Equilibrium prices under hidden Markov fundamentals

Source abstract

We study a representative-agent Epstein-Zin economy with geometric dividends and a hidden finite-state Markov drift. We allow the price-dividend ratio to contain an additional positive, absolutely continuous valuation factor and, within the class $\mathfrak C$ defined below and under the regularity, admissibility, and positivity conditions of our main theorem, equilibrium forces this factor to be constant, yielding belief-Markovian prices. In the two-state case, under the stated positivity condition and strictly positive transition intensities, we prove existence, uniqueness, endpoint smoothness, interior analyticity, and uniform bounds for the positive solution of the pricing equation. For $0 0$, we derive belief-dependent stock volatility, a European option-pricing PDE, and a leading short-maturity conditional risk-neutral log-return skewness expansion.