​Ambiguity, Information Processing, and Financial Intermediation

Abstract

This paper incorporates ambiguity and information processing constraints into a model of intermediary asset pricing. Financial intermediaries are assumed to possess greater information processing capacity. Households purchase this capacity, and then delegate their investment decisions to intermediaries. As in He and Krishnamurthy (2012), the delegation contract is constrained by a moral hazard problem, which gives rise to a minimum capital requirement. Both households and intermediaries have a preference for robustness, reflecting ambiguity about asset returns (Hansen and Sargent (2008)). We show that ambiguity aversion tightens the capital constraint, and amplifies its effects. Detection error probabilities are used to discipline the degree of ambiguity aversion. The model can explain both the unconditional moments of asset returns and their state dependence, even with detection error probabilities in excess of 20%.

Keywords: Ambiguity, Rational Inattention, Asset Pricing, Financial Crisis

JEL Classification: D81, G01, G12