Recursive Utility and Jump-Diffusions

48 Pages Posted: 30 Jan 2015

See all articles by Knut K. Aase

Knut K. Aase

Norwegian School of Economics (NHH) - Department of Business and Management Science

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Date Written: January 30, 2015

Abstract

We derive the equilibrium interest rate and risk premiums using recursive utility for jump-diffusions. Compared to to the continuous version, including jumps allows for a separate risk aversion related to jump size risk in addition to risk aversion related to the continuous part. The jump part also introduces moments of higher orders that may matter in many circumstances. 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. We demonstrate how the stochastic process for the market portfolio is determined in terms the corresponding processes for future utility and aggregate consumption. It is indicated that this model has the potential to give reasonable explanations of empirical puzzles.

Keywords: Recursive utility, jump dynamics, the stochastic maximum principle

JEL Classification: G10, G12, D9, D51, D53, D90, E21

Suggested Citation

Aase, Knut K., Recursive Utility and Jump-Diffusions (January 30, 2015). NHH Dept. of Business and Management Science Discussion Paper No. 2015/6. Available at SSRN: https://ssrn.com/abstract=2557921 or http://dx.doi.org/10.2139/ssrn.2557921

Knut K. Aase (Contact Author)

Norwegian School of Economics (NHH) - Department of Business and Management Science ( email )

Helleveien 30
Bergen, NO-5045
Norway

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