Robustness to model uncertainty and the nominal term premium puzzle

Abstract

This paper examines how concerns about robustness to model uncertainty affect the pricing of nominal bonds. We consider an otherwise standard consumption-based asset pricing model except that the representative agent has limited information about the economy. Specifically, he does not know the true model of the economy and therefore decides to pursue optimal consumption paths that are robust to model misspecification. The empirical results show that this robustness concern can account for many features of the bond yields in the US. In particular, it can solve the term premium puzzle faced by standard consumption-based models.