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Do Investors Need Kink to Cope with Ambiguity?

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  • Nishiwaki, Takashi

Abstract

This study proposes a possible explanation for demand for derivatives that have kinks, such as plain vanilla options, using a market equilibrium model. In our setting, there is one risky asset and one ambiguous additive background risk, and a complete market exists for the risky asset. Under this environment, the optimal payoff function for an ambiguity-averse investor who has an exponential utility function exhibits kinks.

Suggested Citation

  • Nishiwaki, Takashi, 2020. "Do Investors Need Kink to Cope with Ambiguity?," International Review of Economics & Finance, Elsevier, vol. 70(C), pages 391-397.
    • Handle: RePEc:eee:reveco:v:70:y:2020:i:c:p:391-397
    DOI: 10.1016/j.iref.2020.08.001
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    References listed on IDEAS

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    1. Leland, Hayne E, 1980. "Who Should Buy Portfolio Insurance?," Journal of Finance, American Finance Association, vol. 35(2), pages 581-594, May.
    2. Olaf Korn, 2010. "How firms should hedge: An extension," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 30(9), pages 834-845, September.
    3. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
    4. Gregory W. Brown & Klaus Bjerre Toft, 2002. "How Firms Should Hedge," The Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1283-1324.
    5. Li, Jingyuan, 2011. "The demand for a risky asset in the presence of a background risk," Journal of Economic Theory, Elsevier, vol. 146(1), pages 372-391, January.
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    Cited by:

    1. Takashi Nishiwaki, 2020. "Does Ambiguity Generate Demand for Options?," Working Papers 2011, Waseda University, Faculty of Political Science and Economics.

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    More about this item

    Keywords

    Ambiguity; Multiple prior model; Background risk; Kink;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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