Model Uncertainty, Ambiguity Aversion, and Market Participation
43 Pages Posted: 17 Jan 2017 Last revised: 30 Sep 2017
Date Written: September 29, 2017
Ambiguity aversion is a leading explanation for the market nonparticipation puzzle. However, we show that in a rational expectations equilibrium model with a fund offering the risk-adjusted market portfolio (RAMP), all investors, including those who are ambiguous about some or all assets, participate in all asset markets directly or via the fund. This result follows from a new separation theorem. In equilibrium, the asset risk premia satisfy the CAPM with the fund as the pricing portfolio. We conclude that considerations other than ambiguity aversion alone, such as a failure of funds to offer RAMP or other forms of investor bias, are needed to explain the nonparticipation puzzle.
Keywords: index fund, limited participation, ambiguity aversion, risk premium
JEL Classification: G11, G12, D84
Suggested Citation: Suggested Citation