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Abstract:
Extreme market outcomes are often followed by a lack of liquidity and a lack of trade. This market collapse seems particularly acute for markets where traders rely heavily on a specific empirical model such as in derivative markets. Asset pricing and trading, in these cases, are intrinsically model dependent. Moreover, the observed behavior of traders and institutions that places a large emphasis on "worst-case scenarios" through the use of "stress testing" and "value-at-risk" seems different than Savage rationality (expected utility) would suggest. In this paper we capture model-uncertainty explicitly using an Epstein and Wang (1994) uncertainty-averse utility function with an ambiguous underlying asset-returns distribution. To explore the connection of uncertainty with liquidity, we specify a simple market where a monopolist financial intermediary makes a market for a propriety derivative security. The market-maker chooses bid and ask prices for the derivative, then, conditional on trade in this market, chooses an optimal portfolio and consumption. We explore how uncertainty can increase the bid-ask spread and, hence, reduces liquidity. In addition, hedge portfolios for the market-maker, an important component to understanding spreads, can look very different from those implied by a model without Knightian uncertainty. Our infinite-horizon example produces short, dramatic decreases in liquidity even though the underlying environment is stationary.

Abstract:
Extreme market outcomes are often followed by a lack of liquidity and a lack of trade. This market collapse seems particularly acute for markets where traders rely heavily on a specific empirical model such as in derivative markets. Asset pricing and trading, in these cases, are intrinsically model dependent. Moreover, the observed behavior of traders and institutions that places a large emphasis on "worst-case scenarios" through the use of "stress testing" and "value-at-risk" seems different than Savage rationality (expected utility) would suggest. In this paper we capture model-uncertainty explicitly using an Epstein-Wang (1994) uncertainty-averse utility function with an ambiguous underlying asset-returns distribution. To explore the connection of uncertainty with liquidity, we specify a simple market where a monopolist financial intermediary makes a market for a proprietary derivative security. The market-maker chooses bid and ask prices for the derivative, then, conditional on trade in this market, chooses an optimal portfolio and consumption. We explore how uncertainty can increase the bid-ask spread and, hence, reduces liquidity. In addition, "hedge portfolios" for the market-maker, an important component to understanding spreads, can look very different from those implied by a model without Knightian uncertainty. Our infinite-horizon example produces short, dramatic decreases in liquidity even though the underlying environment is stationary.

Abstract:
We model oil price dynamics in a general equilibrium production economy with two goods: a consumption good and oil. Production of the consumption good requires drawing from oil reserves. Investment necessary to replenish oil reserves is costly and irreversible. We solve for the optimal consumption, production and oil reserves policy for a representative agent. We analyze the equilibrium price of oil, as well as the term structure of oil futures prices. Because investment in oil reserves is irreversible and costly, the optimal investment in new oil reserves is periodic and lumpy. Investment occurs when the crude oil is relatively scarce in the economy. This generates an equilibrium oil price process that has distinct behavior across two regions (characterized by the abundance/scarcity of oil). We undertake three empirical tests suggested by our model. First, we estimate key parameters using SMM to match moments of oil price futures as well as other macro-economic properties of the data. Second, we estimate an affine regime switching model of the oil price, which captures the main features of our equilibrium model and preserves the tractability of reduced-form models. Lastly, we compare the risk premium in oil futures implied by our model to the data.

Commodity prices, Futures prices, Convenience yield, Scarcity, Investment, Irreversibility, General equilibrium, Simulated Method of Moments (SMM), Regime-switching model, risk premium

Abstract:
We provide a userâ¬"s guide to â¬Sexoticâ¬? preferences: nonlinear time aggregators, departures from expected utility, preferences over time with known and unknown probabilities, risk sensitive and robust control, â¬Shyperbolicâ¬? discounting, and preferences over sets (â¬Stemptationsâ¬?). We apply each to a number of classic problems in macroeconomics and finance, including consumption and saving, portfolio choice, asset pricing, and Pareto optimal allocations.

time preference, risk, uncertainty, ambiguity, robust control, temptation, dynamic consistency, hyperbolic discounting, precautionary saving, equity premium, risk sharing

Abstract:
We provide a userâ¬"s guide to â¬Sexoticâ¬? preferences: nonlinear time aggregators, departures from expected utility, preferences over time with known and unknown probabilities, risk sensitive and robust control, â¬Shyperbolicâ¬? discounting, and preferences over sets (â¬Stemptationsâ¬?). We apply each to a number of classic problems in macroeconomics and finance, including consumption and saving, portfolio choice, asset pricing, and Pareto optimal allocations.

time preference, risk, uncertainty, ambiguity, robust control, temptation, dynamic consistency, hyperbolic discounting, precautionary saving, equity premium, risk sharing

Abstract:
We provide a user's guide to 'exotic' preferences: nonlinear time aggregators, departures from expected utility, preferences over time with known and unknown probabilities, risk-sensitive and robust control, 'hyperbolic' discounting, and preferences over sets ('temptations'). We apply each to a number of classic problems in macroeconomics and finance, including consumption and saving, portfolio choice, asset pricing, and Pareto optimal allocations.

