Economic Implications of Ambiguity
Lead Research Organisation:
University of Essex
Department Name: Economics
Abstract
Ambiguity, or Knightian uncertainty, refers to situations where the probabilities governing outcomes are not objectively known and it may be difficult to precisely assess their relative likelihood based on available information. This is arguably a pervasive phenomenon. The probability of an economic crash is not objectively provided anywhere, at least not in the days prior to the autumn of 2007, nor is that of a recovery despite the best laid plans of governments, nor is the probability of war in West Asia in the next two years, nor the probability that a single political party will win an outright majority in the next election.
Since the work of Daniel Ellsberg in the 1960s, which built on the distinction drawn by Frank Knight and John Maynard Keynes in the 1920s between `risk' where probabilities are known and `uncertainty' where they are not, it has been recognised that ambiguity can affect individual behaviour. More recently, it has also been widely suggested that ambiguity is important for understanding key aspects of how the recent economic crisis unfolded, such as market freezes or the aftermath of the Lehmann Brothers collapse, and how the economy has evolved since.
Traditional economic analysis and models have precluded a role for ambiguity by considering settings with ambiguity-insensitive or -neutral participants. The goal of this proposal is to study how ambiguity and ambiguity sensitive individuals can affect or change the functioning and outcomes of common settings of economic choices and interaction such as markets and games.
The projects in this proposal study how ambiguity affects economic interactions and choices in hitherto little explored areas and build on existing foundational work that models individual decision making under ambiguity. The projects are theoretical studies with the immediate audience being the academic research community. However, the content of the projects should be of broader interest also because the projects seek to (a) develop general models which may then be specialized and used for specific applied economic and policy analysis and (b) examine some empirical phenomena considered puzzling given existing economic analyses.
The research proposal comprises three projects. The first project attempts to understand the value of ambiguous information for ambiguity-sensitive decision-makers and how it affects their economic choices, such as in financial markets. It examines conditions under which ambiguous information may in fact be ignored by decision-makers in general as they find it to be of no or negative utility value. It then uses these results to examine how portfolio choices in financial markets are affected by ambiguous information and what effects this may have on market prices and market functioning when the ambiguous information is publicly and freely known.
The second project aims to understand the existence and institutional nature of contracts between investors and mutual fund managers in the financial sector. These have been puzzling from the viewpoint of traditional economic models since they ostensibly restrict the fund managers from pursuing profitable investment opportunities. It further seeks to understand the general nature of incentive contracts in financial intermediation when the participants are ambiguity sensitive.
The final project seeks to build theoretical foundations for the analysis of strategic interaction among agents whose preferences may not be of the form usually assumed in economic theory and in particular may exhibit sensitivity to ambiguity and other factors. This paves the way for analysing the sensitivity of predictions in such settings to simplifying restrictions commonly used for applied analysis such as when the coordination behaviour of people may trigger an acute event like a bank run or speculative currency attacks.
Two of these projects involve international collaboration with scholars in the US and Israel.
Since the work of Daniel Ellsberg in the 1960s, which built on the distinction drawn by Frank Knight and John Maynard Keynes in the 1920s between `risk' where probabilities are known and `uncertainty' where they are not, it has been recognised that ambiguity can affect individual behaviour. More recently, it has also been widely suggested that ambiguity is important for understanding key aspects of how the recent economic crisis unfolded, such as market freezes or the aftermath of the Lehmann Brothers collapse, and how the economy has evolved since.
Traditional economic analysis and models have precluded a role for ambiguity by considering settings with ambiguity-insensitive or -neutral participants. The goal of this proposal is to study how ambiguity and ambiguity sensitive individuals can affect or change the functioning and outcomes of common settings of economic choices and interaction such as markets and games.
The projects in this proposal study how ambiguity affects economic interactions and choices in hitherto little explored areas and build on existing foundational work that models individual decision making under ambiguity. The projects are theoretical studies with the immediate audience being the academic research community. However, the content of the projects should be of broader interest also because the projects seek to (a) develop general models which may then be specialized and used for specific applied economic and policy analysis and (b) examine some empirical phenomena considered puzzling given existing economic analyses.
The research proposal comprises three projects. The first project attempts to understand the value of ambiguous information for ambiguity-sensitive decision-makers and how it affects their economic choices, such as in financial markets. It examines conditions under which ambiguous information may in fact be ignored by decision-makers in general as they find it to be of no or negative utility value. It then uses these results to examine how portfolio choices in financial markets are affected by ambiguous information and what effects this may have on market prices and market functioning when the ambiguous information is publicly and freely known.
The second project aims to understand the existence and institutional nature of contracts between investors and mutual fund managers in the financial sector. These have been puzzling from the viewpoint of traditional economic models since they ostensibly restrict the fund managers from pursuing profitable investment opportunities. It further seeks to understand the general nature of incentive contracts in financial intermediation when the participants are ambiguity sensitive.
