Uncertainty and Risk in Financial Markets
AbstractThis paper considers a general equilibrium model in which the distinction between un-certainty and risk is formalized by assuming agents have incomplete preferences over state-contingent consumption bundles, as in Bewley (1986). Without completeness, individual decision making depends on a set of probability distributions over the state space. A bundle is preferred to another if and only if it has larger expected utility for all probabilities in this set. When preferences are complete this set is a singleton, and the model reduces to standard expected utility. In this setting, we characterize Pareto optima and equilibria, and show that the presence of uncertainty generates robust indeterminacies in equilibrium prices and allocations for any specification of initial endowments. We derive comparative statics results linking the degree of uncertainty with changes in equilibria. Despite the presence of robust indeterminacies, we show that equilibrium prices and allocations vary continuously with underlying fundamentals. Equilibria in a standard risk economy are thus robust to adding small degrees of uncertainty. Finally, we give conditions under which some assets are not traded due to uncertainty aversion.
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Bibliographic InfoPaper provided by Department of Economics, Institute for Business and Economic Research, UC Berkeley in its series Department of Economics, Working Paper Series with number qt6m42r5rr.
Date of creation: 02 Nov 2001
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Other versions of this item:
- Rigotti, Luca & Shannon, Chris, 2001. "Uncertainty and Risk in Financial Markets," Department of Economics, Working Paper Series qt7pp7113z, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
- Luca Rigotti & Chris Shannon=20, 2002. "Uncertainty and Risk in Financial Markets," Game Theory and Information 0201001, EconWPA.
- D0 - Microeconomics - - General
- D5 - Microeconomics - - General Equilibrium and Disequilibrium
- D8 - Microeconomics - - Information, Knowledge, and Uncertainty
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