Dynamic Asset Pricing with {\alpha}-MEU Model

TL;DR

This paper develops a dynamic asset pricing model incorporating ambiguity aversion using the {\alpha}-maxmin expected utility, demonstrating how perceived ambiguity influences key asset prices and market equilibrium.

Contribution

It introduces a novel intra-personal equilibrium framework for ambiguity-averse agents in dynamic asset markets and proves the existence and uniqueness of equilibrium prices.

Findings

Higher perceived ambiguity lowers the risk-free rate.

Increased ambiguity raises stock prices and risk premiums.

Ambiguity perception reduces stock volatility.

Abstract

We study a dynamic asset pricing problem in which a representative agent is ambiguous about the aggregate endowment growth rate and trades a risky stock, human capital, and a risk-free asset to maximize her preference value of consumption represented by the {\alpha}-maxmin expected utility model. This preference model is known to be dynamically inconsistent, so we consider intra-personal equilibrium strategies for the representative agent and define the market equilibrium as the one in which the strategy that clears the market is an intra-personal equilibrium. We prove the existence and uniqueness of the market equilibrium and show that the asset prices in the equilibrium are the same as in the case when the agent does not perceive any ambiguity but believes in a particular probabilistic model of the endowment process. We show that with reasonable parameter values, the more ambiguity the agent perceives or the more ambiguity-averse she is, the lower the risk-free rate, the higher the stock price, the higher the stock risk premium, and the lower the stock volatility.