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The Affine Nature of Aggregate Wealth Dynamics

The paper derives a parsimonious two-component affine diffusion model for a world stock index to capture the dynamics of aggregate wealth. The observable state variables of the model are the normalized index and the inverse of the stochastic market activity, both modeled as square root processes. The square root process in market activity time for the normalized aggregate wealth emerges from the affine nature of aggregate wealth dynamics, which will be derived under basic assumptions and does not contain any parameters that have to be estimated. The proposed model employs only three well interpretable structural parameters, which determine the market activity dynamics, and three initial parameters. It is driven by the continuous, nondiversifiable uncertainty of the market and no other source of uncertainty. The model, to be valid over long time periods, needs to be formulated in a general financial modeling framework beyond the classical no-arbitrage paradigm. It reproduces a list of major stylized empirical facts, including Student-t distributed log-returns and typical volatility properties. Robust methods for fitting and simulating this model are demonstrated.

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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 322.

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Length: 53 pages
Date of creation: 01 Dec 2012
Date of revision:
Handle: RePEc:uts:rpaper:322
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  8. Eckhard Platen & Renata Rendek, 2009. "Exact Scenario Simulation for Selected Multi-dimensional Stochastic Processes," Research Paper Series 259, Quantitative Finance Research Centre, University of Technology, Sydney.
  9. Nicola Bruti-Liberati, 2007. "Numerical Solution of Stochastic Differential Equations with Jumps in Finance," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 1.
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  13. Eckhard Platen & Renata Rendek, 2010. "Approximating the Numeraire Portfolio by Naive Diversification," Research Paper Series 281, Quantitative Finance Research Centre, University of Technology, Sydney.
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  18. Peter Carr & Helyette Geman & Dilip Madan & Marc Yor, 2004. "From local volatility to local Levy models," Quantitative Finance, Taylor & Francis Journals, vol. 4(5), pages 581-588.
  19. Alan L. Lewis, 2000. "Option Valuation under Stochastic Volatility," Option Valuation under Stochastic Volatility, Finance Press, number ovsv, December.
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  23. Yor, Marc & Madan, Dilip B. & Carr, Peter & Geman, HĂ©lyette, 2004. "From Local Volatility to Local Levy Models," Economics Papers from University Paris Dauphine 123456789/1448, Paris Dauphine University.
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