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Uncertainty and Risk in Financial Markets

  • Luca Rigotti

    (CentER, Tilburg University)

  • Chris Shannon=20

    (University of California, Berkeley)

This paper considers a general equilibrium model in which the=20 distinction between un-certainty and risk is formalized by assuming agents= =20 have incomplete preferences over state-contingent consumption bundles, as=20 in Bewley (1986). Without completeness, individual decision making depends= =20 on a set of probability distributions over the state space. A bundle is=20 preferred to another if and only if it has larger expected utility for all= =20 probabilities in this set. When preferences are complete this set is a=20 singleton, and the model reduces to standard expected utility. In this=20 setting, we characterize Pareto optima and equilibria, and show that the=20 presence of uncertainty generates robust indeterminacies in equilibrium=20 prices and allocations for any speci=AFcation of initial endowments. We=20 derive comparative statics results linking the degree of uncertainty with=20 changes in equilibria. Despite the presence of robust indeterminacies, we=20 show that equilibrium prices and allocations vary continuously with=20 underlying fundamentals. Equilibria in a standard risk economy are thus=20 robust to adding small degrees of uncertainty. Finally, we give conditions= =20 under which some assets are not traded due to uncertainty aversion.

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Paper provided by EconWPA in its series Game Theory and Information with number 0201001.

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Length: 52 pages
Date of creation: 04 Jan 2002
Date of revision:
Handle: RePEc:wpa:wuwpga:0201001
Note: 52 pages, Acrobat .pdf
Contact details of provider: Web page: http://econwpa.repec.org

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