Ambiguity Aversion Research Articles

Ambiguous price formation

We study the price and liquidity of an asset in a model where market makers face ambiguity about the asset payoff. This ambiguity explains liquidity deteriorations and improvements in financial markets. We show that the ambiguity influences how market makers perceive adverse selection risk, and therefore, distorts market liquidity. The perceived adverse selection risk increases (resp. decreases) with the ambiguity when the market maker is sufficiently (resp. insufficiently) ambiguity averse. Our model also helps to understand how ambiguity and ambiguity aversion of market makers impact price and liquidity dynamics under various trading histories.

Uncertainty aversion predicts the neural expansion of semantic representations.

Correctly identifying the meaning of a stimulus requires activating the appropriate semantic representation among many alternatives. One way to reduce this uncertainty is to differentiate semantic representations from each other, thereby expanding the semantic space. Here, in four experiments, we test this semantic-expansion hypothesis, finding that uncertainty-averse individuals exhibit increasingly differentiated and separated semantic representations. This effect is mirrored at the neural level, where uncertainty aversion predicts greater distances between activity patterns in the left inferior frontal gyrus when reading words, and enhanced sensitivity to the semantic ambiguity of these words in the ventromedial prefrontal cortex. Two direct tests of the behavioural consequences of semantic expansion further reveal that uncertainty-averse individuals exhibit reduced semantic interference and poorer generalization. Together, these findings show that the internal structure of our semantic representations acts as an organizing principle to make the world more identifiable.

Robust Optimal Investment Strategies with Exchange Rate Risk and Default Risk

The problem of robust optimal investment with exchange rate risk and default risk is studied. We assume that investors are ambiguity averse and they have access not only to the domestic market but also to the foreign market. The corresponding Hamilton–Jacobi–Bellman (HJB) equations are first obtained through the robust stochastic optimal control theory. Then, we discuss the optimal investment problems before and after default, and the value functions and optimal investment strategies are obtained. Finally, we find that the optimal investment strategies of pre-default are affected by the intensity of default and the credit spread, and the investors cannot hold defaultable bonds in the post-default case. Numerical results also show that the exchange rate risk, default risk and ambiguity aversion have a great effect on the optimal investment strategies.

Cross-sectional implications of dynamic asset pricing with stochastic volatility and ambiguity aversion

Building on recent research that highlights the importance of macroeconomic volatility and ambiguity aversion in explaining the dynamics of stock returns, in this paper we propose a dynamic asset pricing model that simultaneously accounts for stochastic macroeconomic volatility and ambiguity, assuming that investors deal with uncertainty about the mechanics of macroeconomic fluctuations using first-release consumption and revisions to aggregate consumption on vintage data. Our results show that the proposed model captures a large fraction of the cross-sectional variation of excess returns for a wide range of market anomaly portfolios. Furthermore, while the price of risk for ambiguity is positive and significant for the vast majority of assets under study, macroeconomic volatility yields ambiguous outcomes, although it significantly increases the explanatory power of the model for specific assets. Our results suggest that macroeconomic volatility and ambiguity complement each other in explaining the cross-sectional behavior of stock returns.

Robust leverage choice of hedge funds with rare disasters

We study the effects of hedge fund manager’s ambiguity aversion for jump and diffusion risks on the leverage policy under a high-water mark contract. We find that the jump risk has an inverted U-shaped effect on the leverage choice, which can be explained by the variance effect and skewness effect. Our result also indicates that diffusion ambiguity aversion has a larger negative impact on leverage than jump ambiguity aversion. Manager’s ambiguity aversion in jump risk amplifies the skewness effect when the price jump is positive. Our findings provide some insights into the risk taking strategy of hedge fund under ambiguity.

