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Model Uncertainty and Liquidity

52 Pages Posted: 20 Mar 2002  

Bryan Routledge

Carnegie Mellon University - David A. Tepper School of Business

Stanley E. Zin

Carnegie Mellon University; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: November 2001

Abstract

Extreme market outcomes are often followed by a lack of liquidity and a lack of trade. This market collapse seems particularly acute for markets where traders rely heavily on a specific empirical model such as in derivative markets. Asset pricing and trading, in these cases, are intrinsically model dependent. Moreover, the observed behavior of traders and institutions that places a large emphasis on "worst-case scenarios" through the use of "stress testing" and "value-at-risk" seems different than Savage rationality (expected utility) would suggest. In this paper we capture model-uncertainty explicitly using an Epstein and Wang (1994) uncertainty-averse utility function with an ambiguous underlying asset-returns distribution. To explore the connection of uncertainty with liquidity, we specify a simple market where a monopolist financial intermediary makes a market for a propriety derivative security. The market-maker chooses bid and ask prices for the derivative, then, conditional on trade in this market, chooses an optimal portfolio and consumption. We explore how uncertainty can increase the bid-ask spread and, hence, reduces liquidity. In addition, hedge portfolios for the market-maker, an important component to understanding spreads, can look very different from those implied by a model without Knightian uncertainty. Our infinite-horizon example produces short, dramatic decreases in liquidity even though the underlying environment is stationary.

JEL Classification: G10, G13, G20

Suggested Citation

Routledge, Bryan and Zin, Stanley E., Model Uncertainty and Liquidity (November 2001). EFA 2002 Berlin Meetings Presented Paper. Available at SSRN: https://ssrn.com/abstract=302485 or http://dx.doi.org/10.2139/ssrn.302485

Bryan R. Routledge (Contact Author)

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
(412) 268-7588 (Phone)
(412) 268-7064 (Fax)

Stanley E. Zin

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Carnegie Mellon University ( email )

Pittsburgh, PA 15213-3890
United States

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