TY - UNPB

T1 - Risk Matters

T2 - Breaking Certainty Equivalence

AU - Parra-Alvarez, Juan Carlos

AU - Polattimur, Hamza

AU - Posch, Olaf

PY - 2020/3

Y1 - 2020/3

N2 - 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.

AB - 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.

KW - Certainty equivalence

KW - Perturbation methods

KW - Pricing errors

M3 - Working paper

T3 - CREATES Research Papers

BT - Risk Matters

PB - CREATES, Institut for Økonomi, Aarhus Universitet

CY - Aarhus

ER -