Extreme 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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Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.
Volume (Year): 12 (2009) Issue (Month): 4 (October) Pages: 543-566 Download reference. The following formats are available: HTML
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Find related papers by JEL classification: 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
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Grossman, S.J. & Miller, M.H., 1988.
"Liquidity And Market Structure,"
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88, Princeton, Department of Economics - Financial Research Center.
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