Nonrecursive separation of risk and time preferences

Matthias Albrecht Fahrenwaldt, Ninna Reitzel Jensen and Mogens Steffensen

Journal of Mathematical Economics, 2020, vol. 90, issue C, 95-108

Abstract: Recursive utility disentangles preferences with respect to time and risk by recursively building up a value function of local increments. This involves certainty equivalents of indirect utility. Instead we disentangle preferences with respect to time and risk by building up a value function as a non-linear aggregation of certainty equivalents of direct utility of consumption. This entails time-consistency issues which are dealt with by looking for an equilibrium control and an equilibrium value function rather than a classical optimal control and a classical optimal value function. We characterize the solution in a general diffusive incomplete market model and find that, in certain special cases of utmost interest, the characterization coincides with what would arise from a recursive utility approach. But also importantly, in other cases, it does not: The two approaches are fundamentally different but match, exclusively but importantly, in the mathematically special case of homogeneity of the value function.

Keywords: Time-consistency; Time-global preferences; Recursive utility; Equilibrium strategies; Generalized Hamilton–Jacobi–Bellman equation; Certainty equivalents (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:mateco:v:90:y:2020:i:c:p:95-108

DOI: 10.1016/j.jmateco.2020.07.002

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