Risk premia: Exact solutions vs. log-linear approximations

Frederik Lundtofte () and Anders Wilhelmsson

Journal of Banking & Finance, 2013, vol. 37, issue 11, 4256-4264

Abstract: We derive exact expressions for the risk premia for general distributions in a Lucas economy and show that the errors when using log-linear approximations can be economically significant when the shocks are nonnormal. Assuming growth rates are Normal Inverse Gaussian (NIG) and fitting the distribution to the data used in Mehra and Prescott (1985), the coefficient of relative risk aversion required to match the equity premium is more than halved compared to the finding in their article. We also consider a standard long-run risk model and, by comparing our exact solutions to the log-linear approximations, we show that the approximation errors are substantial, especially for high levels of risk aversion.

Keywords: Log-linear approximations; Equity premium puzzle; Cumulants; NIG distribution; Long-run risk (search for similar items in EconPapers)
JEL-codes: C13 G12 (search for similar items in EconPapers)
Date: 2013
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:37:y:2013:i:11:p:4256-4264

DOI: 10.1016/j.jbankfin.2013.07.035

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