Knightian Uncertainty in Financial Markets: An Assessment

TLDR: In this paper, it is proved that an agent's attitude towards ambiguity has a crucial role in asset price determination and portfolio choice, and the agent's beliefs may be represented by a capacity or a set of additive probabilities.

Abstract: If information is too vague and imprecise to be summarized by a unique additive probability measure, an agent faces Knightian uncertainty or ambiguity rather than risk. Under Knightian uncertainty, an agent's beliefs may be represented by a capacity or a set of additive probabilities. It is proved that an agent's attitude towards ambiguity has a crucial role in asset price determination and portfolio choice. Knightian uncertainty attitude provides an alternative explanation of financial market failures and enables puzzles to be solved, such as market breakdowns, price indeterminacy and volatility, bid and ask spreads, portfolio inertia, violation of call and put parity. (J.E.L.: D81, G11, G12).