Empirical asset pricing with nonlinear risk premia

Details Empirical asset pricing with nonlinear risk premia Empirical asset pricing with nonlinear risk premia

2009-11-04

arxiv.org/abs/0911.0928v1

Economy

Quantitative Finance

Statistical Finance

24 pages, 3 figures

Scientific paper

In this paper we introduce a simple continuous-time asset pricing framework, based on general multi-dimensional diffusion processes, that combines semi-analytic pricing with a nonlinear specification for the market price of risk. Our framework guarantees existence of weak solutions of the nonlinear SDEs under the physical measure, thus allowing to work with nonlinear models for the real world dynamics not considered in the literature so far. It emerges that the additional flexibility in the time series modelling is econometrically relevant: a nonlinear stochastic volatility diffusion model for the joint time series of the S&P 100 and the VXO implied volatility index data shows superior forecasting power over the standard specifications for implied and realized variance forecasting.

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