Research

Lars Peter Hansen is a leading expert in economic dynamics who works at the forefront of economic thinking and modeling. He draws approaches from macroeconomics, finance, and statistics.

Hansen’s current work investigates three interconnecting areas: (1) macroeconomic uncertainty and financial markets; (2) struggling with a complex future; and (3) understanding investor beliefs through asset market data.

In this 4-minute documentary, “Incertitudes”, Lars explains why he seeks to better understand the role uncertainty plays in financial markets and the economy. (Produced by Histoire courtes.)

1. Tackling Uncertainty When Confronting Climate Change

Hansen and his collaborators develop and apply methods for confirming uncertainty and its impacts, broadly speaking, for the design and conduct of public policy. This research brings tools from decision theory and asset pricing to study uncertainty evaluation including the particular ramifications for the social cost of carbon.

Specifically, Hansen places emphasis on quantitative storytelling as a credible way to conduct policy analysis in dynamic settings. It combines so-called “stylized modeling” with empirical evidence. Hansen and his co-authors purposefully consider multiple stories, with carefully worked-out narratives that are formally captured as models, which have different ramifications for the environment and the economy. For dynamic problems such as the one of climate uncertainty, multiple “stories” are virtually impossible to dismiss on either theoretical or empirical grounds.

In their quantitative application, Hansen and his collaborators show that the social cost of carbon could become very large without additional forms of mitigation, technological change, adaptation and/or policy intervention. They abstract from regional and developmental heterogeneity, which should be part of a more full accounting. Of course, these limitations should be explored and they will alter the implied social cost of carbon. They are actively engaged in revealing extensions that will allow us to confront some of these shortcomings along with more ambitious climate inputs. In summary, this paper is not meant as the answer, but as their initial step in incorporating broad notions of uncertainty in a formal policy analysis while avoiding overstated claims of our current knowledge base.

2. Struggling with a Complex Future

Hansen and his collaborators explore important questions about the consequences for financial markets when investors are unsure about the future.

Formal and informal evidence from financial markets suggests that the markets vary over time in their concerns about uncertainty. What drives these fluctuations and how are they related to speculations about future macroeconomic performance? How should public policy be designed given our incomplete understanding how policy impacts the economy in subtle and not so subtle ways.

To investigate these issues formally requires a modeling framework where investors within the model sometimes struggle with how to make projections about future economic performance and even about which model is the best one to use

Hansen and his coauthors study how different forms of uncertainty, including risk, ambiguity and their resulting skepticism, impact financial market performance. They seek to advance understanding about the implications of uncertainty, especially for behavior of markets and the design of economic policy.

Relevant Research

3. The Pricing Impact of Macroeconomic Uncertainty

Applied macroeconomic research quantifies how random impulses or “shocks” to the dynamic economic system transmit throughout the economy and  affect  outcomes over time.

Hansen’s recent collaborative research aims to assign prices to these shocks by building on and extending insights from asset pricing theory.

In financial markets, we know that investors are compensated for their exposure to added macroeconomic uncertainty, but we don’t yet know how or by how much. Hansen’s research seeks to answer the question, “What are the implied investor compensations for exposure to macroeconomic shocks over alternative payoff or investment horizons?”  

Thus, his work is designed to provide a pricing counterpart to the impulse response functions used by macroeconomists. The drive to  identify the long-term impacts of uncertainty motivates this work, and as a result, features revealing characterizations of the importance of the contributions to pricing that persist over time.

Relevant Research

4. Investor beliefs as revealed by asset market data

Asset markets are forward-looking. They encode information about investor beliefs about the future and about investors’ concerns for risk. How can we use financial market data to extract information about these two components in a reliable way? Financial market prices can change because investors change their subjective beliefs about the future and because the risk prices that they are exposed to change. This research, which Hansen pursues with his collaborators, investigates this question by formally exploring the interplay among , investors’ beliefs, rational expectations, and the long-term consequences of exposure to risk.

Relevant Research

(See complete paper archive.)