Generalized Robustness and Dynamic Pessimism

Pascal J. Maenhout, Andrea Vedolin and Hao Xing

No 26970, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: G11 G4 (search for similar items in EconPapers)
Date: 2020-04
New Economics Papers: this item is included in nep-ore and nep-rmg
Note: AP
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Citations: View citations in EconPapers (1)

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