Trading Ambiguity : A Tale of Two Heterogeneities

We consider financial markets with heterogeneously ambiguous assets and heterogeneously ambiguity averse investors. Investors' preferences, a version of the smooth ambiguity model, are a parsimonious extension of the standard mean-variance framework. We consider, in a unified setting, portfolio choice, equilibrium prices, and trade upon arrival of public information, and show, in each case, there are departures from the outcome in standard theory. These departures are of significance as they occur in the direction of empirical regularities that belie the standard theory. In particular, our theory speaks to several puzzling phenomena in a unified fashion: the asset allocation puzzle, the beta, size and value anomalies, and the observation that earnings announcements are often followed by significant trading volume with small price change. Our findings parallel the recent developments in the macro-finance literature where ambiguity aversion has been shown to successfully address aggregate pricing puzzles such as the dynamics of equity premium and excess volatility. Many of the alternative new theories, which are good at explaining these aggregate puzzles, do not have similar explanatory power when it comes to cross-sectional puzzles discussed in this paper