Model uncertainty and liquidity

Extreme market outcomes are often followed by a lack of liquidity and a lack of trade. This market collapse seems particularly acute for markets where traders rely heavily on a speci¯c empirical model such as in derivative markets like the market for mortgage backed securities or credit derivatives. Moreover, the observed behavior of traders and institutions that places a large emphasis on \worst-case scenarios " through the use of \stress testing " and \value-at-risk " seems di®erent than Savage expected utility would suggest. In this paper, we capture model-uncertainty using an Epstein and Wang (1994) uncertainty-averse utility function with an ambiguous underlying asset-returns distribution. To explore the connection of uncertainty with liquidity, we specify a simple market where a monopolist ¯nancial intermediary makes a marke