New Formulations of Ambiguous Volatility with an Application to Optimal Dynamic Contracting

TL;DR

This paper introduces new models of ambiguity aversion related to volatility, compares them with existing models, and explores their implications in portfolio choice, contracting, and asset pricing.

Contribution

It proposes novel preference formulations for ambiguity about volatility and analyzes their effects in static and dynamic economic models.

Findings

Ambiguity aversion influences portfolio choices and contract design.

New formulations differ from maxmin expected utility and variational models.

Implications for investor beliefs and asset pricing are discussed.

Abstract

I introduce novel preference formulations which capture aversion to ambiguity about unknown and potentially time-varying volatility. I compare these preferences with Gilboa and Schmeidler's maxmin expected utility as well as variational formulations of ambiguity aversion. The impact of ambiguity aversion is illustrated in a simple static model of portfolio choice, as well as a dynamic model of optimal contracting under repeated moral hazard. Implications for investor beliefs, optimal design of corporate securities, and asset pricing are explored.