Ambiguity and Asset Markets
The Ellsberg paradox suggests that people behave differently in risky situations -- when they are given objective probabilities -- than in ambiguous situations when they are not told the odds (as is typical in financial markets). Such behavior is inconsistent with subjective expected utility theory (SEU), the standard model of choice under uncertainty in financial economics. This article reviews models of ambiguity aversion. It shows that such models -- in particular, the multiple-priors model of Gilboa and Schmeidler -- have implications for portfolio choice and asset pricing that are very different from those of SEU and that help to explain otherwise puzzling features of the data.
Epstein acknowledges financial support from the National Science Foundation (award SES-0917740). We thank Lorenzo Garlappi, Tim Landvoigt, Jianjun Miao, Monika Piazzesi and Juliana Salomao for helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Larry G. Epstein & Martin Schneider, 2010. "Ambiguity and Asset Markets," Annual Review of Financial Economics, Annual Reviews, vol. 2(1), pages 315-346, December. citation courtesy of