Literature Review

The changes in stock market participation have been extensively studied using the theoretical models of Portfolio choice. These models that incorporate ambiguity predict that investors propensity to invest in equities is reduced when ambiguity in the stock market increases.

The seminal work of Ellsberg suggests that people behave differently in risky situations when they are given objective probabilities than in ambiguous situations when they are not told the odds. Since then, several authors have argued that ambiguity is relevant to financial markets.

Dow and Werlang (1992) show that when traders are ambiguity averse there exists a "no-trade zone" of prices for which investors neither buy nor sell. These investors solve typical portfolio choice problems, choosing between a riskless and an ambiguous asset to optimize their own welfare. An important class of investors purchases assets, primarily derivatives, in order to hedge against financial risks created by their core activities. If returns on assets are ambiguous and if these potential hedgers are ambiguity averse, no-trade zones such as those found by Dow and Werlang would inhibit the use of financial derivatives to hedge against inherent risk because the no-trade zones raise the possibility that no sellers will offer instruments that hedgers will buy.

Mukerji and Tallon (2001) study points out that ambiguity aversion can exacerbate the tension between the two kinds of risks namely, Incomes risks and Idiosyncratic risk, to the point that classes of agents may not want to trade financial assets, thus making risk sharing opportunities offered by financial markets less complete than it would be otherwise.

Similarly, David Easley and Maureen O’Hara (2009) investigated the implications of ambiguity aversion for performance and regulation of markets. They demonstrate that non-participation arises from the rational decision by some traders to avoid ambiguity. In equilibrium, these participation decisions affect the equilibrium risk premium, and distort market performance when viewed from the perspective of traditional asset pricing models. They demonstrate how regulation, particularly regulation of unlikely events, can moderate the effects of ambiguity, thereby increasing participation and generating welfare gains.

Epstein and Schneider (2010) study also reviews models of ambiguity aversion. It shows that such models-in particular, the multiple-priors model of Gilboa and Schmeidler - have implications for portfolio choice and asset pricing that are very different from those of Subjective Expected Utility (SEU).

Antoniou, RDF Harris, R Zhang (2015) finally tests the hypothesis, measuring participation using equity fund flows and Ambiguity with dispersion in analyst forecasts about aggregate returns and confirms that controlling for other factors that affect flows, increases in ambiguity are associated with outflows from equity funds. Moreover, they also conclude that increases in ambiguity significantly reduce the likelihood that the average household invests in equities.

In the light of the above discussion, General objective of my research would be to examine Ambiguity aversion and its effect on stock market participation in India.

References

Dow, J., Werlang, S., 1992. Ambiguity aversion, Risk aversion and the optimal choice of portfolio, Econometrica.

Mukerji, S., Tallon, J.M., 2001. Ambiguity aversion and incompleteness of financial markets, Review of Economic studies.

David Easley and Maureen O’Hara, 2009. Ambiguity and Nonparticipation: The role of regulation, Review of financial studies.

Epstein and Schneider, 2010. Ambiguity and Asset market, Annual review of financial economics.

Antoniou, RDF Harris, R Zhang, 2015. Ambiguity aversion and stock market participation, Journal of banking and finance.