No good deals—no bad models
Faced with the problem of pricing complex contingent claims, investors seek to make their valuations robust to model uncertainty. We construct a notion of a model-uncertainty-induced utility function and show that model uncertainty increases investors’ effective risk aversion. Using this utility function, we extend the “no good deals” methodology of Cochrane and Saá-Requejo (2000) to compute lower and upper good-deal bounds in the presence of model uncertainty. We illustrate the methodology using some numerical examples.
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