Ambiguous Information, Portfolio Inertia, and Excess Volatility
Philipp K. Illeditsch
University of Pennsylvania - Finance Department
Journal of Finance, Forthcoming
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, then investors may not react to price changes although 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.
Number of Pages in PDF File: 54
Keywords: Learning from Ambiguous Signals, Portfolio Inertia, Excess Volatility, Ambiguity Aversion, Knightian Uncertainty, Heterogenous Agents
JEL Classification: D81, D83, G11, G12
Date posted: May 5, 2010 ; Last revised: December 7, 2011
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