Linearity-Generating Processes: A Modelling Tool Yielding Closed Forms for Asset Prices
44 Pages Posted: 3 Nov 2008
Date Written: September 2007
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
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