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Uncertainty and Risk in Financial Markets

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Listed:
  • Luca Rigotti
  • Chris Shannon
Abstract
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. Copyright The Econometric Society 2005.

Suggested Citation

  • Luca Rigotti & Chris Shannon, 2005. "Uncertainty and Risk in Financial Markets," Econometrica, Econometric Society, vol. 73(1), pages 203-243, January.
    • Handle: RePEc:ecm:emetrp:v:73:y:2005:i:1:p:203-243
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    File URL: http://hdl.handle.net/10.1111/j.1468-0262.2005.00569.x
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    JEL classification:

    • D0 - Microeconomics - - General
    • D5 - Microeconomics - - General Equilibrium and Disequilibrium
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty

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