Would Ambiguity Averse Investors Hedge Risk in Equity Markets?

50 Pages Posted: 19 Dec 2019 Last revised: 18 Feb 2020

See all articles by Gleb Gertsman

Gleb Gertsman

Tilburg University - Department of Finance

Rik Frehen

Tilburg University - Department of Finance

Bas J. M. Werker

Tilburg University - Center for Economic Research (CentER)

Date Written: November 1, 2019

Abstract

This paper studies the conjecture that investors prefer derivative markets over the equity market when hedging risks. An investor who wants to hedge, say inflation or crash risk, generally faces substantially more beta uncertainty in the stock market than in the derivatives market. We show that an investor with smooth ambiguity aversion preferences avoids a hedge portfolio consisting of stocks, which is typically subject to large beta uncertainty. The ambiguity averse investor prefers to hedge using derivatives (TIPS and options) which are not subject to beta uncertainty. More specifically, we show that equilibrium risk premiums for assets with large beta uncertainty (long-short portfolio of stocks) decline once derivatives with less beta uncertainty (TIPS and options) are introduced. In line with this theory, we find that the inflation risk premium decreases significantly, in absolute terms, when TIPS are introduced.

Keywords: hedging uncertainty, ambiguity aversion, inflation risk

JEL Classification: G11, G12

Suggested Citation

Gertsman, Gleb and Frehen, Rik and Werker, Bas J.M., Would Ambiguity Averse Investors Hedge Risk in Equity Markets? (November 1, 2019). Available at SSRN: https://ssrn.com/abstract=3497644 or http://dx.doi.org/10.2139/ssrn.3497644

Gleb Gertsman (Contact Author)

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Rik Frehen

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, DC Noord-Brabant 5000 LE
Netherlands

Bas J.M. Werker

Tilburg University - Center for Economic Research (CentER) ( email )

Econometrics and Finance Group
5000 LE Tilburg
Netherlands

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