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

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Author Info
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://www.fiu.edu/orgs/economics/wp2008/08-10.pdf
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File Function: First version, 2008
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Publisher 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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Related research
Keywords: asset pricing; long run risks; equity risk premium; fat tails; Dampened Power Law; Levy process;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates

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  1. Ravi Bansal, 2007. "Long-Run Risks and Financial Markets," NBER Working Papers 13196, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Mariano M. Croce & Martin Lettau & Sydney C. Ludvigson, 2007. "Investor Information, Long-Run Risk, and the Duration of Risky Cash-Flows," NBER Working Papers 12912, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08. [Downloadable!] (restricted)
    Other versions:
  4. Liuren Wu, 2006. "Dampened Power Law: Reconciling the Tail Behavior of Financial Security Returns," Journal of Business, University of Chicago Press, vol. 79(3), pages 1445-1474, May. [Downloadable!]
    Other versions:
  5. Benoit Mandelbrot, 1963. "The Variation of Certain Speculative Prices," Journal of Business, University of Chicago Press, vol. 36, pages 394. [Downloadable!]
  6. Ravi Bansal, 2007. "Long-run risks and financial markets," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 283-300. [Downloadable!]
  7. 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., vol. 9(2), pages 181-200, April-Jun. [Downloadable!] (restricted)
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  8. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March. [Downloadable!] (restricted)
  9. 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, vol. 31(3), pages 887-905, March. [Downloadable!] (restricted)
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  10. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November. [Downloadable!] (restricted)
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  11. Prasad V. Bidarkota & Brice V. Dupoyet & J. Huston McCulloch, 2005. "Asset Pricing with Incomplete Information under Stable Shocks," Working Papers 0514, Florida International University, Department of Economics. [Downloadable!]
  12. Geweke, John, 2001. "A note on some limitations of CRRA utility," Economics Letters, Elsevier, vol. 71(3), pages 341-345, June. [Downloadable!] (restricted)
  13. 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. [Downloadable!] (restricted)
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  14. 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, vol. 57(4), pages 937-69, July. [Downloadable!] (restricted)
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