Knightian risk and uncertainty pdf

Equilibria in a standard risk economy are thus robust to adding small degrees of uncertainty. Henceforth i use the term uncertainty or ambiguity in the sense of knight 1921, who first defined risk and uncertainty independently. In carroll 2015 and antic 2015, the principal does not know what actions are available to the agent and demands robustness. An infogap perspective decision making in times of. Labor supply, selfinsurance and knightian uncertainty. Knight put forward his ideas on uncertainty in his doctoral thesis and then turned it into his classic book risk, uncertainty and profit 1921. Knightian uncertainty that predict joint movements in perceived knightian uncertainty and measured risk premia, such as those present in credit spreads. Knightian uncertainty critique of the probabilistic model frank knight. Viability and arbitrage under knightian uncertainty.

Knightian uncertainty and risk article pdf available in journal of strategy and management 74. The uncertainty that the worker faces is much broader and deeper, and thus, our assumption of no learning taking place is a reasonable one for knightian uncertainty. Infogap models of uncertainty provide a nonprobabilistic quanti. For this reason, the crisis has cast new attention on an idea about risk from decades past. Using a di erenceindi erence methodology, i nd that when uncertainty is resolved, a me dian rm in the u. Difference between risk and uncertainty with comparison. In this sense, the existence of knightian uncertainty is not just a quasiphilosophical dispute. Frank knight was an idiosyncratic economist who formalized a distinction between risk and uncertainty in his 1921 book, risk, uncertainty, and profit. The risk is defined as the situation of winning or losing something worthy. This paper models how knightian uncertainty over risk exposures to the collapsed assets a. Knightian uncertainty, general equilibrium theory, financial markets, determi. The difference between risk and uncertainty can be drawn clearly on the following grounds. Asymmetric information and security design under knightian.

Knightian uncertainty 2 june 2010, by peter dizikes the global economic crisis of the last two years has stemmed, in part, from the inability of financial. Uncertainty, however, describes events with unknown or objectively unmeasurable probabilities. Politics, at its core, is a dense and sticky web of relationships. In this paper we are concerned with action dynamics under general forms of uncertainty. In each period, an unemployed worker draws a wage offer, from a wage distribution 5 f0. As knight saw it, an everchanging world brings new opportunities for.

I provide two continuous time applications extended from the discrete time applications in miao and wang 2011 that show the value of waiting which increases with risk decreases with. In economics, knightian uncertainty is a lack of any quantifiable knowledge about some possible occurrence, as opposed to the presence of quantifiable risk e. A critical assessment with jonathan weinstein a bayesian approach to precautionary policies uncertainty and disagreement in equilibrium models with eran shmaya. Insert table 1 about here the key difference between knightian uncertainty and the other two types is that knightian uncertainty involves dealing with a future that has no discernible distribution whatsoever, not even in theory. Knightian uncertainty and interbank lending matthew pritsker. The text has been altered as little as possible from the original edition risk, uncertainty, and profit, frank h. Monetary policymaking in the presence of knightian. Knight wrote that risk is randomness in which events have measurable probabilities. Uncertainty is a condition where there is no knowledge about the future events.

Labor supply, selfinsurance and knightian uncertainty hening liu northern illinois university abstract the focus of this paper is on the implications of income uncertainty for the optimal labor supply. A note on consumption and savings under knightian uncertainty. Moreover, under knightian uncertainty the structure of an equilibrium depends strongly on the completeness of the underlying economy. Alnajjar and jonathan weinstein dtea, paris may 20 presentation also draws from ideas in. Full facsimile of the original edition, not reproduced with optical recognition software. Risk is objective, testable, consistent with standard empirical methodologies e. Risk can be measured and quantified, through theoretical models. Policy uncertainty corrupts the formulaic risk modeling engaged in by economists and quants. Even though, in its purest form, a predictable future would render humans mere automatons unwinding in a clockwork universe, humans find the uncertainty posed by the unknowability of the future so unnerving that we go to great lengths to avoid it. The meaningful distinction between knightian uncertainty, which is often attributed to frank knight 1921, and risk is allowed. In particular, knight used the word risk to describe the measurable uncertainty, where the possible outcomes are known and they can be classi. In chapter three, i consider a firms decision to exercise real options, when the firm faces knightian uncertainty about the evolution of project value. Risk, uncertainty, and pro t risk \roulette objective probabilities uncertainty \horse races no probabilities many entrepreneurial decisions are \horseraces startup nancial markets. For example, unlike the standard risk neutral model, it is no longer possible for the.

To address this puzzle, i examine the e ect of knightian uncertainty on leverage. By introducing the concept of knightian uncertainty, dow and werlang 1992 account for the existence of portfolio inertia, which has not been accounted for under the concept of risk. In technical parlance, this is knightian uncertainty, named for frank knight, an economist who wrote a 1921 book. Iptsjrcec oecd conference on eied december 9, 2014 1 1. Knightian uncertainty is named after university of chicago economist frank knight.

Risk is ergodic probabilities, knightian uncertainty is mixtures of ergodic measures. Risk, robustness and knightian uncertainty in continuous. If knightian uncertainty is recognized in these models, a reference measure need not exist, see, e. Risk and uncertainty as reflected in required capital calculations address only adverse consequences, while provision for uncertainty in the valuation of liabilities or in. The concept acknowledges some fundamental degree of ignorance, a limit to knowledge, and an essential unpredictability of future events. We show that optimal contracts with knightian uncertainty can differ from those without. A few corrections of obvious typos were made for this website edition. For instance, within complete production economies we find that knightian uncertainty can generate an endogenous stock market participation, a feature that cannot be obtained by the other robustness definitions. Noise traders may cause rational investors to rethink their own analysis in light of the new information provided through the market price or volume data generated by the noise traders. Knightian uncertainty is often referred to as uncertainty about the extent to which the expected mean a key parameter of the probability distribution is incorrect. Finally, we give conditions under which some assets are not traded due to uncertainty aversion. In economics, knightian uncertainty is risk that is immeasurable, impossible to calculate.