Ambiguous Volatility and Asset Pricing in Continuous Time
60 Pages Posted: 8 Jan 2013
Date Written: November 7, 2012
This paper formulates a model of utility for a continuous time frame-work that captures the decision-maker’s concern with ambiguity about both volatility and drift. Corresponding extensions of some basic results in asset pricing theory are presented. First, we derive arbitrage-free pricing rules based on hedging arguments. Ambiguous volatility implies market incompleteness that rules out perfect hedging. Consequently, hedging arguments determine prices only up to intervals. However, sharper predictions can be obtained by assuming preference maximization and equilibrium. Thus we apply the model of utility to a representative agent endowment economy to study equilibrium asset returns. A version of the C-CAPM is derived and the effects of ambiguous volatility are described.
Keywords: ambiguity, option pricing, recursive utility, G-Brownian motion, robust stochastic volatility, sentiment, overconfidence, optimism
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