| Robustness and Pricing with Uncertain Growth (2000) | |||||||||||||||
Abstract | |||||||||||||||
| . We develop models of robust decision-making and pricing when there are simultaneously big shocks and small shocks. We illustrate these models using a stochasticgrowth economy. Big shocks are infrequent changes in the technological growth rate and are modeled as a Markov jump process. Small shocks are continuous movements in the technology process and are modeled as a Brownian motion. Robust decision making is formalized as a two-player game. The original decision-maker fears model misspecications. As an algorithmic device to enforce robustness, he imagines a second, malevolent, player, who has the ability to perturb the baseline model. We consider three games, one in which jumps are observable, and two in which they are not. The two games with partial information represent dierent ways in which the second player can disturb the underlying model. We show that robustness induces an additional precautionary motive to accumulate capital. Moreover, it increases the measured risk-return ... | |||||||||||||||
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