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

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.

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)
Pages: 43
Date: 2020-03-16
New Economics Papers: this item is included in nep-mac and nep-ore
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

Downloads: (external link)
https://repec.econ.au.dk/repec/creates/rp/20/rp20_02.pdf (application/pdf)

Related works:
Working Paper: Risk Matters: Breaking Certainty Equivalence (2020)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2020-02

Access Statistics for this paper

More papers in CREATES Research Papers from Department of Economics and Business Economics, Aarhus University
Bibliographic data for series maintained by ().