Arbeitspapier

Risk Matters: Breaking Certainty Equivalence

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.

Sprache
Englisch

Erschienen in
Series: CESifo Working Paper ; No. 8250

Klassifikation
Wirtschaft
Mathematical Methods
Optimization Techniques; Programming Models; Dynamic Analysis
Computational Techniques; Simulation Modeling
General Aggregative Models: Neoclassical
Business Fluctuations; Cycles
Asset Pricing; Trading Volume; Bond Interest Rates
Thema
certainty equivalence
perturbation methods
pricing errors

Ereignis
Geistige Schöpfung
(wer)
Parra-Alvarez, Juan Carlos
Polattimur, Hamza
Posch, Olaf
Ereignis
Veröffentlichung
(wer)
Center for Economic Studies and ifo Institute (CESifo)
(wo)
Munich
(wann)
2020

Handle
Letzte Aktualisierung
10.03.2025, 11:42 MEZ

Datenpartner

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Objekttyp

  • Arbeitspapier

Beteiligte

  • Parra-Alvarez, Juan Carlos
  • Polattimur, Hamza
  • Posch, Olaf
  • Center for Economic Studies and ifo Institute (CESifo)

Entstanden

  • 2020

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