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Pricing of the time-change risks

Authors
Journal
Journal of Economic Dynamics and Control
0165-1889
Publisher
Elsevier
Publication Date
Volume
35
Issue
6
Identifiers
DOI: 10.1016/j.jedc.2011.01.003
Keywords
  • Time Deformation
  • Risk Premium
  • Recursive Utility

Abstract

Abstract We develop an equilibrium endowment economy with Epstein–Zin recursive utility and a Lévy time-change subordinator, which represents a clock that connects business and calendar time. Our setup provides a tractable equilibrium framework for pricing non-Gaussian jump-like risks induced by the time-change, with closed-form solutions for asset prices. Persistence of the time-change shocks leads to predictability of consumption and dividends and time-variation in asset prices and risk premia in calendar time. In numerical calibrations, we show that the risk compensation for Lévy risks accounts for about one-third of the overall equity premium.

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