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

  • Gianluca Benigno

    ()

  • Pierpaolo Benigno

    ()

  • Salvatore Nistico

    ()

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 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 alsotime varying.

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File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/DP677_2011_SecondOrder.pdf
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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp677.

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Date of creation: Mar 2011
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Handle: RePEc:fmg:fmgdps:dp677
Contact details of provider: Web page: http://www.lse.ac.uk/fmg/

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  22. Benigno, Gianluca & Benigno, Pierpaolo, 2001. "Monetary Policy Rules and the Exchange Rate," CEPR Discussion Papers 2807, C.E.P.R. Discussion Papers.
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