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Survival with Ambiguity

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  • Ani Guerdijkova

    (THEMA, Université de Cergy-Pontoise)

  • Emanuela Sciubba

    (Department of Economics, Mathematics & Statistics, Birkbeck)

Abstract

We analyze a market populated by expected utility maximizers and smooth ambiguity-averse consumers. We study conditions under which ambiguity-averse consumers survive and affect prices in the limit. If ambiguity vanishes with time or if the economy exhibits no aggregate risk, ambiguity-averse consumers survive, but have no long-run impact on prices. In both scenarios, ambiguity-averse consumers are fully insured against ambiguity in equilibrium and, thus, behave as expected utility maximizers with correct beliefs. If ambiguity-averse consumers are not fully insured against ambiguity, they behave as expected utility maximizers with effectively wrong beliefs and an effective discount factor which might be higher or lower than their actual discount factor. Using this insight, we demonstrate that consumers with constant absolute ambiguity aversion vanish in expectations, whenever the economy faces aggregate risk. In contrast, consumers with constant relative (and thus, decreasing absolute) ambiguity aversion survive in expectation and with positive probability and have a non-trivial impact on prices in the limit.

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File URL: http://www.bbk.ac.uk/ems/research/wp/2012/PDFs/BWPEF1216.pdf
File Function: First version, 2012
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Bibliographic Info

Paper provided by Birkbeck, Department of Economics, Mathematics & Statistics in its series Birkbeck Working Papers in Economics and Finance with number 1216.

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Date of creation: Oct 2012
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Handle: RePEc:bbk:bbkefp:1216

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Keywords: ambiguity; ambiguity-aversion; survival;

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  1. Beker, Pablo & Chattopadhyay, Subir, 2010. "Consumption dynamics in general equilibrium: A characterisation when markets are incomplete," Journal of Economic Theory, Elsevier, vol. 145(6), pages 2133-2185, November.
  2. Larry G. Epstein & Martin Schneider, 2008. "Ambiguity, Information Quality, and Asset Pricing," Journal of Finance, American Finance Association, vol. 63(1), pages 197-228, 02.
  3. Stephen Ross & Mark Westerfield & Jiang Wang & Leonid Kogan, 2009. "Market Selection," 2009 Meeting Papers 274, Society for Economic Dynamics.
  4. Tarek Coury & Emanuela Sciubba, 2006. "Belief Heterogeneity and Survival in Incomplete Markets," Birkbeck Working Papers in Economics and Finance 0613, Birkbeck, Department of Economics, Mathematics & Statistics.
  5. Shannon, Chris & Strzalecki, Tomasz & Rigotti, Luca, 2008. "Subjective Beliefs and Ex Ante Trade," Scholarly Articles 3637104, Harvard University Department of Economics.
  6. Hongjun Yan, 2008. "Natural Selection in Financial Markets: Does it Work?," Yale School of Management Working Papers amz2648, Yale School of Management, revised 01 May 2008.
  7. Massimo Marinacci & Luigi Montrucchio, 2007. "Unique Solutions of Some Recursive Equations in Economic Dynamics," Carlo Alberto Notebooks 46, Collegio Carlo Alberto.
  8. Jaroslav Borovicka, 2009. "Heterogeneous beliefs under recursive preferences," 2009 Meeting Papers 892, Society for Economic Dynamics.
  9. Scott Condie, 2008. "Living with ambiguity: prices and survival when investors have heterogeneous preferences for ambiguity," Economic Theory, Springer, vol. 36(1), pages 81-108, July.
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