NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Model Uncertainty and Liquidity

Bryan R. Routledge, Stanley E. Zin

NBER Working Paper No. 8683
Issued in December 2001
NBER Program(s):   AP

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-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.

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Document Object Identifier (DOI): 10.3386/w8683

Published: Bryan Routledge & Stanley Zin. "Model Uncertainty and Liquidity," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 543-566, October 2009.

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