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Twisted probabilities, uncertainty, and prices

Lars Hansen, Bálint Szőke, Lloyd S. Han and Thomas Sargent ()

Journal of Econometrics, 2020, vol. 216, issue 1, 151-174

Abstract: A decision maker constructs a convex set of nonnegative martingales to use as likelihood ratios that represent alternatives that are statistically close to a decision maker’s baseline model. The set is twisted to include some specific models of interest. Max–min expected utility over that set gives rise to equilibrium prices of model uncertainty expressed as worst-case distortions to drifts in a representative investor’s baseline model. Three quantitative illustrations start with baseline models having exogenous long-run risks in technology shocks. These put endogenous long-run risks into consumption dynamics that differ in details that depend on how shocks affect returns to capital stocks. We describe sets of alternatives to a baseline model that generate countercyclical prices of uncertainty.

Keywords: Risk; Uncertainty; Relative entropy; Robustness; Asset prices; Exponential quadratic stochastic discount factor (search for similar items in EconPapers)
JEL-codes: C52 C58 D81 D84 G12 (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eee:econom:v:216:y:2020:i:1:p:151-174

DOI: 10.1016/j.jeconom.2020.01.011

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Journal of Econometrics is currently edited by T. Amemiya, A. R. Gallant, J. F. Geweke, C. Hsiao and P. M. Robinson

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