Dynamic Valuation Decomposition Within Stochastic Economies

Abstract

I explore the equilibrium value implications of economic models that incorporate responses to a stochastic environment with growth. I propose dynamic valuation decompositions (DVD's) designed to distinguish components of an underlying economic model that influence values over long investment horizons from components that impact only the short run. A DVD represents the values of stochastically growing claims to consumption payoffs or cash flows using a stochastic discount process that both discounts the future and adjusts for risk. It is enabled by constructing operators indexed by the elapsed time between the trading date and the date of the future realization of the payoff. Thus formulated, methods from applied mathematics permit me to characterize valuation behavior and the term structure of risk prices in a revealing manner. I apply this approach to investigate how investor beliefs and the associated uncertainty are reflected in current-period values and risk-price elasticities.

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