LIQUIDITY PREFERENCE AND KNIGHTIAN UNCERTAINTY

Abstract

We consider an infinite-horizon model of a risk-neutral fund-manager who contemplates
in each period whether or not to make an irreversible investment which, if made, generates
some return under a stochastic environment. Here, the fund-manager evaluates uncertainty
by the Choquet expected utility with respect to a convex capacitary kernel and hence she
exhibits uncertainty aversion. We provide the exact solution to this problem and show that
it takes the form of a reservation strategy: There exists the reservation function such that
if the current return exceeds the value of this function, the fund-manager should invest
all the money subject to a cash-in-advance constraint; if it does not, she should not make
any investment. We also conduct some sensitivity analyses to show that if risk increases
in the sense of mean-preserving spread, then the reservation function is raised and that if
uncertainty increases in the sense that the set of priors expands, then the reservation function
is lowered.