Becker Friedman Institute
for Research in Economics
The University of Chicago

Research. Insights. Impact. Advancing the Legacy of Chicago Economics.

Sets of Models and Prices of Uncertainty

December 2015
Lars Peter Hansen, Tom Sargent

A decision maker constructs a convex set of nonnegative martingales to use as likelihood ratios that represent parametric alternatives to a baseline model and also nonparametric models statistically close to both the baseline model and the parametric alternatives. Max-min expected utility over that set gives rise to equilibrium prices of model uncertainty expressed as worst-case distortions to drifts in a representative investor's baseline model. We offer quantitative illustrations for baseline models of consumption dynamics that display long-run risk. We describe a set of parametric alternatives that generates countercyclical prices of uncertainty.

NBER Working Paper No. 22000