Asset Prices and Ambiguity

Abstract

Modern portfolio theory, developed in the expected utility paradigm, focuses on the relationship between risk and return, assuming away ambiguity, uncertainty over the probability space. In this paper, we assume that ambiguity affects asset prices and we test the relationship between risk, ambiguity and return based on a model developed by Izhakian (2011). Our contribution is twofold; we propose an ambiguity measure that is derived theoretically and computed from intraday stock market prices. Second, we use it in conjunction with risk measures to test the basic relationship between risk, ambiguity and return. We find that our ambiguity measure has a consistently negative effect on returns and that our risk measure has mostly a positive effect. The best evidence, judging by statistical significance, is obtained when we use the change in volatility alongside the measure of ambiguity.