Les Cahiers de Recherche - HEC Paris
Risk versus Ambiguity and International Security Design
() and Tomasz Michalski
Abstract: This paper studies portfolio allocation in the
international financial market when investors exhibit ambiguity aversion
towards assets issued in foreign locations. Entrepreneurs located in each
country have access to a risky technology and want to attract capital. The
authors characterize contracts issued by firms in such an environment.
Increases in the variance of the risky production process causes firms to
increase the variable payment (equity) offered to investors. On the other
hand, increases in investor ambiguity lead to less risk-sharing.
Entrepreneurs located in countries with low levels of domestic wealth issue
assets with a higher fixed payment and a lower risky payment. As a result,
they are exposed to higher volatility per unit of consumption as they
finance themselves relatively more through debt than equity. An increase in
ambiguity or ambiguity aversion that characterizes crises may explain
flight of capital to capital-abundant countries – dubbed sometimes as
“flight to quality”.
Keywords: ambiguity aversion; risk aversion; debt/equity choice; international capital flows; international insurance; home bias; (follow links to similar papers)
JEL-Codes: D81; F21; F34; G11; G15; (follow links to similar papers)
38 pages, February 21, 2014
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