Get access

AN EQUILIBRIUM GUIDE TO DESIGNING AFFINE PRICING MODELS

Authors


  • We thank two anonymous referees and the associate editor for valuable comments. We have also benefited from discussions with Ravi Bansal, Tim Bollerslev, Xin Huang, George Tauchen, Stanley Zin, and seminar participants at University of Washington, the Lijiang Mathematical Finance workshop and the Duke Financial Econometrics workshop.

Address correspondence to Bjørn Eraker, Wisconsin School of Business, Department of Finance, Grainger Hall, 975 University Avenue, Madison, WI 53706; e-mail:beraker@bus.wisc.edu.

Abstract

The paper examines equilibrium models based on Epstein–Zin preferences in a framework in which exogenous state variables follow affine jump diffusion processes. A main insight is that the equilibrium asset prices can be computed using a standard machinery of affine asset pricing theory by imposing parametric restrictions on market prices of risk, determined inside the model by preference and model parameters. An appealing characteristic of the general equilibrium setup is that the state variables have an intuitive and testable interpretation as driving the consumption and dividend dynamics. We present a detailed example where large shocks (jumps) in consumption volatility translate into negative jumps in equilibrium prices of the assets as agents demand a higher premium to compensate for higher risks. This endogenous “leverage effect,” which is purely an equilibrium outcome in the economy, leads to significant premiums for out-of-the-money put options. Our model is thus able to produce an equilibrium “volatility smirk,” which realistically mimics that observed for index options.

Ancillary