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Second-Order Approximation of Dynamic Models with Time-Varying Risk

Listed author(s):
  • Gianluca Benigno

    (London School of Economics)

  • Pierpaolo Benigno

    (LUISS "Guido Carli" and EIEF)

  • Salvatore Nisticò

    (Università di Roma "Tor Vergata" and LUISS "Guido Carli")

This paper provides first and second-order approximation methods for the solution of non-linear dynamic stochastic models in which the exogenous state variables follow conditionally-linear stochastic processes displaying time-varying risk. The first-order approximation is consistent with a conditionally-linear model in which risk is still time-varying but has no distinct role - separated from the primitive stochastic disturbances - in influencing the endogenous variables. The second-order approximation of the solution, instead, is sufficient to get this role. Moreover, risk premia, evaluated using only a first-order approximation of the solution, will be also time varying.

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File URL: http://www.eief.it/files/2012/09/wp-21-second-order-approximation-of-dynamic-models-with-time-varying-risk.pdf
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Paper provided by Einaudi Institute for Economics and Finance (EIEF) in its series EIEF Working Papers Series with number 1021.

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Length: 24 pages
Date of creation: 2010
Date of revision: Dec 2010
Handle: RePEc:eie:wpaper:1021
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