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The price of risk and ambiguity in an intertemporal general equilibrium model of asset prices

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  • Gonçalo Faria

    ()

  • João Correia-da-Silva

    ()

Abstract

We 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

Suggested Citation

  • Gonçalo Faria & João Correia-da-Silva, 2012. "The price of risk and ambiguity in an intertemporal general equilibrium model of asset prices," Annals of Finance, Springer, vol. 8(4), pages 507-531, November.
  • Handle: RePEc:kap:annfin:v:8:y:2012:i:4:p:507-531
    DOI: 10.1007/s10436-012-0197-y
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    Cited by:

    1. Gonçalo Faria & João Correia-da-Silva, 2014. "A closed-form solution for options with ambiguity about stochastic volatility," Review of Derivatives Research, Springer, vol. 17(2), pages 125-159, July.
    2. Meglena Jeleva & Jean-Marc Tallon, 2016. "Ambiguïté, comportements et marchés financiers," Post-Print halshs-01109639, HAL.
    3. Escobar, Marcos & Ferrando, Sebastian & Rubtsov, Alexey, 2015. "Robust portfolio choice with derivative trading under stochastic volatility," Journal of Banking & Finance, Elsevier, vol. 61(C), pages 142-157.
    4. Gonçalo Faria & João Correia-da-Silva, 2016. "Is stochastic volatility relevant for dynamic portfolio choice under ambiguity?," The European Journal of Finance, Taylor & Francis Journals, vol. 22(7), pages 601-626, May.
    5. Jeleva, Meglena & Tallon, Jean-Marc, 2016. "Ambiguïté, comportements et marchés financiers," L'Actualité Economique, Société Canadienne de Science Economique, vol. 92(1-2), pages 351-383, Mars-Juin.
    6. repec:spr:annopr:v:262:y:2018:i:2:d:10.1007_s10479-015-2079-y is not listed on IDEAS

    More about this item

    Keywords

    Ambiguity; Asset pricing; Equilibrium price of uncertainty; Robust optimization; C68; D81; G13;

    JEL classification:

    • 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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