A Simple Model of Trading and Pricing RiskyAssets Under Ambiguity: Any Lessons forPolicy-Makers?

The 2007-2008 financial crises 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 isolatedshocks into systemic panic attacks. We develop a simple two-period model populated by bothstandard expected utility maximizers and by ambiguity-averse investors that trade in the market fora risky asset. We show that, provided there is a sufficient amount of ambiguity, market breakdownswhere large portions of traders withdraw from trading are endogeneous and may be triggered bymodest re-assessments of the range of possible scenarios on the performance of individualsecurities....