International audience

We study how decision-makers' concerns about robustness affect prices and quantities in a stochastic growth model. In the model economy, growth rates in technology are altered by infrequent large shocks and continuous small shocks. An investor observes movements in the technology level but cannot perfectly distinguish their sources. Instead the investor solves a signal extraction problem. We depart from most of the macro-economics and finance literature by presuming that the investor treats the specification of technology evolution as an approximation. To promote a decision rule that is robust to model misspecification, an investor acts as if a malevolent player threatens to perturb the actual data-generating process relative to his approximating model. We study how a concern about robustness alters asset prices. We show that the dynamic evolution of the risk-return trade-off is dominated by movements in the growth-state probabilities and that the evolution of the dividend-price ratio is driven primarily by the capital-technology ratio.

Use It or Lose It: Teaching Literacy in the Economics Principles Course by W. Lee Hansen, Michael K. Salemi and John J. Siegfried. Published in volume 92, issue 2, pages 463-472 of American Economic Review, May 2002

. We develop models of robust decision-making and pricing when there are contemporaneous big and small shocks. We illustrate these models using a stochasticgrowth economy. Large shocks are infrequent changes in the technological growth rate, and small shocks are continuous movements in the technology process. Large shocks evolve as a Markov jump process whereas small shocks are a Brownian motion. Robust decision-making is formalized as a two-player game. In contrast to rational expectations agents, our investors are decision-makers who treat models as approximations and fear misspecication. As an algorithmic device to enforce robustness, investors imagine a second, malevolent player, who has the ability to perturb the baseline model. We study two economies, each of which decentralizes a robust resource allocation problem with hidden growth rates. The economies dier in the manner in which the the model is viewed as an approximation. We compare the pricing implications to those that em...