A simple model of trading and pricing risky assets under ambiguity: any lessons for policy-makers?
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)
Volume (Year): 20 (2010)
Issue (Month): 1-2 ()
|Contact details of provider:|| Web page: http://www.tandfonline.com/RAFE20|
|Order Information:||Web: http://www.tandfonline.com/pricing/journal/RAFE20|
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.:
- Bryan R. Routledge & Stanley E. Zin, 2001.
"Model Uncertainty and Liquidity,"
NBER Working Papers
8683, National Bureau of Economic Research, Inc.
- Bryan Routledge & Stanley Zin, . "Model Uncertainty and Liquidity," GSIA Working Papers 2001-E17, Carnegie Mellon University, Tepper School of Business.
- Bryan R. Routledge, Stanley E. Zin, 2000. "Model Uncertainity And Liquidity," Computing in Economics and Finance 2000 368, Society for Computational Economics.
- Bryan R. Routledge & Stanley E. Zin, 2000. "Model Uncertainty and Liquidity," Econometric Society World Congress 2000 Contributed Papers 1617, Econometric Society.
- 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.
- Sujoy Mukerji & Jean-Marc Tallon, 2004. "An overview of economic applications of David Schmeidler's models of decision making under uncertainty," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00502534, HAL.
- Larry Epstein & Martin Schneider, 2005.
"Ambiguity, Information Quality and Asset Pricing,"
RCER Working Papers
519, University of Rochester - Center for Economic Research (RCER).
- 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.
- Mukerji, S. & Tallon, J.-M., 1999. "Ambiguity Aversion and Incompleteness of Financial Markets," Papiers d'Economie MathÃ©matique et Applications 1999-28, UniversitÃ© PanthÃ©on-Sorbonne (Paris 1).
- Sujoy Mukerji & Jean-Marc Tallon, 2000. "Ambiguity Aversion and Incompleteness of Financial Markets," Economics Series Working Papers 46, University of Oxford, Department of Economics.
- Sujoy Mukerji & Jean-Marc Tallon, 2001. "Ambiguity Aversion and Incompleteness of Financial Markets," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00174539, HAL.
- 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.
- Fabio Maccheroni & Massimo Marinacci & Aldo Rustichini, 2006. "Ambiguity Aversion, Robustness, and the Variational Representation of Preferences," Econometrica, Econometric Society, vol. 74(6), pages 1447-1498, November.
- 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.
- Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
- Larry G. Epstein, 2001. "Sharing Ambiguity," American Economic Review, American Economic Association, vol. 91(2), pages 45-50, May.
- David Easley & Maureen O'Hara, 2010. "Microstructure and Ambiguity," Journal of Finance, American Finance Association, vol. 65(5), pages 1817-1846, October.
- 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.
- Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
- Nicholas Barberis & Richard Thaler, 2002.
"A Survey of Behavioral Finance,"
NBER Working Papers
9222, National Bureau of Economic Research, Inc.
- Thomas J. Sargent & LarsPeter Hansen, 2001. "Robust Control and Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 60-66, May.
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 references are entirely missing, you can add them using this form.