Working Paper Series Model Uncertainty, Bond Pricing and the Nonrobustness of Affine Term Structures MODEL UNCERTAINTY, BOND PRICING AND THE NONROBUSTNESS OF AFFINE TERM STRUCTURES

Abstract We develop a continuous time general equilibrium model for the term structure of interest rates where economic agents are averse to model uncertainty and consider the possibility of a misspecified dynamic model for the latent risk factors driving interest rates. Aversion to model uncertainty is parameterized through a specific form of Knightian uncertainty which induces first order risk aversion effects in equilibrium. We find that a small concern for model uncertainty significantly affects the implied term structures in equilibrium. Indeed, equilibrium risk premia and interest rates have a different functional form than in the standard model, due to a model uncertainty premium that mimics a first order risk aversion effect. Moreover, otherwise unpriced factors in the standard model receive a premium for model uncertainty which is of a particularly rich structure in the multiple factors setting. All these features induce in equilibrium term structure levels and shapes that are very different from the ones in the standard model. For instance, in a simple Co