A tractable formalization of the Knightian uncertainty faced by an economist and market participants in an intertemporal asset-price model.
We extend Lucas’s classic asset-price model by opening the stochastic process driving dividends to Knightian uncertainty arising from unforeseeable change. Implementing Muth’s hypothesis, we represent participants’ expectations as being consistent with our model’s predictions and formalize their ambiguity-averse decisions with maximization of intertemporal multiple-priors utility. We characterize the asset-price function with a stochastic Euler equation and derive a novel prediction that the relationship between prices and dividends undergoes unforeseeable change. Our approach accords participants’ expectations, driven by both fundamental and psychological factors, an autonomous role in driving the asset price over time, without presuming that participants are irrational.
