Risk Matters: Breaking Certainty Equivalence

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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 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.
Original languageEnglish
Place of publicationAarhus
PublisherCREATES, Institut for Økonomi, Aarhus Universitet
Number of pages45
Publication statusPublished - Mar 2020
SeriesCREATES Research Paper
Number2020-02

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