Strategic uncertainty aversion in bargaining — Experimental evidence

Strategic uncertainty aversion in bargaining — Experimental evidence

Robust irreversible investment strategy with ambiguity to jump and diffusion risk

AbstractThis paper constructs a robust and irreversible investment rule applicable to a series of adjacent models. The project value follows a jump‐diffusion process and the investor exhibits complete ambiguity aversion or partial ambiguity aversion to the diffusion, jump amplitude, and jump frequency components. The impact of ambiguity aversion with respect to different components on the optimal investment strategy is examined. The investment decision is mainly driven by ambiguity aversion to the jump amplitude rather than frequency, and an increase in jump intensity leads to the greater importance of ambiguity aversion to jumps. We further show that ambiguity aversion regarding jumps plays a dominant role in determining the investment boundary for low volatility values, and the influence of ambiguity aversion to the diffusion part gradually outweighs that of ambiguity aversion to jumps as volatility grows.

Gene‐edited or genetically modified food? The impacts of risk and ambiguity on Chinese consumers' willingness to pay

AbstractThis study investigates consumer preferences for newly introduced gene‐edited (GE) food. We focus on how risk and ambiguity aversion affect consumers’ willingness to pay (WTP) to avoid genetically modified (GM) food or GE food and whether the impacts of risk and ambiguity aversion differ between GM and GE food. We collected the data in 2020 through a nationwide online survey in China. The multiple price list method is used to estimate the premiums that consumers are willing to pay for conventional rice to avoid GM/GE rice. Our results show that Chinese urban consumers are more concerned about the health, environmental, and ethical impacts of genetic modification than gene editing technology. They are willing to pay lower premiums when the alternative is GE rice than when it is GM rice. We further find that both risk aversion and ambiguity aversion have significant negative impacts on respondents’ WTP for food derived from gene technologies, with ambiguity aversion being more influential than risk aversion for both GM and GE rice. However, there is no significant difference in how risk aversion and ambiguity aversion affect the respondents’ WTP to avoid GM or GE rice.

Three Layers of Uncertainty

Abstract We explore decision-making under uncertainty using a framework that decomposes uncertainty into three distinct layers: (1) risk, which entails inherent randomness within a given probability model; (2) model ambiguity, which entails uncertainty about the probability model to be used; and (3) model misspecification, which entails uncertainty about the presence of the correct probability model among the set of models considered. Using a new experimental design, we isolate and measure attitudes toward each layer separately. We conduct our experiment on three different subject pools and document the existence of a behavioral distinction between the three layers. In addition to providing new insights into the underlying processes behind ambiguity aversion, we provide the first empirical evidence of the role of model misspecification in decision-making under uncertainty.

The negativity bias and perceived return distributions: Evidence from a pandemic

We hypothesize that the well-documented negativity bias, the psychological tendency to asymmetrically emphasize negative over positive aspects, can help explain several financial market phenomena: why most individuals hold strongly bearish views of both short- and long-term equity return distributions, why individuals exhibit heterogeneous beliefs, and the stock market participation puzzle. Using variation in the perceived risk of mortality from the swine flu pandemic as our primary proxy for an individual's negativity bias, we find strong support for our hypothesis even when controlling for alternative mechanisms including optimism, risk aversion, ambiguity aversion, and anxiety.

Aversion, interpretation and determinability: Three factors of uncertainty that may play a role in psychopathology.

This opinion piece considers the construct of tolerance of uncertainty and suggests that it should be viewed in the context of three psychological factors: uncertainty aversion, uncertainty interpretation, and uncertainty determinability. Uncertainty aversion refers to a dislike of situations in which the outcomes are not deterministic and is similar to conventional conceptions of (in)tolerance of uncertainty. Uncertainty interpretation refers to the extent to which variability in an observed outcome is interpreted as random fluctuation around a relatively stable base-rate versus frequent and rapid changes in the base-rate. Uncertainty determinability refers to the (actual or perceived) capacity of the individual to generate any meaningful expectancy of the uncertain outcome, which may be undeterminable if predictions are updated too quickly. We argue that uncertainty interpretation and determinability are psychological responses to the experience of probabilistic events that vary among individuals and can moderate negative affect experienced in response to uncertainty. We describe how individual differences in basic parameters of associative learning (modelled by a simple learning window) could lead to this variation. To explain these hypotheses, we utilise the distinction between aleatory uncertainty (the inherent unpredictability of individual stochastic events) and epistemic uncertainty (obtainable knowledge that the individual lacks or perceives to be lacking). We argue that when expectancies are updated quickly, epistemic uncertainty will dominate the individual's representation of the events around them, leading to a subjective experience of the world as one that is volatile and unpredictable.

