Risk matters: Breaking certainty equivalence in linear approximations

Juan Carlos Parra-Alvarez*, Hamza Polattimur, Olaf Posch

*Corresponding author af dette arbejde

Publikation: Bidrag til tidsskrift/Konferencebidrag i tidsskrift /Bidrag til avisTidsskriftartikelForskningpeer review

Abstract

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 derive a risk-sensitive first-order perturbation solution for a general class of rational expectations models. 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 perturbation provides a sensible approximation to the effects of risk in continuous-time models. It reduces pricing errors by around 90% relative to the certainty equivalent linear approximation.

OriginalsprogEngelsk
Artikelnummer104248
TidsskriftJournal of Economic Dynamics and Control
Vol/bind133
Antal sider25
ISSN0165-1889
DOI
StatusUdgivet - dec. 2021

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