Ambiguity Aversion, Asset Prices, and the Welfare Costs of Aggregate Fluctuations (original) (raw)
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Induced uncertainty, market price of risk, and the dynamics of consumption and wealth
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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
Consumption, asset markets, and macroeconomic fluctuations
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A broad exploratory data analysis is conducted to assess the promise of a kind of model in which long-term asset prices change through time primarily due to consumption related changes in the rate of discount. Aggregate consumption data are used to infer ex-post marginal rates of substitution. Prices of stocks, bonds, short debt, land and housing are examined for the period 1890 to 1980. Methods are explored of evaluating this kind of model in the absence of accurate data on consumpticn.
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Consumption-based asset-pricing models have experienced success in recent years by augmenting the consumption process in 'exotic' ways. Two notable examples are the Long-Run Risk and rare disaster frameworks. Such models are difficult to characterize from consumption data alone. Accordingly, concerns have been raised regarding their specification. Acknowledging that both phenomena are naturally subject to ambiguity, we show that an ambiguity-averse agent may behave as if Long-Run Risk and disasters exist even if they do not or exaggerate them if they do. Consequently, prices may be misleading in characterizing these phenomena since they encode a pessimistic perspective of the data-generating process.
Consumption dynamics, asset pricing, and welfare effects under information processing constraints
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This paper studies consumption dynamics, asset returns and optimal portfolio choice, and welfare losses under information processing constraints (it is also called "rational inattention" (RI) in Sims (2003).) in two canonical macroeconomic models: the permanent income hypothesis model (PIH) and the consumption-based capital asset pricing model (CCAPM). It is shown that incorporating RI into these otherwise standard macroeconomic models can provide an additional propagation mechanism and largely affect the intertemporal allocation of consumption, which makes the models better explain the data in some important aspects.
Ambiguity aversion and asset prices in production economies. Working paper
2013
We introduce ambiguity and ambiguity aversion into a standard one-sector production-based real business cycle model where mean productivity growth rates are uncertain. We show that with mild capital adjustment costs and a low coefficient of relative risk aversion, the model can explain several salient features about macroeconomic quantities and asset prices including a high equity premium, a low and smooth risk-free rate, a low consumption growth volatility and a high investment growth volatility relative to output growth volatility. Moreover, the model can generate long horizon predictability of equity returns by price-dividend ratios, investment-capital ratios, Tobin's Q and consumptionwealth ratios. Introducing an unobservable state and Bayesian learning into the model can further account for countercyclical equity premia. JEL Classification: C61; D81; G11; G12.
Ambiguity Aversion and Asset Prices in Production Economies
Social Science Research Network, 2012
We introduce ambiguity and ambiguity aversion into a standard one-sector production-based real business cycle model where mean productivity growth rates are uncertain. We show that with mild capital adjustment costs and a low coefficient of relative risk aversion, the model can explain several salient features about macroeconomic quantities and asset prices including a high equity premium, a low and smooth risk-free rate, a low consumption growth volatility and a high investment growth volatility relative to output growth volatility. Moreover, the model can generate long horizon predictability of equity returns by price-dividend ratios, investment-capital ratios, Tobin's Q and consumptionwealth ratios. Introducing an unobservable state and Bayesian learning into the model can further account for countercyclical equity premia.
2016
We study an investor who is unsure of the dynamics of the economy. Not only are parameters unknown, but the investor does not even know what order model to estimate. She estimates her consumption process nonparametrically-allowing potentially infinite-order dynamics-and prices assets using a pessimistic model that minimizes lifetime utility subject to a constraint on statistical plausibility. The equilibrium is exactly solvable and we show that the pricing model always includes long-run risks. With risk aversion of 4.7, the model matches major facts about asset prices, consumption, and dividends. The paper provides a novel link between ambiguity aversion and non-parametric estimation.
Asset Prices with Heterogeneity in Preferences and Beliefs
Review of Financial Studies, 2014
In this paper, we study asset prices in a dynamic, continuous-time, general-equilibrium endowment economy where agents have power utility and differ with respect to both beliefs and their preference parameters for time discount and risk aversion. We solve in closed form for the following quantities: optimal consumption and portfolio policies of individual agents; the riskless interest rate and market price of risk; the stock price, equity risk premium, and volatility of stock returns; and, the term structure of interest rates. Our solution allows us to identify the strengths and limitations of the model with heterogeneity in both preferences and beliefs. We find that beliefs about the mean growth rate of the aggregate endowment that are pessimistic on average (across investors) lead to a significant increase in the market price of risk, while heterogeneity in risk aversion increases stock-return volatility. Consequently, the equity risk premium, which is the product of the market price of risk and stock return volatility, is considerably higher in the model where average beliefs are pessimistic and risk aversions are heterogeneous, and this is not accompanied by an increase in either the level or the volatility of the short-term riskless rate. The main limitation of the model is that it is stationary only for a restricted set of parameter values, and for these parameter values one can get a high market price of risk and equity risk premium but not excess stock return volatility.
Prices and allocations in asset markets with heterogeneous attitudes towards ambiguity
Review of Financial …, 2007
This paper studies the impact of ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitude toward ambiguity is heterogeneous in the population, just as attitude toward risk is heterogeneous in the population, but that heterogeneity in attitude toward ambiguity has different implications than heterogeneity in attitude toward risk. Specifically, agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This leads to a wider range of state price densities and to potential reversals of ranking of state price-probability ratios relative to aggregate wealth. In addition, the distribution of holdings will have a new mode, with highly ambiguity averse agents holding securities with ambiguous payoffs in equal proportions. Under pure risk, the distribution of holdings has a single mode equal to the market portfolio weight. Experiments confirm the theoretical predictions. While price patterns often look little different from those under pure risk, portfolio choices display strong effects from the presence of ambiguity. The experiments also suggest a positive correlation between risk aversion and ambiguity aversion, which may explain the "value effect" in field data. † We are grateful for comments to seminar audiences at CIRANO, U.C. Irvine, Kobe University, Collegio
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.