Open AccessRecursive utility using the stochastic maximum principle
Author(s) -
Aase Knut K.
Publication year - 2016
Publication title -
quantitative economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 4.062
H-Index - 27
eISSN - 1759-7331
pISSN - 1759-7323
DOI - 10.3982/qe473
Subject(s) - incomplete markets , consumption (sociology) , markov process , expected utility hypothesis , isoelastic utility , stochastic differential equation , economics , portfolio , function (biology) , mathematical economics , interest rate , aggregate (composite) , econometrics , mathematical optimization , mathematics , microeconomics , finance , social science , statistics , materials science , evolutionary biology , sociology , composite material , biology
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 use the stochastic maximum principle to analyze the model. This method uses forward/backward stochastic differential equations, and works when the economy is not Markovian, which can be the case with recursive utility. With existence granted, the wealth portfolio is characterized in equilibrium in terms of utility and aggregate consumption. The equilibrium real interest rate is derived, and the resulting model is shown to be consistent with reasonable values of the parameters of the utility function when calibrated to market data, under various assumptions.