A simple model of trading and pricing risky assets under ambiguity: any lessons for policy-makers?

A simple model of trading and pricing risky assets under ambiguity: any lessons for policy-makers?
Document type
Working Paper
Author(s)
Guidolin, Massimo; Rinaldi, Francesca
Publisher
Manchester Business School
Date of publication
1 October 2009
Series
University of Manchester Business School Working Papers. No. 580
Subject(s)
Trends: economic, social and technology trends affecting business
Collection
Business and management
Material type
Reports

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The 2007-2008 financial crises 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 by ambiguity-averse investors that trade in the market for a risky asset. This paper shows that, provided there is a sufficient amount of ambiguity, market breakdowns where large portions of traders withdraw from trading are endogeneous 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.

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