Asset Pricing and Ambiguity: Empirical Evidence

Abstract:     
Modern portfolio theory focuses on the relationship between risk andreturn, assuming away ambiguity, uncertainty over the probability space.This paper assumes that ambiguity affects asset prices and tests therelationship between risk, ambiguity and return based on a modeldeveloped by Izhakian (2011). Its contribution is twofold; it proposesan ambiguity measure that is derived theoretically and computed fromstock market prices. Second, it uses ambiguity in conjunction with riskto test the basic relationship between risk, ambiguity and return. Thispaper finds that ambiguity has a consistently negative effect on returnsand risk mostly has a positive effect.

Number of Pages in PDF File: 37

Keywords: Ambiguity, Knightian uncertainty, Equity premium, Ambiguity measure

working papers series