Increase In Ambiguity Aversion Research Articles

Optimal investment under ambiguous technology shocks

This paper analyzes the behavior of a firm facing an ambiguous technology shock and the effects of the attitude toward ambiguity on optimal capital investment using the smooth ambiguity model of Klibanoff et al. (2005). Although it seems intuitive that an increase in ambiguity aversion always reduces the optimal capital investment, this is not necessarily true because the shape of the production function plays a key role in determining the effect. Under some conditions, we show that the optimal amount of capital investment increases (decreases) in ambiguity aversion if the production function is substitute (complement), and that this result is counterintuitive when the production function is substitute. Furthermore, our main results hold if we assume the α-maxmin preferences in Ghirardato et al. (2004).

Optimal dividend-distribution strategy under ambiguity aversion

This paper considers the optimal dividend policy for an insurance company facing model uncertainty. We provide an explicit solution and show that an increase in ambiguity aversion leads to more conservative dividend policy. Interestingly, we find the ambiguity averse manager exhibits risk loving attitude when the company is close to bankruptcy. Finally, concerns about model misspecification have ambiguous effects on the marginal value of cash, which depends on the cash reserve.

Trading Foreign Exchange Triplets

We develop the optimal trading strategy for a foreign exchange (FX) broker who must liquidate a large position in an illiquid currency pair. To maximize revenues, the broker considers trading in a currency triplet which consists of the illiquid pair and two other liquid currency pairs. The liquid pairs in the triplet are chosen so that one of the pairs is redundant. The broker is risk-neutral and accounts for model ambiguity in the FX rates to make her strategy robust to model misspecification. When the broker is ambiguity neutral (averse) the trading strategy in each pair is independent (dependent) of the inventory in the other two pairs in the triplet. We employ simulations to illustrate how the robust strategies perform. For a range of ambiguity aversion parameters, we find the mean profit and loss (P&L) of the strategy increases and the standard deviation of the P&L decreases as ambiguity aversion increases.

Risk and ambiguity aversion behavior in index-based insurance uptake decisions: Experimental evidence from Ethiopia

Index-based insurance (IBI) is an innovative pro-poor climate risk management strategy that suffers from low uptake. Evidence on the role of behavioral impediments in adoption of IBI is scant. We conducted lab-in-the-field experiments with 1139 smallholders out of whom 596 have adopted IBI in Ethiopia to elicit their risk and ambiguity aversion behavior, and examine whether risk and/or ambiguity aversion can explain actual IBI uptake decisions. Our study suggests that an increase in risk-aversion increases uptake, but an increase in ambiguity-aversion lowers uptake of IBI. We also find evidence that an increase in risk aversion speeds-up the uptake of IBI, while an increase in ambiguity aversion delays the adoption of IBI.

Is ambiguity aversion bad for innovation?

Not necessarily. I consider two firms that compete both on the research market and on the product market. Assuming the product market outcome is ambiguous, i.e., uncertainty is described by multiple distribution of outcomes, I show that an increase in firms' ambiguity aversion increases the ex ante likelihood that they invest in R&D. An increase in their risk aversion on the other hand decreases innovation. The result holds when the innovation has a business-stealing effect as in a Cournot duopoly with vertical differentiation. The key intuition is that ambiguity aversion exacerbates the competitive threat whereas risk aversion diminishes the profit incentive to invest. In addition to showing that an increase in ambiguity aversion leads to more projects being pursued, I show that an increase in ambiguity aversion can lead to an increase in investment for incremental projects. In the case of more radical projects, an increase in ambiguity aversion can, but not necessarily, lead to lower investment in equilibrium. Overall, ambiguity aversion has a positive effect on most innovative projects but can sometimes have a negative effect on some of the more radical, game-changing ones.

Reinsurance contract design when the insurer is ambiguity-averse

This paper investigates proportional and excess-loss reinsurance contracts in a continuous-time principal–agent framework, in which the insurer is the agent and the reinsurer is the principal. Insurance claims follow the classic Cramér–Lundberg process. The insurer believes that the claim intensity is uncertain and he chooses robust risk retention levels to maximize the penalty-dependent multiple-priors utility. The reinsurer designs reinsurance contracts subject to the insurer’s incentive compatibility constraints. The analytical expressions of the two robust reinsurance contracts are derived. Our results show that the robust reinsurance demand and price are greater than their respective standard values without model ambiguity, and increase as the insurer’s ambiguity aversion increases. Moreover, the reinsurer specifies a decreasing reinsurance price to induce increasing demand over time. Specifically, the price of excess-loss reinsurance is higher, relative to that of proportional reinsurance. Further, only if the insurer’s risk aversion is high or the reinsurer’s risk aversion is low, the insurer prefers the excess-loss reinsurance contract.

Ambiguity attitudes and self-confirming equilibrium in sequential games

We consider a game in extensive form recurrently played by agents who are randomly drawn from large populations and matched. We assume that preferences over actions at any information set admit a smooth-ambiguity representation in the sense of Klibanoff et al. (2005), which may induce dynamic inconsistencies. We take this into account in our analysis of self-confirming equilibrium (SCE) given players' feedback about the path of play. Battigalli et al. (2015) show that the set of SCE's of a simultaneous-move game with feedback expands as ambiguity aversion increases. We show by example that SCE in a sequential game is not equivalent to SCE applied to the strategic form of such game, and that the previous monotonicity result does not extend to general sequential games. Still, we provide sufficient conditions under which the monotonicity result holds for SCE.

