On Ambiguity-Seeking Behavior in Finance Models with Smooth Ambiguity

Abstract

Ambiguity-seeking behavior is universally disregarded in a large theoretical finance literature with smooth ambiguity preferences. This paper questions the three rationales for this practice. First, smooth ambiguity models are not ill-defined under ambiguity-seeking. Second, a representative investor need not be ambiguity-averse when an average individual trader is ambiguity-averse. Third, individual traders need not be ambiguity-averse when a representative investor is ambiguity-averse. Our constructive suggestion is that researchers should calculate the allowed levels of ambiguity-seeking for which their model is wellposed, and then let the data speak for themselves whether ambiguity-seeking or ambiguity-aversion can better explain empirical evidence.

Keywords: ambiguity-loving, smooth ambiguity, investor heterogeneity, representative investor, limited participation

JEL Classification: D81, G12, G11