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

Walter Pohl, Karl H Schmedders, Ole Wilms

Research output: Contribution to journalArticle

12 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 languageEnglish (US)
Pages (from-to)1061-1111
Number of pages51
JournalJournal of Finance
Volume73
Issue number3
DOIs
StatePublished - Jun 2018

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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