Ambiguity and Information Tradeoffs

Abstract

We model investors facing ambiguity about the number of informed traders and characterize equilibrium in both financial and information markets. In the financial market, this ambiguity leads to a premium that can be positive or negative, depending on traders’ ambiguity attitude. The premium always increases with ambiguity aversion but only increases with ambiguity level when traders are sufficiently ambiguity averse. We show that traders’ effective ambiguity aversion increases with the number of informed traders, resulting in a non-monotonic relation between the equity premium and informed traders. In the information market, we determine a unique proportion of informed traders given the cost of information.

Keywords: Information acquisition, ambiguity, ambiguity aversion, equity premium

JEL Classification: D4, D81, D82, G14