Consumption-based asset-pricing models have experienced success in recent years by augmenting the consumption process in ‘exotic’ ways. Two notable examples are the Long-Run Risk and rare disaster frameworks. Such models are difficult to characterize from consumption data alone. Accordingly, concerns have been raised regarding their specification. Acknowledging that both phenomena are naturally subject to ambiguity, we show that an ambiguity-averse agent may behave as if Long-Run Risk and disasters exist even if they do not or exaggerate them if they do. Consequently, prices may be misleading in characterizing these phenomena since they encode a pessimistic perspective of the data-generating process.
Smith, Matthew E., and Rhys Bidder. 2013. “Doubts and Variability: A Robust Perspective on Exotic Consumption Series,” Federal Reserve Bank of San Francisco Working Paper 2013-28. Available at https://doi.org/10.24148/wp2013-28