Monday, October 12, 2020

DSGE Models As Arbitrage-Free Pricing Models — Brian Romanchuk

From the perspective of a fixed income practitioner, the easiest way to interpret dynamic stochastic general equilibrium (DSGE) models is that they are a form of arbitrage-free pricing models, albeit with a novel definition of arbitrage. This is not too controversial, as DSGE models are an extremely wide classification of models, and pricing models are one recognised sub-category. The issue is that if we look at DSGE macro models -- models which have some resemblance to a core real business cycle (RBC) model -- they inherit some of the limitations of such models. Furthermore, since there is no way to engage in such arbitrage trades in the real world, one is faced with the question why one would insist upon the required mathematical complexity needed to support them.

(Note: this article follows up one that discusses arbitrage-free pricing for fixed income instruments without optionality. It is a digression within a cycle of articles about DSGE macro models that I outlined in this piece. The arguments here are somewhat orthogonal to the discussion that will appear in other articles, but they do explain how I visualise these models. My feeling is that there is too much mysticism attached to these models, and so one needs to understand the big picture before going after more technical arguments.)
Bond Economics
DSGE Models As Arbitrage-Free Pricing Models
Brian Romanchuk

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