No Good Deals — No Bad Models

62 Pages Posted: 22 Dec 2012 Last revised: 17 Jul 2014

See all articles by Nina Boyarchenko

Nina Boyarchenko

Federal Reserve Bank of New York

Mario Cerrato

London Metropolitan University - Department of Economics, Finance and International Business (EFIB)

John Crosby

University of Maryland - Robert H. Smith School of Business

Stewart D. Hodges

University of Warwick - Financial Options Research Centre (FORC)

Date Written: July 14, 2014

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

Suggested Citation

Boyarchenko, Nina and Cerrato, Mario and Crosby, John and Hodges, Stewart D., No Good Deals — No Bad Models (July 14, 2014). FRB of New York Staff Report No. 589; 26th Australasian Finance and Banking Conference 2013. Available at SSRN: https://ssrn.com/abstract=2192559 or http://dx.doi.org/10.2139/ssrn.2192559

Nina Boyarchenko

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-7339 (Phone)
212-720-1582 (Fax)

Mario Cerrato

London Metropolitan University - Department of Economics, Finance and International Business (EFIB) ( email )

Economics Subject Group, LMBS
London EC2M 6SQ, EC2M 6SQ
United Kingdom

John Crosby (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
+447979901892 (Phone)

HOME PAGE: http://www.john-crosby.co.uk/

Stewart D. Hodges

University of Warwick - Financial Options Research Centre (FORC) ( email )

Warwick Business School
Coventry CV4 7AL
United Kingdom
01203-523606 (Phone)

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