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Ambiguity, Learning, and Asset Returns

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  • Nengjiu Ju
  • Jianjun Miao

Abstract

We propose a novel generalized recursive smooth ambiguity model which permits a three-way separation among risk aversion, ambiguity aversion, and intertemporal substitution. We apply this utility model to a consumption-based asset pricing model in which consumption and dividends follow hidden Markov regime-switching processes. Our calibrated model can match the mean equity premium, the mean risk-free rate, and the volatility of the equity premium observed in the data. In addition, our model can generate a variety of dynamic asset pricing phenomena, including the procyclical variation of price-dividend ratios, the countercyclical variation of equity premia and equity volatility, the leverage e?ect, and the mean reversion of excess returns. The key intuition is that an ambiguity averse agent behaves pessimistically by attaching more weight to the pricing kernel in bad times when his continuation values are low.

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Bibliographic Info

Paper provided by China Economics and Management Academy, Central University of Finance and Economics in its series CEMA Working Papers with number 438.

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Length: 36 pages
Date of creation: Nov 2010
Date of revision:
Publication status: Forthcoming in Econometrica.
Handle: RePEc:cuf:wpaper:438

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Web page: http://cema.cufe.edu.cn/
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Keywords: Ambiguity aversion; learning; asset pricing puzzles; model uncertainty; robustness; pessimism; regime switching;

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