Observable Long-Run Ambiguity and Long-Run Risk
I propose an equilibrium model where the investor is uncertain about which data generating process drives the predictable (long-run risk) component in consumption growth and inflation. This type of observable Knightian uncertainty makes the equilibrium marginal utility to be heteroscedastic, even if consumption and inflation are conditionally homoscedastic. I find that the model explains how model misspecification doubts about the predictable components feeds into time-varying bond premiums and option implied volatilities that are unspanned by the yield curve. The equilibrium explains the volatility skew and 50% of variations in the equity-index options and T-Note futures options.
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