Working Paper: NBER ID: w26970
Authors: Pascal J. Maenhout; Andrea Vedolin; Hao Xing
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.
Keywords: dynamic pessimism; asset prices; robust control; Cressie-Read divergences
JEL Codes: G11; G4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| dynamic pessimism (D80) | risk aversion (D81) |
| risk aversion (D81) | portfolio decisions (G11) |
| portfolio decisions (G11) | equilibrium asset prices (G19) |
| dynamic pessimism (D80) | equilibrium asset prices (G19) |
| distorted beliefs (D91) | asset price dynamics (G19) |
| time-varying pessimism (E32) | excess volatility (G17) |
| time-varying pessimism (D84) | high equity premium (G12) |