
Market dynamics: belief, risk, and ambiguity effects
To understand financial market dynamics, it is helpful to distinguish beliefs, attitudes towards risk, and attitudes towards ambiguity. Beliefs are subjective evaluations of future cash flows. Risk refers to uncertainty within a model of the asset’s return. And ambiguity means uncertainty about the model and probability distributions. Accordingly, one can separate price dynamics into three effects: changes in beliefs, changes in risk premia and changes in ambiguity premia. Ambiguity premia seem to be dominant, particularly when investors have little information about the nature of a particular risk. Traditional risk premia seem to be much less significant. Belief effects are negligible when ambiguity is high but increase as information accumulates. Often trading opportunities arise from the mean reversion of ambiguity premia and the “under-adjustment” of beliefs.