Ambiguity Measurement

Abstract

Ordering alternatives by their degree of ambiguity is a crucial element in decision-making processes in general and in asset pricing in particular. Thus far the literature has not provided an applicable measure of ambiguity allowing for such ordering. The current paper addresses this need by introducing a novel empirically applicable ambiguity measure derived from a new model of decision making under ambiguity in which probabilities of events are themselves random. In this model a complete distinction is attained between preferences and beliefs and between risk and ambiguity that enables the degree of ambiguity to be measured. A merit of the model is that ambiguous probabilities can be incorporated into asset prices and an ambiguity premium can be measured empirically.

Keywords: Ambiguity Measure, Ambiguity Aversion, Ambiguity Premium, Choquet Expected Utility, Cumulative Prospect Theory, Ellsberg Paradox, Knightian Uncertainty, Random Probabilities.

JEL Classification: C44, D81, D83, G11, G12.