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High Order Smooth Ambiguity Preferences and Asset Prices

This paper extends the recursive smooth ambiguity decision model developed in Klibanoff, Marinacci, and Mukerji (2005, 2009) by relaxing the uniformity imposed on higher order acts. This generalization permits a separation of intertemporal substitution, risk aversion, and ambiguity aversion towards different sources of uncertainty. Our decision model is suited in situations where subjects may treat several kinds of uncertainty in different manners. We apply our preference specification to a consumption-based asset pricing model with long-run risks and assess the impact of ambiguity on asset prices and predictability patterns. We find that modeling attitudes towards uncertainty through high order smooth ambiguity preferences has important implications for asset prices. Our model significantly improves upon the special cases of Epstein and Zin (1989) utility and standard smooth ambiguity preferences.