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Recursive utility using the stochastic maximum principle

Knut Aase

No 2014/3, Discussion Papers from Department of Business and Management Science, Norwegian School of Economics

Abstract: Motivated by the problems of the conventional model in rationalizing market data, we derive the equilibrium interest rate and risk premiums using recursive utility in a continuous time model. We consider the version of recursive utility which gives the most unambiguous separation of risk preference from time substitution, and use the stochastic maximum principle to analyze the model. This method uses forward/backward stochastic differential equations. With existence granted, the market portfolio is determined in terms of future utility and aggregate consumption in equilibrium. The equilibrium real interest rate is also derived, and the the model is shown to be consistent with reasonable values of the parameters of the utility function when calibrated to market data, under various assumptions.

Keywords: The equity premium puzzle; the risk-free rate puzzle; recursive utility; the stochastic maximum principle (search for similar items in EconPapers)
JEL-codes: D51 D53 D90 E21 G10 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac, nep-ore and nep-upt
Date: 2014-02-20, Revised 2015-03-25
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