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Generalized Robustness and Dynamic Pessimism

Author

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  • Pascal J. Maenhout
  • Andrea Vedolin
  • Hao Xing

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.

Suggested Citation

  • Pascal J. Maenhout & Andrea Vedolin & Hao Xing, 2020. "Generalized Robustness and Dynamic Pessimism," NBER Working Papers 26970, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:26970
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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G4 - Financial Economics - - Behavioral Finance

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