| Robustness and pricing with uncertain growth (2002) | |||||||||||||||
Abstract | |||||||||||||||
| Abstract. We construct models of robust decision-making and pricing when contemporaneous big and small shocks hit a stochastic-growth economy. Large shocks are infrequent changes and small shocks are continuous movements in the technology process. Large shocks evolve as a Markov jump process. Small shocks are a Brownian motion. Decision makers treat models as approximations and fear misspecification. Robust decisionmaking is formalized as a two-player game. To promote robustness, investors imagine that a malevolent player perturbs a baseline model. We study two economies, each of which decentralizes a robust resource allocation problem with hidden growth rates. The economies di#er in how the same base line model is viewed as an approximation. We compare prices to those for an economy in which the growth state is fully revealed. We study the time-series implications for the measured risk-return tradeo # and the price-dividend ratio. 1 | |||||||||||||||
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