No Good Deals — No Bad Models

Abstract

Faced with the problem of pricing complex contingent claims, an investor seeks to make her valuations robust to model uncertainty. We construct a notion of a model-uncertainty-induced preference functional and extend the "No Good Deals" methodology of Cochrane and Saa-Requejo (2000) to compute lower and upper good deal bounds in the presence of model uncertainty. We illustrate the methodology using numerical examples. Estimating a time-series of the degree of aversion to model uncertainty for an investor in the S&P 500 market, we find that increases in uncertainty aversion correspond to worsening financial market conditions.

Keywords: good deal bounds, model-uncertainty-induced preference functional, asset pricing theory, Knightian uncertainty, model uncertainty, contingent claim pricing

JEL Classification: G12, G13