Ambiguous Price Formation

Markets often experience liquidity deteriorations during financial crisis and improvements during reforms in trading rules. To explain these phenomena, we present a price formation model in which market makers are subject to ambiguity. When the market maker is sufficiently ambiguity averse, the illiquidity naturally arises in ambiguous market episodes due to the increased perceived adverse selection risk. Ambiguity can also improve liquidity when the market maker is insufficiently ambiguity averse. Consequently, the liquidity improvements can increase the value of information to informed traders and welfare to society. Furthermore, the presence of ambiguity leads the informed traders to trade large quantities