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Robust control and model misspecification

TLDR
Alternative sequential and nonsequential versions of robust control theory imply identical robust decision rules that are dynamically consistent in a useful sense.
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This article is published in Journal of Economic Theory.The article was published on 2006-05-01 and is currently open access. It has received 354 citations till now. The article focuses on the topics: Robust control & Decision rule.

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Collective Risk Management in a Flight to Quality Episode

TL;DR: In this article, the authors present a model of optimal intervention in a flight to quality episode, where agents make risk management decisions with incomplete knowledge, but are uncertain of how correlated their own shocks are with systemwide shocks, treating the latter uncertainty as Knightian.
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Collective Risk Management in a Flight to Quality Episode

TL;DR: In this article, the authors present a model of crisis and central bank policy that incorporates Knightian uncertainty, and identify a social cost of these behaviors, and a benefit of a lender of last resort facility.
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The impact of risk and uncertainty on expected returns.

TL;DR: In this article, the authors study asset pricing in economies featuring both risk and uncertainty and find stronger empirical evidence for an uncertainty-return trade-off than for the traditional risk return tradeoff.
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Uncertainty, Time-Varying Fear, and Asset Prices

TL;DR: In this paper, the authors construct an equilibrium model that captures salient properties of index option prices, equity returns, variance, and the risk-free rate, and show empirically consistent fundamentals and reasonable model uncertainty explain option prices and the variance premium.
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Axiomatic Foundations of Multiplier Preferences

TL;DR: The authors axiomatizes the robust control criterion of multiplier preferences introduced by Hansen and Sargent (2001) and establishes a link between the parameters of the multiplier criterion and the observable behavior of the agent.
References
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Book

Brownian Motion and Stochastic Calculus

TL;DR: In this paper, the authors present a characterization of continuous local martingales with respect to Brownian motion in terms of Markov properties, including the strong Markov property, and a generalized version of the Ito rule.
Book

Continuous martingales and Brownian motion

Daniel Revuz, +1 more
TL;DR: In this article, the authors present a comprehensive survey of the literature on limit theorems in distribution in function spaces, including Girsanov's Theorem, Bessel Processes, and Ray-Knight Theorem.
Book

Optimization by Vector Space Methods

TL;DR: This book shows engineers how to use optimization theory to solve complex problems with a minimum of mathematics and unifies the large field of optimization with a few geometric principles.
Journal ArticleDOI

Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework

Larry G. Epstein, +1 more
- 01 Jul 1989 - 
TL;DR: In this paper, a class of recursive, but not necessarily expected utility, preferences over intertemporal consumption lotteries is developed, which allows risk attitudes to be disentangled from the degree of inter-temporal substitutability, leading to a model of asset returns in which appropriate versions of both the atemporal CAPM and the inter-time consumption-CAPM are nested as special cases.
Book

Controlled Markov processes and viscosity solutions

TL;DR: In this paper, an introduction to optimal stochastic control for continuous time Markov processes and to the theory of viscosity solutions is given, as well as a concise introduction to two-controller, zero-sum differential games.
Frequently Asked Questions (18)
Q1. What contributions have the authors mentioned in the paper "Robust control and model misspecification" ?

In this paper, the authors consider the problem of robustness of a decision-maker to model misspecification in the context of zero-sum games. 

Among other possibilities, this allows the approximating model to miss the serial correlation of exogenous variables and the dynamics of how those exogenous variables impinge on endogenous state variables. This specification keeps the decision maker concerned about models that can be difficult to distinguish from the approximating model from a continuous record of observations on the state vector of a finite length. Via statistical detection error probabilities, Anderson, Hansen, and Sargent ( 2003 ) show how the penalty parameter or the constraint parameter in the robust control problems can be used to identify a set of perturbed models that are difficult to distinguish statistically from the approximating model in light of a continuous record of finite length T of observations on xt. 

By relaxing the linear space structure the authors can achieve compactness by adding points (say the point ∞) to the control set, provided that the authors can extend χ(·, ȟ, x̌) to be upper semicontinuous. 

Taking continuation entropy as a state variable is a convenient way to restrict the models entertained at time t by the minimizing player in the recursive version of constraint game. 

It is useful to restate the benchmark problem in terms of the probability space that the Brownian motion induces over continuous functions of time, thereby converting it into a nonsequential problem that pushes the state x into the background. 

To analyze outcomes under a sequential timing protocol, the authors think of varying the initial state and define a value function M(x0, z0) as the optimized objective function (28) for the martingale problem. 

By including a hidden state vector and appropriately decomposing the density of next period’s observables conditional on a history of signals, Hansen and Sargent (2005b) extend the approach of this paper to allow a decision maker to have multiple models and to seek robustness to the specification of a prior over them. 

Because minimization occurs first, without the assumption the second equality would have to be replaced by a less than or equal sign ( ≤). 

By modifying the set of priors over time, constraint problem (4) states a recursive version of that nonsequential constraint problem. 

The risk sensitive interpretation excludes worries about misspecified dynamics and instead enhances the control objective with aversion to risk in a way captured by the local variance of the continuation value. 

Relative entropy is well known to be convex in the probability measure q̃ (e.g. see Dupuis and Ellis (1997)), and hence R̃ is convex in q. 

The authors introduce discounting in part to provide an alternative interpretation of the recursive formulation of risk-sensitive control as expressing a fear of model misspecification rather than extra aversion to well understood risks. 

Via statistical detection error probabilities, Anderson, Hansen, and Sargent (2003) show how the penalty parameter or the constraint parameter in the robust control problems can be used to identify a set of perturbed models that are difficult to distinguish statistically from the approximating model in light of a continuous record of finite length T of observations on xt. 

Jacobson (1973) and Whittle (1981) first showed that the risk-sensitive control law can be computed by solving a robust penalty problem of the type the authors have studied here, but without discounting. 

An advantage of working with the induced distributions is that a convexity property that helps to establish the connection between the two games is easy to demonstrate. 

The contribution to entropy coming from the distortionof the probabilities is the discrete state analogue of ∫ log (dqt dq0t) dqt, namely,I(pt) = pt log pt + (1− pt) log(1− pt) + log 2. 

Hansen and Sargent (1995) showed how to introduce discounting and still preserve much of the mathematical structure for the linear-quadratic, Gaussian risk-sensitive control problem. 

If multiple priors truly are a statement of a decision maker’s subjective beliefs, the authors think it is not appropriate to dismiss such beliefs on the grounds of dynamic inconsistency.