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Doubts or variability?

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  • Barillas, Francisco
  • Hansen, Lars Peter
  • Sargent, Thomas J.

Abstract

Reinterpreting most of the market price of risk as a price of model uncertainty eradicates a link between asset prices and measures of the welfare costs of aggregate fluctuations that was proposed by Hansen, Sargent, and Tallarini [17], Tallarini [30], Alvarez and Jermann [1]. Prices of model uncertainty contain information about the benefits of removing model uncertainty, not the consumption fluctuations that Lucas [22] and [23] studied. A max-min expected utility theory lets us reinterpret Tallarini's risk-aversion parameter as measuring a representative consumer's doubts about the model specification. We use model detection instead of risk-aversion experiments to calibrate that parameter. Plausible values of detection error probabilities give prices of model uncertainty that approach the Hansen and Jagannathan [11] bounds. Fixed detection error probabilities give rise to virtually identical asset prices as well as virtually identical costs of model uncertainty for Tallarini's two models of consumption growth.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 144 (2009)
Issue (Month): 6 (November)
Pages: 2388-2418

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Handle: RePEc:eee:jetheo:v:144:y:2009:i:6:p:2388-2418

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Web page: http://www.elsevier.com/locate/inca/622869

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Keywords: Risk aversion Model misspecification Robustness Market price of risk Equity premium puzzle Risk-free rate puzzle Detection error probability Costs of model uncertainty;

References

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  1. Hansen, Lars Peter & Sargent, Thomas J. & Wang, Neng E., 2002. "Robust Permanent Income And Pricing With Filtering," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 6(01), pages 40-84, February.
  2. Weil, Philippe, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 105(1), pages 29-42, February.
  3. Fernando Alvarez & Urban J. Jermann, 2004. "Using Asset Prices to Measure the Cost of Business Cycles," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 112(6), pages 1223-1256, December.
  4. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  5. Sujoy Mukerji & Peter Klibanoff, 2002. "A Smooth Model of Decision,Making Under Ambiguity," Economics Series Working Papers 113, University of Oxford, Department of Economics.
  6. Tomasz Strzalecki, 2011. "Axiomatic Foundations of Multiplier Preferences," Levine's Working Paper Archive 786969000000000126, David K. Levine.
  7. John H. Cochrane, 1997. "Where is the market going? Uncertain facts and novel theories," Economic Perspectives, Federal Reserve Bank of Chicago, Federal Reserve Bank of Chicago, issue Nov, pages 3-37.
  8. TallariniJr., Thomas D., 2000. "Risk-sensitive real business cycles," Journal of Monetary Economics, Elsevier, Elsevier, vol. 45(3), pages 507-532, June.
  9. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, American Economic Association, vol. 93(1), pages 1-14, March.
  10. Kocherlakota, Narayana R, 1990. " Disentangling the Coefficient of Relative Risk Aversion from the Elasticity of Intertemporal Substitution: An Irrelevance Result," Journal of Finance, American Finance Association, American Finance Association, vol. 45(1), pages 175-90, March.
  11. Hansen, Lars Peter & Sargent, Thomas J., 2005. "Robust estimation and control under commitment," Journal of Economic Theory, Elsevier, Elsevier, vol. 124(2), pages 258-301, October.
  12. Jim Dolmas, 1998. "Risk Preferences and the Welfare Cost of Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(3), pages 646-676, July.
  13. Maccheroni, Fabio & Marinacci, Massimo & Rustichini, Aldo, 2006. "Dynamic variational preferences," Journal of Economic Theory, Elsevier, Elsevier, vol. 128(1), pages 4-44, May.
  14. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, Econometric Society, vol. 57(4), pages 937-69, July.
  15. Fabio Maccheroni & Massimo Marinacci & Aldo Rustichini, 2004. "Ambiguity Aversion, Robustness, and the Variational Representation of Preferences," Carlo Alberto Notebooks, Collegio Carlo Alberto 12, Collegio Carlo Alberto, revised 2006.
  16. Thomas J. Sargent & LarsPeter Hansen, 2001. "Robust Control and Model Uncertainty," American Economic Review, American Economic Association, American Economic Association, vol. 91(2), pages 60-66, May.
  17. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 99(2), pages 263-86, April.
  18. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of security market data for models of dynamic economies," Discussion Paper / Institute for Empirical Macroeconomics 29, Federal Reserve Bank of Minneapolis.
  19. Kreps, David M & Porteus, Evan L, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Econometrica, Econometric Society, Econometric Society, vol. 46(1), pages 185-200, January.
  20. Lars Hansen & Thomas Sargent & Thomas Tallarini, . "Robust Permanent Income and Pricing," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 1997-51, Carnegie Mellon University, Tepper School of Business.
  21. Hansen, Lars Peter & Sargent, Thomas J., 2007. "Recursive robust estimation and control without commitment," Journal of Economic Theory, Elsevier, Elsevier, vol. 136(1), pages 1-27, September.
  22. Evan W. Anderson & Lars Peter Hansen & Thomas J. Sargent, 2003. "A Quartet of Semigroups for Model Specification, Robustness, Prices of Risk, and Model Detection," Journal of the European Economic Association, MIT Press, MIT Press, vol. 1(1), pages 68-123, 03.
  23. Obstfeld, Maurice, 1994. "Evaluating risky consumption paths: The role of intertemporal substitutability," European Economic Review, Elsevier, vol. 38(7), pages 1471-1486, August.
  24. Thomas J. Sargent & Riccardo Colacito & Lars P. Hansen & Timothy Cogley, 2008. "Robustness and US Monetary," 2008 Meeting Papers 228, Society for Economic Dynamics.
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