased trading activity and portfolio rebalancing toward safer assets by individual (retail) investors.

Investor Sentiment: Too Contagious to Ignore?

This article empirically investigates the role of investor sentiment as a determinant of financial contagion during crises periods. The focus is on developed equity markets as well as emerging equity markets during 1990-2015. By using a multivariate GARCH methodology, cross-equity market correlations are documented to be substantially increasing during financial crises. Investor sentiment is negatively related cross-equity market correlation. This inverse relationship becomes even stronger during times of financial crises, indicating the existence of financial contagion. This finding can be motivated by loss-averse and ambiguity-averse investors in equity markets. The relationship between investor sentiment and cross-equity market correlation persists after controlling for trade linkages, financial linkages, and other macroeconomic similarities between countries. The findings are robust to changes in crises definition.

The pricing effects of ambiguous private information

When private information is observed by ambiguity averse investors, asset prices may be informationally inefficient in rational expectations equilibrium. This inefficiency implies lower asset prices as uninformed investors require a premium to hold assets and higher return volatility relative to informationally efficient benchmarks. Moreover, asset returns are negatively skewed and may be leptokurtic. Inefficiency also leads to amplification in price of small changes in news, relative to informationally efficient benchmarks. Public information affects the nature of unrevealed private information and the informational inefficiency of prices. Asset prices may be lower (higher) with good (bad) public information.

Investment Decisions Under Ambiguity: Evidence from Mutual Fund Investor Behavior

We provide novel evidence on the role of ambiguity aversion in determining the response of mutual fund investors to fund performance. Our analysis is motivated by theoretical models of decision making by ambiguity-averse investors. A key implication of the models is that when investors face information signals of uncertain quality, they place a greater weight on the worst signal. We find strong empirical support for this prediction in the form of heightened sensitivity of investor fund flows to the worst performance measure across multiple horizons. This effect is particularly pronounced for retail funds in contrast to institutional funds. This paper was accepted by Neng Wang, finance.

Comovement or safe haven? The effect of corruption on the market risk of sovereign bonds of emerging economies during financial crises

In this study, I explore the role of corruption in the cross-market time-varying linkage between sovereign bonds of emerging markets and the US stock market. I show that corruption plays a prominent role in the behaviour of comovement under various market conditions. Sovereign bonds’ sensitivity to systematic shocks increases during financial crises when those bonds are issued by countries perceived to be more corrupt. The returns on bonds issued by less corrupt countries are determined more idiosyncratically under extreme market conditions and realize more hedging benefits against S&P 500 risk. To explain these findings, I propose a comovement model built on Barberis et al. (2005). When sentiment deteriorates, ambiguity-averse investors load more worldwide news on sovereign bonds issued by more corrupt countries where information uncertainty is perceived to be higher.