Asset Pricing under Knightian Uncertainty: A Case for Optimism
49 Pages Posted: 22 Dec 2021 Last revised: 3 Jul 2022
Date Written: December 21, 2021
We apply a representative agent model separating beliefs, Knightian uncertainty, and uncertainty attitude, to empirical puzzles for the aggregate stock market. Allowing for optimistic uncertainty attitudes helps match the risk-free rate, equity premium, variance risk premium, and risk-neutral entropy, and produces the observed pricing kernel U-shape. The low (high) persistence of market uncertainty (market optimism) generates return predictability of the price-dividend ratio, variance risk premium, market crash probability, and market correlation and helps explain short-run (long-run) dynamics of the pricing kernel. Accounting for the interaction of market volatility, uncertainty, and optimism helps identify the risk-return tradeoff for the aggregate market.
Keywords: Optimism, Uncertainty, Ambiguity, Skewness, NEO-EU CAPM, Stock Market Anomalies
JEL Classification: D8, G40, G41
Suggested Citation: Suggested Citation