We study aversion to model ambiguity and misspecification in dynamic portfolio choice. Risk-averse investors (relative risk aversion ) fear return persistence, while risk-tolerant investors () fear mean reversion, when confronting model misspecification concerns of identically and independently distributed (IID) returns. The intuition is that risk-averse investors, who want to hedge intertemporally, endogenously fear return persistence, which precludes hedging. A log investor is myopic and unaffected by model misspecification, therefore only worrying about model ambiguity. Our model can generate belief scarring, nonparticipation in equity markets, and extrapolative return expectations. Extending beyond IID returns, we study model misspecification for a mean-reverting Sharpe ratio.

Errors in survey expectations display waves of pessimism and optimism and significant sluggishness. This paper develops a novel theoretical framework of time-varying beliefs capturing these empirical facts. In our model, the dynamic beliefs arise endogenously due to agents’ attitude toward alternative models. Decision-maker’s distorted beliefs generate countercyclical risk aversion, procyclical portfolio weights, countercyclical equilibrium asset returns, and excess volatility. A calibrated version of our model is shown to match salient features in equity markets.

This paper develops a theory of dynamic pessimism and its impact on asset prices. Notions of time-varying pessimism arise endogenously in our setting as a consequence of agents’ concern for model misspecification. We generalize the robust control approach of Hansen and Sargent (2001) by replacing relative entropy as a measure of discrepancy between models by the more general family of Cressie-Read discrepancies. As a consequence, the decision-maker’s distorted beliefs appear as an endogenous state variable driving risk aversion, portfolio decisions, and equilibrium asset prices. Using survey data, we estimate time-varying pessimism and find that such a proxy features a strong business cycle component. We then show that using our measure of pessimism helps match salient features in equity markets such as excess volatility and high equity premium.

Motivated by extensive evidence that stock-return correlations are stochastic, we analyze whether the risk of correlation changes (affecting diversification benefits) may be priced. We propose a direct and intuitive test by comparing option-implied correlations between stock returns (obtained by combining index option prices with prices of options on all index components) with realized correlations. Our parsimonious model shows that the substantial gap between average implied (39.5% for S&P500 and 46.0% for DJ30) and realized correlations (32.5% and 35.5%, respectively) is direct evidence of a large negative correlation risk premium. Empirical implementation of our model also indicates that the index variance risk premium can be attributed to the high price of correlation risk. Finally, we provide evidence that option-implied correlations have remarkable predictive power for future stock market returns, which also stays significant after controlling for a number of fundamental market return predictors.

We study international integration of markets for jump and volatility risk, using index option data for the main global markets. To explain the cross-section of expected option returns we focus on return-based multi-factor models. For each market separately, we provide evidence that volatility and jump risk are priced risk factors. There is little evidence, however, of global unconditional pricing of these risks. We show that UK and US option markets have become increasingly interrelated, and using conditional pricing models generates some evidence of international pricing. Finally, the benefits of diversifying jump and volatility risk internationally are substantial, but declining. (C) 2012 Elsevier B.V. All rights reserved.

We study whether exposure to market-wide correlation shocks affects expected option returns, using data on S&P100 index options, options on all components, and stock returns. We present evidence of priced correlation risk based on prices of index and individual variance risk. A trading strategy exploiting priced correlation risk generates a high alpha and is attractive for CRRA investors without frictions. Correlation risk exposure explains the cross-section of index and individual option returns well. The correlation risk premium cannot be exploited with realistic trading frictions, providing a limits to arbitrage interpretation of our ýndings of a high price of correlation risk.

