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

See all articles by Yehuda (Yud) Izhakian

Yehuda (Yud) Izhakian

City University of New York, Baruch College - Zicklin School of Business - Department of Economics and Finance

Simon Benninga

Tel Aviv University - Faculty of Management

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

Izhakian, Yehuda (Yud) and Benninga, Simon, The Uncertainty Premium in an Ambiguous Economy (June 26, 2007). The Quarterly Journal of Finance, 2011, vol. 1 (2), pp. 323-354, Available at SSRN: https://ssrn.com/abstract=951149 or http://dx.doi.org/10.2139/ssrn.951149

Yehuda (Yud) Izhakian (Contact Author)

City University of New York, Baruch College - Zicklin School of Business - Department of Economics and Finance ( email )

17 Lexington Avenue
New York, NY 10010
United States

HOME PAGE: http://people.stern.nyu.edu/yizhakia/

Simon Benninga

Tel Aviv University - Faculty of Management ( email )

P.O. Box 39010
Ramat Aviv, Tel Aviv, 69978
Israel
+972-3-640-6317 (Phone)
+972-2-673-4675 (Fax)

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