Abstract:
We summarize the class of recursive preferences. These preferences fit naturally with recursive solution methods and hold the promise of generating new insights into familiar problems. Portfolio choice is used as an example.

time preference, risk, uncertainty, ambiguity, robust control, temptation, dynamic consistency, hyperbolic discounting, precautionary saving, equity premium, risk sharing

Abstract:
We provide an axiomatic model of preferences over atemporal risks that generalizes Gul (1991) 'A Theory of Disappointment Aversion' by allowing risk aversion to be 'first order' at locations in the state space that do not correspond to certainty. Since the lotteries being valued by an agent in an asset-pricing context are not typically local to certainty, our generalization, when embedded in a dynamic recursive utility model, has important quantitative implications for financial markets. We show that the state-price process, or asset-pricing kernel, in a Lucas-tree economy in which the representative agent has generalized disappointment aversion preferences is consistent with the pricing kernel that resolves the equity-premium puzzle. We also demonstrate that a small amount of conditional heteroskedasticity in the endowment-growth process is necessary to generate these favorable results. In addition, we show that risk aversion in our model can be both state-dependent and counter-cyclical, which empirical research has demonstrated is necessary for explaining observed asset-pricing behavior.

Abstract:
We model equilibrium spot and futures oil prices in a general equilibrium production economy. In our model production of the consumption good requires two inputs: the consumption good and a commodity, e.g., Oil. Oil is produced by wells whose flow rate is costly to adjust. Investment in new oil wells is costly and irreversible. As a result in equilibrium, investment in oil wells is infrequent and lumpy. Even though the state of the economy is fully described by a one-factor Markov process, the spot oil price is not Markov (in itself). Rather it is best described as a regime-switching process, the regime being an investment 'proximity' indicator. The resulting equilibrium oil price exhibits mean-reversion and heteroscedasticity. Further, the risk premium for exposure to commodity risk is time-varying, positive in the far-from-investment regime but negative in the near-investment regime. Further, our model captures many of the stylized facts of oil futures prices, such as backwardation and the 'Samuelson effect.' The futures curve exhibits backwardation as a result of a convenience yield, which arises endogenously. We estimate our model using the Simulated Method of Moments with economic aggregate data and crude oil futures prices. The model successfully captures the first two moments of the futures curves, the average non-durable consumption-output ratio, the average oil consumption-output and the average real interest rate. The estimation results suggest the presence of convex adjustment costs for the investment in new oil wells. We also propose and test a linear approximation of the equilibrium regime-shifting dynamics implied by our model, and test its empirical implication for time-varying risk-premia.

Abstract:
We investigate adaptive or evolutionary learning in a repeated version of the Grossman and Stiglitz (1980) model. We demonstrate that any process that is a monotonic selection dynamic will converge to the rational expectations asset demands if the proportion of informed traders is fixed. We also show that these learning processes have a unique asymptotically stable fixed point at the Grossman-Stiglitz (GS) equilibrium. The robustness of learning to noisy experimentation is studied using Binmore and Samuelson's (1995) deterministic drift approximation. Conditions on economic and learning process parameters for adaptive learning to lead to the GS rational expectations equilibrium are presented.

Abstract:
This paper studies limited managerial capacity and the role it plays in determining the optimal assignment of decision rights. Limited managerial capacity has two effects. First, it leads to an option value of capacity to both the firm's managers and the firm's owner, the value of which is different for the owner than it is for each of the managers because of an externality within the firm. Second, it results in period-one project approval and assignment decisions having an effect on the option value of period-two capacity. Roughly stated, the owner's interests are best served if either of the two managers (but not both) is kept free for the next period. Each manager's interests are best served if he is the one who is kept free to implement a period-two project. Under the conditions presented in our proposition, decentralization (delegating the decision rights for project approval and assignment to one of the managers) mitigates the goal incongruence created by limited managerial capacity.