Uncertainty and Risk in Financial Markets

This paper considers a general equilibrium model in which the distinction between uncertainty and risk is formalized by assuming agents have incomplete preferences over state-contingent consumption bundles, as in Bewley (1986). Without completeness, individual decision making depends on a set of pro...

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Bibliographic Details
Published in:Econometrica 2005-01, Vol.73 (1), p.203-243
Main Authors: Rigotti, Luca, Shannon, Chris
Format: Article
Language:English
Subjects:
absence of trade
Applications
Applied sciences
Capital market
Decision theory
determinacy of equilibria
Econometrics
Economic models
Economic theory
Economic uncertainty
Endowments
Equilibrium
Equilibrium prices
Exact sciences and technology
Expected utility
Finance
financial markets
Financial risk
General economic equilibrium
general equilibrium theory
incomplete preferences
Inertia
Insurance, economics, finance
Knightian uncertainty
Mathematics
Operational research and scientific management
Operational research. Management science
Pareto efficiency
Pareto optimum
Preferences
Probability and statistics
Risk
Risk aversion
Risk theory. Actuarial science
Sciences and techniques of general use
Securities markets
Statistics
Studies
Trade
Uncertainty
Utility measurement
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Summary:This paper considers a general equilibrium model in which the distinction between uncertainty and risk is formalized by assuming agents have incomplete preferences over state-contingent consumption bundles, as in Bewley (1986). Without completeness, individual decision making depends on a set of probability distributions over the state space. A bundle is preferred to another if and only if it has larger expected utility for all probabilities in this set. When preferences are complete this set is a singleton, and the model reduces to standard expected utility. In this setting, we characterize Pareto optima and equilibria, and show that the presence of uncertainty generates robust indeterminacies in equilibrium prices and allocations for any specification of initial endowments. We derive comparative statics results linking the degree of uncertainty with changes in equilibria. Despite the presence of robust indeterminacies, we show that equilibrium prices and allocations vary continuously with underlying fundamentals. Equilibria in a standard risk economy are thus robust to adding small degrees of uncertainty. Finally, we give conditions under which some assets are not traded due to uncertainty aversion.
ISSN:0012-9682
1468-0262
DOI:10.1111/j.1468-0262.2005.00569.x