Model Uncertainty and Liquidity
AbstractExtreme market outcomes are often followed by a lack of liquidity and a lack of trade. This market collapse seems particularly acute for derivative markets where traders rely heavily on a specific empirical model. Asset pricing and trading, in these cases, are intrinsically model dependent. Moreover, observed behavior of traders and institutions suggests that attitudes toward "model uncertainty" may be qualitatively different than Savage rationality would suggest. For example, a large emphasis is placed on "worst-case scenarios" through the pervasive use of "stress testing" and "value-at-risk" calculations. In this paper we use Knightian uncertainty to describe model uncertainty, and use Choquet-expected-utility preferences to characterize investors aversion to this uncertainty. We show that an increase in model uncertainty can lead to a reduction in liquidity as measured by the bid-ask spread set by a monopoly market maker. In addition, the non-standard nature of hedging model uncertainty can lead to broader portfolio adjustment effects like "flight to quality" and "contagion." (Copyright: Elsevier)
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Bibliographic InfoArticle provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.
Volume (Year): 12 (2009)
Issue (Month): 4 (October)
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Other versions of this item:
- Bryan Routledge & Stanley Zin, . "Model Uncertainty and Liquidity," GSIA Working Papers 2001-E17, Carnegie Mellon University, Tepper School of Business.
- Bryan R. Routledge & Stanley E. Zin, 2000. "Model Uncertainty and Liquidity," Econometric Society World Congress 2000 Contributed Papers 1617, Econometric Society.
- Bryan Routledge & Stanley Zin, 2009. "Code files for "Model Uncertainty and Liquidity"," Computer Codes 08-143, Review of Economic Dynamics.
- Bryan R. Routledge, Stanley E. Zin, 2000. "Model Uncertainity And Liquidity," Computing in Economics and Finance 2000 368, Society for Computational Economics.
- Bryan R. Routledge & Stanley E. Zin, 2001. "Model Uncertainty and Liquidity," NBER Working Papers 8683, National Bureau of Economic Research, Inc.
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G20 - Financial Economics - - Financial Institutions and Services - - - General
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