Download This PaperGeneralized Robustness and Dynamic Pessimism
43 Pages Posted: 20 Apr 2020 Last revised: 12 Mar 2026
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Generalized Robustness and Dynamic Pessimism
Generalized Robustness and Dynamic Pessimism
Date Written: April 2020
Abstract
This paper develops a theory of dynamic pessimism and its impact on asset prices. Notions of time-varying pessimism arise endogenously in our setting as a consequence of agents’ concern for model misspecification. We generalize the robust control approach of Hansen and Sargent (2001) by replacing relative entropy as a measure of discrepancy between models by the more general family of Cressie-Read discrepancies. As a consequence, the decision-maker’s distorted beliefs appear as an endogenous state variable driving risk aversion, portfolio decisions, and equilibrium asset prices. Using survey data, we estimate time-varying pessimism and find that such a proxy features a strong business cycle component. We then show that using our measure of pessimism helps match salient features in equity markets such as excess volatility and high equity premium.
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