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Higher-Order Dynamics in Asset-Pricing Models with Recursive Preferences

Author

Listed:
  • Walter POHL

    (University of Zurich)

  • Karl SCHMEDDERS

    (University of Zurich and Swiss Finance Institute)

  • Ole WILMS

    (University of Zurich)

Abstract

This paper presents an analysis of the higher-order dynamics of key financial quantities in asset-pricing models with recursive preferences. For this purpose, we first describe a projection-based algorithm for solving such models. The method outperforms common methods like discretization and log-linearization in terms of efficiency and accuracy. Our algorithm allows us to document the presence of strong nonlinear effects in the modern long-run risks models which cannot be captured by the common methods. For example, for a prominent recent calibration of a popular long-run risks model, the log-linearization approach overstates the equity premium by 100 basis points or 22.5%. The increasing complexity of state-of-the-art asset-pricing models leads to complex nonlinear equilibrium functions with considerable curvature which in turn have sizable economic implications. Therefore, these models require numerical solution methods, such as the projection methods presented in this paper, that can adequately describe the higher-order equilibrium features.

Suggested Citation

  • Walter POHL & Karl SCHMEDDERS & Ole WILMS, 2014. "Higher-Order Dynamics in Asset-Pricing Models with Recursive Preferences," Swiss Finance Institute Research Paper Series 14-68, Swiss Finance Institute, revised Nov 2015.
  • Handle: RePEc:chf:rpseri:rp1468
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    File URL: http://ssrn.com/abstract=2540586
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    Cited by:

    1. Jaroslav Borovička & John Stachurski, 2020. "Necessary and Sufficient Conditions for Existence and Uniqueness of Recursive Utilities," Journal of Finance, American Finance Association, vol. 75(3), pages 1457-1493, June.
    2. Tsai, Jerry & Wachter, Jessica A., 2018. "Pricing long-lived securities in dynamic endowment economies," Journal of Economic Theory, Elsevier, vol. 177(C), pages 848-878.

    More about this item

    Keywords

    Asset pricing; discretization; log-linearization; nonlinear dynamics; projection methods;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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