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Thomas J. Sargent

March 8, 2015

Abstract

A representative consumer expresses distrust of a baseline probability model by using

a convex set of martingales as likelihood ratios to represent other probability models.

The consumer constructs the set to include martingales that represent particular

parametric alternatives to the baseline model as well as others representing only

vaguely specified models statistically close to the baseline model. The representative

consumers max-min expected utility over that set gives rise to equilibrium prices

of model uncertainty expressed as worst-case distortions to the drifts in his baseline

model. We calibrate a quantitative example to aggregate US consumption data.

Key words: Risk, uncertainty, uncertainty prices, Chernoff entropy, robustness, shock

price elasticities, affine stochastic discount factor

We thank Scott Lee, Botao Wu, and especially Lloyd Han and Paul Ho for carrying out the computations.

Introduction

Specifying a set of probability distributions is an essential part of applying the Gilboa and

Schmeidler (1989) max-min expected utility model. This paper proposes a new way to

imagine that a decision maker forms that set and provides an application to asset pricing.

When a representative investor describes risks with a set of probability models, uncertainty premia augment prices of exposures to those risks. We describe how our method for

specifying that set affects prices of model uncertainty.

Our experiences as applied econometricians attract us to robust control theory. We

always regard our own quantitative models as approximations to better models that we had

not formulated. This is also the attitude of the robust decision maker modeled in Hansen

and Sargent (2001) and Hansen et al. (2006). The decision maker has a single baseline

probability model with a finite number of parameters. He wants to evaluate outcomes

under alternative models that are statistically difficult to distinguish from his baseline

model. He expresses distrust of his baseline model by surrounding it with an uncountable

number of alternative models, many of which have uncountable numbers of parameters. He

represents these alternative models by multiplying the baseline probabilities with likelihood

ratios whose entropies relative to the baseline model are less than a bound that expresses

the idea that alternative models are statistically close to the baseline model.

The decision theory presented in this paper retains the starting point of a single baseline

model but differs from Hansen et al. (2006) in how it forms the set surrounding the baseline

model. A new object appears: a quadratic function of a Markov state that defines alternative parametric models to be included within a set of models surrounding the baseline

model. The decision maker wants valuations that are robust to these models in addition

to other vaguely specified models expressed as before by multiplying the baseline model

by likelihood ratios. The quadratic function can be specified to include alternatives to the

baseline model including ones with fixed parameters, time varying parameters, and other

less structured forms of model uncertainty.

For asset pricing, a key object that emerges from the analysis in Hansen and Sargent

(2010) is a vector of worst-case drift distortions to the baseline model. The negative of

the drift distortion vector equals the vector of market prices of model uncertainty that

compensate the representative investor for bearing model uncertainty. The effects that our

new object the quadratic function indexing particular alternative models has on market prices of uncertainty are all intermediated through this drift distortion. We show how

the quadratic function can produce drift distortions that imply stochastic discount factors

resembling ones attained by earlier authors under different assumptions about the sources

of risks. For example, models that posit that a representative consumers consumption

process has innovations with stochastic volatility introduce new risk exposures in the form

of the shocks to volatilities. Their presence induces time variation in equilibrium compensations for exposures to shocks that include both the stochastic volatility shock as well as

the original shocks whose volatilities now move. By way of contrast, we introduce no

stochastic volatility and no new risks. Instead, we amplify the prices of exposures to the

original shocks. We induce fluctuations in those prices by modeling how the representative consumer struggles to confront his doubts about the baseline model. We extend these

insights to the analysis of uncertainty prices over alternative investment horizons.

Section 2 describes a representative consumers baseline probability model and martingale perturbations to it. Section 3 describes two convex sets of martingales that perturb

the baseline model. Section 4 uses one of these sets to form a robust planning problem that

generates a worst-case model that we use to calibrate key parameters measuring the size

of a convex set of models. Section 5 constructs a recursive representation of a competitive

equilibrium. Then it links the worst-case model that emerges the robust planning problem

to competitive equilibrium compensations that the representative consumer earns for bearing model uncertainty. This section also describes a term structure of these market prices

of uncertainty. By borrowing from Hansen and Sargent (2010), section 6 describes a quantitative version of a baseline model as well as a class of models that particularly concern the

robust consumer and the robust planner. Section 7 uses the quantitative model to compare

the set of models that concern both our robust planner and our representative consumer

with two other sets featured in Anderson et al. (2003) and Hansen and Sargent (2010),

one based on Chernoff entropy, the other on relative entropy. Section 8 offers concluding

remarks. Six appendices provide technical details.

The model

2.1

Mathematical framework

.

A representative consumer cares about a stochastic process for Y = {Yt : t } described

by the baseline model1

d log Yt = (.01) (

+ Xt ) dt + (.01) dWt

dXt = dt

Xt dt + dWt ,

(1)

b and

||2 is the date t growth

variable X0 governed by probability distribution Q,

+Xt + .01

2

, , Q)

b characterizes the baseline

rate of Y expressed as a percent. The quintet (

,

, ,

model.2

Because he doesnt trust the baseline model, the consumer also cares about Y under

probability models obtained by multiplying probabilities associated with the baseline model

(1) by likelihood ratios. We represent a likelihood ratio by a stochastic process Z h that is

a positive martingale with respect to the baseline model and that satisfies3

dZth = Zth ht dWt ,

(2)

or

1

(3)

d log Zth = ht dWt |ht |2 dt,

2

where h is adapted to the filtration F = {Ft : t 0} associated with the Brownian motion

W and satisfies

Z

t

|hu |2 du <

(4)

with probability one. Imposing the initial condition Z0h = 1, we express the solution of

stochastic differential equation (2) as:

Zth

= exp

Z

t

0

1

ht dWt

2

t

2

|hu | du .

0

(5)

We let X denote the stochastic process, Xt the process at date t, and x a realized value of the state.

In earlier papers, we sometimes referred to what we now call the baseline model as the decision makers

approximating model or benchmark model.

3

James (1992), Chen and Epstein (2002), and Hansen et al. (2006) used this representation.

2

a Borel measurable function g > 0 satisfying Eg(X0 ) = 1 and consider martingales equal

to

g(X0)Zth .

Let G denote the collection of all such functions g(x). A pair (g, h) represents a perturbation

of the baseline model (1).

Definition 2.1. Z denotes the set of all martingales g(X0 )Z h constructed via representation (5) with some process h adapted to F = {Ft : t 0} and satisfying (4) and g G.

