Trading Ambiguity: A Tale of Two Heterogeneities
50 Pages Posted: 3 Dec 2018 Last revised: 25 Aug 2021
Date Written: August 22, 2021
We consider financial markets with heterogeneously ambiguous assets and heterogeneously ambiguity averse investors. Investors' preferences, a version of the smooth ambiguity model, are a parsimonious extension of the standard mean-variance framework. We consider, in a unified setting, portfolio choice, and trade upon arrival of public information, and show, in both cases, there are systematic departures from the predictions of standard theory. These departures are of significance as they occur in the direction of empirical regularities that belie the standard theory. In particular, our theory speaks to several puzzling phenomena in a unified fashion: the asset allocation puzzle, the observation that earnings announcements are often followed by significant trading volume with small price change, and that increases in uncertainty are positively associated with increased trading activity and portfolio rebalancing toward safer assets by individual (retail) investors.
Keywords: ambiguity, ambiguity aversion, earnings announcements, parameter uncertainty, portfolio choice, trading volume
JEL Classification: D81, G11, G12
Suggested Citation: Suggested Citation