Speculative trading of electricity contracts in interconnected locations

We derive an investor's optimal trading strategy of electricity contracts traded in two locations joined by an interconnector. The investor employs a price model which includes the impact of her own trades. The investor's trades have a permanent impact on prices because her trading activity affects the demand of contracts in both locations. Additionally, the investor receives prices which are worse than the quoted prices as a result of the elasticity of liquidity provision of contracts. Furthermore, the investor is ambiguity averse, so she acknowledges that her model of prices may be misspecified and considers other models when devising her trading strategy. We show that as the investor's degree of ambiguity aversion increases, her trading activity decreases in both locations, and thus her inventory exposure also decreases. Finally, we show that there is a range of ambiguity aversion parameters where the Sharpe ratio of the trading strategy increases when ambiguity aversion increases.

Trading Foreign Exchange Triplets

We develop the optimal trading strategy for a Foreign Exchange (FX) broker who must liquidate a large position in an illiquid currency pair. To maximize revenues, the broker considers trading in a currency triplet which consists of the illiquid pair and two other liquid currency pairs. The liquid pairs in the triplet are chosen so that one of the pairs is redundant. The broker is risk-neutral and accounts for model ambiguity in the FX rates to make her strategy robust to model misspecification. When the broker is ambiguity neutral (averse) the trading strategy in each pair is independent (dependent) of the inventory in the other two pairs in the triplet. We employ simulations to illustrate how the robust strategies perform. For a range of ambiguity aversion parameters, we find the mean Profit and Loss (P&L) of the strategy increases and the standard deviation of the P&L decreases as ambiguity aversion increases.

AN ECONOMIC PREMIUM PRINCIPLE UNDER THE DUAL THEORY OF THE SMOOTH AMBIGUITY MODEL

AbstractThis study considers a pure exchange economy with insurance against ambiguous loss. Ambiguity preferences are represented by the dual theory of the smooth ambiguity model from Iwaki and Osaki (2014). The economic premium principle of Bühlmann (1980, 1984) is extended to ambiguity. We also perform some comparative statics and present sufficient conditions under which an increase in ambiguity aversion increases insurance demand and insurance premiums. Contrary to the result in Tsanakas and Christofides (2006), the optimal demand for insurance is not always comonotonic, because our model permits an economy comprising both ambiguity averse and ambiguity loving agents.

Speculative Trading of Electricity Contracts in Interconnected Locations

We derive an investor’s optimal trading strategy of electricity contracts traded in two locations joined by an interconnector. The investor employs a price model which includes the impact of her own trades. The investor’s trades have a permanent impact on prices because her trading activity affects the demand of contracts in both locations. Additionally, the investor receives prices which are worse than the quoted prices as a result of the elasticity of liquidity provision of contracts. Furthermore, the investor is ambiguity averse, so she acknowledges that her model of prices may be misspecified and considers other models when devising her trading strategy. We show that as the investor’s degree of ambiguity aversion increases, her trading activity decreases in both locations, and thus her inventory exposure also decreases. Finally, we show that there is a range of ambiguity aversion parameters where the Sharpe ratio of the trading strategy increases when ambiguity aversion increases.

Self-Confirming Equilibrium and Model Uncertainty

We analyze a notion of self-confirming equilibrium with non-neutral ambiguity attitudes that generalizes the traditional concept. We show that the set of equilibria expands as ambiguity aversion increases. The intuition is quite simple: by playing the same strategy in a stationary environment, an agent learns the implied distribution of payoffs, but alternative strategies yield payoffs with unknown distributions; increased aversion to ambiguity makes such strategies less appealing. In sum, a kind of “status quo bias” emerges; in the long run, the uncertainty related to tested strategies disappears, but the uncertainty implied by the untested ones does not. (JEL C72, C73, D81, D83)

Insurance bargaining under ambiguity

This paper investigates the effects of an increase in ambiguity aversion and an increase in ambiguity in an insurance bargaining game with a risk-and-ambiguity-neutral insurer and a risk-and-ambiguity-averse client. Both a cooperative and a non-cooperative bargaining game are examined. We show that, in both games, full coverage is optimal in the presence of ambiguity, and that the optimal premium is higher in the presence of ambiguity than in the absence of it. Furthermore, the optimal premium will increase with both the degree of ambiguity aversion and an increase in ambiguity.

Scientific Ambiguity and Climate Policy

Economic evaluation of climate policy traditionally treats uncertainty by appealing to expected utility theory. Yet our knowledge of the impacts of climate policy may not be of sufficient quality to be described by unique probabilistic beliefs. In such circumstances, it has been argued that the axioms of expected utility theory may not be the correct standard of rationality. By contrast, several axiomatic frameworks have recently been proposed that account for ambiguous knowledge. In this paper, we apply static and dynamic versions of a smooth ambiguity model to climate mitigation policy. We obtain a general result on the comparative statics of optimal abatement and ambiguity aversion, and then extend our analysis to a more realistic, dynamic setting, where we introduce scientific ambiguity into the well-known DICE model of the climate-economy system. For policy-relevant exogenous mitigation policies, we show that the value of emissions abatement increases as ambiguity aversion increases, and that this 'ambiguity premium' can in some plausible cases be very large. In these cases the effect of ambiguity aversion on welfare is comparable to that of other much studied welfare parameters. Thus ambiguity aversion may be an important neglected aspect of climate change economics, and seems likely to provide another argument for strong abatement policy.

Ambiguity aversion, higher-order risk attitude and optimal effort

In this paper, we examine whether a more ambiguity-averse individual will invest in more effort to shift her initial starting wealth distribution toward a better target distribution. We assume that the individual has ambiguous beliefs regarding two target (starting) distributions and that one distribution is preferred to the other. We find that an increase in ambiguity aversion will decrease (increase) the optimal effort when the cost of effort is non-monetary. When the cost of effort is monetary, the effect depends on whether the individual would make more effort when the target (starting) distribution is the preferred distribution than the target (starting) distributions, the inferior one. We further characterize the individual’s higher-order risk preferences to examine the sufficient conditions.