We use a martingale g(X0)Z h to construct an alternative probability distribution as

follows. Starting from the probability distribution associated with the baseline model (1),

we use h to represent another probability distribution conditioned on F0 . To do this, think

of taking any Ft -measurable random variable Yt and multiplying it by Zth before computing

expectations conditioned on X0 . Associated with h are probabilities defined implicitly by

E h [Bt |F0 ] = E Zth Bt |F0

for any t 0 and any bounded Ft -measurable random variable Bt . Similarly, we write

E g B0 = E [g(X0)B0 ]

for any bounded random variable B0 in the date zero information set F0 .

Here the positive random variable Zth acts as a Radon-Nikodym derivative for the

date t conditional expectation operator E h [|X0 ]. The martingale property of the process

Z h ensures that the conditional expectations operators for different ts are compatible in

the sense that they satisfy a Law of Iterated Expectations. The random variable g(X0 )

acts as a Radon-Nikodym derivative for the date zero unconditional distribution vis a

b over the date zero state vector X0 .

vis a baseline probability distribution Q

While under the baseline model W is a standard Brownian motion, under the alternative

h model distribution this process has increments

dWt = ht dt + dWth ,

(6)

where W h is a standard Brownian motion. While (3) expresses the evolution of log Z h in

1

d log Zth = ht dWth + |ht |2 dt.

2

(7)

d log Yt = (.01) (

+ Xt ) dt + (.01) ht + (.01) dWth

dXt = dt

Xt dt + ht + dW h ,

t

+ Xt + ht + .01

||2 under the h model.4

2

2.2

Discounted relative entropy quantifies how a (g, h) pair distorts baseline model probabilities.

We construct discounted relative entropy in two steps. First, we condition on X0 = 0 and

b

focus solely on h; second, we focus on misspecifications of Q.

i) Our first step is to compute

(Z ; x) =

exp(t)E Zth log Zth X0 = x dt

0 Z

1

exp(t)E Zth |ht |2 X0 = x dt

=

2

0

h

(8)

write as a function of Z h instead of h because is convex in Z h . The discounted

entropy concept (8) quantifies how h distorts baseline probabilities.5

b is the

ii) Our second step applies when we dont condition on X0 . Suppose that Q

stationary probability distribution for X under the baseline model and that g is the

b We average over the initial state via

density used to alter Q.

h

(g; Z )

b

(Z ; x)g(x)Q(dx)

+

h

b

g(x) log g(x)dQ

(9)

4

The growth rate includes a multiplication by 100 that offsets one of the .01s.

Hansen et al. (2006) used the representation of discounted relative entropy that appears on the right

side of the first line of (8).

5

Two convex sets that surround the baseline model are designed to include parametric

probability models that a decision maker cares about. One set can readily be used for

robust control problems, but the other cannot. Nevertheless, the second set is useful

because it generalizes Chernoff (1952) entropy to a Markov environment and thereby has

an explicit statistical interpretation. We are interested in how these two convex sets are

related.

3.1

The following parametric model nests baseline model (1) within a bigger class:

d log Ct = .01 ( + Xt ) dt + .01 dWth

dXt = dt Xt dt + dWth ,

(10)

where W h is a Brownian motion and (6) continues to describe the relationship between the

processes W and W h . Here (

, ,

) are parameters of the baseline model (1), (, , ) are

parameters of model (10), and (, ) are parameters common to both models. We want to

use drift distortions h for W to represent models in a parametric class defined by (10). We

can express model (10) in terms of our section 2.1 structure by setting

ht = (Xt ) 0 + 1 Xt

and using (1), (6), and (10) to deduce the following restrictions on 0 and 1 :

"

#

" #

0 =

"

#

" #

0

1 =

.

(11)

class of models having the parametric form (10). Among other possibilities, we can set

b to assign all of the probability to an initial state or we can set it equal to the stationQ

ary distribution implied by the baseline model, in which case we can construct g so that

b

g(x)dQ(x)

is the stationary distribution under the alternative model implied by (0 , 1 ).

6

conditioned on X0 .

Definition 3.1. Z + is the set of martingales g(X0)Z h constructed by (i) selecting a pair

(0 , 1 ) that satisfies (11), (ii) pinning down an associated ht = 0 +1 Xt , (iiii) constructing

an implied martingale Z h via (2), and (iv) selecting g G.

We can further restrict a family of models by using a nonnegative quadratic function of x

.

=

(x)

0 + 21x + 2 x2 0

(12)

capture a prespecified

, form

1

.

=

(

)2 x2 .

(x)

0 + 21x + 2 x2 =

||2

This choice of makes both =

and = 2

that are among the models to be included in a convex set of Zs. More generally, we can

select (

, ,

) and compute 1 and 1 by solving the counterpart to (11). Then

= |

(x)

0 + 1 x|2 .

We again pick up additional parametric models by casting our restrictions in terms of the

quadratic function .

Definition 3.2.

n

o

t)

Z o = Z h Z + : |ht |2 (X

Next we construct a larger set of martingales that contains Z o but allows departures

from the parametric structure (10).

Definition 3.3.

n

o

h

2

e

Z = Z Z : |ht | (Xt )

(13)

models whose parameters vary over time.6

3.2

a baseline model. For that purpose, we shall replace the instant-by-instant inequality in

the definition (13) of Ze with restrictions cast in terms of probability weighted averages

of |ht |2 . These restrictions allow the trade-offs among intertemporal dimensions of model

comprehended by statistical model discrimination criteria.7

3.3

We construct our first convex set of martingales Z h by starting with a drift distortion h

that represents a particular alternative parametric model created along lines described in

section 3.1. We use the following functional of a process Z h :

Z

2

Z ; |h| , x =

exp(u)E Zuh log Zuh du|X0 = x

h

i

u | du|X0 = x

exp(u)E Zuh | h

Z0

h

i

1

h

2

2

exp(u)E

|hu | |hu | |X0 = x .

=

2 0

(14)

i) is convex in Z h ;

ii) can readily be computed under the h model;

only through the scalar process |h|

2.

iii) depends on h

This is accomplished by requiring Z h to belong to Z rather than Z + .

e we impose the instant-by-instant constraint on ht described in (13). But

In constructing Z o and Z,

some models that dont satisfy such an instant-by-instant constraint are equally difficult to distinguish

statistically from the baseline model. The ambiguity averse decision maker of Chen and Epstein (2002)

considers a set of models characterized by martingales that are generated by h processes that satisfy

instant-by-instant constraints on h. Anderson et al. (1998) explored consequences of this type of constraint

without the state dependence.

6

Let

2 = (x)

|h|

and introduce a positive number .

Definition 3.4.

Z h

Z

i

h

h

b

b

Z = g(X0 )Z Z : Z ; (X), x g(x)Q(dx) + g(x) log g(x)Q(x) 0 .

