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

60 Pages Posted: 20 Dec 2014 Last revised: 5 Nov 2020

See all articles by Walt Pohl

Walt Pohl

NHH Norwegian School of Economics; University of Zurich

Karl Schmedders

IMD Lausanne

Ole Wilms

Tilburg University - Tilburg University School of Economics and Management

Date Written: May 18, 2018

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 Pohl, Walt and Schmedders, Karl and Wilms, Ole, Higher-Order Effects in Asset-Pricing Models with Long-Run Risks (May 18, 2018). Journal of Finance, 73(3), 1061-1111, 2018., Available at SSRN: https://ssrn.com/abstract=2540586 or http://dx.doi.org/10.2139/ssrn.2540586

Walt Pohl

NHH Norwegian School of Economics ( email )

Helleveien 30
N-5045 Bergen
Norway

University of Zurich ( email )

Moussonstrasse 15
Z├╝rich, 8044
Switzerland

Karl Schmedders (Contact Author)

IMD Lausanne ( email )

Lausanne, CH-1003
Switzerland
+41 (0)79 596 8956 (Phone)

Ole Wilms

Tilburg University - Tilburg University School of Economics and Management ( email )

PO Box 90153
Tilburg, 5000 LE Ti
Netherlands

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