Ambiguity, Risk Aversion and Excess Volatility

Abstract

The paper investigates how ambiguous information in stock markets affects the occurrence of excess volatility of stock prices. To do this, we adopt the framework of Grossman and Stiglitz (1980) where uninformed traders have ambiguous information about a stock’s fundamental value. First, we find that excess volatility never arises when only uninformed traders without ambiguous information are risk-neutral. Including ambiguity and risk aversion in our model, we carefully investigate the roles of ambiguity and risk aversion in generating excess volatility. In generating excess volatility, the role of ambiguity depends on risk aversion. If the degree of risk aversion is sufficiently low, excess volatility does not arise, even when the degree of ambiguity is extremely high. On the contrary, if traders are sufficiently risk-averse, excess volatility occurs irrespective of ambiguity. Only when traders are moderately risk-averse, a higher degree of ambiguity leads to a higher likelihood of excess volatility.