Microstructure and Ambiguity

A goal for stock exchanges is to increase participation by firms and investors. We show how specific features of the microstructure can reduce perceived ambiguity, and induce participation by both investors and issuers. We develop a model with sophisticated traders, who we view as expected utility maximizers with rational expectations, and unsophisticated traders, who we view as rational traders facing ambiguity about the payoffs to participating in the market. We show how designing markets to reduce ambiguity can benefit investors through greater liquidity, exchanges through greater volume, and issuing firms through a lower cost of capital. Copyright (c) 2010 the American Finance Association.