TITLE:
Equity Pricing and Risk Premium under Long-Run Risks and Incomplete Information
AUTHORS:
Ji Zhou, Alex Paseka
KEYWORDS:
Long-Run Risk, Recursive Preferences, Incomplete Information, Equity Pricing
JOURNAL NAME:
Journal of Mathematical Finance,
Vol.4 No.4,
August
28,
2014
ABSTRACT: In this paper we derive a
pricing kernel for continuous-time long-run risks economy with the Epstein-Zin
utility function, non-i.i.d. consumption growth, and
incomplete information about fundamentals. In equilibrium, agents learn about
latent conditional mean of consumption growth and price equity simultaneously.
We demonstrate our analytical results by applying the model to a well-known
complete information equity valuation model. Calibration of the model reveals
that it can match price-earnings ratio of the market index, equity premium, and
a short term interest rate in the data, which, as we show, we can only achieve
for high levels of latent state variable persistence. There is a trade-off
between the persistence necessary to fit the data and parameters controlling
the inference process. The easier the inference is, the larger
persistence is required to fit the data.