Ambiguity in Asset Pricing and Portfolio Choice: A Review of the Literature

Massimo Guidolin and Francesca Rinaldi

No 417, Working Papers from IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University

Abstract: Empirical research suggests that investors’ behavior is not well described by the traditional paradigm of (subjective) expected utility maximization under rational expectations. A literature has arisen that models agents whose choices are consistent with models that are less restrictive than the standard subjective expected utility framework. In this paper we survey the literature that has explored the implications of decision-making under ambiguity for financial market outcomes, such as portfolio choice and equilibrium asset prices. We conclude that the ambiguity literature has led to a number of significant advances in our ability to rationalize empirical features of asset returns and portfolio decisions, such as the failure of the two-fund separation theorem in portfolio decisions, the modest exposure to risky securities observed for a majority of investors, the home equity preference in international portfolio diversification, the excess volatility of asset returns, the equity premium and the risk-free r ate puzzles, and the occurrence of trading break-downs. JEL codes: G10, G18, D81. Keywords: ambiguity, ambiguity-aversion, participation, liquidity, asset pricing.By Massimo Guidolin, Francesca Rinaldi

Date: 2011
New Economics Papers: this item is included in nep-cba, nep-cbe, nep-cis, nep-neu and nep-upt
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Journal Article: Ambiguity in asset pricing and portfolio choice: a review of the literature (2013)
Working Paper: Ambiguity in asset pricing and portfolio choice: a review of the literature (2010)
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