Boyarchenko, Nina Cerrato, Mario Crosby, John Hodges, Stewart
Year of Publication:
Staff Report 589
Faced with the problem of pricing complex contingent claims, investors seek to make their valuations robust to model uncertainty. We construct a notion of a modeluncertainty-induced utility function and show that model uncertainty increases investors' effective risk aversion. Using this utility function, we extend the no good deals methodology of Cochrane and Saá-Requejo (2000) to compute lower and upper gooddeal bounds in the presence of model uncertainty. We illustrate the methodology using some numerical examples.
asset pricing theory good-deal bounds Knightian uncertainty model uncertainty contingent claim pricing model-uncertainty-induced utility function