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On the relation between linearity‐generating processes and linear‐rational models

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  • Damir Filipović
  • Martin Larsson
  • Anders B. Trolle

Abstract

We review the notion of a linearity‐generating (LG) process introduced by Gabaix and relate LG processes to linear‐rational (LR) models studied by Filipović et al. We show that every LR model can be represented as an LG process and vice versa. We find that LR models have two basic properties that make them an important representation of LG processes. First, LR models can be easily specified and made consistent with nonnegative interest rates. Second, LR models go naturally with the long‐term risk factorization due to Alvarez and Jermann, Hansen and Scheinkman, and Qin and Linetsky. Every LG process under the long forward measure can be represented as a lower dimensional LR model.

Suggested Citation

  • Damir Filipović & Martin Larsson & Anders B. Trolle, 2019. "On the relation between linearity‐generating processes and linear‐rational models," Mathematical Finance, Wiley Blackwell, vol. 29(3), pages 804-826, July.
    • Handle: RePEc:bla:mathfi:v:29:y:2019:i:3:p:804-826
    DOI: 10.1111/mafi.12198
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    Cited by:

    1. Neuhierl, Andreas & Varneskov, Rasmus T., 2021. "Frequency dependent risk," Journal of Financial Economics, Elsevier, vol. 140(2), pages 644-675.

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