Portfolio selections for insurers with ambiguity aversion: minimizing the probability of ruin

ABSTRACT In this paper, we investigate the impacts of model misspecification on the insurer’s investment behaviours. Model misspecification comes from either the financial market or insurance business due to economic fluctuation. From the risk control point of view, we assume that an insurer has ambiguity aversion and we study the robust optimal investment strategy for the insurer under several settings. As a benchmark, we firstly obtain the optimal investment strategy for the insurer without considering model misspecification. Then, by assuming that model misspecification only exists in the financial market, we obtained the robust optimal investment strategy by solving the corresponding Hamilton–Jacobi–Bellman (HJB) equation under the objective of minimizing the probability of ruin. The results tells us the insurer’s ambiguity aversion leads to a more conservative investment behaviour. At last, we incorporate the model misspecification for both financial market and insurance business in a general framework. The robust optimal investment is also obtained and we find that the investment is enlarged due to the insurer’s ambiguity aversion on the insurance business because of the motivation of ambiguity hedging. The numerical examples display that different ambiguity aversion level on the financial market and insurance business have different impacts on the robust investment strategy.

Approximate Bayesian implementation and exact maxmin implementation: An equivalence

This paper provides a micro-foundation for approximate incentive compatibility using ambiguity aversion. In particular, we propose a novel notion of approximate interim incentive compatibility, approximate local incentive compatibility, and establish an equivalence between approximate local incentive compatibility in a Bayesian environment and exact interim incentive compatibility in the presence of a small degree of ambiguity. We then apply our result to the implementation of efficient allocations. In particular, we identify two economic settings—including ones in which approximately efficient allocations are implementable and ones in which agents are informationally small—in which efficient allocations are approximately locally implementable when agents are Bayesian. Applying our result to those settings, we conclude that efficient allocations are exactly implementable when agents perceive a small degree of ambiguity.

Pricing Principle via Tsallis Relative Entropy in Incomplete Markets

A pricing principle is introduced for nonattainable -exponential bounded contingent claims in an incomplete Brownian motion market setting. The buyer evaluates the contingent claim under the “distorted Radon–Nikodym derivative” and adjustment by Tsallis relative entropy over a family of equivalent martingale measures. The pricing principle is proved to be a time consistent and arbitrage-free pricing rule. More importantly, this pricing principle is found to be closely related to backward stochastic differential equations with generators of type. The pricing functional is compatible with prices for attainable claims. Except translation invariance, the pricing principle possesses lots of elegant properties, such as monotonicity and concavity. The pricing functional is shown between minimal martingale measure pricing and conditional certainty equivalent pricing under -exponential utility. The asymptotic behavior of the pricing principle for the ambiguity aversion coefficient is also investigated.

A smooth ambiguity model of investment timing under asymmetric information

AbstractThis paper incorporates ambiguity into a principal–agent framework wherein an owner delegates the investment decision of a project in continuous time to a manager. Information is asymmetric in that the owner faces ambiguity regarding the uncertain investment cost of the project (low or high) but the manager privately observes the true value. Ambiguity aversion is shown to induce the owner to act in a pessimistic manner with a perception that the probability of having the low investment cost is smaller than what the objective beliefs suggest, resulting in a distortion on the equilibrium tradeoff between investment efficiency and information rent.

The Role of Ambiguity Aversion in Contract-farming Supply Chains: A Distributionally Robust Approach

Contract farming is an important tool to promote the agricultural development in the developing countries. In this paper, we study three types of contracts commonly used in a contract-farming agricultural supply chain with a farmer and an agribusiness firm, including fixed procurement price contract, market spot price contract and protection procurement price contract. To accurately capture the correlation between uncertainties and avoid the misspecification of true distribution, a moment-based distributionally robust optimization framework is introduced to analyze the three contracts. We then derive equilibrium solutions of both the farmer and the agribusiness firm under each price contract. Leveraging these results, we can prove that the protection procurement price contract is equivalent to either the fixed procurement price contract or the market spot price contract, which depends on under which contract the farmer can obtain a larger marginal revenue. We further investigate the intrinsic mechanism of the protection procurement price contract, including its impact on the performance of both contract parties and the entire supply chain. Finally, we provide numerical comparisons of our ambiguity-averse solution with the ambiguity-neutral one and also discuss the impact of demand and yield unertainties on the equilibrium profits of both contract parties.

