On the Economic Impact of Modeling Non-Linearities: The Asset Pricing Example

Abstract

We investigate the economic importance of modeling non-linearities in the dynamics of exogenous processes on the implied moments of endogenous variables in the context of the consumption-based asset pricing model. For this purpose, we model the endowment process alternatively as a linear autoregression and as a non-linear threshold autoregression. The asset pricing model with non-linear endowment is solved using quadrature techniques. A comparison of the moments of the model-implied rates of return in the two cases suggests that the economic impact of modeling non-linearities is small.

Keywords: Asset pricing, rates of returns, non-linearities, threshold autoregressions, numerical solutions

JEL Classification: G12, C22, C52, C63