Working Paper: NBER ID: w22000
Authors: Lars P. Hansen; Thomas J. Sargent
Abstract: A decision maker constructs a convex set of nonnegative martingales to use as likelihood ratios that represent parametric alternatives to a baseline model and also non-parametric models statistically close to both the baseline model and the parametric alternatives. 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. We offer quantitative illustrations for baseline models of consumption dynamics that display long-run risk. We describe a set of parametric alternatives that generates countercyclical prices of uncertainty.
Keywords: Model Uncertainty; Equilibrium Pricing; Decision Making
JEL Codes: C01; C02; C14; C52; E3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| model uncertainty (D80) | equilibrium prices of model uncertainty (D89) |
| convex set of nonnegative martingales (D52) | equilibrium prices of model uncertainty (D89) |
| maxmin expected utility over convex set of models (D81) | equilibrium prices of model uncertainty (D89) |
| alternative parametric models (C51) | countercyclical prices of uncertainty (D89) |