(15)

Z includes martingales in Ze that are associated with the parametric probability models

of Section 3.1. In light of feature i) , the set Z is is convex in g(X0 )Z h and necessarily

contains Z h and Z h = 1. Feature ii) makes it tractable to use Z to pose a recursive robust

to include parametric

decision problem. Feature iii) provides a convenient way to use {}

In section 5, we pose a robust decision problem in which Z serves as a family of positive

martingales. Evidently, both the baseline model (1) and the alternative models captured

play important roles in shaping the set Z . These models

also shape our next convex set, which considers the entropy of a Z Z relative to the

baseline model (1).

3.4

Zb

While the drift distortions h

that emerges from studying how Brownian motions disguise probability distortions of a

baseline model, making them difficult to distinguish statistically. To construct Zb we use

Chernoff (1952) entropy, which differs from discounted relative entropy. Although Chernoff

entropys connection to a specific statistical decision problem makes it attractive, it has the

disadvantage that it is less tractable than relative entropy for the types of robust decision

In the spirit of Anderson et al. (2003), we use Chernoff (1952) entropy to measure

a distortion Z to a baseline model. Think of a pairwise model selection problem that

statistically compares the baseline model (1) with a model generated by the martingale

Z h . The logarithm of the martingale evolves according to

1

d log Zth = |ht |2 dt + ht dWt .

2

9

Consider a statistical model selection rule based on a data history of length t that takes the

form log Zth log , where Zth is the likelihood ratio associated with the alternative model

for a sample size t. To construct a bound on the probability that this model selection rule

incorrectly chooses the alternative model when the baseline model governs the data, we use

an argument from large deviations theory that starts from the inequality

1{log Z h } = 1{r +r log Z h 0} = 1{exp(r )(Z h )r 1} exp(r )(Zth )r ,

t

t

t

which holds for 0 r 1. The expectation of the term on the left side equals the

probability of mistakenly selecting the alternative model when the data are a sample of

size t generated by the baseline model. We bound this mistake probability for large t by

following Donsker and Varadhan (1976) and Newman and Stuck (1979) and studying

lim sup

t

r

r

1

1

log E exp(r ) Zth = lim sup log E Zth

t

t

t

for alternative choices of r. The threshold does not affect this limit. Furthermore, the

limit is often independent of the initial state X0 = x. To get the best bound, we compute

inf lim sup

0r1

r

1

log E Zth ,

t

a limit that is typically negative because mistake probabilities decay with sample size. A

measure of Chernoff entropy is then

(Z h , x) = inf lim sup

0r1

r

1

log E Zth .

t

(16)

To help interpret (Z h , x), consider the following argument. If the actual decay rate

of mistake probabilities were constant, then mistake probabilities for two sample sizes

Ti , i = 1, 2, would be

mistake probabilityi = .5 exp(Ti )

for = (Z h , x). We define a half-life as an increase in the sample size T2 T1 > 0 that

multiplies the mistake probability by a factor of .5:

.5 =

mistake probability2

exp(T2 )

.

=

mistake probability1

exp(T1 )

10

T2 T1 =

log .5

.

(17)

The preceding back-of-the-envelope calculation justifies the detection error bound computed by Anderson et al. (2003). The bound on the decay rate should be interpreted

cautiously because, while it is constant, the actual decay rate is not. Furthermore, the pairwise comparison oversimplifies the challenge truly facing a robust decision maker, which is

statistically to discriminate among multiple models.

We could conduct a symmetrical calculation that reverses the roles of the two models,

so that the h model with martingale Z h becomes the model on which we condition. It is

straightforward to show that the limiting rate remains the same. Thus, when we select a

model by comparing a log likelihood ratio to a constant threshold, the two types of mistakes

share the same asymptotic decay rate.

Our second convex set is a ball formed using Chernoff entropy (16).

Definition 3.5.

Zb = Z h Z : (Z h ; x) .

(18)

Calibrating and

In subsections 4.1 and 4.2, we formulate a robust planning problem for an economy with

a representative consumer having an instantaneous utility function that is logarithmic in

consumption. Associated with the worst-case probability from the robust planning problem

is a greatest lower bound of expected discounted utility over the family Z of alternative

probability distributions. In subsections 4.3, 4.4, and 4.5, we represent the worst-case

probability as a drift distortion to the multivariate Brownian motion in the baseline model

(1). We then use that drift distortion to guide the calibration of the parameters and

that pin down the size of the set Z . In section 5, we show how that same worst-case drift

distortion appears in a recursive representation of competitive equilibrium prices for an

economy with a representative investor. We deduce uncertainty prices and connect them

to the worst-case drift distortion from our robust planning problem.

11

4.1

use a family martingales in the set Z to represent alternative probabilities. We take the

function to be

= (x),

(x)

where for the moment is an arbitrary parameter and is pre-specified. Eventually, we will

allow to be specified a priori up to a scale determined by a scalar that well calibrate

by imposing a model detection probability half-life defined in terms of Chernoff entropy.

Let be a multiplier on the constraint:

Z

Z

h

i

h

b

b

Z ; (X), x g(x)Q(dx) + g(x) log g(x)Q(x)

0

(19)

drift distortion.

4.2

1

0 = min (x, , ) + (.01)(

+ x) (x, )

x + ||2 (x, , )

h

2

2

2

(20)

(x, , ) =

1

2 (, )x2 + 21 (, )x + 0 (, ) ,

2

1

h (x, , ) = [.01 2 (, )x 1 (, )] .

4.3

(21)

Determining

To set , we must decide how to weight the initial state. Previous research by Petersen et al.

b to be a mass point over single value of x and thereby

(2000) and Hansen et al. (2006) set Q

12

b having density q with

Under the baseline model, X has a stationary distribution Q

and variance ||2 /(2

mean /

). Consider any g G. Introduce a nonnegative parameter

probability measure over the initial state, compute g given (, ) by solving

min

gG

b

(x, , ) g(x)Q(dx)

+

Z

b

log g(x)g(x)Q(dx)

.

(22)

1

g(x, , ) exp (x, , )

(23)

(, ) =

and mean

1

2

2 (, )

2

||

"

#

1 2

1

(, ) =

+ 1 (, ) .

||2

problem:

max log

>0

Z

1

b

exp (x, , ) Q(dx) .

Let (

defining the set of alternative models, we know and through representation (21) have a

complete characterization of the worst-case model. In the next subsection we describe how

to use a half-life for a model detection statistic to determine . This will tell us how to

scale for a given value of . We could specify a priori. But in the next subsection, we

suggest an alternative approach.

13

Specifying

4.4

Z

, ), ] log g[x, (

, ), ]Q(dx)

b

g[x, (

= .

