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The impact of fat tails on equilibrium rates of return and term premia

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  • Bidarkota, Prasad V.
  • Dupoyet, Brice V.

Abstract

We investigate the impact of ignoring fat tails observed in the empirical distributions of macroeconomic time series on the equilibrium implications of the consumption-based asset-pricing model with habit formation. Fat tails in the empirical distributions of consumption growth rates are modeled as a dampened power law process that nevertheless guarantees finiteness of moments of all orders. This renders model-implied mean equilibrium rates of return and equity and term premia finite. Comparison with a benchmark Gaussian process reveals that accounting for fat tails lowers the model-implied mean risk-free rate by 20 percent, raises the mean equity premium by 80 percent and the term premium by 20 percent, bringing the model implications closer to their empirically observed counterparts.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 31 (2007)
Issue (Month): 3 (March)
Pages: 887-905

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Handle: RePEc:eee:dyncon:v:31:y:2007:i:3:p:887-905

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  13. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 15(2), pages 145-161, March.
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Citations

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Cited by:
  1. Zhiguang (Gerald) Wang & Prasad V. Bidarkota, 2010. "A Long-Run Risks Model of Asset Pricing with Fat Tails," Review of Finance, European Finance Association, European Finance Association, vol. 14(3), pages 409-449.
  2. Ivan Shaliastovich & George Tauchen, 2009. "Pricing of the Time-Change Risks," Working Papers, Duke University, Department of Economics 10-71, Duke University, Department of Economics.
  3. Zimper, Alexander, 2012. "Asset pricing in a Lucas fruit-tree economy with the best and worst in mind," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 36(4), pages 610-628.
  4. Bidarkota, Prasad V. & Dupoyet, Brice V. & McCulloch, J. Huston, 2009. "Asset pricing with incomplete information and fat tails," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 33(6), pages 1314-1331, June.
  5. Dupoyet, B. & Fiebig, H.R. & Musgrove, D.P., 2010. "Gauge invariant lattice quantum field theory: Implications for statistical properties of high frequency financial markets," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 389(1), pages 107-116.

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