Hedging Demand and Excess Volatility in Dynamic Economies
30 Pages Posted: 29 Sep 2005
Date Written: September 2005
This paper introduces an endowment model that can be interpreted as a continuous time, continuous space generalization of Mehra and Prescott (1985) in which the state variable is a weighted average of past growth. The model is tractable enough to provide exact analytical solutions for term and risk premia and for the excess volatility of the market portfolio. These results have been explored in the discrete time literature, but only numerically or through analytical approximations. I demonstrate that stochastic volatility is the duration of the price-dividend ratio with respect to the state variable of the economy. This result shows how the representative investor's hedging demand translates into the volatility of the market portfolio, and is the general equilibrium extension of a known result in Wachter (2002).
Keywords: Volatility, Hedging demand.
JEL Classification: G12, G11
Suggested Citation: Suggested Citation