Rational Expectations and Ambiguity: A Comment on Abel (2002)

Alexander Ludwig and Alexander Zimper

No 04-66, Sonderforschungsbereich 504 Publications from Sonderforschungsbereich 504, Universität Mannheim, Sonderforschungsbereich 504, University of Mannheim

Abstract: Abel (2002) proposes a resolution of the riskfree rate and the equity premium puzzles} by considering pessimism and doubt. Pessimism is characterized by subjective probabilistic beliefs about asset returns that are stochastically dominated by the objective distribution of these returns. The subjective distribution is characterized by doubt if it is a mean-preserving spread of the objective distribution. This note offers a decision theoretic foundation of Abel's ad-hoc definitions of pessimism and doubt under the assumption that individuals exhibit ambiguity attitudes in the sense of Schmeidler (1989). In particular, we show that the behavior of a representative agent, who resolves her uncertainty with respect to the true distribution of asset returns in a pessimistic way, is the equivalent to pessimism in Abel's sense. Furthermore, a representative agent, who takes into account pessimistic as well as optimistic considerations, may result in the equivalent to doubt in Abel's sense.

Pages: 14 pages
Date: 2004-12-22
Note: We thank Juergen Eichberger, Itzhak Gilboa, and David Schmeidler for helpful comments and suggestions. Financial support from Deutsche Forschungsgemeinschaft, Sonderforschungsbereich 504, is gratefully acknowledged.
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Related works:
Journal Article: Rational expectations and ambiguity: A comment on Abel (2002) (2006)
Working Paper: Rational expectations and ambiguity: a comment on Abel (2002) (2004)
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