Ambiguity and the Historical Equity Premium
45 Pages Posted: 19 May 2011
Date Written: May 10, 2011
This paper assesses the quantitative impact of ambiguity on the historically observed equity premium. We consider a Lucas-tree pure exchange economy with a single agent where we introduce two key non-standard assumptions. First, the agent's beliefs about the dividend/consumption process is ambiguous, i.e. she is uncertain about the exact probability distribution governing the realization of future dividends and consumption. Second, the agent's preferences are sensitive to this ambiguity, a property formalized using the smooth ambiguity model. The consumption and dividend process is assumed to evolve according to a hidden state model, popularized by Bansal and Yaron (2004), where a persistent latent state variable describes temporary shocks to the mean of consumption growth prospects. We further extend the model to allow for uncertainty about the magnitude of the persistence of the latent state. The agent's beliefs are ambiguous due to the uncertainty about the conditional mean of the probability distribution on consumption and dividends in the next period. We show that in this model ambiguity is endogenously dynamic, for example, increasing during recessions. This results in an endogenously volatile and (counter-)cyclical equity premium. We calibrate the level of ambiguity aversion to match only the first moment of the risk-free rate in data, and ambiguity to match the uncertainty conditional on the historical growth path, and evaluate the model using moderate levels of risk aversion. We find that this simple modification of a Lucas-tree model accounts for a large part of the historical equity premium, both in terms of its level and variation over time.
Keywords: Ambiguity version, asset pricing, equity premium puzzle
JEL Classification: G12, E21, D81, C63
Suggested Citation: Suggested Citation