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

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  • WALTER POHL
  • KARL SCHMEDDERS
  • OLE WILMS

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.

Suggested Citation

  • Walter Pohl & Karl Schmedders & Ole Wilms, 2018. "Higher Order Effects in Asset Pricing Models with Long‐Run Risks," Journal of Finance, American Finance Association, vol. 73(3), pages 1061-1111, June.
    • Handle: RePEc:bla:jfinan:v:73:y:2018:i:3:p:1061-1111
    DOI: 10.1111/jofi.12615
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