Doubts or variability?
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] and [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.
Year of publication: |
2009
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Authors: | Barillas, Francisco ; Hansen, Lars Peter ; Sargent, Thomas J. |
Published in: |
Journal of Economic Theory. - Elsevier, ISSN 0022-0531. - Vol. 144.2009, 6, p. 2388-2418
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Publisher: |
Elsevier |
Keywords: | Risk aversion Model misspecification Robustness Market price of risk Equity premium puzzle Risk-free rate puzzle Detection error probability Costs of model uncertainty |
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