(24)

Let denote the resulting and let () = (

(g; Z h ) from equation (9)

h

(g; Z )

where

b

g(x)(Z ; x)Q(dx)

+

h

1

(Z ; x) =

2

h

b

g(x) log g(x)Q(dx),

exp(u)E h |hu |2 |X0 = x .

The relative entropy measure includes an adjustment for distorting the initial distribution.

R

b

By imposing (24), we have set exactly to offset the term g(x) log g(x)Q(dx)

when

evaluating the constraint (19) at the minimizing choice of g and Z.

4.5

We refine a suggestion of Anderson et al. (1998). Compute h [x, (), ] and evaluate the

associated Chernoff entropy. Then adjust to match a target half-life.8 A larger value of

should lead to a smaller half-life. Call the resulting , and let

g (x) = g [x, ( ), ]

bearing risks presented by the environment described by baseline model (1) in light of his

concerns about model misspecification as expressed with the set Z . We construct equilibrium prices by appropriately extracting shadow prices from the robust planning problem of

subsection 4.1. We decompose risk prices into separate equilibrium compensations for bearing risk and for bearing model uncertainty. We also describe an equilibrium term structure

8

14

consumers portfolio choice problem.

5.1

individual wealth K evolves as

dKt = Ct dt + (.01)Kt (Xt )dt + Kt At dWt + (.01)Kt (Xt ) At dt,

(25)

where At = a is a vector of chosen risk exposures, (x) is the instantaneous risk free rate

expressed as a percent, and (x) is the vector of risk prices evaluated at state Xt = x.

Initial wealth is K0 . The investor has discounted logarithmic preferences but distrusts his

probability model.

Key inputs to a representative consumers robust portfolio problem are the baseline

model (1), the wealth evolution equation (25), the vector of risk prices (x), and the

quadratic function in (12) that defines the alternative explicit models that concern the

representative consumer. As in the robust planners problem analyzed in section 4.1, let

be a penalty parameter or Lagrange multiplier on the constraint (19). For the recursive

competitive equilibrium, we take (, ) as given. We described how we calibrate these

parameters in section 4.

Under the guess that the value function takes the form (x, , ) + log k + log , the

HJB equation for the robust portfolio allocation problem is

0 = max min (x, , ) log k log + log c

a,c

c

+ (.01)(x)

k

|a|2

+ (.01)(x) a + a h

+

x (x, , ) + h (x, , )

22

|h|

2

||2

2 x + 21 x + 0 .

(x, , ) +

+

2

2

2

(26)

1

= ,

c

k

which implies that c = k, an implication that flows partly from the representative consumers unitary elasticity of intertemporal substitution. First-order conditions for a and h

15

are

(.01)(x) + h (x, , ) a (x, , ) = 0

(27a)

(27b)

Here we appeal to arguments like those in Hansen and Sargent (2008, ch. 7) to justify

stacking first-order conditions and not worrying about who goes first in the two-person

zero-sum game.9

5.2

We show here that the drift distortion h that emerges from the robust planners problem of

subsection 4.1 determines prices that a competitive equilibrium awards for bearing model

uncertainty. To compute a vector (x) of competitive equilibrium vector of risk prices, we

find a robust planners marginal valuation of exposure to the W shocks. We decompose

that price vector into separate compensations for bearing risk and for accepting model

uncertainty.

Noting from the robust planners problem that the shock exposure vectors for log K

and log Y must coincide implies

a = (.01).

Thus, from (27a), = , where

(x) = 100h(x, ).

(28)

the drifts for log K and log Y must coincide:

+ (.01)(x) + (.01)[(.01) h (x)]

.0001

= (.01)(

+ x),

2

so that = , where

(x) = 100 + (

+ x) + h (x, )

9

.01

.

2

(29)

If we were to use a timing protocol that allows the maximizing player to take account of the impact

of its decisions on the minimizing agent, we would obtain the same equilibrium decision rules as those

described in the text.

16

We can use these formulas for equilibrium prices to construct a solution to the HJB equation

of a representative consumer in a competitive equilibrium by letting = and g = (.01).

5.3

selection problem that confronts a representative consumer who has a completely trusted

model for the exogenous state dynamics and whose decision rule matches the decision rule

that attains the value function associated with the HJB equation (26) for the robust

representative consumer portfolio problem. This consumers completely trusted model

of course differs from the baseline model (1). Hansen et al. (2006) call this an ex post

problem because it comes from exchanging orders of maximization and minimization in

the two-person zero-sum game that gives rise to the robust portfolio choice rule. This ex

post portfolio problem is a special case of a Merton problem with a state evolution that is

distorted relative to the baseline model. The distorted evolution imputes to the process W

a drift h so that

dWt = h (Xt )dt + dWt

= (0 + 1 Xt ) dt + dWt ,

where W is a multivariate standard Brownian motion under the h probability distribution.

Thus,

d log Yt = .01(

+ Xt )dt + (.01)h (Xt )dt + (.01)

dWt

dXt =

Xt dt + h (Xt )dt + dWt .

A value function e + log a satisfies the HJB equation

a,c

[

x +

1 x] e (x)

|a|2

c

+ (.01)(x) + (.01)(x) a + a (0 + 1 x)

k

2

||2 e

+

(x).

2

1

=0

c

k

17

(.01)(x) + 0 + 1 x a = 0,

which lead to decision rules c = k and

a = (.01)(x) + 0 + 1 x.

Because the exposure and drift for log K and log Y should coincide in equilibrium, it follows

that

+ (.01)(x) + .01 (x) + .0001

.0001

= (.01) [

+ x + h (x)] .

2

Thus, the ordinary decision rules that solve the ex post portfolio problem imply the same

equilibrium prices as the robust portfolio problem, so that = and = , as given by

(28) and (29), respectively.

5.4

We now study how competitive equilibrium uncertainty prices vary over an investment horizon by computing a pricing counterpart to an impulse response function. Our continuoustime formulation means that the pertinent shock that occurs during the next instant is

an incremental change that will have incremental effects on prices across all future time

periods. An asset exposed to these shocks earns compensations that depend on the horizon.

Shock-price elasticities are state dependent because they vary with the growth state. In

this section, we compute the elasticities and produce what we regard as a dynamic value

decomposition. We present a quantitative example in section 7.3.10

5.4.1

The equilibrium stochastic discount factor process for our robust representative consumer

economy is

1

d log St = dt .01 (

+ Xt ) dt .01 dWt + ht dWt |ht |2 dt.

2

(30)

The stochastic discount factor has a linear local mean and a quadratic local variance.

The exponential-quadratic formulation has been used extensively in empirical asset pricing

10

18

applications. Duffie and Kan (1994) described term structures of interest rates implied by

models with affine stochastic discount factors. Ang and Piazzesi (2003) estimated a term

structure model with an affine stochastic discount factor process driven by macroeconomic

variables.