Author Index Adler, Nancy E., 203 Altonji, JG, 91 Ameriks, John, 18 Attanasio, Orazio, 54, 91 Auerbach, AJ, 91 Autor, D., 201 Baarsma, BE, 188 Baicker, K., 352 Baltagi, Badi H., 264 Banerjee, Abhijit, 323 Banks, James, 11, 356, 359, 370, 402, 404 Barker, David JP, 203, 355 Barro, RJ, 93 Becker, Gary S., 93, 264, 318 Berkel, B., 174, 180 Bhattacharya, Jay, 9, 284, 285, 288n3, 291, 312313315 Bloom, DE, 92 Bodie, Zvi, 18 Börsch-Supan, Axel, 6, 174, 174n1, 179, 180 Bound, J., 175 Bourguignon, F., 91 Brown, JR, 91, 104 Browning, Martin, 54 Caballero, B., 354, 355 Calle, EE, 353 Campbell, John Y., 16, 18, 49 Canning, D … 412 Author Index Farrelly, Matthew C., 266, 268 Feldstein, Martin, 34, 38, 93 Filmer, Deon, 318 Fisher, ES, 352 Flegal, KM, 352 Floud, Roderick, 317, 333 Foege, William H., 203 Fogel, Robert W., 317, 350 Frankenberg, E., 91 Freeman, Vicki A., 210, 284 French, Eric, 130 Fried …

We use a unique database on the ownership stakes and compensation of equity mutual fund directors to analyze whether the directors' incentive structure is related to fund performance. We find that governance plays an economically substantial and statistically significant role. The ownership stakes of both independent and non-independent directors matter for fund performance. Further, the various governance variables interact: funds with high director ownership outperform those with low director ownership only when director compensation is low, and ownership by independent directors only matters when non-independent director ownership is high. We find that funds with high director ownership are better able to continue to perform well than funds with low director ownership. Our results cannot be explained by the previously documented relation between fund governance and mutual fund fees. We also provide evidence that the relation between fund performance and director ownership is not due to directors ex-ante picking the best performing funds.

This paper introduces measures of volatility and jump risk that are based on individual stock options to explain credit spreads on corporate bonds. Implied volatilities of individual options are shown to contain useful information for credit spreads and improve on historical volatilities when explaining the cross-sectional and time-series variation in a panel of corporate bond spreads. Both the level of individual implied volatilities and (to a lesser extent) the implied-volatility skew matter for credit spreads. Detailed principal component analysis shows that a large part of the time-series variation in credit spreads can be explained in this way.

We study whether option-implied jump risk premia can explain the high observed level of credit spreads. We use a structural jump-diffusion firm value model to assess the level of credit spreads generated by option-implied jump risk premia. Prices and returns of equity index and individual options are used to estimate the jump parameters. We further calibrate the model to historical information on default risk and the equity premium. The results show that incorporating option-implied jump risk premia brings predicted credit spread levels much closer to observed levels. The introduction of jumps also helps to improve the fit of the volatility of credit spreads and equity returns.

Prices of equity index put options contain information on the price of systematic downward jump risk. We use a structural jump-diffusion firm value model to assess the level of credit spreads that is generated by option-implied jump risk premia. In our compound option pricing model, an equity index option is an option on a portfolio of call options on the underlying firm values. We calibrate the model parameters to historical information on default risk, the equity premium and equity return distribution, and S&P 500 index option prices. Our results show that a model without jumps fails to fit the equity return distribution and option prices, and generates a low out-of-sample prediction for credit spreads. Adding jumps and jump risk premia improves the fit of the model in terms of equity and option characteristics considerably and brings predicted credit spread levels much closer to observed levels.

I analyze the optimal intertemporal portfolio problem of an investor who worries about model misspecification and insists on robust decision rules when facing a mean-reverting risk premium. The desire for robustness lowers the total equity share, but increases the proportion of the intertemporal hedging demand. I present a methodology for calculation of detection-error probabilities, which is based on Fourier inversion of the conditional characteristic functions of the Radon–Nikodym derivatives. The quantitative effect of robustness is more modest than in i.i.d. settings, because model discrimination between the benchmark and the worst-case alternative model is easier, as indicated by the detection-error probabilities.

This article introduces the symposium on model uncertainty and robustness.

This article solves a realistically calibrated life cycle model of consumption and portfolio choice with non-tradable labor income and borrowing constraints. Since labor income substitutes for riskless asset holdings, the optimal share invested in equities is roughly decreasing over life. We compute a measure of the importance of human capital for investment behavior. We find that ignoring labor income generates large utility costs, while the cost of ignoring only its risk is an order of magnitude smaller, except when we allow for a disastrous labor income shock. Moreover, we study the implications of introducing endogenous borrowing constraints in this incomplete-markets setting. Copyright 2005, Oxford University Press.

