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Asset Pricing in the Frequency Domain: Theory and Empirics

51 Pages Posted: 6 Sep 2013  

Ian Dew-Becker

Kellogg School of Management - Department of Finance

Stefano Giglio

Yale School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Date Written: September 2013

Abstract

In affine asset pricing models, the innovation to the pricing kernel is a function of innovations to current and expected future values of an economic state variable, for example consumption growth, aggregate market returns, or short-term interest rates. The impulse response of this priced variable to fundamental shocks has a frequency (Fourier) decomposition, which captures the fluctuations induced in the priced variable at different frequencies. We show that the price of risk for a given shock can be represented as a weighted integral over that spectral decomposition. The weight assigned to each frequency then represents the frequency-specific price of risk, and is entirely determined by the preferences of investors. For example, standard Epstein-Zin preferences imply that the weight of the pricing kernel lies almost entirely at extremely low frequencies, most of it on cycles longer than 230 years; internal habit-formation models imply that the weight is shifted to high frequencies. We estimate the frequency-specific risk prices for the equity market, focusing on economically interesting frequencies. Most of the pricing weight falls on low frequencies - corresponding to cycles longer than 8 years - broadly consistent with Epstein-Zin preferences.

Suggested Citation

Dew-Becker, Ian and Giglio, Stefano, Asset Pricing in the Frequency Domain: Theory and Empirics (September 2013). NBER Working Paper No. w19416. Available at SSRN: https://ssrn.com/abstract=2321506

Ian Dew-Becker (Contact Author)

Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States

Stefano Giglio

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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