Ambiguity, Asset Illiquidity, and Price Variability
35 Pages Posted: 5 Sep 2017 Last revised: 21 Mar 2021
Date Written: March 21, 2021
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 analyses confirm that the implication of price variability is robust to the modelling techniques of ambiguity.
Keywords: Ambiguity Aversion, Ambiguity Premium, Liquidity, Price Variability
JEL Classification: D81, D82 G14, G23, G28
Suggested Citation: Suggested Citation