The Uncertainty Premium in an Ambiguous Economy

Yehuda Izhakian () and Simon Benninga ()
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Yehuda Izhakian: Stern School of Business, New York University, USA
Simon Benninga: Faculty of Management, Tel Aviv University, Israel

Quarterly Journal of Finance (QJF), 2011, vol. 01, issue 02, 323-354

Abstract: Theuncertainty premiumis the premium that is derived from not knowing the sure outcome (risk premium) and from not knowing the precise odds of outcomes (ambiguity premium). We generalize Pratt's risk premium to uncertainty premium based on Klibanoffet al.'s (2005) smooth model of ambiguity. We show that the uncertainty premium can decrease with an increase in decision maker's risk aversion. This happens because increasing risk aversion always results in a lower ambiguity premium. The positive ambiguity premium may provide an additional explanation to the equity premium puzzle.

Keywords: Uncertainty; risk; ambiguity; risk aversion; ambiguity aversion; utility; premium (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (19)

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DOI: 10.1142/S2010139211000109

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