The impact of uncertainty on farmers’ adoption of straw returning technology in Northwest China

Straw returning technology has the potential to not only enhance the crop’s nitrogen yield but also protect the ecological environment and enhance crop yield. This paper explores the impact of uncertainty on rural households’ adoption of straw returning technology using an experimental method based on 703 wheat planting households in the Loess Plateau, China. The results show that 1) most farmers are inclined to risk aversion, and farmers generally have the characteristics of ambiguity aversion. 2) Risk preference and ambiguity preference obviously and negatively impact the possibility of adopting straw returning technology, and when the farmer’s risk preference and ambiguity preference increase by 0.1 units, the probability of adopting straw returning technology will decrease by 19.4% and 17.1%, respectively. 3) When we take the risk preference and ambiguity preference together into account, risk preference has sufficiently large effects on farmers’ decision on adopting straw returning technology relative to ambiguity preference. Overall, this research provides a micro-foundation and policy recommendations for farmers’ straw returning technology promotion in rural China and sheds light upon how the government can formulate relevant policies to promote green environmental development.

Chimpanzee and Human Risk Preferences Show Key Similarities

Risk preference impacts how people make key life decisions related to health, wealth, and well-being. Systematic variations in risk-taking behavior can be the result of differences in fitness expectations, as predicted by life-history theory. Yet the evolutionary roots of human risk-taking behavior remain poorly understood. Here, we studied risk preferences of chimpanzees (86 Pan troglodytes; 47 females; age = 2–40 years) using a multimethod approach that combined observer ratings with behavioral choice experiments. We found that chimpanzees’ willingness to take risks shared structural similarities with that of humans. First, chimpanzees’ risk preference manifested as a traitlike preference that was consistent across domains and measurements. Second, chimpanzees were ambiguity averse. Third, males were more risk prone than females. Fourth, the appetite for risk showed an inverted-U-shaped relation to age and peaked in young adulthood. Our findings suggest that key dimensions of risk preference appear to emerge independently of the influence of human cultural evolution.

Ambiguity and asset prices: a closer look in an emerging market

PurposeThis study empirically documents the effect of ambiguity on stock returns in a major emerging market along with the ambiguity attitudes under various market conditions.Design/methodology/approachAmbiguity is measured as the volatility of return probability distributions extracted from high frequency intraday data via a method developed by Brenner and Izhakian (2018). The impact of ambiguity is then tested on stock market returns.FindingsThe results show that ambiguity is a priced factor in Turkish stock market with a positive premium that is distinct from risk premium. In contrast with the findings in the US market, the investors in Turkey show an increasing level of ambiguity aversion as expected probability of favorable returns deviate from the mean value. The investors are effectively ambiguity neutral in lateral markets. The results are robust to testing with higher moments, sentiment measures and under recession conditions.Originality/valueThis study contributes to empirically documenting ambiguity and ambiguity aversion in a major emerging market along with the opportunity to observe international differences in ambiguity attitudes.

Testing Hurwicz Expected Utility

Gul and Pesendorfer (2015) propose a promising theory of decision under uncertainty, they dub Hurwicz expected utility (HEU). HEU is a special case of α‐maxmin EU that allows for preferences over sources of uncertainty. It is consistent with most of the available empirical evidence on decision under risk and uncertainty. We show that HEU is also tractable and can readily be measured and tested. We do this by deriving a new two‐parameter functional form for the probability weighting function, which fits our data well and which offers a clean separation between ambiguity perception and ambiguity aversion. In two experiments, we find support for HEU's predictions that ambiguity aversion is constant across sources of uncertainty and that ambiguity aversion and first order risk aversion are positively correlated.