Doubts or variability?

Francisco Barillas, Lars Peter Hansen, Thomas J. Sargent

    Research output: Contribution to journalArticlepeer-review

    Abstract

    Reinterpreting most of the market price of risk as a price of model uncertainty eradicates a link between asset prices and measures of the welfare costs of aggregate fluctuations that was proposed by Hansen, Sargent, and Tallarini [17], Tallarini [30], Alvarez and Jermann [1]. Prices of model uncertainty contain information about the benefits of removing model uncertainty, not the consumption fluctuations that Lucas [22,23] studied. A max-min expected utility theory lets us reinterpret Tallarini's risk-aversion parameter as measuring a representative consumer's doubts about the model specification. We use model detection instead of risk-aversion experiments to calibrate that parameter. Plausible values of detection error probabilities give prices of model uncertainty that approach the Hansen and Jagannathan [11] bounds. Fixed detection error probabilities give rise to virtually identical asset prices as well as virtually identical costs of model uncertainty for Tallarini's two models of consumption growth.

    Original languageEnglish (US)
    Pages (from-to)2388-2418
    Number of pages31
    JournalJournal of Economic Theory
    Volume144
    Issue number6
    DOIs
    StatePublished - Nov 2009

    Keywords

    • Costs of model uncertainty
    • Detection error probability
    • Equity premium puzzle
    • Market price of risk
    • Model misspecification
    • Risk aversion
    • Risk-free rate puzzle
    • Robustness

    ASJC Scopus subject areas

    • Economics and Econometrics

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