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Higher-order effects in asset-pricing models with long-run risks

Pohl,W.
; 
Schmedders,K.
; 
Wilms,Ole
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.
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Date
2018-06
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Tilburg University Research Output Collection
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Keywords
asset pricing, discretization, log-linearization, nonlinear dynamics, projection methods, G11 - Portfolio Choice ; Investment Decisions, G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates
Citation
Pohl, W, Schmedders, K & Wilms, O 2018, 'Higher-order effects in asset-pricing models with long-run risks', Journal of Finance, vol. 73, no. 3, pp. 1061-1111. https://doi.org/10.1111/jofi.12615
URI
https://hdl.handle.net/20.500.14602/67519
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