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Ambiguity and Asset Markets

  • Larry G. Epstein
  • Martin Schneider

    ()

    (Department of Economics, Boston University, Boston, Massachusetts 02215
    Department of Economics, Stanford University, Stanford, California 94305)

The Ellsberg paradox suggests that people's behavior is different in risky situations—when they are given objective probabilities—from their behavior in ambiguous situations—when they are not told the odds (as is typical in financial markets). Such behavior is inconsistent with subjective expected utility (SEU) theory, the standard model of choice under uncertainty in financial economics. This article reviews models of ambiguity aversion. It shows that such models—in particular, the multiple-priors model of Gilboa and Schmeidler—have implications for portfolio choice and asset pricing that are very different from those of SEU and that help to explain otherwise puzzling features of the data.

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Article provided by Annual Reviews in its journal Annual Review of Financial Economics.

Volume (Year): 2 (2010)
Issue (Month): 1 (December)
Pages: 315-346

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Handle: RePEc:anr:refeco:v:2:y:2010:p:315-346
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