Doubts and variability: a robust perspective on exotic consumption series

In order for consumption based asset pricing models to reconcile data on returns with that on consumption, researchers have resorted to augmenting the consumption series in exotic ways. When an agent’s consumption series is subject to changes in volatility, we show that concerns for model misspecification can induce fears of both disasters and long run risk. We appeal to this pessimistic view to explain why introducing stochastic volatility in the presence of model uncertainty helps generate a more plausible unconditional market price of risk and time variation in the conditional market price of risk. Our analysis is based on a parameterization derived from Bayesian estimation of our stochastic volatility model using US consumption data.