Risk premia: Exact solutions vs. log-linear approximations
AbstractWe 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.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Banking & Finance.
Volume (Year): 37 (2013)
Issue (Month): 11 ()
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Web page: http://www.elsevier.com/locate/jbf
Log-linear approximations; Equity premium puzzle; Cumulants; NIG distribution; Long-run risk;
Find related papers by JEL classification:
- C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
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