Robust control, Regime Switching Risk and Asset Prices
It has been recognized that (i) decision makers' concerns about robustness affect prices and quantities; and (ii) uncertainty are generated by infrequent large shocks as well as continuous small shocks. An investor observes movements in variable levels but cannot perfectly distinguish their sources. Instead, the investor solves a signal extraction problem. We depart from most of the macroeconomics and finance literature by presuming that the investor treats the infrequent risk as non-diversifiable and hence the risk has to be priced. We study how a concern about robustness alters asset prices. We analyze the dynamic evolution of the risk-return tradeoff and the evolution of the dividend-price ratio. We also gauge the impact of the regime switching risk on asset prices
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