Download this Paper Open PDF in Browser

Higher-Order Effects in Asset-Pricing Models with Long-Run Risks

60 Pages Posted: 20 Dec 2014 Last revised: 19 May 2017

Walt Pohl

University of Zurich

Karl Schmedders

University of Zurich

Ole Wilms

Tilburg School of Economics and Management

Date Written: May 18, 2017

Abstract

This paper shows that the latest generation of asset pricing models with long-run risk exhibits economically significant nonlinearities, and thus the ubiquitous Campbell--Shiller log-linearization can generate large numerical errors. These errors in turn translate 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 very persistent processes, which cause the exogenous states to attain values far away from their long-run means with non-negligible probability. These extreme values have a significant impact on asset price dynamics.

Keywords: Asset pricing, discretization, log-linearization, nonlinear dynamics, projection methods

JEL Classification: G11, G12

Suggested Citation

Pohl, Walt and Schmedders, Karl and Wilms, Ole, Higher-Order Effects in Asset-Pricing Models with Long-Run Risks (May 18, 2017). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2540586 or http://dx.doi.org/10.2139/ssrn.2540586

Walt Pohl

University of Zurich ( email )

Moussonstrasse 15
Zürich, 8044
Switzerland

Karl Schmedders (Contact Author)

University of Zurich ( email )

Moussonstrasse 15
Zürich, CH-8044
Switzerland
+41 (0)44 634 3770 (Phone)

Ole Wilms

Tilburg School of Economics and Management ( email )

PO Box 90153
Tilburg, 5000 LE Ti
Netherlands

Paper statistics

Downloads
154
Rank
162,271
Abstract Views
698