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Portfolio Choices and Asset Prices: The Comparative Statics of Ambiguity Aversion

The Review of Economic Studies · 2011 · 244 citations · 35 references

TL;DR

The study examines how increasing ambiguity aversion, defined by Klibanoff et al., affects portfolio choices, noting that contrary to intuition it need not lower demand for risky assets and that this can occur when plausible return distributions are ordered by a monotone likelihood ratio. The authors aim to derive sufficient conditions under which higher ambiguity aversion reduces demand for the risky asset and raises the equity premium. They analyze a static two‑asset portfolio model with one safe and one risky asset to derive these conditions. They find that ambiguity aversion distorts the price kernel in a complete‑market contingent‑claim portfolio problem.

Abstract

This paper investigates the comparative statics of "more ambiguity aversion" as defined by Klibanoff, Marinacci and Mukerji (2005, "A Smooth Model of Decision Making under Ambiguity", Econometrica, 73 (6), 1849–1892). The analysis uses the static two-asset portfolio problem with one safe asset and one uncertain one. While it is intuitive that more ambiguity aversion would reduce demand for the uncertain asset, this is not necessarily the case. We derive sufficient conditions for a reduction in the demand for the uncertain asset and for an increase in the equity premium. An example that meets the sufficient conditions is when the set of plausible distributions for returns on the uncertain asset can be ranked according to their monotone likelihood ratio. It is also shown how ambiguity aversion distorts the price kernel in the alternative portfolio problem with complete markets for contingent claims.