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Journal of Finance Vol. 73 No. 3 2018

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

Walter Pohl1,2,3; Karl Schmedders1,2,3; Ole Wilms4

1 University of Zurich · 2 University of Münster · 3 Norwegian School of Economics · 4 Ansys (United States)

open access

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.

DOI
10.1111/jofi.12615
Volume
73
Issue
3
Pages
1061-1111
Language
en
Sources
bibtex:phds-export.bib crossref openalex

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