Asset Prices Under Knightian Uncertainty

Roman Frydman (), Soren Johansen, Anders Rahbek () and Morten Tabor ()
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Roman Frydman: Department of Economics, New York University
Anders Rahbek: Department of Economics, University of Copenhagen
Morten Tabor: Institute for New Economic Thinking

No inetwp172, Working Papers Series from Institute for New Economic Thinking

Abstract: We extend Lucas's classic asset-price model by opening the stochastic process driving dividends to Knightian uncertainty arising from unforeseeable change. Implementing Muth's hypothesis, we represent participants' expectations as being consistent with our model's predictions and formalize their ambiguity-averse decisions with maximization of intertemporal multiple-priors utility. We characterize the asset-price function with a stochastic Euler equation and derive a novel prediction that the relationship between prices and dividends undergoes unforeseeable change. Our approach accords participants' expectations, driven by both fundamental and psychological factors, an autonomous role in driving the asset price over time, without presuming that participants are irrational.

Keywords: Asset Prices; Unforeseeable Change; Knightian Uncertainty; Muth's Hypothesis; Model Ambiguity; Rational Expectations (REH); Behavioral Finance. (search for similar items in EconPapers)
JEL-codes: D84 E00 G12 G41 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2021-12-07
New Economics Papers: this item is included in nep-cwa, nep-isf, nep-mac, nep-ore and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:thk:wpaper:inetwp172

DOI: 10.36687/inetwp172

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