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Ambiguity and the historical equity premium

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Author Info

  • Fabrice Collard

    ()
    (Department of Economics - University of Bern)

  • Sujoy Mukerji

    ()
    (Department of Economics and University College - University of Oxford)

  • Kevin Sheppard

    ()
    (Department of Economics and Oxford-Man Institute of Quantitative Finance - University of Oxford)

  • Jean-Marc Tallon

    ()
    (Centre d'Economie de la Sorbonne - Paris School of Economics)

Abstract

This paper assesses the quantitative impact of ambiguity on the historically observed equity premium. We consider a Lucas-tree pure-exchange economy with a single agent where we introduce two key non-standard assumptions. First, the agent's beliefs about the dividend/consumption process is ambiguous. Second, the agent's preferences are sensitive to this ambiguity. We further extend the model to allow for uncertainty about the magnitude of the persistence of the latent state. The agent's beliefs are ambiguous due to the uncertainty about the conditional mean of the probability distribution on consumption and dividends in the next period. This results in an endogenously volatile and (counter-) cyclical equity premium. We calibrate the level of ambiguity aversion to match only the first moment of the risk-free rate in data, and ambiguity to match the uncertainty conditional on the historical growth path, and evaluate the model using moderate levels of risk aversion. We find that this simple modification of Lucas-tree model accounts for a large part of the historical equity premium, both in terms of its level and variation over time.

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Bibliographic Info

Paper provided by Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne in its series Documents de travail du Centre d'Economie de la Sorbonne with number 11032.

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Length: 57 pages
Date of creation: May 2011
Date of revision:
Handle: RePEc:mse:cesdoc:11032

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Keywords: Equity premium; ambiguity.;

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References

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Citations

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Cited by:
  1. Nengjiu Ju & Jianjun Miao, 2010. "Ambiguity, Learning, and Asset Returns," CEMA Working Papers 438, China Economics and Management Academy, Central University of Finance and Economics.
  2. Michèle Cohen & Jean-Marc Tallon & Jean-Christophe Vergnaud, 2011. "An experimental investigation of imprecision attitude and its relation with risk attitude and impatience," Theory and Decision, Springer, vol. 71(1), pages 81-109, July.
  3. Gierlinger, Johannes & Gollier, Christian, 2008. "Socially Efficient Discounting under Ambiguity Aversion," IDEI Working Papers 561, Institut d'Économie Industrielle (IDEI), Toulouse.
  4. Gollier, Christian, 2009. "Portfolio Choices and Asset Prices: The Comparative Statics of Ambiguity Aversion," IDEI Working Papers 357, Institut d'Économie Industrielle (IDEI), Toulouse, revised 2011.
  5. Massimo Guidolin & Hening Liu, 2013. "Ambiguity Aversion and Under-diversification," Working Papers 483, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  6. Jayant Ganguli & Scott Condie & Philipp Karl Illeditsch, 2012. "Information Inertia," Economics Discussion Papers 719, University of Essex, Department of Economics.
  7. Fabio Maccheroni & Massimo Marinacci & Doriana Ruffino, 2013. "Alpha as Ambiguity: Robust Mean‐Variance Portfolio Analysis," Econometrica, Econometric Society, vol. 81(3), pages 1075-1113, 05.
  8. Daniele Pennesi, 2013. "Asset Prices in an Ambiguous Economy," Carlo Alberto Notebooks 315, Collegio Carlo Alberto.
  9. Oliver Walker & Simon Dietz, 2011. "A representation result for choice under conscious unawareness," Grantham Research Institute on Climate Change and the Environment Working Papers 59, Grantham Research Institute on Climate Change and the Environment.
  10. Pierre Collin-Dufresne & Michael Johannes & Lars A. Lochstoer, 2013. "Parameter Learning in General Equilibrium: The Asset Pricing Implications," NBER Working Papers 19705, National Bureau of Economic Research, Inc.
  11. Hua Chen & Michael Sherris & Tao Sun & Wenge Zhu, 2013. "Living With Ambiguity: Pricing Mortality-Linked Securities With Smooth Ambiguity Preferences," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 80(3), pages 705-732, 09.
  12. Jianjun Miao & Bin Wei & Hao Zhou, 2012. "Ambiguity Aversion and Variance Premium," Boston University - Department of Economics - Working Papers Series WP2012-009, Boston University - Department of Economics.
  13. Ruffino, Doriana, 2013. "A Robust Capital Asset Pricing Model," Finance and Economics Discussion Series 2014-1, Board of Governors of the Federal Reserve System (U.S.).
  14. : Constantinos Antoniou & : Richard D.F. Harris & : Ruogu Zhang, 2013. "Ambiguity Aversion and Stock Market Participation: Evidence from Fund Flows," Working Papers wpn13-01, Warwick Business School, Finance Group.

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