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Ambiguity in Asset Markets: Theory and Experiment

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  • Peter Bossaerts
  • Paolo Ghirardato
  • Serena Guarnaschelli
  • William R. Zame

Abstract

This paper studies the impact of ambiguity and ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitudes toward ambiguity are heterogeneous across the population, just as attitudes toward risk are heterogeneous across the population, but that heterogeneity of attitudes toward ambiguity has different implications than heterogeneity of attitudes toward risk. In pa rticular, when some state probabilities are not known, agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This suggests a different cross section of portfolio choices, a wider range of state price/probability ratios, and different rankings of state price/probability ratios than would be predicted if state probabilities were known. Experiments confirm all of these suggestions. Our findings contradict the claim that investors who have cognitive biases do not affect prices because they are inframarginal: ambiguity-averse investors have an indirect effect on prices because they change the per capita amount of risk that is to be shared among the marginal investors. Our experimental data also suggest a positive correlation between risk aversion and ambiguity aversion that might explain the "value effect" in historical data. The Author 2010 Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

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Bibliographic Info

Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 23 (2010)
Issue (Month): 4 (April)
Pages: 1325-1359

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Handle: RePEc:oup:rfinst:v:23:y:2010:i:4:p:1325-1359

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References

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  1. Uppal, Raman & Wang, Tan, 2002. "Model Misspecification and Under-Diversification," CEPR Discussion Papers 3304, C.E.P.R. Discussion Papers.
  2. Peter Bossaerts & Charles Plott & William R. Zame, 2006. "Prices and Portfolio Choices in Financial Markets: Theory and Experiment," Levine's Bibliography 122247000000001322, UCLA Department of Economics.
  3. Uri Gneezy & Arie Kapteyn & Jan Potters, 2003. "Evaluation Periods and Asset Prices in a Market Experiment," Journal of Finance, American Finance Association, vol. 58(2), pages 821-838, 04.
  4. Ghirardato, Paolo & Maccheroni, Fabio & Marinacci, Massimo, 2004. "Differentiating ambiguity and ambiguity attitude," Journal of Economic Theory, Elsevier, vol. 118(2), pages 133-173, October.
  5. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
  6. Rose-Anne Dana, 2004. "Ambiguity, uncertainty aversion and equilibrium welfare," Economic Theory, Springer, vol. 23(3), pages 569-587, March.
  7. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
  8. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  9. Epstein, Larry G. & Miao, Jianjun, 2003. "A two-person dynamic equilibrium under ambiguity," Journal of Economic Dynamics and Control, Elsevier, vol. 27(7), pages 1253-1288, May.
  10. Dana, Rose-Anne, 2004. "Ambiguity, uncertainty aversion and equilibrium welfare," Economics Papers from University Paris Dauphine 123456789/5393, Paris Dauphine University.
  11. Peter Bossaerts & Charles Plott, 2004. "Basic Principles of Asset Pricing Theory: Evidence from Large-Scale Experimental Financial Markets," Review of Finance, Springer, vol. 8(2), pages 135-169.
  12. Brian D. Kluger & Steve B. Wyatt, 2004. "Are Judgment Errors Reflected in Market Prices and Allocations? Experimental Evidence Based on the Monty Hall Problem," Journal of Finance, American Finance Association, vol. 59(3), pages 969-998, 06.
  13. Marco Cagetti & Lars Peter Hansen & Thomas Sargent & Noah Williams, 2002. "Robustness and Pricing with Uncertain Growth," Review of Financial Studies, Society for Financial Studies, vol. 15(2), pages 363-404, March.
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