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The Impact of Fat Tails on Equilibrium Rates of Return and Term Premia

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  • Prasad V. Bidarkota

    ()
    (Department of Economics, Florida International University)

  • Brice V. Dupoyet

    ()
    (Department of Finance, Florida International University)

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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File URL: http://casgroup.fiu.edu/pages/docs/2245/1280267967_04-11.pdf
File Function: First version, 2004
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Bibliographic Info

Paper provided by Florida International University, Department of Economics in its series Working Papers with number 0411.

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Length: 32 pages
Date of creation: Jul 2004
Date of revision:
Handle: RePEc:fiu:wpaper:0411

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Keywords: pricing model; habit formation; term premium; equity premium; fat tails; dampened power law;

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Cited by:
  1. 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, vol. 33(6), pages 1314-1331, June.
  2. Zhiguang Wang & Prasad V. Bidarkota, 2008. "A Long-Run Risks Model of Asset Pricing with Fat Tails," Working Papers 0810, Florida International University, Department of Economics.
  3. 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.
  4. Ivan Shaliastovich & George Tauchen, 2010. "Pricing of the Time-Change Risks," Working Papers 10-10, Duke University, Department of Economics.
  5. 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, vol. 36(4), pages 610-628.

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