Equilibrium Asset Pricing with Time-Varying Pessimism

EFA 2003 Annual Conference Paper No. 841; Tilburg U CentER Working Paper No. 2002-102

43 Pages Posted: 10 Dec 2002

See all articles by Alessandro Sbuelz

Alessandro Sbuelz

Catholic University of Milan - Department of Mathematics, Quantitative Finance, and Econometrics; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Fabio Trojani

Swiss Finance Institute; University of Geneva

Date Written: October 2002

Abstract

We study the equilibrium pricing effects of a sentiment for pessimism. Pessimism has the form of Knightian model uncertainty aversion for a neighborhood of indistinguishable model specifications that are constrained in their relative entropy from a given reference model. We fully characterise the equilibrium of a pessimistic, representative agent, exchange economy with intertemporal consumption, stochastic opportunity set, and a relative entropy constraint that can depend on the state of the economy. We find that Knightian pessimism generates substantial First Order Risk Aversion (FORA) effects that enhance excess equity returns by pushing riskfree rates down. However, we find that the structure of equity returns is virtually unaffected by a Knightian concern for model uncertainty. We compute and calibrate explicit equilibrium examples of a pessimistic economy with an amount of pessimism associated to an 11% upper probability bound of confusing the relevant worst-case model and the given reference model. Relative entropy is the key in fixing such a realistic amount of pessimism in our calibrations. Even for log utility, such small amount of pessimism generates some 55 basis points more of unconditional equity premium. Knightian pessimism provides an economically and observationally different description of excess equity returns. Our findings show that realistic amounts of both pessimism and standard risk aversion yield substantial equity premia and low riskfree rates.

Keywords: Asset Pricing, General Equilibrium, Model Misspecification, Knightian Uncertainty, First Order Risk Aversion

JEL Classification: G11, G12

Suggested Citation

Sbuelz, Alessandro and Trojani, Fabio, Equilibrium Asset Pricing with Time-Varying Pessimism (October 2002). EFA 2003 Annual Conference Paper No. 841; Tilburg U CentER Working Paper No. 2002-102, Available at SSRN: https://ssrn.com/abstract=347382 or http://dx.doi.org/10.2139/ssrn.347382

Alessandro Sbuelz (Contact Author)

Catholic University of Milan - Department of Mathematics, Quantitative Finance, and Econometrics ( email )

largo A. Gemelli 1
I-20123 Milan
Italy
+39 02 7234 2345 (Phone)
+39 02 7234 2671 (Fax)

HOME PAGE: http://ppd.unicatt.it/docenti/alessandro_sbuelz

Bocconi University - CAREFIN - Centre for Applied Research in Finance

Via Sarfatti, 25
Milan, 20136
Italy

Fabio Trojani

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

University of Geneva ( email )

Geneva, Geneva
Switzerland

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