The entries of the vector, (Xt ) given by (28), which equal minus the local exposures to

the Brownian shocks, are usually interpreted as local risk prices, but we shall reinterpret

them. Motivated by the decomposition

minus stochastic discount factor exposure =

.01

risk price

ht ,

uncertainty price

we prefer to think of .01 as risk prices induced by the curvature of log utility and ht

as uncertainty prices induced by a representative investors doubts about the baseline

model. Here ht = 0 + 1 x, as described in equation (21). When 1 = 0, ht is constant;

but when 1 differs from zero, the uncertainty prices ht = h (Xt ) are time varying and

depend linearly on the growth state Xt . When the dependence of h on x is positive, these

uncertainty prices are higher in bad times than in good times. Countercyclical uncertainty

prices emerge endogenously from a baseline model that excludes stochastic volatility in the

underlying consumption risk as an exogenous input. Such fluctuations emerge endogenously

from a baseline model that excludes stochastic volatility in the underlying consumption risk

as an exogenous input. Stochastic volatility models introduce new risks to be priced while

also inducing fluctuations in the prices of the original risks. The mechanism in this

paper simultaneously enhances and induces fluctuations in the uncertainty prices, but it

introduces no new sources of risk. Instead, it focuses on the impact of uncertainty about

the implications of those risks.

Following Borovicka et al. (2011), we assign horizon-dependent uncertainty prices to risk

exposures. To represent shock price elasticities, we study the dependence of logarithms of

expected returns on an investment horizon. The logarithm of the expected return from a

consumption payoff at date t is

log E

!

"

#

Ct

Ct

X0 = x log E St

X0 = x .

C0

C0

(31)

The first term captures the expected payoff and the second the cost of the payoff. A shock

in the next instance affects the consumption and the stochastic discount factor processes.

19

In continuous time, this leads formally to what is called a Malliavin derivative. There is

one such derivative for each Brownian increment. The date zero shock influences both the

expected asset payoff at date t (aggregate consumption in this case) and the cost of an asset

with this payoff. Its impact on the logarithm of the expected return is the price elasticity

and its impact on the logarithm of the expected payoff is the exposure elasticity.

Consider initially the expected payoff term on the left side of (31). Let D0 Ct denote

the derivative vector of Ct with respect to dW0 . The familiar formula for a derivative of a

logarithm applies so that

D0 Ct = Ct D0 log Ct .

A contribution to the elasticity vector for horizon t is

E

i

log Ct |X0 = x

h

i

.

E CC0t |X0 = x

Ct

D

C0 0

There is a distinct elasticity for each shock. Since log C has linear dynamics, D0 log Ct can

be shown to be the same as the vector of impulse responses of log Ct to shocks at date zero,

which does not depend on the Markov state. We call this an exposure elasticity.

Consider next the cost term on the right-hand side of (31). For the product M = SC, a

calculation analogous to the preceding one confirms that the contribution of the cost term

to the elasticity is

i

h

Mt

D

log

M

|X

=

x

E M

0

t

0

0

h

i

.

Mt

E M

|X

=

x

0

0

The dynamic evolution of the stochastic discount factor is not linear in the state variable,

and as a result

D0 log Mt = D0 log St + D0 log Ct

is no longer a deterministic function of time.

The shock price elasticity combines these calculations:

E

h

h

i

i

i

Mt

Mt

E M

E

log Ct |X0 = x

D

log

M

|X

=

x

D

log

S

|X

=

x

0

t

0

t

0

M0 0

0

i

i

i

h

h

h

=

. (32)

Mt

Mt

|X

=

x

|X

=

x

E CC0t |X0 = x

E M

E

0

0

M0

0

Ct

D

C0 0

This is a valuation analogue of the impulse response function routinely estimated by em-

20

elasticities for each shock. We give nearly analytical formulas for these in Appendix F.

A quantitative example

For a laboratory, we use our baseline model (1) evaluated at the following maximum likelihood estimates computed by Hansen and Sargent (2010):11

= .465,

"

#

.468

=

0

= 0

= .185

"

#

0

=

.149

(33)

and 120 quarters. For comparison, we include a model with no concern for robustness, which

is equivalent to a half-life equal to infinity. We consider two specifications of :

= x2

(x)

= 1.

(x)

Tables 1 and 2 report worst case models that emerge from the robust planners HJB

= x2 and (x)

= 1, respectively. The worst-case

models endow X with a negative mean given by . This in turn shifts the implied growth

in consumption. Since the worst case model also includes a change in , we report the

composite outcome + . As we reduce the half-life, the worst-case model makes the

constant parameter adjustment smaller. When = x2 , we also increase the persistence in

the growth-rate process. Notice that while the minimizing agent could choose to reduce

persistence even more, he instead chooses to allocate some of the entropy distortion to the

11

The estimates are for Y being consumption of nondurables and services for aggregate U.S. data over

the period 1948II to 2009 IV.

21

constant terms.

Consistent with findings of Anderson et al. (2003) and Hansen and Sargent (2010), when

= 1, there is no change in the persistence parameter . The worst-case model targets

(x)

the constant terms in the consumption evolution and the state evolution. The worst-case

analysis reduces to a determination of how much to distort the respective constant terms

only.

Half-Life

+ (/)

0.4650

0.1850

0.4650

120

0.2562

80

0.2024

40

0.0579

Table 1: Worst-case parameter values for (x)

Half-Life

+ (/)

0.4650

0.1850

0.4650

120

0.2648

80

0.2198

40

0.1182

Table 2: Worst-case parameter values for (x)

figures 1 and 2 plot the expected

consumption growth over horizon t. The expected growth rate at t is:

h

i

1 0 exp

"

# !" #

0 1

t

= + exp(t).

0

Integrating this growth rate over an interval [0, t] gives a worst-case trend for log consumption:

t + 2 exp(t) 2

+

(34)

Notice that the initial growth trend growth rate is and that the eventual growth rate is

+ . In this calculation, we impose the distorted model starting at date zero and consider

22

its implications going forward. The shift in the constant term for the evolution of X has

no immediate impact on the growth of log C. Its eventual impact is determined in part by

the persistence parameter . We applied formula (34) to alternative models including the

worst-case models to compute the long-run drifts reported in Figures 1 and 2.

Figure 1: Long-run drift of log Ct for the three target half-lives when = x2 .

23

Figure 2: Long-run drift of log Ct for the three target half-lives when = 1.

