Prasad V. Bidarkota () (Department of Economics, Florida International University) Brice V. Dupoyet () (Department of Finance, Florida International University)
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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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Paper provided by Florida International University, Department of Economics in its series Working Papers with number
0411.
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