Trading Ambiguity: A Tale of Two Heterogeneities
54 Pages Posted: 3 Dec 2018 Last revised: 12 Jun 2019
Date Written: June 7, 2019
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, equilibrium prices, and trade upon arrival of public information, and show, in each case, there are departures from the outcome in 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 size and value premia, the empirical security market line being flatter than the one predicted by the CAPM, and the observation that earnings announcements are often followed by significant trading volume with small price change.
Keywords: ambiguity, ambiguity aversion, asset pricing, cross-sectional returns, earnings announcements, parameter uncertainty, portfolio choice, trading volume
JEL Classification: D81, G11, G12
Suggested Citation: Suggested Citation