Risk versus Ambiguity and International Security Design
82 Pages Posted: 22 Feb 2014 Last revised: 17 Jan 2018
Date Written: December 27, 2017
We study portfolio allocation and characterize contracts issued by firms in the international financial market when investors exhibit ambiguity aversion and perceive ambiguity in assets issued in foreign locations. Increases in the variance of their risky production process cause firms to issue assets with a higher variable payment (equity). Hikes in investors' perceived ambiguity have the opposite effect, and lead to less risk-sharing. Entrepreneurs from capital-scarce countries finance themselves relatively more through debt than equity. They are thus exposed to higher volatility per unit of consumption. The expected returns on capital invested in capital-scarce countries may also be lower. Such results do not hold in the absence of ambiguity, that is, when investors only perceive risk. New facts uncovered from cross-country firm-level data are consistent with our model.
Keywords: ambiguity aversion, risk aversion, debt/equity choice, international capital flows, international insurance, home bias
JEL Classification: F21, F34, G11, G15, D81
Suggested Citation: Suggested Citation