This paper examines the relationship between investors' ambiguity in the financial options market and systemic banks' risk. Eliciting ambiguity information from option pricing data on the twelve major U.S. banks between 2003 and 2010, we show that higher behavioral deviations from risk-neutral and Bayesian valuation (i.e., investor ambiguity) are associated with higher systemic banks' downside, market and credit risks. Consistent with behavioral explanations, we confirm the detrimental effect of ambiguity on financial market outcomes and find strong evidence of ambiguity among call and put option holders. Variance decomposition indicates that such a pattern of behavior explains a significant proportion of U.S. banking risk variance. This effect is more pronounced during periods of economic turbulence and bank stress (i.e., the 2007–2009 crisis), and holds after controlling for size, tail risk, implied volatility, and volatility of volatility dynamics. We also document that ambiguity from the financial market has a depressing impact on real economic activity, including capacity utilization, non-farm payrolls and overall economic performance. Our findings are robust to alternative specifications of ambiguity such as multiple priors and expected utilities with uncertain probabilities.

We provide new evidence on the economic role of growth options behind the profitability, distress, lotteryness, and volatility anomalies. We use idiosyncratic skewness to measure growth options and estimate expected idiosyncratic skewness capturing investors’ expectations about the firm’s mix of growth options versus assets-in-place. We find that investors require a positive premium to hold stocks of inflexible firms with low growth options and negative expected skewness and that a newly proposed skewness factor based on growth options explains the aforementioned anomalies. Thus, the new measure of expected idiosyncratic skewness may serve to reduce the number of anomalies in the literature.