Uncertainty shocks and net positions
Year: 2025
Type: article
Abstract: • Increase in uncertainty may increase a trader’s optimal risk exposure. • Increase in uncertainty may increase the expected spot price. • Impact of an uncertainty shock depends on contextual information. • The results have implications for modeling and interpreting empirical studies. Consider a risk-averse agent with a given underlying position who hedges the price risk by taking a position in a forward contract. The agent bases the probability distribution of the future spot price on multiple sources of information modeled as different noisy signals. This paper develops a simple model to illustrate that an increase in uncertainty relating to one of the signals (referred to as an uncertainty shock) will always increase the variance of the distribution, but may increase or decrease the expected spot price, the agent’s net position and the absolute value of the net position depending on how the signal relates to other relevant information, namely, other signals, their associated uncertainties, and the forward price. In sum, the paper proposes a comprehensive approach to understanding the impact of uncertainty on prices and traders’ positions, and the theoretical results not only provide useful insights to individual traders, but also have implications for modeling and interpreting empirical studies.
Source: Finance Research Open
Author: Vadhindran K. Rao
Institution: Metropolitan State University
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: gold
Estimated APC paid: $1,000
OpenAlex ID: W7106813253