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A simple model of trading and pricing risky assets under ambiguity: any lessons for policy-makers?

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Massimo Guidolin
Francesca Rinaldi

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Abstract

The 2007-2008 financial crises has made it painfully obvious that markets may quickly turn illiquid. Moreover, recent experience has taught us that distress and lack of active trading can jump "around" between seemingly unconnected parts of the financial system contributing to transforming isolated shocks into systemic panic attacks. We develop a simple two-period model populated by both standard expected utility maximizers and by ambiguity-averse investors that trade in the market for a risky asset. We show that, provided there is a sufficient amount of ambiguity, market break-downs where large portions of traders withdraw from trading are endogenous and may be triggered by modest re-assessments of the range of possible scenarios on the performance of individual securities. Risk premia (spreads) increase with the proportion of traders in the market who are averse to ambiguity. When we analyze the effect of policy actions, we find that when a market has fallen into a state of impaired liquidity, bringing the market back to orderly functioning through a reduction in the amount of perceived ambiguity may cause further reductions in equilibrium prices. Finally, our model provides stark indications against the idea that policy makers may be able to "inflate" their way out of a financial crisis.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2009-020.

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Date of creation: 2009
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Handle: RePEc:fip:fedlwp:2009-020

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Related research
Keywords: Risk ; Capital assets pricing model ; Financial crises ; Federal Reserve System;

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References listed on IDEAS
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  4. Barberis, Nicholas & Thaler, Richard, 2003. "A survey of behavioral finance," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 18, pages 1053-1128 Elsevier. [Downloadable!] (restricted)
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  5. Sujoy Mukerji & Jean-Marc Tallon, 2003. "An overview of economic applications of David Schmeidler`s models of decision making under uncertainty," Economics Series Working Papers 172, University of Oxford, Department of Economics. [Downloadable!]
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  6. Larry G. Epstein, 2001. "Sharing Ambiguity," American Economic Review, American Economic Association, vol. 91(2), pages 45-50, May. [Downloadable!] (restricted)
  7. Dow, James & Werlang, Sergio Ribeiro da Costa, 1992. "Uncertainty Aversion, Risk Aversion, and the Optimal Choice of Portfolio," Econometrica, Econometric Society, vol. 60(1), pages 197-204, January. [Downloadable!] (restricted)
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  11. Sujoy Mukerji & Jean-Marc Tallon, 2000. "Ambiguity Aversion and Incompleteness of Financial Markets," Economics Series Working Papers 046, University of Oxford, Department of Economics. [Downloadable!]
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