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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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File URL: http://www.annualreviews.org/doi/abs/10.1146/annurev-financial-120209-133940
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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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  13. Mukerji, S. & Tallon, J.-M., 1999. "Ambiguity Aversion and Incompleteness of Financial Markets," Papiers d'Economie Mathématique et Applications 1999-28, Université Panthéon-Sorbonne (Paris 1).
  14. 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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  23. Trojani, Fabio & Vanini, Paolo, 2002. "A note on robustness in Merton's model of intertemporal consumption and portfolio choice," Journal of Economic Dynamics and Control, Elsevier, vol. 26(3), pages 423-435, March.
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  26. Antonio Mele & Francesco Sangiorgi, 2009. "Ambiguity, Information Acquisition and Price Swings in Asset Markets," FMG Discussion Papers dp633, Financial Markets Group.
  27. Maccheroni, Fabio & Marinacci, Massimo & Rustichini, Aldo, 2006. "Dynamic variational preferences," Journal of Economic Theory, Elsevier, vol. 128(1), pages 4-44, May.
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  29. Sbuelz, Alessandro & Trojani, Fabio, 2008. "Asset prices with locally constrained-entropy recursive multiple-priors utility," Journal of Economic Dynamics and Control, Elsevier, vol. 32(11), pages 3695-3717, November.
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