62 Pages Posted: 22 Dec 2012 Last revised: 17 Jul 2014
Date Written: July 14, 2014
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: 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