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After the FloodHow the Great Recession Changed Economic Thought$
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Edward L. Glaeser, Tano Santos, and E. Glen Weyl

Print publication date: 2017

Print ISBN-13: 9780226443546

Published to Chicago Scholarship Online: September 2017

DOI: 10.7208/chicago/9780226443683.001.0001

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PRINTED FROM CHICAGO SCHOLARSHIP ONLINE (www.chicago.universitypressscholarship.com). (c) Copyright University of Chicago Press, 2019. All Rights Reserved. An individual user may print out a PDF of a single chapter of a monograph in CHSO for personal use.date: 15 October 2019

Stochastic Compounding and Uncertain Valuation

Stochastic Compounding and Uncertain Valuation

Chapter:
(p.21) Chapter Two Stochastic Compounding and Uncertain Valuation
Source:
After the Flood
Author(s):

Lars Peter Hansen

José A. Scheinkman

Publisher:
University of Chicago Press
DOI:10.7208/chicago/9780226443683.003.0002

Exploring long-term implications of valuation leads us to recover and use a distorted probability measure that reflects the long-term implications for risk pricing. This measure is typically distinct from the physical and the risk neutral measures that are well known in mathematical finance. We apply a generalized version of Perron-Frobenius theory to construct this probability measure and present several applications. We employ Perron-Frobenius methods to i) explore the observational implications of risk adjustments and investor beliefs as reflected in asset market data; ii) catalog alternative forms of misspecification of parametric valuation models; and iii) characterize how long-term components of growth-rate risk impact investor preferences implied by Kreps-Porteus style utility recursions.

Keywords:   long-term risk, martingale decomposition, recovery theorem, Perron-Frobenius theory, misspecification, recursive utility

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