Ambiguity Aversion and Incompleteness of Financial Markets

Abstract

It is widely thought that incomes risks can be shared by trading infinancial assets. But financial assets typically carry some riskidiosyncratic to them, hence, disposing incomes risk using financial assetswill involve buying into the inherent idiosyncratic risk. However, standardtheory argues that diversification would reduce the inconvenience ofidiosyncratic risk to arbitrarily low levels. This argument is less robustthan what standard theory leads us to believe: ambiguity aversion canexacerbate the tension between the two kinds of risks to the point thatclasses of agents may not want to trade some financial assets. Thus,theoretically, the effect of ambiguity aversion on financial markets is tomake the risk sharing opportunities offered by financial markets lesscomplete than it would be otherwise.incomplete markets; ambiguity aversion