A simple model of trading and pricing risky assets under ambiguity: any lessons for policy-makers?

The 2007-2008 financial crisis has made it painfully obvious that markets may quickly turn illiquid. Moreover, recent experience has shown that distress and lack of active trading can jump 'around' between seemingly unconnected parts of the financial system contributing to transforming isolated shocks into systemic panic attacks. We develop a simple two-period model populated by both standard expected utility maximizers and ambiguity-averse investors who trade in the market for a risky asset. We show that, provided there is a sufficient amount of ambiguity, market breakdowns where large portions of traders withdraw from trading are endogenous and may be triggered by modest re-assessments of the range of possible scenarios on the performance of individual securities. Risk premia (spreads) increase with the proportion of traders in the market who are averse to ambiguity. When we analyse the effect of policy actions, we find that when a market has fallen into a state of impaired liquidity, bringing the market back to orderly functioning through a reduction in the amount of perceived ambiguity may cause further reductions in equilibrium prices. Finally, our model provides stark indications against the idea that policy-makers may be able to 'inflate' their way out of a financial crisis. 'The trading of legacy loans and securities continues to reveal systematic underpricing at issuance of once seemingly benign risks-credit, liquidity, counterparty, and even sovereign risks […] Until these assessments are more clearly refined and more broadly understood, we are likely to observe elevated levels of volatility and unwillingness by many investors to participate in certain asset markets at virtually any price.' (Warsh, 2009, emphasis added)