Affine General Equilibrium Models
AbstractNo-arbitrage models are extremely flexible modelling tools but often lack economic motivation. This paper describes an equilibrium consumption-based CAPM framework based on Epstein-Zin preferences, which produces analytic pricing formulas for stocks and bonds under the assumption that macro growth rates follow affine processes. This allows the construction of equilibrium pricing formulas while maintaining the same flexibility of state dynamics as in no-arbitrage models. In demonstrating the approach, the paper presents a model that incorporates inflation such that asset prices are nominal. The model takes advantage of the possibility of non-Gaussian shocks and model macroeconomic uncertainty as a jump-diffusion process. This leads to endogenous stock market crashes as stock prices drop to reflect a higher expected rate of return in response to sudden increases in risk. The nominal yield curve in this model has a positive slope if expected inflation growth negatively impacts real growth. This model also produces asset prices that are consistent with observed data, including a substantial equity premium at moderate levels of risk aversion.
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Bibliographic InfoArticle provided by INFORMS in its journal Management Science.
Volume (Year): 54 (2008)
Issue (Month): 12 (December)
finance; investment; asset pricing; probability; diffusion; stochastic model applications;
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- John Y. Campbell & Adi Sunderam & Luis M. Viceira, 2009. "Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds," NBER Working Papers 14701, National Bureau of Economic Research, Inc.
- Ho, Hsiao-Wei & Huang, Henry H. & Yildirim, Yildiray, 2014. "Affine model of inflation-indexed derivatives and inflation risk premium," European Journal of Operational Research, Elsevier, vol. 235(1), pages 159-169.
- Wayne E. Ferson & Suresh K. Nallareddy & Biqin Xie, 2012. "The "Out of Sample" Performance of Long-run Risk Models," NBER Working Papers 17848, National Bureau of Economic Research, Inc.
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