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Model Uncertainty and Liquidity

Author

Listed:
  • Bryan R. Routledge

    (Carnegie Mellon University)

  • Stanley E. Zin

    (Carnegie Mellon University)

Abstract

We investigate the dynamic portfolio problem of a market-maker for a derivative security whose preferences exhibit uncertainty aversion (Knightian uncertainty). The Choquet-expected utility implied by such preference is used to capture the feature that the trader is uncertain about which model should be used. The prices that emerge from the model are similar to standard models and have the feature that as uncertainty is removed, the derivative prices converge to standard prices. However, the optimal changes in the agent's portfolio that results from the option position are quite different than the standard hedge position. It is this feature that links uncertainty with market liquidity.

Suggested Citation

  • Bryan R. Routledge & Stanley E. Zin, 2000. "Model Uncertainty and Liquidity," Econometric Society World Congress 2000 Contributed Papers 1617, Econometric Society.
  • Handle: RePEc:ecm:wc2000:1617
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    References listed on IDEAS

    as
    1. Myron S. Scholes, 2000. "Crisis and Risk Management," American Economic Review, American Economic Association, vol. 90(2), pages 17-21, May.
    2. Grossman, Sanford J & Miller, Merton H, 1988. " Liquidity and Market Structure," Journal of Finance, American Finance Association, vol. 43(3), pages 617-637, July.
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    4. 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.
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    6. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
    7. M. Sbracia & Alessandro Prati, 2002. "Currency Crises and Uncertainty About Fundamentals," IMF Working Papers 02/3, International Monetary Fund.
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    14. Lawrence H. Summers, 2000. "International Financial Crises: Causes, Prevention, and Cures," American Economic Review, American Economic Association, pages 1-16.
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    More about this item

    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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