Return Ambiguity, Portfolio Choice, and Asset Pricing

32 Pages Posted: 28 Nov 2017 Last revised: 12 Nov 2018

See all articles by Yu Liu

Yu Liu

Tsinghua University

Hao Wang

Tsinghua University

Lihong Zhang

Tsinghua University - School of Economics & Management

Date Written: November 11, 2018

Abstract

We formulate a tractable continuous-time rational expectations model in which the agent is ambiguity averse and would like to robustify asset return specification. Ambiguity affects the portfolio rule and asset pricing both individually and collectively with risk. Independently existing ambiguity premium helps to explain why investors appear to underinvest in risky assets and do not exploit the asymptotic arbitrage opportunity emerged from trading inertia where return volatility (risk) is nearly zero (Campbell and Cochrane, 1999). Calibration of our Lucas-style model to the annual and quarterly U.S. asset prices and consumption data yields a relative risk aversion coefficient of five, and attributes 23%, 41%, and 36% of the equity premium to risk, ambiguity, and their interactions, respectively.

Keywords: Return ambiguity, model robustness, ambiguity preferences, portfolio choice, asset pricing

JEL Classification: G11, G12

Suggested Citation

Liu, Yu and Wang, Hao and Zhang, Lihong, Return Ambiguity, Portfolio Choice, and Asset Pricing (November 11, 2018). Available at SSRN: https://ssrn.com/abstract=3076606 or http://dx.doi.org/10.2139/ssrn.3076606

Yu Liu

Tsinghua University ( email )

Beijing, 100084
China
86 15210589482 (Phone)

Hao Wang (Contact Author)

Tsinghua University ( email )

318 Weilun Building
Tsinghua University
Beijing, 100084
China
86 10 62797482 (Phone)
86 10 62794554 (Fax)

Lihong Zhang

Tsinghua University - School of Economics & Management ( email )

Beijing, 100084
China

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