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

Walter Pohl; Karl H Schmedders; Ole Wilms

doi:10.1111/jofi.12615

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

Walter Pohl, Karl H Schmedders, Ole Wilms

EMBA Evanston

Research output: Contribution to journal › Article › peer-review

52 Scopus citations

Abstract

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

Original language	English (US)
Pages (from-to)	1061-1111
Number of pages	51
Journal	Journal of Finance
Volume	73
Issue number	3
DOIs	https://doi.org/10.1111/jofi.12615
State	Published - Jun 2018

Funding

∗Walter Pohl is with Department of Finance, NHH Norwegian School of Economics. Karl Schmedders is with Department of Business Administration, University of Zurich. Ole Wilms is with Department of Finance, Tilburg University. This paper was previously circulated under the title “Higher-Order Dynamics in Asset Pricing Models with Recursive Preferences.” We are grateful to two anonymous referees, an anonymous Associate Editor, and the Editor, Stefan Nagel, for thoughtful reviews of earlier versions. We are indebted to Nicole Branger, Lars Hansen, Ken Judd, Martin Lettau, Malte Schumacher, Che-Lin Su, and particularly our discussant Alexis Akira Toda for helpful discussions on the subject. We thank seminar audiences at the University of Zurich, the Becker Friedman Institute, the University of Münster, and various conferences for comments. We are grateful to the copy editor, Brenda Priebe, for excellent editorial support. Ole Wilms gratefully acknowledges financial support from the Zürcher Universitätsverein. The authors do not have any conflicts of interest as per the Journal of Finance disclosure policy.

ASJC Scopus subject areas

Accounting
Finance
Economics and Econometrics

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10.1111/jofi.12615

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title = "Higher Order Effects in Asset Pricing Models with Long-Run Risks",

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

author = "Walter Pohl and Schmedders, {Karl H} and Ole Wilms",

note = "Funding Information: ∗Walter Pohl is with Department of Finance, NHH Norwegian School of Economics. Karl Schmedders is with Department of Business Administration, University of Zurich. Ole Wilms is with Department of Finance, Tilburg University. This paper was previously circulated under the title “Higher-Order Dynamics in Asset Pricing Models with Recursive Preferences.” We are grateful to two anonymous referees, an anonymous Associate Editor, and the Editor, Stefan Nagel, for thoughtful reviews of earlier versions. We are indebted to Nicole Branger, Lars Hansen, Ken Judd, Martin Lettau, Malte Schumacher, Che-Lin Su, and particularly our discussant Alexis Akira Toda for helpful discussions on the subject. We thank seminar audiences at the University of Zurich, the Becker Friedman Institute, the University of M{\"u}nster, and various conferences for comments. We are grateful to the copy editor, Brenda Priebe, for excellent editorial support. Ole Wilms gratefully acknowledges financial support from the Z{\"u}rcher Universit{\"a}tsverein. The authors do not have any conflicts of interest as per the Journal of Finance disclosure policy. Publisher Copyright: {\textcopyright} 2018 the American Finance Association",

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

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