The Uncertainty Premium in an Ambiguous Economy
The Quarterly Journal of Finance, 2011, vol. 1 (2), pp. 323-354
44 Pages Posted: 12 Dec 2006 Last revised: 8 Mar 2021
Date Written: June 26, 2007
Abstract
The uncertainty premium is the premium that is derived from not knowing the sure outcome (risk premium) and from not knowing the precise odds of outcomes (ambiguity premium). We generalize Pratt's risk premium to uncertainty premium based on Klibanoff, Marinacci and Mukerji (2005) smooth model of ambiguity. We show that the uncertainty premium can decrease with an increase in decision maker's risk aversion. This happens because increasing risk aversion always results in a lower ambiguity premium. The positive ambiguity premium may provide an additional explanation to the equity premium puzzle.
Keywords: Ambiguity, risk aversion, ambiguity aversion, uncertainty, utility
JEL Classification: G12, D81
Suggested Citation: Suggested Citation
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