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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.
This is the peer reviewed version of the following article, which has been published in final form at http://dx.doi.org/10.1111/j.1467-9965.2008.00346.x. This article may be used for non-commercial purposes in accordance with Wiley Terms and Conditions for Self-Archiving.
Eraker, B., & Shaliastovich, I. (2008). An Equilibrium Guide to Designing Affine Pricing Models. Mathematical Finance, 18 (4), 519-543. http://dx.doi.org/10.1111/j.1467-9965.2008.00346.x
Date Posted: 27 November 2017
This document has been peer reviewed.