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Title: Generalized Robustness and Dynamic Pessimism

Author(s): Pascal Maenhout, Andrea Vedolin and Hao Xing

Publication Date: April 2020

Keyword(s): Cressie Read, Pessimism, Robust control and Subjective beliefs

Programme Area(s): Financial Economics

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.

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Bibliographic Reference

Maenhout, P, Vedolin, A and Xing, H. 2020. 'Generalized Robustness and Dynamic Pessimism'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=14592