Next we consider the distributional impacts. The new information about log Ct log C0

(scaled by 100) is:

Z tZ

0

exp(v) dBuv du +

dBu =

0

Z tZ

0

Z tZ

0

1

=

r

t

Z 0t

dBu

dBu

0

+

dBu

0

Z

Z t

1 t

[1 exp[(t r)]] dBr +

=

dBu

0

0

The variance is .0001 times the following object

1

2

2

1

1

= 2 ||2 t + ||2t 3 [1 exp(t)]||2 + 3 [1 exp(2t)]||2 ,

24

where we have used the fact that = 0. Using this calculation, figures 3 and 4

display the interdecile ranges of the distribution for consumption growth over alternative

horizons. These figures depict deciles for both the baseline model and the worst-case models

associated with a half-life of 80. The region between the deciles illustrates a component

of risk in the consumption distribution. The variation across the baseline and worst-case

models reflects a broader notion of uncertainty driven by skepticism about the baseline

model. The upper decile of the worst-case model overlaps the lower decile of the baseline

model in both figures. The interdecile range is somewhat larger when is quadratic in x

than when is constant.

Figure 3: Expected values of log Ct scaled by 100 for the baseline model and for a half-life

of 80 when = x2 . The shaded black and red areas show the .1 and .9 interdecile ranges

under the baseline model and the worst-case model for a half-life of 80. The black line is

the mean growth for the baseline model, and the red circle line is the mean growth for the

worst-case model.

25

Figure 4: Expected values of log Ct scaled by 100 for the baseline model and for a half-life

of 80 when = 1. The shaded black and red areas show the .1 and .9 interdecile ranges

under the the baseline and the worst-case model for a half-life of 80. The black line is the

mean growth for the baseline model, and the red circle line is the mean growth for the

worst-case model.

Z

h

h

b

Z = Z : Z ; , x g (x)Q(dx)

0

baseline model 1. In this section, we compare Z to a corresponding Chernoff entropy ball

Zb and also to another set called an entropy ball that we now describe.

26

7.1

Entropy ball

Anderson et al. (2003) and Hansen and Sargent (2010) focused primarily on entropy balls.

Here we are interested in constructing a new set Z that we define as the smallest entropy

ball that contains Z . An entropy ball is a family of Z h s that satisfy12

h

(Z ) =

Z Z

exp(t)E

Zth

1

b

= x g (x)Q(dx)

2

(35)

for some constant > 0. By constructing an entropy ball that contains Z , we compute

how large relative entropy can be for martingales in the set Z .

and pose a maximum

To determine this magnitude, we take the quadratic function (x)

problem that starts from the observation that a martingale Z h that is biggest in terms of

its relative entropy satisfies the constraint in definition 3.4 at equality:

Z

h

i

t ), x q (x)Q(dx)

b

Z h ; (X

= 0.

Z Z

E

t )dt|X0

exp(t)Zth (X

Z

b

= x g (x)Q(dx)

x g (x)Q(dx)

b

Z h ; ,

0.

1

1

(x, )

0 = max (x, ) + (x)

x + ||2 (x, )

h

2

2

2

2

(36)

We use the term ball loosely because typically a ball in mathematics is defined using a metric. Although

relative entropy quantifies statistical discrepancy, it is not a metric because it depends on which of two

models is taken as the baseline model.

27

h = 0 () + 1 ()X,

it is one of the models in the parametric class from section 3.1. To compute in constraint

(35), we solve

Z

b

= 2 min (x, )g (x)Q(dx).

0

Let

.

Z=

By construction Z Z.

7.2

Z :

1

b

Z ; x g (x)Q(dx)

2

h

Comparing sets

b While it is

We compare intersections of Z o with each of the three sets Z , Z, and Z.

tractable to use the sets Z and Z to formulate robust decision problems, these sets are

not directly linked to statistical discrimination problems. The set Zb is closely linked to

statistical discrimination, but for forming robust decision problems it is not as tractable

b at least in

as the other two. It would be comforting if Z were closely to approximate Z,

regions near the worst-case model that emerges from the robust planners HJB equation

(20).

We compute and report the projection Zb Z o of the Chernoff ball on Z o for three

half-lives in figure 6. We represent these projections using the three parameter values that

characterize Z o . For comparison, we also report (Z Z o ). The sets are distinct, but

the big differences occur for larger values of at which the Chernoff ball contains points

not included in Z . Such large values of turn out not the be the ones that the robust

planner most fears. Overall, the regions are closer for longer specifications of the half-life

of Chernoff entropy.

28

Figure 5: Projections of Sets I and II onto three-parameter axis. From Top to Bottom:

Target half-lives 120, 80, and 40, respectively. Left: = x2 . Right: = 1. (Z Z o ) shown

in blue mesh. (Zb Z o ) shown in yellow. The solution to the robust planners problem is

shown as the red point.

29

Half-Life

69.78

42.19

16.65

+ (/)

0.4650

0

0.1850

0.4650

0.3982 -0.0362 0.1850

0.2024

0.3791 -0.0466 0.1850

0.1273

0.3282 -0.0742 0.1850

-0.0726

Table 3: Worst-case Parameter Values for (x)

= x2 . The left side of this plot shows how large an entropy ball

would have to be to contain the set used in the robust planning problem affiliated with

HJB equation (20). The right side compares the Chernoff ball to this entropy ball. As is

evident from this figure, the resulting entropy ball is much larger. When we solve the robust

planners problem with this constructed ball, we reduce the implied half lives, as reported

in Table 7.2, decline from 120, 80 and 40 to 70, 42 and 17, respectively. The constant terms

for both the consumption equation (the first equation of (10)) and the consumption growth

equation (the second equation of (10)) are reduced while the autoregressive parameter is

not altered in comparison to Table 6.

30

Figure 6: Comparing entropy balls to sets I and II when = x2 . From Top to bottom:

half-lives 120, 80, and 40, respectively. (Z Z o ) shown in blue, (Z Z o ) shown in black

mesh. (Zb Z o ) shown in yellow. The solution to the robust planners problem is the red

point.

31

7.3

Figure 7: Shock-price elasticity to a shock to X for the three target half-lives when = x2 .

From Top to Bottom: the half-lives 120, 80, and 40, respectively. The shaded regions show

interquartile ranges of the shock-price elasticities under the stationary distribution for X.

32

The uncertainty price elasticities depend on the initial state x. In figure 7, we display

the shock elasticities evaluated at the median and the two quartiles of the stationary distribution for X. We shade in interquartile ranges. Figure 7 shows shock price elasticity

trajectories for the growth rate shock. They are nearly constant across horizons. Increasing

the concern for robustness, as reflected by the sizes of the associated Chernoff half lives,

makes the elasticities larger and increases their variation across horizons.

Concluding remarks

We have applied our proposal for constructing a set of models surrounding a decision

makers baseline probability model to an asset pricing model in which a representative

consumers responses to model uncertainty make so-called prices of risk be countercyclical.

