I study the effects of risk and ambiguity (Knightian uncertainty) on optimal portfolios and equilibrium asset prices when investors receive information that is difficult to link to fundamentals. I show that the desire of investors to hedge ambiguity leads to portfolio inertia and excess volatility. Specifically, when news is surprising, investors may not react to price changes even if there are no transaction costs or other market frictions. Moreover, I show that small shocks to cash flow news, asset betas, or market risk premia may lead to drastic changes in the stock price and hence to excess volatility. Disciplines Finance | Finance and Financial ManagementThis journal article is available at ScholarlyCommons: http://repository.upenn.edu/fnce_papers/295Electronic copy available at: http://ssrn.com/abstract=1600299Ambiguous Information, Portfolio Inertia, and Excess Volatility * Philipp Karl Illeditsch † March 2011 Journal of Finance, ForthcomingAbstract I study the effects of risk and ambiguity (Knightian uncertainty) on optimal

We show that inflation disagreement, not just expected inflation, has an impact on nominal interest rates. In contrast to expected inflation, which mainly a↵ects the wedge between real and nominal yields, inflation disagreement a↵ects nominal yields predominantly through its impact on the real side of the economy. We show theoretically and empirically that inflation disagreement raises real and nominal yields and their volatilities. Inflation disagreement is positively related to consumers' cross-sectional consumption growth volatility and trading in fixed income securities. Calibrating our model to disagreement, inflation, and yields reproduces the economically significant impact of inflation disagreement on yield curves. , and seminar participants at several conferences and institutions for comments and suggestions. A special thanks goes to Johannes Ruf for many useful discussions about our theoretical results. . 5 We show in the Internet Appendix that inflation disagreement also has an economically and statistically positive e↵ect on the break-even inflation rate and the inflation risk premium. 6 Armantier, de Bruin, Topa, van der Klaauw, and Zafar (2015) show that consumers act on the inflation expectations they report in the MSC. 7 We also show in the Internet Appendix that real and nominal yields and their volatilities are higher when inflation disagreement is high after controlling for disagreement about real GDP growth and earnings. 12 Other papers that empirically explore the role of inflation beliefs on the term structure include Ang, provides a survey of this literature. N 132 132 132 132 132 132 adj. R 2 0.40 0.39 0.56 0.55 0.16 0.14 0.31 0.33 N 132 132 438 438 132 132 132 132 DisInf 0.37 0.40 0.54 0.64 0.29 0.28 0.45 0.49 t-stat 3.50 3.63 4.55 5.42 2.27 2.12 2.55 3.00 ExpInf 0.43 0.40 0.26 0.14 0.35 0.36 0.25 0.24 N 132 132 438 438 132 132 132 132The coe cients for disagreement are positive as well as economically and statistically significant for the SPF and MSC at all maturities, as shown in the top panel of Table 2. An increase in disagreement by one standard deviation for the SPF (0.34%) and the MSC (1.95%) raises the two-year nominal yield by 36% and 51% of its standard deviation (3.42% and 3.63%, respectively). The economic significance of inflation disagreement is large and N 132

We introduce a reduced-form term structure model with closed-form solutions for yields where the short rate and market prices of risk are nonlinear functions of Gaussian state variables. The nonlinear model with three factors matches the time-variation in expected excess returns and yield volatilities of U.S. Treasury bonds from 1961 to 2014. Yields and their variances depend on only three factors, yet the model exhibits features consistent with unspanned risk premia (URP) and unspanned stochastic volatility (USV).

We study how information about an asset affects optimal portfolios and equilibrium asset prices when investors are not sure about the model that predicts future asset values and thus treat the information as ambiguous. We show that this ambiguity leads to optimal portfolios that are insensitive to news even though there are no information processing costs or other market frictions. In equilibrium, we show that stock prices may not react to public information that is worse than expected and this mispricing of bad news leads to profitable trading strategies based on public information.

I study the effects of aversion to risk and ambiguity (uncertainty in the sense of Knight (1921)) on the value of the market portfolio when investors receive information that they find difficult to link to fundamentals and hence treat as ambiguous. Investors consider a set of models that consists of a single normally distributed marginal for fundamentals and a family of normally distributed conditionals that relate information to fundamentals. Hence, they neither know the posterior mean nor the posterior variance of fundamentals. I show that when investors receive ambiguous information, then the interpretation of this information can drastically change. This leads to a discontinuity in the equilibrium price of the market portfolio, excess volatility, negative skewness, and excess kurtosis of stock market returns. Moreover, a higher signal value does not always lead to a higher price.