A Parsimonious Inverse Cox-Ingersoll-Ross Process for Financial Price Modeling

Li Lin and Didier Sornette
Additional contact information
Li Lin: East China University of Science and Technology
Didier Sornette: ETH Zurich, Southern University of Science and Technology (SUSTech); Tokyo Institute of Technology, and Swiss Finance Institute

No 23-41, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We propose a formulation to construct new classes of financial price processes based on the insight that the key variable driving prices P is the earning-over-price ratio γ ≃ 1/ P, which we refer to as the earning yield and is analogous to the yield-to-maturity of an equivalent perpetual bond. This modeling strategy is illustrated with the choice for real-time γ in the form of the Cox-Ingersoll-Ross (CIR) process, which allows us to derive analytically many stylised facts of financial prices and returns, such as the power law distribution of returns, transient super-exponential bubble behavior, and the fat-tailed distribution of prices before bubbles burst. Our model sheds new light on rationalizing the excess volatility and the equity premium puzzles. The model is calibrated to five well-known historical bubbles in the US and China stock markets via a quasi-maximum likelihood method with the L-BFGS-B optimization algorithm. Using ϕ-divergence statistics adapted to models prescribed in terms of stochastic differential equations, we show the superiority of the CIR process for γt against three alternative models.

Keywords: asset pricing; financial risks; financial bubbles; excess volatility; fat tail distribution of returns; equity puzzle; earning yield; earning-over-price. (search for similar items in EconPapers)
JEL-codes: G01 G12 (search for similar items in EconPapers)
Pages: 49 pages
Date: 2023-02
New Economics Papers: this item is included in nep-rmg
References: Add references at CitEc
Citations:

Downloads: (external link)
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4366971 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2341

Access Statistics for this paper

More papers in Swiss Finance Institute Research Paper Series from Swiss Finance Institute Contact information at EDIRC.
Bibliographic data for series maintained by Ridima Mittal ().