Return Ambiguity, Portfolio Choice, and Asset Pricing

We formulate a tractable continuous-time rational expectations model in which the agent is ambiguity averse and would like to robustify asset return specification. Ambiguity affects the portfolio rule and asset pricing both individually and collectively with risk. Independently existing ambiguity premium helps to explain why investors appear to underinvest in risky assets and do not exploit the asymptotic arbitrage opportunity emerged from trading inertia where return volatility (risk) is nearly zero (Campbell and Cochrane, 1999). Calibration of our Lucas-style model to the annual and quarterly U.S. asset prices and consumption data yields a relative risk aversion coefficient of five, and attributes 23%, 41%, and 36% of the equity premium to risk, ambiguity, and their interactions, respectively