A Note on Robustness in Merton's Model of Intertemporal Consumption and Portfolio Choice

Posted: 12 May 2003

See all articles by Paolo Vanini

Paolo Vanini

University of Basel

Fabio Trojani

Swiss Finance Institute; University of Geneva

Abstract

The paper presents a robust version of a simple two-assets Merton (1969, Review of Economics and Statistics 51, 247-57) model where the optimal choices and the implied shadow market prices of risk for a representative robust decision maker (RDM) can be easily described. With the exception of the log-utility case, precautionary behaviour is induced in the optimal consumption-investment rules through a substitution of investment in risky assets with both current consumption and riskless saving. For the log-utility case, precautionary behaviour arises only through a substitution between risky and riskless assets. On the financial side, the decomposition of the market price of risk in a standard consumption based component and a further price for model uncertainty risk (which is positively related to the robustness parameter) is independent of the underlying risk aversion parameter.

Keywords: Merton's model, Knightian uncertainty, Model contamination, Model misspecification, Robust decision-making

JEL Classification: C60, C61, G11

Suggested Citation

Vanini, Paolo and Trojani, Fabio, A Note on Robustness in Merton's Model of Intertemporal Consumption and Portfolio Choice. Available at SSRN: https://ssrn.com/abstract=382560

Paolo Vanini (Contact Author)

University of Basel ( email )

Petersplatz 1
Basel, CH-4003
Switzerland

Fabio Trojani

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

University of Geneva ( email )

Geneva, Geneva
Switzerland

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