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Robust Equilibrium Yield Curves

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  • Isaac Kleshchelski
  • Nicolas Vincent

Abstract

This paper studies the quantitative implications of the interaction between robust control and stochastic volatility for key asset pricing phenomena. We present an equilibrium term structure model in which output growth is conditionally heteroskedastic. The agent does not know the true model of the economy and chooses optimal policies that are robust to model misspecification. The choice of robust policies greatly amplifies the effect of conditional heteroskedasticity in consumption growth, improving the model's ability to explain asset prices. In a robust control framework, stochastic volatility in consumption growth generates both a state-dependent market price of model uncertainty and a stochastic market price of risk. We estimate the model using data from the bond and equity market, as well as consumtion data. We show that the model is consistent with key empirical regularities that characterize the bond and equity markets. We also characterize empirically the set of models the robust representative agent entertains, and show that this set is "small". In other words, it is statistically difficult to distinguish between models in this set.

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Bibliographic Info

Paper provided by CIRPEE in its series Cahiers de recherche with number 0907.

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Date of creation: 2009
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Handle: RePEc:lvl:lacicr:0907

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Keywords: Yield curve; market price of uncertainty; robust control;

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References

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Citations

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Cited by:
  1. Larry G. Epstein & Martin Schneider, 2010. "Ambiguity and Asset Markets," NBER Working Papers 16181, National Bureau of Economic Research, Inc.
  2. Cosmin L. Ilut, 2010. "Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle," Working Papers 10-53, Duke University, Department of Economics.
  3. Ulrich, Maxim, 2013. "Inflation ambiguity and the term structure of U.S. Government bonds," Journal of Monetary Economics, Elsevier, vol. 60(2), pages 295-309.
  4. Rhys Bidder & Matthew E. Smith, 2013. "Doubts and variability: a robust perspective on exotic consumption series," Working Paper Series 2013-28, Federal Reserve Bank of San Francisco.
  5. Hisashi Nakamura & Keita Nakayama & Akihiko Takahashi, 2008. "Term Structure of Interest Rates Under Recursive Preferences in Continuous Time," Asia-Pacific Financial Markets, Springer, vol. 15(3), pages 273-305, December.

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