Risk versus Ambiguity and International Security Design

This paper studies portfolio allocation in the international financial market when investors exhibit ambiguity aversion towards assets issued in foreign locations. Entrepreneurs located in each country have access to a risky technology and want to attract capital. The authors characterize contracts issued by firms in such an environment. Increases in the variance of the risky production process causes firms to increase the variable payment (equity) offered to investors. On the other hand, increases in investor ambiguity lead to less risk-sharing. Entrepreneurs located in countries with low levels of domestic wealth issue assets with a higher fixed payment and a lower risky payment. As a result, they are exposed to higher volatility per unit of consumption as they finance themselves relatively more through debt than equity. An increase in ambiguity or ambiguity aversion that characterizes crises may explain flight of capital to capital-abundant countries – dubbed sometimes as “flight to quality”.