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 "notrade 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 OHara (2009) investigated the implications of
ambiguity aversion for performance and regulation of markets. They demonstrate that nonparticipation 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 OHara, 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.