Optimal payoffs under smooth ambiguity

An Chen, Steven Vanduffel () and Morten Wilke

European Journal of Operational Research, 2025, vol. 320, issue 3, 754-764

Abstract: We study optimal payoff choice for an investor in a one-period model under smooth ambiguity preferences, also called KMM preferences as proposed by Klibanoff et al. (2005). In contrast to the existing literature on optimal asset allocation for a KMM investor in a one-period model, we also allow payoffs that are non-linear in the market asset. Our contribution is fourfold. First, we characterize and derive the optimal payoff under KMM preferences. Second, we demonstrate that a KMM investor solves an equivalent problem to an investor under classical subjective expected utility (CSEU) with adjusted second-order probabilities. Third, we show that a KMM investor with exponential ambiguity attitude implicitly maximizes CSEU utility under the ‘worst-case’ second-order probabilities determined by his ambiguity aversion. Fourth, we reveal that optimal payoffs under ambiguity are not necessarily monotonically increasing in the market asset, which we illustrate using a log-normal market asset under drift and volatility uncertainty.

Keywords: Finance; Model ambiguity; KMM preferences; Ambiguity aversion; Drift and volatility uncertainty (search for similar items in EconPapers)
Date: 2025
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:320:y:2025:i:3:p:754-764

DOI: 10.1016/j.ejor.2024.08.008

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