Ambiguity, no Arbitrage, and the Limits to Rational Expectations

36 Pages Posted: 6 Mar 2008

See all articles by Hendri Adriaens

Hendri Adriaens

CentERdata, Tilburg University

Bas Donkers

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Erasmus Research Institute of Management (ERIM); Tinbergen Institute

Bertrand Melenberg

Tilburg University - Center for Economic Research (CentER)

Date Written: February 2008

Abstract

The traditional finance approach combines the rational expectations hypothesis with the assumption of no arbitrage. However, the numerous anomalies reported in the finance literature reject this approach. The behavioral finance approach takes rational expectations as the maintained hypothesis with as null hypothesis no arbitrage versus the alternative of limits to arbitrage. Anomalies are interpreted as rejecting the null, suggesting that non-rational noise traders affect the outcomes in financial markets, explaining the anomalies. Alternatively, we take no arbitrage as maintained hypothesis and consider as null hypothesis rational expectations versus the alternative of expectations characterized by ambiguity. But also under ambiguity arbitrage opportunities will be exploited, making no arbitrage the relevant maintained hypothesis. Expectations are modeled as output of an econometric model. Ambiguity arises when the econometric model generates multiple probability distributions, for instance, when modeling a complicated, hard to fully understand financial market, possibly with unforeseen contingencies. Anomalies are then a violation of the null of rational expectations, implying that anomalies need not arise due to the presence of non-rational investors, but are just an artefact of imposing the possibly unrealistically strong assumption of rational expectations.

Keywords: Asset pricing, ambiguity, rational expectations, behavioral finance

JEL Classification: G12

Suggested Citation

Adriaens, Hendri and Donkers, Bas and Melenberg, Bertrand, Ambiguity, no Arbitrage, and the Limits to Rational Expectations (February 2008). Available at SSRN: https://ssrn.com/abstract=1102337 or http://dx.doi.org/10.2139/ssrn.1102337

Hendri Adriaens (Contact Author)

CentERdata, Tilburg University ( email )

NL-5000 LE Tilburg
Netherlands

Bas Donkers

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
Rotterdam, NL 3000 DR
Netherlands
+31 10 408 2411 (Phone)
+31 10 408 9169 (Fax)

HOME PAGE: http://https://www.eur.nl/en/people/bas-donkers

Erasmus Research Institute of Management (ERIM) ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands
+31 10 408 2411 (Phone)
+31 10 408 9169 (Fax)

HOME PAGE: http://https://www.eur.nl/en/people/bas-donkers

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Bertrand Melenberg

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2730 (Phone)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
254
Abstract Views
2,731
Rank
232,925
PlumX Metrics