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Recursive utility and disappearing puzzles for continuous-time models

Author

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  • Aase, Knut K.

    (Dept. 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. Two ordinally equivalent versions are considered. The state price is not Markov in any of the versions, so instead of using dynamic programming we use the stochastic maximum principle. The resulting equilibriums are consistent with low values of the parameters of the utility functions when calibrated to market data. One version is consistent with preference for early resolution of uncertainty, the other for late for the US-data. We therefore consider heterogeneity with recursive utilities. Our resulting model rationalize data well, and can explain both the Equity Premium Puzzle and the Risk-Free Rate Puzzle with good margins.

Suggested Citation

  • Aase, Knut K., 2013. "Recursive utility and disappearing puzzles for continuous-time models," Discussion Papers 2013/2, Norwegian School of Economics, Department of Business and Management Science.
    • Handle: RePEc:hhs:nhhfms:2013_002
    as

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    More about this item

    Keywords

    The equity premium puzzle; the risk-free rate puzzle; recursive utility; utility gradients; the stochastic maximum principle; heterogeneity; limited market participation; optimal asset allocation;
    All these keywords.

    JEL classification:

    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D90 - Microeconomics - - Micro-Based Behavioral Economics - - - General
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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