The Effect of Ambiguity on Price Formation and Trading Behavior in Financial Markets

41 Pages Posted: 16 Nov 2021

See all articles by Wenhui Li

Wenhui Li

SAFE Goethe University Frankfurt

Peter Ockenfels

Goethe University Frankfurt - Institute of Economics

Christian Wilde

Goethe University Frankfurt - Department of Finance

Date Written: November 02, 2021

Abstract

This paper sets up an experimental asset market in the laboratory to investigate the effects of ambiguity on price formation and trading behavior in financial markets. The obtained trading data is used to analyze the effect of ambiguity on various market outcomes (the price level, volatility, trading activity, market liquidity, and the degree of speculative trading) and to test the quality of popular empirical market-based measures for the degree of ambiguity. We find that ambiguity decreases market prices and trading activity; ambiguity leads to lower market liquidity through wider bid-ask spreads; and ambiguity leads to less speculative trading. We also find that popular market-based measures of ambiguity used in the empirical literature do not seem to correctly capture the true degree of ambiguity.

Keywords: ambiguity, financial market, market price, volatility, trading activity, bid-ask spread, market-based measure of ambiguity, laboratory experiment

JEL Classification: D81, G10

Suggested Citation

Li, Wenhui and Ockenfels, Peter and Wilde, Christian, The Effect of Ambiguity on Price Formation and Trading Behavior in Financial Markets (November 02, 2021). SAFE Working Paper No. 326, Available at SSRN: https://ssrn.com/abstract=3963688 or http://dx.doi.org/10.2139/ssrn.3963688

Wenhui Li

SAFE Goethe University Frankfurt ( email )

Gr├╝neburgplatz 1
Frankfurt
Germany

Peter Ockenfels

Goethe University Frankfurt - Institute of Economics ( email )

In house Post Box 81
Frankfurt am Main 60054
Germany

Christian Wilde (Contact Author)

Goethe University Frankfurt - Department of Finance ( email )

House of Finance
Grueneburgplatz 1
Frankfurt am Main, Hessen 60323
Germany

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