The Journal of Finance publishes leading research across all the major fields of finance. It is one of the most widely cited journals in academic finance, and in all of economics. Each of the six issues per year reaches over 8,000 academics, finance professionals, libraries, and government and financial institutions around the world. The journal is the official publication of The American Finance Association, the premier academic organization devoted to the study and promotion of knowledge about financial economics.
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Higher Order Effects in Asset Pricing Models with Long‐Run Risks
Published: 02/02/2018 | DOI: 10.1111/jofi.12615
WALTER POHL, KARL SCHMEDDERS, OLE WILMS
This paper shows that the latest generation of asset pricing models with long‐run risk exhibit economically significant nonlinearities, and thus the ubiquitous Campbell‐Shiller log‐linearization can generate large numerical errors. These errors translate in turn to considerable errors in the model predictions, for example, for the magnitude of the equity premium or return predictability. We demonstrate that these nonlinearities arise from the presence of multiple highly persistent processes, which cause the exogenous states to attain values far away from their long‐run means with nonnegligible probability. These extreme values have a significant impact on asset price dynamics.