Pricing of the Time-Change Risks
University of Pennsylvania - Finance Department
Duke University - Economics Group
April 1, 2008
Economic Research Initiatives at Duke (ERID) Working Paper No. 4
We develop a discrete-time real endowment economy featuring Epstein-Zin recursive utility and a Levy time-change subordinator, which represents a clock that connects business time to calendar time. This setup provides a convenient equilibrium framework for pricing non-Gaussian risks, where the solutions for financial prices are available up to integral operations in general, or in closed-form for tempered stable shocks. The non-Gaussianity of fundamentals due to time-deformation induces compensations for higher order moments and co-moments of consumption and dividend growth rates of the assets. Forecastability of the time change leads to predictability of the endowment streams and therefore to time-variation in financial prices and risk premia on assets. In numerical calibrations, we quantitatively analyze the compensations for different types of systematic risk.
Number of Pages in PDF File: 41
Keywords: Risk premium, time change, Levy processes, recursive preferences
JEL Classification: G12, D51, C51
Date posted: August 1, 2008 ; Last revised: December 13, 2011
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