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Higher order effects in asset pricing models with long-run risks


Pohl, Walter; Schmedders, Karl; Wilms, Ole (2018). Higher order effects in asset pricing models with long-run risks. Journal of Finance, 73(3):1061-1111.

Abstract

This paper shows that the latest generation of asset pricing models with long‐run risk exhibit economically significant nonlinearities, and thus the ubiquitous Campbell‐Shiller log‐linearization can generate large numerical errors. These errors translate in turn to considerable errors in the model predictions, for example, for the magnitude of the equity premium or return predictability. We demonstrate that these nonlinearities arise from the presence of multiple highly persistent processes, which cause the exogenous states to attain values far away from their long‐run means with nonnegligible probability. These extreme values have a significant impact on asset price dynamics.

Abstract

This paper shows that the latest generation of asset pricing models with long‐run risk exhibit economically significant nonlinearities, and thus the ubiquitous Campbell‐Shiller log‐linearization can generate large numerical errors. These errors translate in turn to considerable errors in the model predictions, for example, for the magnitude of the equity premium or return predictability. We demonstrate that these nonlinearities arise from the presence of multiple highly persistent processes, which cause the exogenous states to attain values far away from their long‐run means with nonnegligible probability. These extreme values have a significant impact on asset price dynamics.

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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Business Administration
Dewey Decimal Classification:330 Economics
Language:English
Date:2 February 2018
Deposited On:05 Sep 2019 12:18
Last Modified:01 Feb 2020 01:00
Publisher:Wiley-Blackwell Publishing, Inc.
ISSN:0022-1082
OA Status:Green
Free access at:Publisher DOI. An embargo period may apply.
Publisher DOI:https://doi.org/10.1111/jofi.12615
Other Identification Number:merlin-id:18106

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