A Long-Run Risks Model of Asset Pricing with Fat Tails

Abstract

WWe explore the effects of fat tails on the equilibrium implications of the long run risks model of asset pricing by introducing innovations with dampened power law to consumption and dividends growth processes. We estimate the structural parameters of the proposed model by maximum likelihood. We find that the homoskedastic model with fat tails leads to significant increase in implied risk premia and volatility of price-dividend ratio over the benchmark Gaussian model, but similar volatility of market return, expected risk free rate and its volatility.asset pricing, long run risks, equity risk premium, fat tails, Dampened Power Law, Levy process