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Risk Matters: Breaking Certainty Equivalence
- Source :
- SSRN Electronic Journal.
- Publication Year :
- 2020
- Publisher :
- Elsevier BV, 2020.
-
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.
Details
- ISSN :
- 15565068
- Database :
- OpenAIRE
- Journal :
- SSRN Electronic Journal
- Accession number :
- edsair.doi.dedup.....95fc8e0d4704b952c8fa74d0f33943c6