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A Discrete‐Time Intertemporal Asset Pricing Model: GE Approach with Recursive Utility
Author(s) -
Ma Chenghu
Publication year - 1998
Publication title -
mathematical finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.98
H-Index - 81
eISSN - 1467-9965
pISSN - 0960-1627
DOI - 10.1111/1467-9965.00055
Subject(s) - economics , stochastic discount factor , isoelastic utility , capital asset pricing model , mathematical economics , equity premium puzzle , econometrics , discrete time and continuous time , risk aversion (psychology) , markov chain , expected utility hypothesis , mathematics , statistics
This paper studies the equilibrium characterization of asset pricing in a discrete‐time Lucas exchange economy (Lucas 1978) with the intertemporal recursive utility function of Epstein and Zin (1989). A general formulation of equilibrium asset pricing is presented. It is shown that risk aversion of a certainty equivalent corresponds to risk aversion in the intertemporal asset pricing model. The discrete‐time analogue of Ma's (1993) option pricing formula is derived in an i.i.d. environment, with which we prove an observational nonequivalence theorem in distinguishing the differences of the betweenness recursive utility functions and the expected utility functions. Additionally, when the consumption growth rate follows a first‐order Markov process, it is shown that the observational nonequivalence result holds for Kreps–Porteus expected utility. Finally, as by‐products, this paper also contains derivations of closed‐form formulas for the aggregate equity (with endogenously determined yields), the term structure of interest rates, and European call options on the aggregate equity in a Markov setting.