Trading Complex Risks

71 Pages Posted: 12 Dec 2017 Last revised: 13 Jun 2018

See all articles by Felix Fattinger

Felix Fattinger

University of Melbourne - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: June 4, 2018

Abstract

Complex risks differ from simple risks in that agents facing them only possess imperfect information about the underlying objective probabilities. This paper studies how complex risks are priced by and shared among heterogeneous investors in a Walrasian market. I apply decision theory under ambiguity to derive robust predictions regarding the trading of complex risks in the absence of aggregate uncertainty. I test these predictions in the laboratory. The experimental data provides strong evidence for theory’s predicted reduction in subjects’ price sensitivity under complex risks. While complexity induces more noise in individual trading decisions, market outcomes remain theory-consistent. This striking feature can be reconciled with a random choice model, where the bounds on rationality are reinforced by complexity. When moving from simple to complex risks, equilibrium prices become more sensitive whereas risk allocations turn less sensitive to noise introduced by imperfectly rational subjects. Markets’ effectiveness in aggregating beliefs about complex risks is determined by the trade-off between reduced price sensitivity and reinforced bounded rationality. Moreover, my results imply that complexity has similar but more pronounced effects on market outcomes than ambiguity induced by conventional Ellsberg urns.

Keywords: Complexity, Risk Sharing, Information Aggregation, Bounded Rationality

JEL Classification: G12, G14, G41

Suggested Citation

Fattinger, Felix, Trading Complex Risks (June 4, 2018). Available at SSRN: https://ssrn.com/abstract=3086358 or http://dx.doi.org/10.2139/ssrn.3086358

Felix Fattinger (Contact Author)

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010
Australia

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