Risk, Robustness and Knightian Uncertainty in Continuous-Time, Heterogenous Agents, Financial Equilibria (original) (raw)

Robustness and Ambiguity Aversion in General Equilibrium

Review of Finance, 2000

We analyze the empirical predictions arising from settings of ambiguity aversion in intertemporal heterogenous agents economies. We study equilibria for two tractable wealth-homothetic settings of ambiguity aversion in continuous time. Such settings are motivated by a different robust control optimization problem. We show that ambiguity aversion affects optimal portfolio exposures in a way that is similar to an increase in risk aversion. A distinct property of the second of our settings of ambiguity aversion is that such increase is state-dependent and highly pronounced at moderate portfolio exposures. This feature causes quite prudent levels of equity market participation over a nontrivial set of states of the economy. In general equilibrium, ambiguity aversion tends to induce a higher equilibrium equity premium and lower interest rates. A distinct feature of the second of our settings of ambiguity aversion is that the equity premium part due to ambiguity aversion dominates when the exogenous random factors in the economy have low volatility. Thus, such setting can account for some distinct empirical predictions -like a limited equity market participation and ambiguity equity premia that dominate equity premia for small equity volatilities -which are unavailable under the first of our settings of ambiguity aversion.

UNCERTAINTY AVERSION, ROBUST CONTROL AND ASSET HOLDINGS WITH A STOCHASTIC INVESTMENT OPPORTUNITY SET

International Journal of Theoretical and Applied Finance, 2007

Optimal portfolio rules are derived under uncertainty aversion by formulating the portfolio choice problem as a robust control problem. The robust portfolio rule indicates that the total holdings of risky assets as a proportion of the investor's wealth could increase as compared to the holdings under the Merton rule, which is the standard risk aversion case. In particular, with two risky assets and one risk-free asset, we show that uncertainty aversion could lead to an increase in the holdings of the one risky asset, accompanied by a reduction in the holdings of the other risky asset. Furthermore, in the optimal robust portfolio the investor may increase the holdings of the asset for which there is or less ambiguity, and reduce the holdings of the asset for which there is more ambiguity, a result that might provide an explanation of the home bias puzzle. We would like to thank William Brock and Angelos Kanas for helpful comments and suggestions. 1

Uncertainty Aversion, Robust Control and Asset Holdings in Stochastic Enviroment

Uncertainty Aversion, Robust Control and Asset Holdings

2004

On the Robustness of Economic Models

2001

We investigate the different ways in which the results of theoretical models can be 'robust'. We identify three kinds of 'robustness': (1) robustness to changes in the model's idealisations; (2) robustness to changes in the 'background' conditions; (3) robustness to changes in the implied causal mechanism. Each of these is discussed and illustrated by means of examples from economic practice.

Induced uncertainty, market price of risk, and the dynamics of consumption and wealth

Journal of Economic Theory

In this paper we examine implications of model uncertainty due to robustness (RB) for consumption and saving and the market price of uncertainty under limited information-processing capacity (rational inattention or RI). We first solve the robust permanent income models with inattentive consumers and show that RI by itself creates an additional demand for robustness that leads to higher "induced uncertainty" facing consumers. Second, we explore how the induced uncertainty composed of (i) model uncertainty due to RB and (ii) state uncertainty due to RI, affects consumption-saving decisions and the market price of uncertainty. We find that induced uncertainty can better explain the observed market price of uncertainty-low attention increases the effect of model misspecification. We also show the observational equivalence between RB and risk-sensitivity (RS) in environment. * This paper was previously circulated under tht title "Consumption, Market Price of Risk, and Wealth Accumulation under Induced Uncertainty". We are indebted to Tom Sargent for helpful guidance and suggestions. We also would like to thank

Uncertainty Aversion and Robust Portfolio Choices with Stochastic Investment Opportunity Set

2005

Optimal portfolio rules are derived under uncertainty aversion by formulating the portfolio choice problem as a robust control problem. Using a power utility function of the form C with 0 < < 1; we present the solution of the robust portfolio choice problem in the cases of one and two risky assets. In particular, for two risky assets and one risk-free asset case, we con…rm our earlier theoretical result , that under uncertainty aversion the total holdings of risky assets as a proportion of the investor's wealth could increase as compared to the holdings under the Merton rule, which is the standard risk aversion case.

Uncertainty Aversion and Robust Portfolio Choices

2004

Robustness and macroeconomic policy

2011

This paper considers the design of macroeconomic policies in the face of uncertainty. In recent years, several economists have advocated that when policymakers are uncertain about the environment they face and find it difficult to assign precise probabilities to the alternative scenarios that may characterize this environment, they should design policies to be robust in the sense that they minimize the worstcase loss these policies could ever impose. I review and evaluate the objections cited by critics of this approach. I further argue that, contrary to what some have inferred, concern about worst-case scenarios does not always lead to policies that respond more aggressively to incoming news than the optimal policy would respond absent any uncertainty.

Incomplete Markets: Specification Errors and Robustness

neumann.hec.ca

When markets are incomplete, absence of arbitrage implies that there is a multiplicity of equivalent martingale measures. These correspond to different choices of the market price of risk. This paper provides a framework for studying the connection between the choice of the market price of risk and security prices in an incomplete market. We construct a benchmark complete market which is the limit of a sequence of incomplete markets that share the same market price of risk. We employ tools from the the theory of large deviations to define a distance measure between an incomplete market and the benchmark complete market model. This framework leads to a natural characterization of robustness. We illustrate the approach using a stochastic volatility model.

Risk, Robustness and Knightian Uncertainty in Continuous-Time, Heterogenous Agents, Financial Equilibria (original) (raw)

Related papers