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Risk Matters: Breaking Certainty Equivalence

Juan Parra-Alvarez (), Hamza Polattimur and Olaf Posch ()

No 8250, CESifo Working Paper Series from CESifo

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)
Date: 2020
New Economics Papers: this item is included in nep-mac and nep-ore
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