This link has been bookmarked by 1 people . It was first bookmarked on 20 Jun 2008, by Jim McClintock.
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20 Jun 08
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Indeed, getting the ex ante distribution of returns right is often the most important element of successful ‘risk’ management in actual financial markets, where the distribution of returns is an equilibrium outcome, not a preordained physical constant.
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However, under certain circumstances, it is crucially important to distinguish between the risk of undertaking an investment and the possibility of substantial uncertainty regarding the range of possible distributions of investment outcomes that an investor may confront.
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financial markets might operate very differently in a period of uncertainty than they function during periods in which there is broad agreement among investors on the distribution of possible investment outcomes
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An event is uncertain or ambiguous if it has unknown probability.
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ncertainty and risk are distinct characteristics of random environments, and they can also affect individuals’ behavior very differently…
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When uncertainty is prevalent, some [financial] markets might break down, resulting in equilibrium with no trade. Moreover, indeterminacy may also arise [and this] can generate excess price volatility.”
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The global financial system right now is going through a serious bout of Knightian uncertainty, which may have significant consequences for investing and global financial markets for some time to come.4 The proximate cause of this “hard day’s Knight” was the more or less simultaneous realization by millions of global investors that their underlying assumption about the distribution of returns on a wide “variety of asset-backed securities” was fundamentally flawed
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hey didn’t know what they didn’t know
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s predicted by the economics of Knightian uncertainty, many financial markets, in effect, failed to function and price discovery was substantially impaired in those markets that did trade.6
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