Consumption-Portfolio Optimization with Recursive Utility in Incomplete Markets

Abstract:     
In an incomplete market we study the optimal consumption-portfolio decision of an investor with recursive preferences of Epstein-Zin type. Applying a classical dynamic programming approach, we formulate the associated Hamilton-Jacobi-Bellman equation and provide a suitable verification theorem. The proof of this verification theorem is complicated by the fact that the Epstein-Zin aggregator is non-Lipschitz, so standard verification results (e.g., in Duffie and Epstein (1992)) are not applicable. We provide new explicit solutions to the Bellman equation with Epstein-Zin preferences in an incomplete market for non-unit EIS and apply our verification result to prove that they solve the consumption-investment problem. We also compare our exact solutions to the Campbell-Shiller approximation and assess its accuracy.

Number of Pages in PDF File: 32

Keywords: consumption-portfolio optimization, recursive utility, stochastic control approach, stochastic volatility, unspanned state process, Campbell-Shiller approximation

JEL Classification: G11, D91, C61

working papers series