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  4. September 2016
  5. Long-Run Risk Is the Worst-Case Scenario

Long-Run Risk Is the Worst-Case Scenario

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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 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 nonparametric estimation.

Citation

Bidder, Rhys, and Ian Dew-Becker. 2016. "Long-Run Risk Is the Worst-Case Scenario." American Economic Review, 106 (9): 2494-2527. DOI: 10.1257/aer.20150585

Additional Materials

JEL Classification

  • D11 Consumer Economics: Theory
  • D12 Consumer Economics: Empirical Analysis
  • D81 Criteria for Decision-Making under Risk and Uncertainty
  • G11 Portfolio Choice; Investment Decisions
  • G12 Asset Pricing; Trading volume; Bond Interest Rates