No Good Deals–No Bad Models December 27, 2012 at 7:45 pm
From Boyarchenko et al. (HT Alea):
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 model-uncertainty-induced utility function and show that model uncertainty increases investors’ effective risk aversion… the impact of model uncertainty is to give greater weight (i.e. greater than the investor’s marginal utility) to states in which losses are relatively large.