[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.]

[We use a laboratory market to investigate the behavior of traders who lack informational advantages and have no exogenous reason to trade. We find that these uninformed traders behave largely as irrational contrarian "noise traders," trading against recent price movements to their own detriment. The uninformed traders provide some benefits to the market: increasing market volume and depth, while reducing bid-ask spreads and the temporary price impact of trades. However, their noise trading also diminishes the ability of market prices to adjust to new information. A securities transaction tax reduces uninformed trader activity, but it reduces informed trader activity by approximately the same amount; as a result, the tax does not alter the impact of noise trading on the informational efficiency of the market.]

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.

We use a laboratory market to investigate the behavior of traders who lack informational advantages and have no exogenous reason to trade. We find that these uninformed traders behave largely as irrational contrarian “noise traders,” trading against recent price movements to their own detriment. The uninformed traders provide some benefits to the market: increasing market volume and depth, while reducing bid-ask spreads and the temporary price impact of trades. However, their noise trading also diminishes the ability of market prices to adjust to new information. A securities transaction tax reduces uninformed trader activity, but it reduces informed trader activity by approximately the same amount; as a result, the tax does not alter the impact of noise trading on the informational efficiency of the market.