Generalized Robustness and Dynamic Pessimism

Andrea Vedolin, Pascal Maenhout and Hao Xing

No 14592, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper develops a theory of dynamic pessimism and its impact on asset prices. Notions of time-varying pessimism arise endogenously in our setting as a consequence of agents’ concern for model misspecification. We generalize the robust control approach of Hansen and Sargent (2001) by replacing relative entropy as a measure of discrepancy between models by the more general family of Cressie-Read discrepancies. As a consequence, the decision-maker’s distorted beliefs appear as an endogenous state variable driving risk aversion, portfolio decisions, and equilibrium asset prices. Using survey data, we estimate time-varying pessimism and find that such a proxy features a strong business cycle component. We then show that using our measure of pessimism helps match salient features in equity markets such as excess volatility and high equity premium.

Keywords: Cressie read; Robust control; Subjective beliefs; Pessimism (search for similar items in EconPapers)
JEL-codes: F31 G15 (search for similar items in EconPapers)
Date: 2020-04
New Economics Papers: this item is included in nep-upt
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Citations: View citations in EconPapers (1)

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