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RFS Advance Access originally published online on January 22, 2009
Review of Financial Studies 2009 22(5):1817-1843; doi:10.1093/rfs/hhn100
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© The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org.

Ambiguity and Nonparticipation: The Role of Regulation

David Easley
Department of Economics, Cornell University

Maureen O’Hara
Johnson Graduate School of Management, Cornell University

Send correspondence to David Easley, Department of Economics, Cornell University, Ithaca, NY 14853, and Maureen O’Hara, Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853. E-mail: dae3{at}cornell.edu, mo19{at}cornell.edu.

JEL Classification: G1, G2, D8


  Abstract

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 generating welfare gains. Our analysis demonstrates how legal systems affect participation in financial markets through their influence on ambiguity.

We would like to thank seminar participants at Arizona State, Cornell University, Dartmouth, HEC-Lausanne, HEC-Paris, INSEAD, the University of Michigan, Yale University, and the Western Finance Associate Meeting. We have also benefited from advice and comments from Matt Spiegel (the editor), an anonymous referee, Franklin Allen, Robert Bloomfield, Ken French, Jerry Hass, Jonathan Ingersoll, Jonathan Macey, Pascal Maenhout, Meijun Qian, and Ramon Uppal.


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