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Risk versus Ambiguity and International Security Design

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  • Hill, Brian

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  • Michalski, Tomasz

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Abstract

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”.

Suggested Citation

  • Hill, Brian & Michalski, Tomasz, 2014. "Risk versus Ambiguity and International Security Design," HEC Research Papers Series 1032, HEC Paris.
  • Handle: RePEc:ebg:heccah:1032
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    Cited by:

    1. Marcus Miller & Dania Thomas, 2013. "Eurozone sovereign debt restructuring: keeping the vultures at bay," Oxford Review of Economic Policy, Oxford University Press, vol. 29(4), pages 745-763, WINTER.

    More about this item

    Keywords

    ambiguity aversion; risk aversion; debt/equity choice; international capital flows; international insurance; home bias;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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