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Ambiguity Aversion and Incompleteness of Financial Markets

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Author Info
Mukerji, S.
Tallon, J.-M.

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Abstract

We consider a stylized bond-equity economy, which though incomplete per se, has a rich enough set of assets available for trade such that given standard assumptions about behavior under uncertainty, the equilibrium allocation would arbitrarily approximate a complete market allocation. We show, however, that when agents' beliefs are given by a set of probabilities and agents are ambiguity averse, a certain subset of the available assets will not be actually traded in equilibrium, given "sufficient" ambiguity aversion. What determines an asset's vulnerability to ambiguity aversion is whether its payoffs have an idiosyncratic component. If, (1) the range of variation of the payoff's idiosyncratic component is "large" relative to the range of the variation of the component correlated with the endowment vector and, (2) the ambiguity of the agents' common belief about the idiosyncratic component is sufficiently high, then the asset will not be traded in any general equilibrium of the finance economy. Moreover, we also find that the effect of idiosyncracy cannot simply be "washed away" by the standard techniques of diversification relying on the laws of large numbers, as it would be if the agents' beliefs were not ambiguous.

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Publisher Info
Paper provided by Université Panthéon-Sorbonne (Paris 1) in its series Papiers d'Economie Mathématique et Applications with number 1999-28.

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Length: 37 pages
Date of creation: 1999
Date of revision:
Handle: RePEc:fth:pariem:1999-28

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Postal: France; Universite de Paris I - Pantheon- Sorbonne, 12 Place de Pantheon-75005 Paris, France
Web page: http://cermsem.univ-paris1.fr/
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Related research
Keywords: MARKET ; RISK ; TRADE;

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Find related papers by JEL classification:
D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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Full references

Cited by:
(explanations, 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.)

  1. Fujikawa, Takemi, 2009. "The hot stove effect in repeated-play decision making under ambiguity," MPRA Paper 17647, University Library of Munich, Germany. [Downloadable!]
  2. Riddel, Mary & Shaw, W. Douglass, 2006. "A Theoretically-Consistent Empirical Non-Expected Utility Model of Ambiguity: Nuclear Waste Mortality Risk and Yucca Mountain," Pre-Prints 23964, Texas A&M University, Department of Agricultural Economics. [Downloadable!]
  3. Akay, Alpaslan & Martinsson, Peter & Medhin, Haileselassie & Trautmann, Stefan T., 2009. "Attitudes toward Uncertainty among the Poor: Evidence from Rural Ethiopia," IZA Discussion Papers 4225, Institute for the Study of Labor (IZA). [Downloadable!]
  4. Carmela Mauro, 2008. "Uncertainty Aversion Vs. Competence: An Experimental Market Study," Theory and Decision, Springer, vol. 64(2), pages 301-331, March. [Downloadable!] (restricted)
  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!]
    Other versions:
  6. Stoneman, Paul & Canepa, Alessandra & Kaivanto, Kim, 2004. "The Public Provision of Sales Contingent Contracts as a Policy Response to Financial Constraints to Innovation in European SMEs," EIFC - Technology and Finance Working Papers 38, United Nations University, Institute for New Technologies. [Downloadable!]
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  7. Jean-Marc Tallon & Sujoy Mukerji, 2004. "Ambiguity aversion and the absence of wage indexation," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00174562_v1, HAL. [Downloadable!]
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  8. Jürgen Eichberger & David Kelsey, 2007. "Ambiguity," Working Papers 0448, University of Heidelberg, Department of Economics, revised Jul 2007. [Downloadable!]
    Other versions:
  9. Thibault Gajdos & Takashi Hayashi & Jean-Marc Tallon & Jean-Christophe Vergnaud, 2006. "Attitude toward imprecise information," Cahiers de la Maison des Sciences Economiques v06081, Université Panthéon-Sorbonne (Paris 1). [Downloadable!]
    Other versions:
  10. Thibault Gajdos & Jean-Marc Tallon & Jean-Christophe Vergnaud, 2002. "Coping with imprecise information : a decision theoretic approach," Cahiers de la Maison des Sciences Economiques v04056, Université Panthéon-Sorbonne (Paris 1), revised May 2004. [Downloadable!]
    Other versions:
  11. Mercè Roca & Robin Hogarth & A. Maule, 2006. "Ambiguity seeking as a result of the status quo bias," Journal of Risk and Uncertainty, Springer, vol. 32(3), pages 175-194, May. [Downloadable!] (restricted)
  12. Fabio Maccheroni & Massimo Marinacci & Aldo Rustichini, 2006. "Dynamic Variational Preferences," Carlo Alberto Notebooks 1, Collegio Carlo Alberto. [Downloadable!]
    Other versions:
  13. Luca Rigotti & Chris Shannon, 2001. "Uncertainty and Risk in Financial Markets," Department of Economics, Working Paper Series 1000, Department of Economics, Institute for Business and Economic Research, UC Berkeley. [Downloadable!]
    Other versions:
  14. Massimo Guidolin & Francesca Rinaldi, 2009. "A simple model of trading and pricing risky assets under ambiguity: any lessons for policy-makers?," Working Papers 2009-020, Federal Reserve Bank of St. Louis. [Downloadable!]
  15. Aldo Montesano, 2009. "Risk allocation and uncertainty: some unpleasant outcomes of financial innovation," International Review of Economics, Springer, vol. 56(3), pages 243-250, September. [Downloadable!] (restricted)
  16. Carlos Carvalho & Nicholas Klagge & Emanuel Moench, 2009. "The persistent effects of a false news shock," Staff Reports 374, Federal Reserve Bank of New York. [Downloadable!]
  17. Larry Epstein & Martin Schneider, 2005. "Ambiguity, Information Quality and Asset Pricing," RCER Working Papers 519, University of Rochester - Center for Economic Research (RCER). [Downloadable!]
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  18. Sujoy Mukerji & Jean-Marc Tallon, 2001. "Ambiguity Aversion and Incompleteness of Financial Markets," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00174539_v1, HAL. [Downloadable!]
    Other versions:
  19. Stefan Trautmann & Ferdinand Vieider & Peter Wakker, 2008. "Causes of ambiguity aversion: Known versus unknown preferences," Journal of Risk and Uncertainty, Springer, vol. 36(3), pages 225-243, June. [Downloadable!] (restricted)
  20. Mary Riddel & W. Shaw, 2006. "A theoretically-consistent empirical model of non-expected utility: An application to nuclear-waste transport," Journal of Risk and Uncertainty, Springer, vol. 32(2), pages 131-150, March. [Downloadable!] (restricted)
  21. Aldo Montesano, 2008. "Effects of Uncertainty Aversion on the Call Option Market," Theory and Decision, Springer, vol. 65(2), pages 97-123, September. [Downloadable!] (restricted)
  22. Gomes, F. A. R., 2007. "The Effect of Future Income Uncertainty in Savings Decision," Ibmec Working Papers wpe_72, Ibmec Working Paper, Ibmec São Paulo. [Downloadable!]
  23. Sujoy Mukerji, 2003. "Ambiguity Aversion and Cost-Plus Procurement Contracts," Economics Series Working Papers 171, University of Oxford, Department of Economics. [Downloadable!]
    Other versions:
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