Jump and volatility risk are important for understanding equity returns, option pricing and asset allocation. This paper is the first to study international integration of markets for jump and volatility risk, using data on index options for each of the three main global markets: US S&P 500 index options), Europe (FTSE index options) and Asia (Nikkei index options). To explain the cross-section of expected returns on these options across strikes and maturities, we focus on return-based multi-factor models, using returns on straddles and out-of-the-money put options as proxies for volatility and jump risk factors. For each market separately, we provide evidence that volatility and jump risk are priced risk factors. There is little evidence, however, of global unconditional pricing of jump and volatility risk. We then investigate the presence of time-variation in the cross-market relationships and find evidence that UK and US option markets have become increasingly interrelated. Incorporating these time-varying patterns in conditional factor pricing models improves their fit substantially and generates some evidence of international pricing. Finally, we show that the benefits of diversifying jump and volatility risk internationally are substantial, but declining over our sample, in line with the hypothesis of increased but imperfect integration of world markets for jump and volatility risk.

I present a new approach to the dynamic portfolio and consumption problem of an investor who worries about model uncertainty (in addition to market risk) and seeks robust decisions along the lines of Anderson, Hansen, and Sargent (2002). In accordance with max-min expected utility, a robust investor insures against some endogenous worst case. I first show that robustness dramatically decreases the demand for equities and is observationally equivalent to recursive preferences when removing wealth effects. Unlike standard recursive preferences, however, robustness leads to environment-specific "effective" risk aversion. As an extension, I present a closed-form solution for the portfolio problem of a robust Duffie-Epstein-Zin investor. Finally, robustness increases the equilibrium equity premium and lowers the risk-free rate. Reasonable parameters generate a 4% to 6% equity premium.

We empirically study the economic benefits of giving investors access to index options in the context of the standard asset allocation problem. We analyze both expected-utility and non-expected-utility investors in order to understand who optimally buys and sells in option markets. We solve the portfolio problem with a flexible empirical methodology that does not rely on specific assumptions about the process of the underlying equity index. Using data on S&P 500 index options (1987-2001) we consider returns on OTM put options and ATM straddles. CRRA investors find it always optimal to short put options and straddles, regardless of their risk aversion. The option positions are economically and statistically significant and robust to corrections for transaction costs, margin requirements, and Peso problems. Surprisingly, loss-averse and disappointment-averse investors also optimally hold short positions in puts and straddles. Because derivatives are in zero net supply, this suggests that generating empirically relevant option prices in an equilibrium model is a challenging task, even with investor heterogeneity and even with commonly-studied behavioral preferences. Only when loss aversion is combined with highly distorted probability assessments, can we obtain positive portfolio weights for puts and straddles.

Hansen and Sargent, and a number of coauthors have recently initiated a research agenda that introduces the notion of robustness to model uncertainty (or a concern with model misspecification) into macroeconomics and finance. Methodologically they modify key techniques from the robust control literature in applied mathematics in order to allow for recursivity, discounting, and stochastic dynamics, which are obvious ingredients of the conventional modeling paradigm in financial economics. The fundamental idea behind robustness is that economic models are at best viewed as stylized approximations of reality rather than perfectly accurate descriptions thereof. It is then natural to entertain the possibility that economic agents making decisions in these models share the concern for model misspecification that economists and econometricians routinely express. When agents use a particular model as guidance in a dynamic decision problem and worry that this model might be misspecified, one would expect them to insist on considering alternative models in order to obtain decision rules that not only work well when the particular baseline model is correct, but that also perform reasonably well when the model is somewhat misspecified. This is the sense in which the decision rule is designed to be robust. The question of course is how agents go about considering alternative models and obtaining a robust decision rule given these alternative models. In this article, as in other work introducing robustness, the agents are assumed to achieve robustness by considering a least-favorable or worst-case model that is similar to and statistically hard to distinguish from the baseline model.

We show that a central planner with two selves, or two "pseudo welfare functions", are sufficient to deliver a market equilibrium that prevails among any (finite) number of heterogeneous individual agents acting competitively in an incomplete financial market. Furthermore, we are able to exhibit a recursive formulation of the two-central planner problem. In that formulation, every aspect of the economy can be derived one step at a time, by a process of backward induction as in dynamic programming.