We say so-called because they are actually compensations for model uncertainty, not risk.

And their countercyclical components are entirely due to fears of model misspecification.

We have produced an affine model (30) of the log stochastic discount factor whose so-called

risk prices reflect a robust planners worst-case drift distortions ht . We describe how these

drift distortions should be interpreted as prices of model uncertainty. The dependency of

these uncertainty prices ht on the growth state x, and thus whether they are pro cyclical or

that describes some particular models

that serve as alternatives to a baseline model. In this way, the theory of countercyclical

risk premia in this paper is all about how our robust consumer responds to the presence

of the particular alternative models among a huge set of more vaguely specified alternative

models that concern our representative consumer. We have demonstrated that this is a

simple way of generating countercyclical risk premia.

It is worthwhile comparing this papers way of inducing countercyclical risk premia with

three other macro/finance models that also get them. Campbell and Cochrane (1999) proceed in the standard rational expectations single-known-probability-model tradition and so

exclude any fears of model misspecification from the mind of their representative consumer.

They construct a history-dependent utility function in which the history of consumption

expresses an externality. This history dependence makes the consumers local risk aversion

depend in a countercyclical way on the economys growth state. Ang and Piazzesi (2003)

use an affine stochastic discount factor in a no-arbitrage statistical model and explore links

between the term structure of interest rates and other macroeconomic variables. Their

approach allows movements in risk prices to be consistent with historical evidence without

33

specifying a general equilibrium model. A third approach introduces stochastic volatility into the macroeconomy by positing that the volatilities of shocks driving consumption

growth are themselves stochastic processes. A stochastic volatility model induces time

variation in risk prices via exogenous movements in the conditional volatilities impinging

on macroeconomic variables.

What drives countercyclical risk prices in Hansen and Sargent (2010) is a particular

kind of robust model averaging occurring inside the head of the representative consumer.

The consumer carries along two difficult-to-distinguish models of consumption growth, one

asserting i.i.d. log consumption growth, the other asserting that the growth in log consumption is a process with a slowly moving conditional mean.13 The consumer uses observations

on consumption growth to update a Bayesian prior over these two models, starting from

an initial prior probability of .5. The prior wanders over the post WWII sample for US

data, but ends up about where it started. Each period, the Hansen and Sargent representative consumer expresses his specification distrust by exponentially twisting a posterior over

the two baseline models in a pessimistic direction. That leads the consumer to interpret

good news as temporary and bad news as persistent, causing him to put countercyclical

uncertainty components into equilibrium risk prices.

In this paper, we propose a different way to induce variation in risk prices. We abstract

from learning and instead consider alternatives models with parameters whose future variations are not discernible from from the past. These time-varying parameter models differ

from the decision makers baseline model, a fixed parameter model whose parameters can

be well estimated from historical data. We ensure that among the class of alternative models are ones that allow for parameters persistently to deviate from those of the baseline

model in statistically subtle and time-varying ways. In addition to this class of alternative

models, the decision maker also includes other statistical specifications in the set of models

that concern him. The robust planners worst-case model responds to these forms of model

ambiguity partly by having more persistence than in a baseline models. Our approach gains

tractability because the worst-case model turns out to be a time-invariant model in which

projections for long-term growth are more cautious and stochastic growth is more persis13

Bansal and Yaron (2004) and Hansen and Sargent (2010) both start from the observation that two such

models are difficult to distinguish empirically, but they draw different conclusions from that observation.

Bansal and Yaron use the observation to justify a representative consumer who with complete confidence

embraces one of the models (the long-run risk model with persistent log consumption growth), while Hansen

and Sargent use the observation to justify a representative consumer who initially puts prior probability

.5 on both models and who continues to carry along both models when evaluating prospective outcomes.

34

tent than in the baseline model. Worst-case shock distributions are shifted in an adverse

fashion and with additional persistence that gives rise to enduring effects on uncertainty

prices. Adverse shifts in the shock distribution that drive up the absolute magnitudes of

uncertainty prices larger were also present in some of our earlier work (for example, see

Hansen et al. (1999) and Anderson et al. (2003)). In this paper, we induce state dependence

in uncertainty prices in a different way, namely, by specifying the set of alternative models

to capture concerns about the baseline models specification of persistence in consumption

growth.

Models of robustness and ambiguity aversion bring new parameters. In this paper,

we extend our earlier work on Anderson et al. (2003) on restricting these parameters by

exploiting connections between models of statistical model discrimination and our way of

formulating robustness. We build on mathematical formulations of Newman and Stuck

(1979), Petersen et al. (2000), and Hansen et al. (2006). We pose an ex ante robustness

problem that pins down a robustness penalty parameter by linking it to an asymptotic

measure of statistical discrimination between models. This asymptotic measure allows us to

quantify a half-life for reducing the mistakes in selecting between competing models based

on historical evidence. A large statistical discrimination rate implies a short half-life for

reducing discrimination mistake probabilities. Anderson et al. (2003) and Hansen (2007)

had studied the connection between conditional discrimination rates and uncertainty prices

that clear security markets. By following Newman and Stuck (1979) and studying asymptotic rates, we link statistical discrimination half-lives to calibrated equilibrium uncertainty

prices.

35

Z Reconsidered

Let h

model.

Let Bt be a bounded Ft -measurable random variable. Define

E h (Bt |X0 ) E Zth Bt |X0

h

i

Here E h denotes an expectation under the h model and E hh denotes an expectation under

model.

the h h

Zh

By using ht h as a Radon-Nykodym derivative at time t, we can represent the h model

Zt

model:

in terms of the h h

E h (Bt |X0 ) = E Zth Bt |X0

"

!

#

Zth

=E

Zthh Bt |X0

hh

Z

!

#

"t

h

Z

t

Bt |X0 .

= E hh

hh

Zt

Recall that under the h probability distribution, W h is a multivariate standard Brownian

motion where from (6), dWt = ht dt + dWth . Thus,

t ) dWt 1 |ht h

t |2 dt

d log Zthh = (ht h

2

h

t |2 dt + (ht h

t ) ht

t ) dW 1 |ht h

= (ht h

t

2

t |2 dt.

t ) dW h + 1 |ht |2 dt 1 |h

= (ht h

t

2

2

(37)

Conditioned on date zero information, the discounted relative entropy of the h model

model is:

with respect to the h h

Z

h

i

1 h

h

h

hh

2

|X0 = x dt = E

exp(t)|ht | dt | F0

2

0

(38)

36

where we have used integration by parts and the evolution in (37). We are interested in the

discrepancy between: (i) the relative entropy (8) of h with respect to the baseline model,

model:

and (ii) the relative entropy (38) of the h model with respect to the h h

Z

h 2

Z ; |h| , x =

exp(t)E Zth log Zth |X0 = x dt

h

i

Z 0

h

i

1

t |2 |X0 = x dt.

exp(t)E h |ht |2 |h

=

2 0

(39)

For a given multiplier, write the value function that solves HJB equation (36) in the form:

(x, ) =

which gives us

1

2 ()x2 + 2 1 ()x + 0 ()

2

1

[ 2 ()x + 1 ()] .