The final project seeks to build theoretical foundations for the analysis of strategic interaction among agents whose preferences may not be of the form usually assumed in economic theory and in particular may exhibit sensitivity to ambiguity and other factors. This paves the way for analysing the sensitivity of predictions in such settings to simplifying restrictions commonly used for applied analysis such as when the coordination behaviour of people may trigger an acute event like a bank run or speculative currency attacks.
Two of these projects involve international collaboration with scholars in the US and Israel.
Planned Impact
The projects I outline in the proposal are essentially targeted toward academic beneficiaries and researchers as described in the statement on academic beneficiaries. However, beneficiaries outside of academia with a direct interest in the projects include policy makers and researchers in central banks and similar institutions and financial/economics media and the general public. The institutions include the Bank of England, the Banque de France, the US Federal Reserve Bank System, and the European Central Bank; government treasuries; regulatory bodies such as the UK's Financial Conduct Authority, Prudential Regulatory Authority, and Money Advice Authority and the US's Securities and Exchange Commission; and international policy organisations such as the World Bank, the IMF, and the OECD.
In the UK, the importance of understanding the effects of ambiguity or Knightian uncertainty has already been highlighted in recent speeches by Charles Bean and Andrew Haldane of the Bank of England. Dr Bean noted recent research showing how ambiguity which arose from informational complexities in mortgage-backed securities could lead to a flight to quality by investors and create a role for government or central bank to beneficially provide liquidity. Mr Haldane noted research which showed how ambiguity could account for assets with similar risks could have a wide range of prices, which is a feature of the recent crisis.
The projects on financial market implications of ambiguity will be of direct interest to researchers or practitioners in the public policy sector and aforementioned institutions. This community could adapt and specialize some of the general models and settings I analyse to explore a range of policy issues related to financial markets.
The project on the value and effects of ambiguous information would be interest to policy-makers and others concerned with the functioning of financial markets and their relation to the rest of economy, particularly in how well asset prices reflect fundamental values and information. It will also be of interest to those concerned with the asset allocation decisions of individuals since it will explore the optimal allocations for investors in the short term and in the long term when information about the asset, particularly publicly available information is ambiguous.
The project on the nature of contractual arrangements in the delegated portfolio management industry will be of interest to policy makers and others interested in the functioning of the financial services industry, particularly in terms of incentives for risk-taking and risk-management by intermediaries. The third project develops foundations for analysis of strategic interaction among individuals, while allowing for a wide range of individual behaviour, for situations such as bank runs, where coordination is an important issue and asset auctions, where individual valuations of objects may not be commonly known but are crucial to sale of the object at appropriate value. These settings and themes will be of direct and indirect interest to the non-academic community.
Due to the current economic climate, there is in addition a strong media and public interest in understanding economic fragilities, particularly how imprecise or vague information relating to financial markets is interpreted and how individuals in sectors such as financial services are incentivised. There is also interest in understanding how allowing for a wide range of individual behaviour may affect the functioning of an economic system. These projects make progress toward addressing these issues and may therefore be of interest to media audiences such the Financial Times, the Wall Street Journal, and the Economist and to the general public.
In the UK, the importance of understanding the effects of ambiguity or Knightian uncertainty has already been highlighted in recent speeches by Charles Bean and Andrew Haldane of the Bank of England. Dr Bean noted recent research showing how ambiguity which arose from informational complexities in mortgage-backed securities could lead to a flight to quality by investors and create a role for government or central bank to beneficially provide liquidity. Mr Haldane noted research which showed how ambiguity could account for assets with similar risks could have a wide range of prices, which is a feature of the recent crisis.
The projects on financial market implications of ambiguity will be of direct interest to researchers or practitioners in the public policy sector and aforementioned institutions. This community could adapt and specialize some of the general models and settings I analyse to explore a range of policy issues related to financial markets.
The project on the value and effects of ambiguous information would be interest to policy-makers and others concerned with the functioning of financial markets and their relation to the rest of economy, particularly in how well asset prices reflect fundamental values and information. It will also be of interest to those concerned with the asset allocation decisions of individuals since it will explore the optimal allocations for investors in the short term and in the long term when information about the asset, particularly publicly available information is ambiguous.
The project on the nature of contractual arrangements in the delegated portfolio management industry will be of interest to policy makers and others interested in the functioning of the financial services industry, particularly in terms of incentives for risk-taking and risk-management by intermediaries. The third project develops foundations for analysis of strategic interaction among individuals, while allowing for a wide range of individual behaviour, for situations such as bank runs, where coordination is an important issue and asset auctions, where individual valuations of objects may not be commonly known but are crucial to sale of the object at appropriate value. These settings and themes will be of direct and indirect interest to the non-academic community.
Due to the current economic climate, there is in addition a strong media and public interest in understanding economic fragilities, particularly how imprecise or vague information relating to financial markets is interpreted and how individuals in sectors such as financial services are incentivised. There is also interest in understanding how allowing for a wide range of individual behaviour may affect the functioning of an economic system. These projects make progress toward addressing these issues and may therefore be of interest to media audiences such the Financial Times, the Wall Street Journal, and the Economist and to the general public.
