Research Publication

A decision maker constructs a convex set of nonnegative martingales to use as likeli-hood 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 con-sumption 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

SSRN link

@techreport{hansensargent:2016sets,
  title={Sets of Models and Prices of Uncertainty},
  author={Hansen, Lars P. and Sargent, Thomas J.},
  year={2016},
  institution={National Bureau of Economic Research}
}