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Ambiguity, Risk and Portfolio Choice under Incomplete Information

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  • Jianjun Miao

    ()
    (Department of Economics, Boston University)

Abstract

This paper studies optimal consumption and portfolio choice in a Mertonstyle model with incomplete information when there is a distinction between ambiguity and risk. The latter distinction is afforded by adoption of recursive multiple-priors utility. The fundamental issues are: (i) How does the agent optimally estimate the unobservable processes as new information arrives over time? (ii) What are the effects of ambiguity and incomplete information on behavior? This paper shows that it is optimal to first use any prior to perform Bayesian estimation and then to maximize expected utility with that prior based on the resulting estimates. Finally, the paper shows that a hedging demand arises that is affected by both ambiguity and estimation risk.

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Bibliographic Info

Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - Working Papers Series with number wp2009-019.

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Length: 23
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Publication status: published, ANNALS OF ECONOMICS AND FINANCE 10-2, 257–279 (2009)
Handle: RePEc:bos:wpaper:wp2009-019

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Keywords: Ambiguity; Recursive multiple-priors utility; Incomplete information; Portfolio choice; Hedging; Estimation risk;

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References

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  1. 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.
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  3. Larry G. Epstein & Martin Schneider, 2001. "Recursive Multiple-Priors," RCER Working Papers 485, University of Rochester - Center for Economic Research (RCER).
  4. Feldman, David, 1992. "Logarithmic Preferences, Myopic Decisions, and Incomplete Information," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(04), pages 619-629, December.
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  7. Gennotte, Gerard, 1986. " Optimal Portfolio Choice under Incomplete Information," Journal of Finance, American Finance Association, vol. 41(3), pages 733-46, July.
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  17. 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.
  18. Evan W. Anderson & Lars Peter Hansen & Thomas J. Sargent, 2003. "A Quartet of Semigroups for Model Specification, Robustness, Prices of Risk, and Model Detection," Journal of the European Economic Association, MIT Press, vol. 1(1), pages 68-123, 03.
  19. Duffie, Darrell & Epstein, Larry G, 1992. "Stochastic Differential Utility," Econometrica, Econometric Society, vol. 60(2), pages 353-94, March.
  20. Nicholas Barberis, 2000. "Investing for the Long Run when Returns Are Predictable," Journal of Finance, American Finance Association, vol. 55(1), pages 225-264, 02.
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  23. Thomas J. Sargent & LarsPeter Hansen, 2001. "Robust Control and Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 60-66, May.
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