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Model Uncertainty and Liquidity

Author

Listed:
  • Bryan Routledge

    (Carnegie Mellon University)

  • Stanley Zin

    (Carnegie Mellon University)

Abstract

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)

Suggested Citation

  • Bryan Routledge & Stanley Zin, 2009. "Model Uncertainty and Liquidity," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 543-566, October.
  • Handle: RePEc:red:issued:08-143
    DOI: 10.1016/j.red.2008.10.002
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    References listed on IDEAS

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    More about this item

    Keywords

    Liquidity; Value-at-Risk; Knightian uncertainty; Derivatives; Market microstructure;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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