The price of risk and ambiguity in an intertemporal general equilibrium model of asset prices
AbstractWe consider a version of the intertemporal general equilibrium model of Cox et al. (Econometrica 53:363–384, 1985 ) with a single production process and two correlated state variables. It is assumed that only one of them, Y 2 , has shocks correlated with those of the economy’s output rate and, simultaneously, that the representative agent is ambiguous about its stochastic process. This implies that changes in Y 2 should be hedged and its uncertainty priced, with this price containing risk and ambiguity components. Ambiguity impacts asset pricing through two channels: the price of uncertainty associated with the ambiguous state variable, Y 2 , and the interest rate. With ambiguity, the equilibrium price of uncertainty associated with Y 2 and the equilibrium interest rate can increase or decrease, depending on: (i) the correlations between the shocks in Y 2 and those in the output rate and in the other state variable; (ii) the diffusion functions of the stochastic processes for Y 2 and for the output rate; and (iii) the gradient of the value function with respect to Y 2 . As applications of our generic setting, we deduct the model of Longstaff and Schwartz (J Financ 47:1259–1282, 1992 ) for interest-rate-sensitive contingent claim pricing and the variance-risk price specification in the option pricing model of Heston (Rev Financ Stud 6:327–343, 1993 ). Additionally, it is obtained a variance-uncertainty price specification that can be used to obtain a closed-form solution for option pricing with ambiguity about stochastic variance. Copyright Springer-Verlag 2012
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Bibliographic InfoArticle provided by Springer in its journal Annals of Finance.
Volume (Year): 8 (2012)
Issue (Month): 4 (November)
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Web page: http://www.springerlink.com/link.asp?id=112370
Ambiguity; Asset pricing; Equilibrium price of uncertainty; Robust optimization; C68; D81; G13;
Other versions of this item:
- Gonçalo Faria & João Correia-da-Silva, 2011. "The Price of Risk and Ambiguity in an Intertemporal General Equilibrium Model of Asset Prices," FEP Working Papers 399, Universidade do Porto, Faculdade de Economia do Porto.
- C68 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computable General Equilibrium Models
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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- Gonçalo Faria & João Correia-da-Silva, 2012. "Is Stochastic Volatility relevant for Dynamic Portfolio Choice under Ambiguity?," FEP Working Papers 472, Universidade do Porto, Faculdade de Economia do Porto.
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