Long-Run Risk is the Worst-Case Scenario

66 Pages Posted: 18 Jul 2016 Last revised: 2 Apr 2023

Date Written: July 2016

Abstract

We study an investor who is unsure of the dynamics of the economy. Not only are parameters unknown, but the investor does not even know what order model to estimate. She estimates her consumption process nonparametrically – allowing potentially infinite-order dynamics – and prices assets using a pessimistic model that minimizes lifetime utility subject to a constraint on statistical plausibility. The equilibrium is exactly solvable and we show that the pricing model always includes long-run risks. With risk aversion of 4.7, the model matches major facts about asset prices, consumption, and dividends. The paper provides a novel link between ambiguity aversion and non-parametric estimation.

Suggested Citation

Bidder, Rhys and Dew-Becker, Ian, Long-Run Risk is the Worst-Case Scenario (July 2016). NBER Working Paper No. w22416, Available at SSRN: https://ssrn.com/abstract=2810926

Rhys Bidder (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of San Francisco

Ian Dew-Becker

Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States

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