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Long-term Risk: An Operator Approach

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  • Lars Peter Hansen
  • Jose A Sheinkman

Abstract

We create an analytical structure that reveals the long run risk-return relationship for nonlinear continuous time Markov environments. We do so by studying an eigenvalue problem associated with a positive eigenfunction for a conveniently chosen family of valuation operators. This family forms a semigroup whose members are indexed by the elapsed time between payoff and valuation dates. We represent the semigroup using a positive process with three components: an exponential term constructed from the eigenvalue, a martingale and a transient eigenfunction term. The eigenvalue encodes the risk adjustment, the martingale alters the probability measure to capture long run approximation, and the eigenfunction gives the long run dependence on the Markov state. We establish existence and uniqueness of the relevant eigenvalue and eigenfunction. By showing how changes in the stochastic growth components of cash flows induce changes in the corresponding eigenvalues and eigenfunctions, we reveal a long-run risk return tradeoff.
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Suggested Citation

  • Lars Peter Hansen & Jose A Sheinkman, 2007. "Long-term Risk: An Operator Approach," Levine's Bibliography 122247000000001669, UCLA Department of Economics.
  • Handle: RePEc:cla:levrem:122247000000001669
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    File URL: http://www.princeton.edu/%7Ejoses/wp/Long_term.pdf
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    References listed on IDEAS

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    1. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
    2. repec:cup:macdyn:v:1:y:1997:i:2:p:333-54 is not listed on IDEAS
    3. Martin Lettau & Jessica A. Wachter, 2007. "Why Is Long-Horizon Equity Less Risky? A Duration-Based Explanation of the Value Premium," Journal of Finance, American Finance Association, vol. 62(1), pages 55-92, February.
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    5. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
    6. Evan W. Anderson & Lars Peter Hansen & Thomas J. Sargent, 2003. "A Quartet of Semigroups for Model Specification, Robustness, Prices of Risk, and Model Detection," Journal of the European Economic Association, MIT Press, vol. 1(1), pages 68-123, March.
    7. Xiaohong Chen & Lars Peter Hansen & Jos´e A. Scheinkman, 2005. "Principal Components and the Long Run," Levine's Bibliography 122247000000000997, UCLA Department of Economics.
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    17. Lars Peter Hansen, 2008. "Modeling the Long Run: Valuation in Dynamic Stochastic Economies," NBER Working Papers 14243, National Bureau of Economic Research, Inc.
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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