Business Intelligence

Ambiguity, Infra-Marginal Investors, And Market Prices

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Executive Summary

It is difficult to explain the price insensitive or infra-marginal behavior, an example of which is the behavior of credit markets during the recent financial crisis, by risk aversion alone. It is known that infra-marginal behavior may arise with ambiguity aversion. Furthermore, there appears to be fairly strong evidence of a close connection between ambiguity and conformity. Here the authors propose an extension of the standard ambiguity framework to incorporate conformity. They find that there are open sets of state-price ratios over which the entire market is price insensitive or infra-marginal. This result has important implications for market equilibrium and volatility.

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