Risk-Free Bond Prices in Incomplete Markets with Recursive Utility Functions and Multiple Beliefs

Abstract

We consider an exchange economy under uncertainty, in which agents' utility functions exhibit constant absolute risk aversion, but they may be recursive and the expected utility calculation may be based on multiple subjective beliefs. The risk aversion coefficients, subjective beliefs, subjective time discount factors, initial endowments, and tradeable assets may differ across agents. We prove that the risk-free bond price goes down (and the interest rate goes up) monotonically as the markets become more complete. We find the range of equilibrium bond prices that depends on the primitives of the economy but not on the structures of financial markets.

Keywords: The risk-free rate puzzle, constant absolute risk aversion, incomplete markets

JEL Classification: D52, D91, E21, E44, G12