No abstract

Modern portfolio theory focuses on the relationship between risk and return, assuming away ambiguity, uncertainty over the probability space. This paper assumes that ambiguity affects asset prices and tests the relationship between risk, ambiguity and return based on a model developed by Izhakian (2011). Its contribution is twofold; it proposes an ambiguity measure that is derived theoretically and computed from stock market prices. Second, it uses ambiguity in conjunction with risk to test the basic relationship between risk, ambiguity and return. This paper finds that ambiguity has a consistently negative effect on returns and risk mostly has a positive effect. Asset Pricing and Ambiguity: Empirical Evidence AbstractModern portfolio theory focuses on the relationship between risk and return, assuming away ambiguity, uncertainty over the probability space. This paper assumes that ambiguity affects asset prices and tests the relationship between risk, ambiguity and return based on a model developed by Izhakian (2011). Its contribution is twofold; it proposes an ambiguity measure that is derived theoretically and computed from stock market prices. Second, it uses ambiguity in conjunction with risk to test the basic relationship between risk, ambiguity and return. This paper finds that ambiguity has a consistently negative effect on returns and risk mostly has a positive effect. JEL Classification Codes: D51, D81, G12.Key Words: Ambiguity, Ambiguity measure, Knightian uncertainty, Equity premium. IntroductionThe fundamental relationship between risk and return of the market portfolio in the mean-variance paradigm is given by the following equation where m r is the return on the market portfolio, f r is the risk free rate, 2 m  is the risk of the market portfolio and     is a measure of risk aversion of a representative agent (or, an aggregation of risk aversion coefficients of investors). This linear relationship has been subjected to several time series empirical tests. Merton (1980) and French, Schwert and Stambaugh (1987) are two classic examples of studies that conducted such tests. While Merton (1980) focuses on estimation issues with the expected market return, French at al. (1987) focus more on alternative measures of risk (volatility). In general, the tests of the risk-return relationship have low R 2 and some of these tests result in negative coefficients of absolute risk aversion.We believe that a missing factor that determines the expected excess return presented in equation (1) is ambiguity (the so called Knightian uncertainty) and the attitude towards it.Though there is an abundance of research on various aspects of ambiguity and ambiguity aversion, there is almost no empirical work providing a measure of ambiguity and incorporating such a measure in tests of the relationship between risk and return.In this paper we introduce a measure of ambiguity, which is an additional factor determining the expected excess market return (also termed the equity premium). Equation (2) below is the e...

No abstract

No abstract

No abstract