The Incentive To Trade Under Ambiguity Aversion

Abstract

This paper examines the behavior of an exporting firm that sells in both the home country and a foreign country. The firm makes its optimal production and export decisions when facing ambiguous exchange rate risk. Ambiguity is modeled by a second-order probability distribution that captures the firm's uncertainty about which of the subjective beliefs govern the exchange rate risk. Ambiguity preferences are modeled by the (second-order) expectation of a concave transformation of the (first-order) expected utility of profit conditional on each plausible subjective distribution of the exchange rate risk. Within this framework, we derive necessary and sufficient conditions under which the ambiguity-averse firm optimally sells more in the home country and exports less to the foreign country in response either to the introduction of ambiguity or to greater ambiguity aversion when ambiguity prevails. We further show that ambiguity and ambiguity aversion have adverse effect on the firm's incentive to export to the foreign country.