Ambiguity, asset illiquidity, and price variability

Tong Zhou

Journal of Economic Behavior & Organization, 2021, vol. 191, issue C, 280-292

Abstract: I develop a sequential trading model with ambiguity-averse market makers and provide a theoretical explanation to the historical coincidence of ambiguous events, asset illiquidity, and price variability. My model implies that the bid-ask spread of an asset contains an additive component of ambiguity premium. As a result, higher ambiguity generally leads to lower asset liquidity. More interestingly, asset prices are variable under particular conditions: specifically, only mixed-strategy equilibria exist, such that market makers probabilistically set multiple prices. Further analysis confirms that, compared with risk, ambiguity plays a unique role in explaining price variability.

Keywords: Ambiguity aversion; Ambiguity premium; Liquidity; Price variability (search for similar items in EconPapers)
JEL-codes: D81 D82 G14 G23 G28 (search for similar items in EconPapers)
Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jeborg:v:191:y:2021:i:c:p:280-292

DOI: 10.1016/j.jebo.2021.08.034

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