Abstract

How non-linear are (log) price-dividend ratios in the fundamental state variables? The accuracy of log-linear approximations lies at the heart of much contemporary asset pricing. We analytically solve a parsimonious partial-equilibrium valuation model and uncover preliminary evidence suggesting that some caution be in order only if the fundamentals are extremely persistent. We work out the stock price's exact exposure to discount rate risk to shed more light on the "good" nature of discount rate risk relative to cashflow risk. Persistence in the price of risk not only inflates such exposure but also renders it markedly dependent on the level of the price of risk.
Original languageEnglish
Number of pages21
Publication statusPublished - 2011

Keywords

  • Price-dividend ratio, equity premium, non-linearity, stochastic discount factor, market price of risk, short rate, persistence, mean-reversion, affine models.

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