Ambiguity, Learning, and Asset Returns

Abstract

We propose a novel generalized recursive smooth ambiguity model which allows a threeway 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.Keywords: Ambiguity aversion, learning, asset pricing puzzles, model uncertainty, robustness, pessimism JEL Classification: D81, E44, G12 * We thank Massimo Marinacci and Tom Sargent for encouragement, Lars Hansen, Hanno Lustig, Zhongjun Qu, Costis Skiadas (AFA discussant), Amir Yaron, and Stanley Zin (AEA discussant) for helpful comments. We are particularly grateful to Massimo Marinacci for his patient explanations of our questions. We have benefitted from comments from seminar participants in

Ambiguity Aversion and Mutual Funds: Evidence from China

“…The key implication and conclusion of my analysis are that when investors face uncertain quality performance signals, they will place the greatest weight on the worst signal. This corresponds to the motivation theoretical research by Epstein and Schneider (2008), Klibanoff, Marinacci and Mukerji (2005) and Ju and Miao (2012). The result of my analysis indicate that ambiguity averse investors are more sensitive to the worst-scenario.…”

Ambiguity aversion: bibliometric analysis and literature review of the last 60 years

“…After the introduction of SAM, many other papers followed the approach (Battigalli et al 2015 ; Battigalli et al 2016 ; Ju and Miao 2012 ; Maccheroni et al 2013 ; Strzalecki 2013 ; Thimme and Völkert 2015 ; van de Kuilen and Wakker 2011 ; Wong 2015 ).…”

Ambiguity and asset prices: a closer look in an emerging market

“…Other studies argue that ambiguity decreases the information quality, resulting in higher volatility (Epstein and Schneider, 2008; Illeditsch, 2011; Caskey, 2009). Ambiguity aversion is also argued to be associated with some puzzles in the literature such as home bias puzzle (Uppal and Wang, 2003), equity premium puzzle and risk-free rate puzzle (Ju and Miao, 2012; Collard et al. , 2018; Hansen et al.…”