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Robust Equilibrium Yield Curves

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 with a representative agent and an output growth process that 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 markets, as well as consumption 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?. That is, it is statistically difficult to distinguish between models in this set.

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File URL: http://www.hec.ca/iea/cahiers/2008/iea0802_nvincent.pdf
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Paper provided by HEC Montréal, Institut d'économie appliquée in its series Cahiers de recherche with number 08-02.

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Length: 67 pages
Date of creation: Nov 2007
Date of revision:
Handle: RePEc:iea:carech:0802
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