Ambiguous Information, Risk Aversion, and Asset Pricing

I study the effects of aversion to risk and ambiguity (uncertainty in the sense of Knight (1921)) on the value of the market portfolio when investors receive public information that they find difficult to link to fundamentals and hence treat as ambiguous. I show that small changes in public information can produce large changes in the stock price and systemic negative news may lead to higher valuations of the stock market than idiosyncratic negative events. Aversion to risk and ambiguity can explain high expected stock market returns and excess volatility and kurtosis of stock market returns. Moreover, the skewness of stock returns is negative (positive) if risk aversion of the marginal investor is high (low).