Ambiguity premium and transaction costs

We generalize the optimal investment model of an ambiguity averse investor with transaction costs. Along the lines of Maenhout (2004), we first show that ambiguity (or model uncertainty) leads to an increase in effective risk aversion by ambiguity aversion even with transaction costs. We compute the utility cost associated with suboptimal investment decisions, which is the so-called ambiguity premium. We then find that ignoring ambiguity aversion with and without transaction costs generates large ambiguity premia when ambiguity aversion is moderate, and the cost of ignoring it becomes larger with higher ambiguity aversion. This would, thus, still support the importance of ambiguity aversion channel for portfolio choice, even concerning the friction markets. (C) 2021 Elsevier B.V. All rights reserved.