We can solve for 2 , 1 , and 0 by comparing the coefficients for x2 , x and the constant

h (x, ) =

q

)2 4 ||2 2 (+1)

+ 2

( + 2

.

2 () =

2

2 ||

1

+ ||2 2 () 1 () = 0.

1 () + ( + 1)1 1 ()

Thus

Finally,

1 () = 2( + 1)

1

2

( + 2

) 4 ||

2 (+1)

1

( + 1)

1

0 () +

2

2

2

2

Thus

1

1

2

2

2

( + 1)0 + 2 ()|| + 1 () || .

0 () =

37

= min 2 ()x2 + 2 1 ()x + 0 ()

0

for X0 = x.

ft

d log Yt = (.01) ( + Xt ) dt + (.01) dW

ft .

dXt = dt Xt dt + dW

"

# " #

= 0

"

# " #

0

= 1

for 1 and 0 .

,

and

ii) For a given r, construct 0 , 1 , 2 ,

, ,

from:

(r + r2 )|h(x)|2 = (r + r2 )|0 + 1 x|2 = 0 + 21 x + 2 x2

= (1 r)

+ r

= (1 r) + r

= r

= (1 r)

+ r

iii) Solve

=

1

0 + 21 x + 2 x2 + ( x

)(log e) (x)

2

38

|| +

||

2

2

2 =

q

(

)2 + 2 ||2

||2

Given 2 , 1 solves

2=0

1

1 + 1 2 ||2 +

or

1 =

Finally,

2

2

1

1

q

.

=

2 ||2

(

)2 + 2 ||2

1

1

1

1.

= 0 ||2 2 ||2 (1 )2

2

2

2

D.1

Solving for

Consider

1

0 = min (x) + (.01)(

+ x) + (x)( +

x) + ||2 (x, )

h

2

2 x2 + 21 x + 0

+ (.01) h + (x, ) h + |h|2

2

2

(x, ) =

which implies

1

2 ()x2 + 21 ()x + 0 ()

2

1

h(x, ) = [.01 2 ()x 1 ()] .

39

We can solve for 2 , 1 , and 0 by matching the coefficients for x2 , x and the constant

terms, respectively. Solving first for 2 :

q

2

2

) 4 || 2

+ 2

( + 2

2 () =

2

2 ||

=

2 ,

.01 .01 ( ) 2 +

2 + 1

q

1 () =2

+ ( + 2

)2 4 ||2 2

1

1

2

2

1 () + || 2 + |.01 1 ()| + 0

+

0 () = .02

1 () =

1,1 + 1,0

0 () =

0,1 + 0,0 + 0,1 1 .

D.2

Solving for

We want to solve

||2

2

2 () ||2

1

max

1 ()2 +

1

log 2

2 () ||2 log (2

) 0 () .

2

2

satisfies

=

2

||2 1,0

+ (2

2 ||2 ) 0,1

2

||2 1,1

+ (2

2 ||2 ) [ log (2

2 ||2 ) + log (2

) + 0,1 + 2]

40

Here is how to compute Chernoff entropies for parametric models of the form (10). Because

the hs associated with them take the form

ht = (Xt ),

these alternative models are Markovian. This allows us to compute Chernoff entropy by

using an eigenvalue approach of Donsker and Varadhan (1976) and Newman and Stuck

r

(1979). We start by computing the drift of Zth f (Xt ) for 0 r 1 at t = 0:

. (r + r2 )

|(x)|2f (x) + rf (x) (x)

[Gf ](x) =

2

f (x) 2

|| ,

f (x)x +

2

where [Gf ](x) is the drift given that X0 = x. Next we solve the eigenvalue problem

[G(r)]e(x, r) = (r)e(x, r),

whose eigenfunction e(x, r) is the exponential of a quadratic function of x. We compute

Chernoff entropy numerically by solving:

(Z h , x) = max (r).

r[0,1]

(log e) (x) =

and

e (x)

e(x)

2

e (x)

e (x)

.

(log e) (x) =

e(x)

e(x)

For a positive f

[Gf ](x) . (r + r2 )

=

|h(x)|2 + r(log f ) (x) h(x) (log f ) (x)x

f (x)

2

log f (x) 2 [log f (x)]2 2

+

|| +

|| .

2

2

41

(40)

[Gf ](x)

.

G(log f ) (x) =

f (x)

G(log e) (x) =

These calculations allow us numerically to compute the largest and smallest Chernoff

entropies attained by members of the set Z o .

i) Stochastic impulse response for log S. We solve the recursion:

dXt1 =

Xt1 dt

dXt =

Xt + dWt

ht = 0 + 1 Xt

h1t = 1 Xt1

where X01 = u and log S01 = .01 u + h (x) u. The quadratic terms in the

evolution equation of log S make log St1 stochastic.

ii) Deterministic impulse response for log C. We solve the recursion:

d log Ct1 = .01Xt1dt

dXt1 =

Xt1 dt,

log Ct1 =

.01

[1 exp (

t)] u + (.01) u

42

iii) Compute

where Mt = St

Ct

C0

. Note that

E (Mt |X0 = x)

1

d log Mt = dt + ht dWt |ht |2 dt.

2

Let dWt have drift ht and compute expectations conditioned on X0 = x recursively:

ft ) ht h1t dt

d log St1 = .01Xt1 dt + h1t (ht dt + dW

ft

= .01X 1 dt + h1 dW

t

dXt1

Xt1 dt

ht = 0 + 1 Xt

h1t = 1 Xt1 ,

.01

E (Mt log St1 |X0 = x)

=

[1 exp (

t)] u .01 u + h (x) u.

E (Mt |X0 = x)

(a) Shock-exposure elasticity for consumption:

E

log Ct1 |X0 = x

.01

=

[1 exp(

t)] u + .01 u,

E CC0t |X0 = x

Ct

C0

(b) Shock-price elasticity

E

log Ct1 |X0 = x

E (Mt log St1 |X0 = x)

E [Mt (log St1 + log Ct1 ) |X0 = x]

=

E (Mt |X0 = x)

E (Mt |X0 = x)

E CC0t |X0 = x

Ct

C0

.01

[1 exp(

t)] u + .01 u h (x) u.

43

44

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