This paper introduces changes in the level of ambiguity as a complementary source of time-varying risk aversion. We show in a consumption-based asset pricing model with simultaneously risky and ambiguous assets that a rise in the level of ambiguity raises investors' risk aversion. The effect is quantified in an application to European sovereign debt markets using a structural VAR to achieve identification in the data. We proxy for ambiguity using a measure of macroeconomic uncertainty and decompose empirically credit default swaps (CDS) for Spain and Italy into three shocks: fundamental default risk, risk aversion, and uncertainty. We find that shocks to uncertainty significantly increase international investors' risk aversion, accounting for about one fifth of its variation at a five week horizon, and have a significant and economically relevant impact on sovereign financing premia.
Time-varying risk aversion Ambiguity Uncertainty Sovereign debt Identification via heteroscedasticity Maxmin