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Ambiguity and Asset Markets

  • Larry G. Epstein
  • Martin Schneider

The Ellsberg paradox suggests that people behave differently in risky situations -- when they are given objective probabilities -- than in ambiguous situations when they are not told the odds (as is typical in financial markets). Such behavior is inconsistent with subjective expected utility theory (SEU), 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16181.

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Date of creation: Jul 2010
Date of revision:
Publication status: published as Larry G. Epstein & Martin Schneider, 2010. "Ambiguity and Asset Markets," Annual Review of Financial Economics, Annual Reviews, vol. 2(1), pages 315-346, December.
Handle: RePEc:nbr:nberwo:16181
Note: AP EFG
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  1. Pierpaolo Benigno & Salvatore Nisticò, 2009. "International Portfolio Allocation under Model Uncertainty," NBER Working Papers 14734, National Bureau of Economic Research, Inc.
  2. Sujoy Mukerji & Jean-Marc Tallon, 2004. "Ambiguity aversion and the absence of indexed debt," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00499352, HAL.
  3. Klibanoff, Peter & Marinacci, Massimo & Mukerji, Sujoy, 2009. "Recursive smooth ambiguity preferences," Journal of Economic Theory, Elsevier, vol. 144(3), pages 930-976, May.
  4. Bryan R. Routledge & Stanley E. Zin, 2001. "Model Uncertainty and Liquidity," NBER Working Papers 8683, National Bureau of Economic Research, Inc.
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  6. Han Ozsoylev & Jan Werner, 2011. "Liquidity and asset prices in rational expectations equilibrium with ambiguous information," Economic Theory, Springer, vol. 48(2), pages 469-491, October.
  7. Larry Epstein & Martin Schneider, 2004. "Ambiguity, Information Quality and Asset Pricing," RCER Working Papers 507, University of Rochester - Center for Economic Research (RCER).
  8. David Easley & Maureen O'Hara, 2009. "Ambiguity and Nonparticipation: The Role of Regulation," Review of Financial Studies, Society for Financial Studies, vol. 22(5), pages 1817-1843, May.
  9. Isaac Kleshchelski & Nicolas Vincent, 2009. "Robust Equilibrium Yield Curves," Cahiers de recherche 0907, CIRPEE.
  10. Mukerji, Sujoy & Tallon, Jean-Marc, 2001. "Ambiguity Aversion and Incompleteness of Financial Markets," Review of Economic Studies, Wiley Blackwell, vol. 68(4), pages 883-904, October.
  11. Laurent BARRAS & Patrick Gagliardini & Paolo Porchia & Fabio Trojani, . "Ambiguity Aversion and the Term Structure of Interest Rates," Swiss Finance Institute Research Paper Series 08-18, Swiss Finance Institute.
  12. Gajdos, T. & Hayashi, T. & Tallon, J.-M. & Vergnaud, J.-C., 2008. "Attitude toward imprecise information," Journal of Economic Theory, Elsevier, vol. 140(1), pages 27-65, May.
  13. Jianjun Miao & NENGJIU JU, 2010. "Ambiguity, Learning, And Asset Returns," Boston University - Department of Economics - Working Papers Series WP2010-031, Boston University - Department of Economics.
  14. Larry G. Epstein & Martin Schneider, 2007. "Learning Under Ambiguity," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1275-1303.
  15. Peter Bossaerts & Paolo Ghirardato & Serena Guarnaschelli & William R. Zame, 2006. "Ambiguity in Asset Markets: Theory and Experiment," Carlo Alberto Notebooks 27, Collegio Carlo Alberto, revised 2009.
  16. Massimo Guidolin & Francesca Rinaldi, 2010. "A simple model of trading and pricing risky assets under ambiguity: any lessons for policy-makers?," Applied Financial Economics, Taylor & Francis Journals, vol. 20(1-2), pages 105-135.
  17. 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.
  18. Peter Klibanoff & Massimo Marinacci & Sujoy Mukerji, 2005. "A Smooth Model of Decision Making under Ambiguity," Econometrica, Econometric Society, vol. 73(6), pages 1849-1892, November.
  19. 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.
  20. Fabio Trojani & Paolo Vanini, 2004. "Robustness and Ambiguity Aversion in General Equilibrium," Review of Finance, Springer, vol. 8(2), pages 279-324.
  21. Mukerji, Sujoy & Tallon, Jean-Marc, 2003. "Ellsberg's two-color experiment, portfolio inertia and ambiguity," Journal of Mathematical Economics, Elsevier, vol. 39(3-4), pages 299-316, June.
  22. Epstein, Larry G. & Schneider, Martin, 2003. "Recursive multiple-priors," Journal of Economic Theory, Elsevier, vol. 113(1), pages 1-31, November.
  23. Fabio Maccheroni & Massimo Marinacci & Aldo Rustichini, 2006. "Dynamic Variational Preferences," Carlo Alberto Notebooks 1, Collegio Carlo Alberto.
  24. Antonio Mele & Francesco Sangiorgi, 2009. "Ambiguity, information acquisition and price swings in asset markets," LSE Research Online Documents on Economics 24424, London School of Economics and Political Science, LSE Library.
  25. David A. Chapman & Valery Polkovnichenko, 2009. "First-Order Risk Aversion, Heterogeneity, and Asset Market Outcomes," Journal of Finance, American Finance Association, vol. 64(4), pages 1863-1887, 08.
  26. Raman Uppal & Tan Wang, 2003. "Model Misspecification and Underdiversification," Journal of Finance, American Finance Association, vol. 58(6), pages 2465-2486, December.
  27. 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.
  28. David Ahn & Syngjoo Choi & Douglas Gale & Shachar Kariv, 2014. "Estimating ambiguity aversion in a portfolio choice experiment," Quantitative Economics, Econometric Society, vol. 5, pages 195-223, 07.
  29. Baillon, Aurélien & Driesen, Bram & Wakker, Peter P., 2012. "Relative concave utility for risk and ambiguity," Games and Economic Behavior, Elsevier, vol. 75(2), pages 481-489.
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