A new approximation for the risk premium with large risks

Abstract

Purpose

The Arrow–Pratt approximation to the risk premium is only valid for small risks. In this paper we consider a second approximation, based on risk-neutral probabilities and which requires no greater information than the Arrow–Pratt approximation, that works well for both small and large risks.

Design/methodology/approach

The paper is theoretical in nature, although it also provides illustrative numerical simulations.

Findings

The new approximation proposed here appears to be significantly superior to Arrow–Pratt for approximating the true value of the risk premium when the risk is large. It may also approximate better even for relatively small risks.

Originality/value

As far as we are aware, there are no other known approximations for the risk premium when the risk involved is large.

Citation

Watt, R. and Gunby, P. (2021), "A new approximation for the risk premium with large risks", Journal of Risk Finance, Vol. 22 No. 3/4, pp. 279-295. https://doi.org/10.1108/JRF-04-2020-0073