Generalized Robustness and Dynamic Pessimism

43 Pages Posted: 20 Apr 2020 Last revised: 11 Sep 2021

See all articles by Pascal J. Maenhout

Pascal J. Maenhout

INSEAD - Finance

Andrea Vedolin

Boston University - Department of Finance & Economics

Hao Xing

Boston University - Questrom School of Business

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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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Suggested Citation

Maenhout, Pascal J. and Vedolin, Andrea and Xing, Hao, Generalized Robustness and Dynamic Pessimism (April 2020). NBER Working Paper No. w26970, Available at SSRN: https://ssrn.com/abstract=3580548

Pascal J. Maenhout (Contact Author)

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France

Andrea Vedolin

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

Hao Xing

Boston University - Questrom School of Business ( email )

595 Commonwealth Avenue
Boston, MA MA 02215
United States

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