Would Ambiguity Averse Investors Hedge Risk in Equity Markets?

This paper studies the conjecture that investors prefer derivative markets over the equity market when hedging risks. An investor who wants to hedge, say inflation or crash risk, generally faces substantially more beta uncertainty in the stock market than in the derivatives market. We show that an investor with smooth ambiguity aversion preferences avoids a hedge portfolio consisting of stocks, which is typically subject to large beta uncertainty. The ambiguity averse investor prefers to hedge using derivatives (TIPS and options) which are not subject to beta uncertainty. More specifically, we show that equilibrium risk premiums for assets with large beta uncertainty (long-short portfolio of stocks) decline once derivatives with less beta uncertainty (TIPS and options) are introduced. In line with this theory, we find that the inflation risk premium is significant and negative before the introduction of TIPS, but has a significant positive change due to the introduction of TIPS.