| 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 |