IDEAS home Printed from
MyIDEAS: Login to save this article or follow this journal

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

  • Massimo Guidolin
  • Francesca Rinaldi

The 2007-2008 financial crisis has made it painfully obvious that markets may quickly turn illiquid. Moreover, recent experience has shown 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 ambiguity-averse investors who trade in the market for a risky asset. We show that, provided there is a sufficient amount of ambiguity, market breakdowns 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 analyse 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. 'The trading of legacy loans and securities continues to reveal systematic underpricing at issuance of once seemingly benign risks-credit, liquidity, counterparty, and even sovereign risks […] Until these assessments are more clearly refined and more broadly understood, we are likely to observe elevated levels of volatility and unwillingness by many investors to participate in certain asset markets at virtually any price.' (Warsh, 2009, emphasis added)

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: Access to full text is restricted to subscribers.

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Taylor & Francis Journals in its journal Applied Financial Economics.

Volume (Year): 20 (2010)
Issue (Month): 1-2 ()
Pages: 105-135

in new window

Handle: RePEc:taf:apfiec:v:20:y:2010:i:1-2:p:105-135
Contact details of provider: Web page:

Order Information: Web:

References listed on IDEAS
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.:

as in new window
  1. Bryan R. Routledge & Stanley E. Zin, 2001. "Model Uncertainty and Liquidity," NBER Working Papers 8683, National Bureau of Economic Research, Inc.
  2. 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 165, University of Oxford, Department of Economics.
  3. Larry Epstein & Martin Schneider, 2005. "Ambiguity, Information Quality and Asset Pricing," RCER Working Papers 519, University of Rochester - Center for Economic Research (RCER).
  4. Mukerji, Sujoy & Tallon, Jean-Marc, 2001. "Ambiguity Aversion and Incompleteness of Financial Markets," Review of Economic Studies, Wiley Blackwell, vol. 68(4), pages 883-904, October.
  5. Fabio Maccheroni & Massimo Marinacci & Aldo Rustichini, 2004. "Ambiguity Aversion, Robustness, and the Variational Representation of Preferences," Carlo Alberto Notebooks 12, Collegio Carlo Alberto, revised 2006.
  6. 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.
  7. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
  8. Larry G. Epstein, 2001. "Sharing Ambiguity," American Economic Review, American Economic Association, vol. 91(2), pages 45-50, May.
  9. David Easley & Maureen O'Hara, 2010. "Microstructure and Ambiguity," Journal of Finance, American Finance Association, vol. 65(5), pages 1817-1846, October.
  10. Paul Mizen, 2008. "The credit crunch of 2007-2008: a discussion of the background, market reactions, and policy responses," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 531-568.
  11. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  12. Nicholas Barberis & Richard Thaler, 2002. "A Survey of Behavioral Finance," NBER Working Papers 9222, National Bureau of Economic Research, Inc.
  13. Thomas J. Sargent & LarsPeter Hansen, 2001. "Robust Control and Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 60-66, May.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:taf:apfiec:v:20:y:2010:i:1-2:p:105-135. 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: (Michael McNulty)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.