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