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Ambiguity, Learning, and Asset Returns

  • Nengjiu Ju

    ()

    (Department of Finance, the Hong Kong University of Science and Technology)

  • Jianjun Miao

    ()

    (Department of Economics, Boston University)

We propose a novel generalized recursive smooth ambiguity model which allows a three-way separation among risk aversion, ambiguity aversion, and intertemporal substitution. We apply this utility 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 riskfree 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, 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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Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - Working Papers Series with number wp2009-014.

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Length: 35
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Handle: RePEc:bos:wpaper:wp2009-014
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