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Taking Ambiguity to Reality: Robust Agents Cannot Trust the Data Too Much

Author

Listed:
  • Fabio TROJANI

    (University of Lugano and Swiss Finance Institute)

  • Christian WIEHENKAMP

    (Goethe University Frankfurt)

  • Jan WRAMPELMEYER

    (University of Zurich and Swiss Finance Institute (SFI PhD Program))

Abstract

Ambiguity aversion in dynamic models is motivated by the presence of unknown time-varying features, which agents do not understand and cannot theorize about. We analyze the consequences of this assumption for economic agents and model builders, who typically need to estimate a model, e.g., to implement optimal robust decision rules or to quantify the equilibrium price of ambiguity. We show that in such contexts robust estimation methods are essential for (i) limiting the sensitivity of robust policies to abnormal time-varying features and (ii) drawing coherent inference on equilibrium variables. We propose a general robust estimation methodology, applicable to many economic settings of ambiguity. In the robust portfolio problem, unknown time-varying features in expected returns or rare events generate large utility losses, which are successfully bounded by our robust approach. Time-varying features can also produce large biases in estimated equilibrium risk or ambiguity premia, while in incomplete derivative markets they tend to systematically produce overestimated bid-ask spreads. We show that a good fraction of these biases can be eliminated, using our robust estimation approach. Finally, in a real-data application with ambiguous predictability our robust approach consistently produces both portfolio weights largely insensitive to abnormal data constellations and larger out-of-sample utilities.

Suggested Citation

  • Fabio TROJANI & Christian WIEHENKAMP & Jan WRAMPELMEYER, "undated". "Taking Ambiguity to Reality: Robust Agents Cannot Trust the Data Too Much," Swiss Finance Institute Research Paper Series 11-33, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp1133
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    File URL: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1668569
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    Cited by:

    1. Hui Chen & Nengjiu Ju & Jianjun Miao, 2014. "Dynamic Asset Allocation with Ambiguous Return Predictability," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 17(4), pages 799-823, October.

    More about this item

    Keywords

    Ambiguity Aversion; Knightian Uncertainty; Robust Econometrics; Portfolio Choice; Option Pricing;

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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