Pricing Systematic Ambiguity in Capital Markets
28 Pages Posted: 28 Jul 2012 Last revised: 10 Sep 2013
Date Written: July 2012
Asset pricing models assume that probabilities of future outcomes are known. In reality, however, there is ambiguity with regard to these probabilities. Accounting for ambiguity in asset pricing theory results in a model with two systematic components, beta risk and beta ambiguity. The focus of this paper is to study the empirical implications of ambiguity for the cross section of equity returns. We find that systematic ambiguity is an important determinant of equity returns. We also find that the Fama-French factors contribute to the explanatory power of the two main drivers of returns; namely, systematic risk and systematic ambiguity.
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