Asset Prices and Ambiguity
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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 present an asset pricing model developed by Izhakian (2011), which incorporates ambiguity as a second factor (in addition to “risk”). Our contribution is two fold; we propose an ambiguity measure that is derived theoretically and computed from intra-day 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.
–Menachem Brenner and Yehuda Izhakian