Date of this Version
The Journal of Finance
I study the effects of risk and ambiguity (Knightian uncertainty) on optimal portfolios and equilibrium asset prices when investors receive information that is difficult to link to fundamentals. I show that the desire of investors to hedge ambiguity leads to portfolio inertia and excess volatility. Specifically, when news is surprising, investors may not react to price changes even if there are no transaction costs or other market frictions. Moreover, I show that small shocks to cash flow news, asset betas, or market risk premia may lead to drastic changes in the stock price and hence to excess volatility.
This is the peer reviewed version of the following article, which has been published in final form at http://dx.doi.org/10.1111/j.1540-6261.2011.01693.x. This article may be used for non-commercial purposes in accordance with Wiley Terms and Conditions for Self-Archiving.
Illeditsch, P. K. (2011). Ambiguous Information, Portfolio Inertia, and Excess Volatility. The Journal of Finance, 66 (6), 2213-2247. http://dx.doi.org/10.1111/j.1540-6261.2011.01693.x
Date Posted: 27 November 2017
This document has been peer reviewed.