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Ambiguity and Volatility: Asset Pricing Implications

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  • Pataracchia, B.

    (Tilburg University, Center for Economic Research)

Abstract

Using a simple dynamic consumption-based asset pricing model, this paper explores the implications of a representative investor with smooth ambiguity averse preferences [Klibano¤, Marinacci and Mukerji, Econometrica (2005)] and provides a comparative analysis of risk aversion and ambiguity aversion. The perception of ambiguity is described by a hidden Markovian consumption growth process. The hidden states di¤er both for the mean and the volatility. We show that the ambiguity-averse investor downweights high-mean states in favor of low-mean ones. However, such distortion appears much stronger in low-volatility regimes: high volatility attenuates the distortion due to ambiguity concerns. It follows that (i) ambiguity aversion always implies higher equity premia but sustained levels of ambiguity aversion do not help explaining the high volatility of the equity premium observed in the data (volatility puzzle); (ii) our calibrated model can match the moments of the equity premium and risk free rate and can generate asset-price stylized facts like a procyclical price-dividend ratio and countercyclical conditional equity premia; however, (iii) high levels of ambiguity aversion, necessary to explain high equity returns, produce counterfactual price-dividend ratio time series across volatility states.

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Bibliographic Info

Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2011-042.

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Date of creation: 2011
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Handle: RePEc:dgr:kubcen:2011042

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Web page: http://center.uvt.nl

Related research

Keywords: Ambiguity aversion; volatility; asset pricing puzzles; robustness;

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References

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  1. 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.
  2. Ju, Nengjiu & Miao, Jianjun, 2009. "Ambiguity, Learning, and Asset Returns," MPRA Paper 14737, University Library of Munich, Germany, revised Apr 2009.
  3. Peter Klibanoff & Massimo Marinacci & Sujoy Mukerji, 2002. "A smooth model of decision making under ambiguity," ICER Working Papers - Applied Mathematics Series 11-2003, ICER - International Centre for Economic Research, revised Apr 2003.
  4. Mark Salmon & Massimiliano Marcellino, 2001. "Robust Decision Theory and the Lucas Critique," Working Papers wp01-10, Warwick Business School, Finance Group.
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