Linearity-Generating Processes: A Modelling Tool Yielding Closed Forms for Asset Prices

44 Pages Posted: 3 Nov 2008

See all articles by Xavier Gabaix

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

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Date Written: September 2007

Abstract

This methodological paper presents a class of stochastic processes with appealingproperties for theoretical or empirical work in finance and macroeconomics, the 'linearity-generating' class. Its key property is that it yields simple exact closed-formexpressions for stocks and bonds, with an arbitrary number of factors. It operates in discrete and continuous time. It has a number of economic modeling applications.These include macroeconomic situations with changing trend growth rates, or stochastic probability of disaster, asset pricing with stochastic risk premia or stochastic dividend growth rates, and yield curve analysis that allows flexibility and transparency. Many research questions may be addressed more simply and in closed form by using the linearity-generating class.

Keywords: Modified Gordon growth model, Stochastic Discount Factor, Long term risk, Interest rate processes, Bond premia, Equity Premium

Suggested Citation

Gabaix, Xavier, Linearity-Generating Processes: A Modelling Tool Yielding Closed Forms for Asset Prices (September 2007). NYU Working Paper No. FIN-07-006. Available at SSRN: https://ssrn.com/abstract=1293140

Xavier Gabaix (Contact Author)

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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