Asset Pricing under Smooth Ambiguity in Continuous Time
41 Pages Posted: 18 Mar 2022
Date Written: March 1, 2022
We study asset pricing implications of a revealing and tractable formulation of smooth ambiguity investor preferences in a continuous-time environment. Investors do not observe a hidden Markov state and instead make inferences about this state using past data. We show that ambiguity about this hidden state distribution alters investor decisions and equilibrium asset prices. Our continuous-time formulation allows us to apply recursive filtering and Hamilton-Jacobi-Bellman methods to solve the modified decision problem. Using such methods, we show how characterizations of portfolio allocations and local uncertainty-return tradeoffs change when investors are ambiguity-averse.
Keywords: Risk, ambiguity, robustness, asset pricing, portfolio allocation, continuous time
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