Risk Premia: Exact Solutions vs. Log-Linear Approximations
Research output: Contribution to journal › Article
We derive exact expressions for the risk premia for general distributions in a Lucas economy and show that the errors when using log-linear approximations can be economically significant when the shocks are nonnormal. Assuming growth rates are Normal Inverse Gaussian (NIG) and fitting the distribution to the data used in Mehra and Prescott (1985), the coefficient of relative risk aversion required to match the equity premium is more than halved compared to the finding in their article. We also consider a standard long-run risk model and, by comparing our exact solutions to the log-linear approximations, we show that the approximation errors are substantial, especially for high levels of risk aversion.
|Research areas and keywords||
Subject classification (UKÄ) – MANDATORY
|Journal||Journal of Banking & Finance|
|Publication status||Published - 2013|