Ambiguity Aversion, Strategic Trading, and Funding Liquidity

43 Pages Posted: 20 May 2011

Date Written: December 24, 2010

Abstract

In this paper, we consider a single-asset model with two large risk-neutral arbitrageurs and a pool of price-taking value traders facing transitory, stochastic demand arising from noise trading. The model focuses on the optimal liquidation process of a distressed arbitrageur, who is forced to liquidate his existing position over two periods, as well as the strategic decisions of a second arbitrageur, a potential entrant to the market. The main contribution of this paper is to examine how the ambiguity over the extent of a deterioration in the underlying fundamental value of the asset, defined as a nite support over which probabilities cannot be attached, changes the nature of this strategic problem when the market participants exhibit ambiguity aversion. Furthermore, we also examine how these arbitrageurs alter their strategic behaviour when the distressed arbitrageur faces limited funding liquidity in the form of a simple margin constraint. Finally, we analyse how the interaction of these two problems, namely fundamental ambiguity and limited funding liquidity, affect the market dynamics. Through this framework, we are able to explain some of the prominent features of the recent financial crisis, such as a distinct lack of trading activity and a heavy downward pressure on the market price over short intervals.

Keywords: Knightian uncertainty, forced liquidation, maxmin utility speciĀ…cation, fundamental uncertainty, margin constraint

JEL Classification: G01, G12, G14

Suggested Citation

Oh, Ji Yeol Jimmy, Ambiguity Aversion, Strategic Trading, and Funding Liquidity (December 24, 2010). International Conference of the French Finance Association (AFFI), May 11-13, 2011. Available at SSRN: https://ssrn.com/abstract=1833426 or http://dx.doi.org/10.2139/ssrn.1833426

Ji Yeol Jimmy Oh (Contact Author)

Hanyang University ( email )

School of Business #513
Wangsimni-ro 222, Seongdong-gu
Seoul, Seoul 04763
Korea, Republic of (South Korea)
+82222202689 (Phone)

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
86
Abstract Views
914
rank
302,939
PlumX Metrics