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Uncertainty and Risk in Financial Markets

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  • Rigotti, Luca
  • Shannon, Chris

Abstract

This paper considers a general equilibrium model in which the=20 distinction between un-certainty and risk is formalized by assuming agents= =20 have incomplete preferences over state-contingent consumption bundles, as=20 in Bewley (1986). Without completeness, individual decision making depends= =20 on a set of probability distributions over the state space. A bundle is=20 preferred to another if and only if it has larger expected utility for all= =20 probabilities in this set. When preferences are complete this set is a=20 singleton, and the model reduces to standard expected utility. In this=20 setting, we characterize Pareto optima and equilibria, and show that the=20 presence of uncertainty generates robust indeterminacies in equilibrium=20 prices and allocations for any speci=AFcation of initial endowments. We=20 derive comparative statics results linking the degree of uncertainty with=20 changes in equilibria. Despite the presence of robust indeterminacies, we=20 show that equilibrium prices and allocations vary continuously with=20 underlying fundamentals. Equilibria in a standard risk economy are thus=20 robust to adding small degrees of uncertainty. Finally, we give conditions= =20 under which some assets are not traded due to uncertainty aversion.

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Bibliographic Info

Paper provided by Department of Economics, Institute for Business and Economic Research, UC Berkeley in its series Department of Economics, Working Paper Series with number qt7pp7113z.

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Date of creation: 01 Nov 2001
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Handle: RePEc:cdl:econwp:qt7pp7113z

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Related research

Keywords: Knightian uncertainty; general equilibrium theory; financial markets; determinancy of equilibria; absence of trade; incomplete preferences; Business; Social and Behavioral Sciences;

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