Ambiguity and Information Processing in a Model of Intermediary Asset Pricing

Abstract

The paper incorporates ambiguity and information processing contraints into a model of intermediary asset pricing. Financial intermediaries are assumed to possess greater information processing capacity. Households purchase this capacity, and then delegate their investment decisions to intermediaries. As in He and Krishnamurthy (2012), the delegation contract is constrained by a moral hazard problem, which gives rise to a minimum capital requirement. Both agents have a preference for robustness, reflecting ambiguity about asset returns (Hansen and Sargent (2008)). We show that ambiguity aversion tightens the capital constraint, and amplifies its effects. Indirect inference is used to calibrate the model's parameters to the stochastic properties of asset returns. Detection error probabilities are used to discipline the degree of ambiguity aversion. The model can explain both the unconditional moments of asset returns and their state dependence, even with DEPs in excess of 20%.