Model Uncertainty and Liquidity
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)
Volume (Year): 12 (2009)
Issue (Month): 4 (October)
|Contact details of provider:|| Postal: Marina Azzimonti, Department of Economics, Stonybrook University, 10 Nicolls Road, Stonybrook NY 11790 USA|
Web page: http://www.EconomicDynamics.org/red/
More information through EDIRC
|Order Information:|| Web: https://www.economicdynamics.org/subscription-information/ Email: |
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.:
- Gilboa, Itzhak & Schmeidler, David, 1989.
"Maxmin expected utility with non-unique prior,"
Journal of Mathematical Economics,
Elsevier, vol. 18(2), pages 141-153, April.
- David Schmeidler, 1989.
"Subjective Probability and Expected Utility without Additivity,"
Levine's Working Paper Archive
7662, David K. Levine.
- Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-87, May.
- Itzhak Gilboa, 1987.
"Expected Utility with Purely Subjective Non-Additive Probabilities,"
- Gilboa, Itzhak, 1987. "Expected utility with purely subjective non-additive probabilities," Journal of Mathematical Economics, Elsevier, vol. 16(1), pages 65-88, February.
- Ho, Thomas & Stoll, Hans R., 1981.
"Optimal dealer pricing under transactions and return uncertainty,"
Journal of Financial Economics,
Elsevier, vol. 9(1), pages 47-73, March.
- Thomas Ho & Hans Stoll, . "Optimal Dealer Pricing Under Transactions and Return Uncertainty," Rodney L. White Center for Financial Research Working Papers 27-79, Wharton School Rodney L. White Center for Financial Research.
- Grossman, S.J. & Miller, M.H., 1988.
"Liquidity And Market Structure,"
88, Princeton, Department of Economics - Financial Research Center.
- Lars Peter Hansen & Thomas J. Sargent & Thomas D. Tallarini Jr., 1997.
"Robust Permanent Income and Pricing,"
Levine's Working Paper Archive
596, David K. Levine.
- Larry G. Epstein, 2001. "Sharing Ambiguity," American Economic Review, American Economic Association, vol. 91(2), pages 45-50, May.
- Alessandro Prati & Massimo Sbracia, 2002.
"Currency crises and uncertainty about fundamentals,"
Temi di discussione (Economic working papers)
446, Bank of Italy, Economic Research and International Relations Area.
- M. Sbracia & Alessandro Prati, 2002. "Currency Crises and Uncertainty About Fundamentals," IMF Working Papers 02/3, International Monetary Fund.
- Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
- 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.
- Lawrence H. Summers, 2000. "International Financial Crises: Causes, Prevention, and Cures," American Economic Review, American Economic Association, vol. 90(2), pages 1-16, May.
- David A. Marshall, 2001. "The crisis of 1998 and the role of the central bank," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q I, pages 2-23.
- Myron S. Scholes, 2000. "Crisis and Risk Management," American Economic Review, American Economic Association, vol. 90(2), pages 17-21, May.
When requesting a correction, please mention this item's handle: RePEc:red:issued:08-143. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christian Zimmermann)
If references are entirely missing, you can add them using this form.