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Risk Premia: Exact Solutions vs. Log-Linear Approximations

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Author

Summary, in English

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.

Publishing year

2013

Language

English

Pages

4256-4264

Publication/Series

Journal of Banking & Finance

Volume

37

Issue

11

Document type

Journal article

Publisher

Elsevier

Topic

  • Business Administration
  • Economics

Keywords

  • Log-linear approximations
  • Equity premium puzzle
  • Cumulants
  • NIG distribution
  • Long-run risk

Status

Published

Research group

  • Knut Wicksell Centre for Financial Studies

ISBN/ISSN/Other

  • ISSN: 1872-6372