Risk Matters: Breaking Certainty Equivalence
Juan Parra-Alvarez (),
Hamza Polattimur and
Olaf Posch ()
CREATES Research Papers from Department of Economics and Business Economics, Aarhus University
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.
Keywords: Certainty equivalence; Perturbation methods; Pricing errors (search for similar items in EconPapers)
JEL-codes: C02 C61 C63 E13 E32 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac and nep-ore
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Working Paper: Risk Matters: Breaking Certainty Equivalence (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2020-02
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