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A Long-Run Risks Model of Asset Pricing with Fat Tails

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  • Zhiguang Wang

    ()
    (Department of Economics, Florida International University)

  • Prasad V. Bidarkota

    ()
    (Department of Economics, Florida International University)

Abstract

WWe explore the effects of fat tails on the equilibrium implications of the long run risks model of asset pricing by introducing innovations with dampened power law to consumption and dividends growth processes. We estimate the structural parameters of the proposed model by maximum likelihood. We find that the homoskedastic model with fat tails leads to significant increase in implied risk premia and volatility of price-dividend ratio over the benchmark Gaussian model, but similar volatility of market return, expected risk free rate and its volatility.

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File URL: http://casgroup.fiu.edu/pages/docs/2249/1275227842_08-10.pdf
File Function: First version, 2008
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Bibliographic Info

Paper provided by Florida International University, Department of Economics in its series Working Papers with number 0810.

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Length: 53 pages
Date of creation: Nov 2008
Date of revision:
Handle: RePEc:fiu:wpaper:0810

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Keywords: asset pricing; long run risks; equity risk premium; fat tails; Dampened Power Law; Levy process;

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  1. Bidarkota, Prasad V. & Dupoyet, Brice V., 2007. "The impact of fat tails on equilibrium rates of return and term premia," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 31(3), pages 887-905, March.
  2. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 15(2), pages 145-161, March.
  3. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 24(3), pages 401-421, November.
  4. Khurshid M. Kiani & Prasad V. Bidarkota, 2004. "On Business Cycle Asymmetries in G7 Countries," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 66(3), pages 333-351, 07.
  5. Ian Martin, 2010. "Consumption-Based Asset Pricing with Higher Cumulants," NBER Working Papers 16153, National Bureau of Economic Research, Inc.
  6. Ravi Bansal, 2007. "Long-Run Risks and Financial Markets," NBER Working Papers 13196, National Bureau of Economic Research, Inc.
  7. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, Econometric Society, vol. 57(4), pages 937-69, July.
  8. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, American Finance Association, vol. 59(4), pages 1481-1509, 08.
  9. Mariano M. Croce & Martin Lettau & Sydney C. Ludvigson, 2007. "Investor Information, Long-Run Risk, and the Term Structure of Equity," NBER Working Papers 12912, National Bureau of Economic Research, Inc.
  10. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," The Journal of Business, University of Chicago Press, vol. 36, pages 394.
  11. Prasad V. Bidarkota & Brice V. Dupoyet & J. Huston McCulloch, 2005. "Asset Pricing with Incomplete Information under Stable Shocks," Working Papers, Florida International University, Department of Economics 0514, Florida International University, Department of Economics.
  12. Liuren Wu, 2006. "Dampened Power Law: Reconciling the Tail Behavior of Financial Security Returns," The Journal of Business, University of Chicago Press, vol. 79(3), pages 1445-1474, May.
  13. Geweke, John, 2001. "A note on some limitations of CRRA utility," Economics Letters, Elsevier, Elsevier, vol. 71(3), pages 341-345, June.
  14. Balke, Nathan S & Fomby, Thomas B, 1994. "Large Shocks, Small Shocks, and Economic Fluctuations: Outliers in Macroeconomic Time Series," Journal of Applied Econometrics, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 9(2), pages 181-200, April-Jun.
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