Ambiguity, Liquidity, and Price Efficiency
2014
We develop a sequential trading model with ambiguity-averse market makers. Bid-ask spread contains a risk premium and an ambiguity premium. Higher ambiguity generally leads to higher market illiquidity, but there exist some thresholds at which liquidity suddenly dries up or floods, and the likelihood of occurrence depends on the salience of ambiguity relative to risk. Ambiguity impedes speed of learning and can generate "jump clustering". Ambiguity skewness predicts future returns, hinders revelation of "tail risk" and can produce price over-reaction. Our model explains the market freezes and the "Flash Crash", reconciles some conflicting empirical results, and provides new testable predictions.
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