Twisted Probabilities, Uncertainty, and Prices
55 Pages Posted: 15 Jan 2019
Date Written: January 14, 2019
A decision maker constructs a convex set of nonnegative martingales to use as likelihood ratios that represent alternatives that are statistically close to a decision maker's baseline model. The set is twisted to include some specific models of interest. Max-min expected utility over that set gives rise to equilibrium prices of model uncertainty expressed as worst-case distortions to drifts in a representative investor's baseline model. Three quantitative illustrations start with baseline models having exogenous long-run risks in technology shocks. These put endogenous long-run risks into consumption dynamics that differ in details that depend on how shocks affect returns to capital stocks. We describe sets of alternatives to a baseline model that generate countercyclical prices of uncertainty.
Keywords: Risk, uncertainty, relative entropy, robustness, asset prices, exponential quadratic stochastic discount factor
JEL Classification: C52, C58, D81, D84, G12
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