Robustness and Dynamic Sentiment
52 Pages Posted: 9 Mar 2021 Last revised: 2 Jun 2021
Date Written: March 5, 2021
Errors in survey expectations display waves of pessimism and optimism and significant sluggishness. This paper develops a novel theoretical framework of time-varying beliefs capturing these empirical facts. In our model, the dynamic beliefs arise endogenously due to agents’ attitude toward alternative models. Decision-maker’s distorted beliefs generate countercyclical risk aversion, procyclical portfolio weights, countercyclical equilibrium asset returns, and excess volatility. A calibrated version of our model is shown to match salient features in equity markets.
Keywords: robust control, subjective beliefs, pessimism, optimism, Cressie-Read
JEL Classification: G11, G12
Suggested Citation: Suggested Citation