Organisations
People |
ORCID iD |
| Jayant Ganguli (Principal Investigator) |
Publications
Ganguli J
(2016)
Universal interactive preferences
in Journal of Economic Theory
ILLEDITSCH P
(2020)
Information Inertia
in The Journal of Finance
Illeditsch P
(2020)
Information Inertia
in Journal of Finance
| Description | The funded research studies how ambiguity or Knightian uncertainty -- the absence of objective probabilities for events -- affects individual choices and social interaction. Likelihoods of economic and social events are inherently subjective. Ambiguity has long been considered to have significant consequences for individual choices. A key research question was how individuals process to information in ambiguous environments and how this effects social interaction. Research with two separate new collaborative networks has yielded new insights. In a financial market, investors process a range of information directly related to traded assets. However, the strength of this relationship may be unknown. When information and asset values are not uniquely linked, investors may not assign unique probabilities over assets return values upon observing information. This ambiguity given information significantly affects individual choices and market outcomes. Market prices of assets are informationally inefficient. They don't reflect existing public information about assets, such as past values of asset prices. This means prices aren't even weakly informationally efficient in the context of the efficient markets hypothesis. This important finding illustrates how functioning of markets can be affected due to ambiguity and in without the presence of any restrictions on trading or processing information or making optimal decisions. The latter have often been invoked, with limited success, to understand much of the empirical work that questions the efficient market hypothesis. Another important finding illustrates how an individual investor's choice of portfolio is affected by such ambiguity. Even though the investor observes information and knows that it is related to the value of the asset, he ignores the information when choosing an investment portfolio. Effectively, ambiguity renders the information opaque to the investor and he finds it optimal to not have the information affect his choice, even if it is relevant. Such choices are suggestive of the type of infrequent adjustment that is observed empirically in financial markets for individual investor portfolios, but also in other economically important scenarios, such as adjustment of prices by firms. The research pertaining to the above findings was undertaken as part of a new collaborative network with scholars based in the Wharton School, University of Pennsylvannia and at Brigham Young University in the US. Finally, in social interactions, including markets but also a range of non-market settings, strategic considerations mean that each individual must not only reason about his own choices but also about the reasoning of other individuals and then reason about their reasoning of his reasoning and so on leading to an infinite regress problem. This is a foundational problem and our research shows how this may be addressed for a very general class of social interactions, where individuals may be affected by ambiguity or by psychological factors which mean their decision-making is more complex than usual. This is important for understanding outcomes of interactions in auction markets or social coordination settings among others. The research underlying the above was undertaken with scholars from the Rotman School, University of Toronto, Canada and the Open University of Israel. |
| Exploitation Route | The research findings on the impact of information in financial markets are of interest to policy bodies like the Bank of England and academic researchers. These findings were well received at a workshop co-organized with the Bank of England. Follow up discussions with staff at the Bank of England are currently underway. These findings can help further policy understanding of the mechanisms underlying efficient functioning of financial markets. These findings have also been presented at other universities and discussed with leading scholars at workshops, directly and by collaborators. The paper has been invited to be resubmitted at a leading finance journal. These findings have direct implications for understanding individual portfolio choice and market efficiency. The impact of ambiguity in financial markets is a very active research area and the findings are of interest to scholars working in the area. The research on foundational issues in social strategic interaction has been presented at an Essex workshop featuring leading scholars in the field and also at international conferences and research seminars, directly and by collaborators. It provides foundation for analysis of strategic interaction in a wide range of scenarios and is being referenced by researchers in this area. |
| Sectors | Financial Services, and Management Consultancy,Government, Democracy and Justice |
| Description | The research funded by this grant is primarily theoretical and foundational. It has already been very positively received among the academic community. The impact of the research among non-academic users is developing. The funded research has been presented at international workshops and conferences that have that have included participation from non-academic users from central banks and the financial services industry. These include events organized by Nobel Laureates Lars Hansen and Thomas Sargent and by the US-based National Bureau of Economic Research (NBER), This engagement was undertaken by me and the international network of scholars with whom I collaborated on the funded research. An important step in developing engagement with non-academic users was a workshop that I co-organized with the Bank of England, which featured research funded by the grant. The attendees and participants in this workshop comprised a number of staff from the Bank of England, including Andrew Haldane (Chief Economist and Executive Director, Monetary Policy and Analysis). The workshop was very much appreciated by the non-academic attendees. There was mutual keenness from the Bank co-organizers and me on in developing further engagement following on the workshop. This is in progress. The workshop also provided an excellent venue for showcasing the research findings to and for getting valuable feedback to non-academic users. Building on this feedback, I am developing the research further and aim to undertake further engagement with the Bank in the coming year. I also hope to build on this to develop engagement with the financial services industry. |
| First Year Of Impact | 2015 |
| Sector | Financial Services, and Management Consultancy,Government, Democracy and Justice |
| Impact Types | Economic,Policy & public services |