Ambiguity and Nonparticipation: The Role of Regulation

We investigate the implications of ambiguity aversion for performance and regulation of markets. In our model, agents ’ decision making may incorporate both risk and ambiguity, and we 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. We demonstrate how regulation, particularly regulation of unlikely events, can moderate the effects of ambiguity, thereby increasing participation and gener-ating welfare gains. Our analysis demonstrates how legal systems affect participation in financial markets through their influence on ambiguity. (JEL G1, G2, D8) One of the more puzzling aspects of financial markets is the surprisingly large fraction of individuals who do not participate. For the period 1982–1995, the U.S. Consumer Expenditure Survey found that more than two-thirds of households held neither stocks nor bonds (cited in Paiella 2006). Campbell (2006), using data from the 2001 Survey of Consumer Finance, found that even at the eightieth percentile of wealth, almost 20 % of households had no public equity evenwhen their retirement savings are considered.1 Looking across asset classes reveals similar nonparticipation issues, as does looking internationally, where participation rates are shown to vary substantially across countries.2 Because such behavior is inconsistent with standardmodels of optimal portfolio We would like to thank seminar participants at Arizona State, Cornell University, Dartmouth, HEC-Lausanne