Ambiguity and Nonparticipation: The Role of Regulation

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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.

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