Revisiting the CAPM: pricing ambiguity and the size factor

This paper models ambiguity as a second dimension of investor preferences, extending the CAPM framework to incorporate ambiguity aversion alongside risk aversion. We derive an asset pricing model under ambiguity that leads to the emergence of a size factor. Market simulations demonstrate that the size factor's impact contradicts its empirical characterization in the literature. This is because extreme ambiguity is associated with the equally weighted portfolio, such that larger deviations from this reference point command a greater premium. Additionally, ambiguity introduces heterogeneity in equity portfolio holdings, influencing the determination of the risk-free rate. The risk-free rate in our model can be endogenously determined through market equilibrium or remain exogenous if set by an external agency balancing aggregate demand to meet macroeconomic objectives beyond the model's scope.