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Risk Matters: Breaking Certainty Equivalence

Publikation: Working paper/Preprint Working paperForskning


  • rp20_02

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In this paper, we use the property that certainty equivalence, as implied by a first-order approximation to the solution of stochastic discrete-time models, breaks in its equivalent continuous-time version. We study the extent to which a first-order approximated solution built by perturbation methods accounts for risk. We show that risk matters economically in a real business cycle (RBC) model with habit formation and capital adjustment costs and that neglecting risk leads to substantial pricing errors. A first-order approximation in continuous time reduces pricing errors by 90 percent relative to the certainty equivalent linear solution.
UdgiverCREATES, Institut for Økonomi, Aarhus Universitet
Antal sider45
StatusUdgivet - mar. 2020
SerietitelCREATES Research Paper


  • Certainty equivalence, Perturbation methods, Pricing errors

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