Commentary on "Long-run risks and financial markets"

Financial markets ; Risk

Robust Optimal Control for a Consumption-investment Problem

We give an explicit PDE characterization for the solution of the problem of maximizing the utility of both terminal wealth and intertemporal consumption under model uncertainty. The underlying market model consists of a risky asset, whose volatility and long-term trend are driven by an external stochastic factor process. The robust utility functional is defined in terms of a HARA utility function with risk aversion parameter 0Optimal Consumption, Robust Control, Model Uncertainty, Incomplete Markets, Stochastic Volatility, Coherent Risk Measures, Convex Duality

Measuring the Financial Markets’ Perception of EMU Enlargement: The Role of Ambiguity Aversion

Market views on EMU enlargement are measured by a new indicator based on the short-term dynamics of forward spreads. Conceptually, this indicator stems from the notion of ambiguity-averse agents in the sense of Knight. Specifically, we attempt to operationalize the incomplete preferences framework, which may allow for multiple equilibria supported by one set of fundamentals. This equilibrium indeterminacy may offer a way to reconcile short-term fluctuations of market prices with a relatively stable underlying economic environment and expectations. The method was applied to data from Central European countries, including the Czech Republic, Hungary, Poland, and Slovakia. Comparing our results with financial market opinion surveys, the results of the proposed method seems to be in accordance with market expectations.ambiguity aversion, EMU calculators, EMU enlargement, EMU Poll, forwards, uncertainty

Fear of model misspecification and the robustness premium

Robust decision making implies welfare costs or robustness premia when the approximating model is the true data generating process. To examine the importance of these premia at the aggregate level we employ a simple two-sector dynamic general equilibrium model with human capital and introduce an additional form of precautionary be- havior. The latter arises from the robust decision maker's ability to reduce the effects of model misspecification through allocating time and existing human capital to this end. We find that the extent of the robustness premia critically depends on the productivity of time rela- tive to that of human capital. When the relative efficiency of time is low, despite transitory welfare costs, there are gains from following ro- bust policies in the long-run. In contrast, high relative productivity of time implies misallocation costs that remain even in the long-run. Fi- nally, depending on the technology used to reduce model uncertainty, we find that while increasing the fear of model misspecification leads to a net increase in precautionary behavior, investment and output can fall.

Fear of Model Misspecification and the Robustness Premium

Robust decision making implies welfare costs or robustness premia when the approximating model is the true data generating process. To examine the importance of these premia at the aggregate level we employ a simple two-sector dynamic general equilibrium model with human capital and introduce an additional form of precautionary behavior. The latter arises from the robust decision maker’s ability to reduce the effects of model misspecification through allocating time and existing human capital to this end. We find that the extent of the robustness premia critically depends on the productivity of time relative to that of human capital. When the relative efficiency of time is low, despite transitory welfare costs, there are gains from following robust policies in the long-run. In contrast, high relative productivity of time implies misallocation costs that remain even in the long-run. Finally, depending on the technology used to reduce model uncertainty, we find that while increasing the fear of model misspecification leads to a net increase in precautionary behavior, investment and output can fall.robustness premium, model misspecification, precautionary behavior

Measuring the Financial Markets' Perception of EMU Enlargement: The Role of Ambiguity Aversion

Market views on EMU enlargement are measured by a new indicator based on the short-term dynamics of forward spreads. Conceptually, this indicator stems from the notion of uncertainty averse agents and equilibrium indeterminacy. The method was applied on data from central European countries, including the Czech Republic, Hungary, Poland and Slovakia. Comparing our results with financial market opinion surveys, the results of the proposed method seems to be in accordance with market expectations.Ambiguity aversion, EMU calculators, EMU Enlargement, EMU Poll, forwards,uncertainty.

On the Welfare Costs of Business-Cycle Fluctuations and Economic-Growth Variation in the 20th Century

Lucas (1987) has shown a surprising result in business-cycle research: the welfare cost ofbusiness cycles are very small. Our paper has several original contributions. First, in computingwelfare costs, we propose a novel setup that separates the effects of uncertainty stemming frombusiness-cycle fluctuations and economic-growth variation. Second, we extend the sample from which to compute the moments of consumption: the whole of the literature chose primarily to work with post-WWII data. For this period, actual consumption is already a result of counter-cyclical policies, and is potentially smoother than what it otherwise have been in their absence. So, we employ also pre-WWII data. Third, we take an econometric approach and compute explicitly the asymptotic standard deviation of welfare costs using the Delta Method. Estimates of welfare costs show major differences for the pre-WWII and the post-WWII era. They can reach up to 15 times for reasonable parameter values -β=0.985, and ∅=5. For example, in the pre-WWII period (1901-1941), welfare cost estimates are 0.31% of consumption if we consider only permanent shocks and 0.61% of consumption if we consider only transitory shocks. In comparison, the post-WWII era is much quieter: welfare costs of economic growth are 0.11% and welfare costs of business cycles are 0.037% - the latter being very close to the estimate in Lucas (0.040%). Estimates of marginal welfare costs are roughly twice the size of the total welfare costs. For the pre-WWII era, marginal welfare costs of economic-growth and business- cycle fluctuations are respectively 0.63% and 1.17% of per-capita consumption. The same figures for the post-WWII era are, respectively, 0.21% and 0.07% of per-capita consumption.

Status Quo Bias, Multiple Priors and Uncertainty Aversion

Motivated by the extensive evidence about the relevance of status quo bias both in experiments and in real markets, we study this phenomenon from a decision-theoretic prospective, focusing on the case of preferences under uncertainty. We develop an axiomatic framework that takes as a primitive the preferences of the agent for each possible status quo option, and provide a characterization according to which the agent prefers her status quo act if nothing better is feasible for a given set of possible priors. We then show that, in this framework, the very presence of a status quo induces the agent to be more uncertainty averse than she would be without a status quo option. Finally, we apply the model to a financial choice problem and show that the presence of status quo bias as modeled here might induce the presence of a risk premium even with risk neutral agents.Status quo bias, Ambiguity Aversion, Endowment Effect, Risk Premium