Asset Pricing with Recursive Utility and Heterogenous Investors

Fundamental research in asset pricing is concerned with the determinants of expected returns on risky assets as a function of fundamental dynamics and investor characteristics. In this project, the focus was on recursive utility which significantly generalizes the standard time-additive preferences mostly of the type featuring constant relative risk aversion (CRRA). Furthermore, the assumption of only one type of investors being present in the economy was also relaxed. The form of heterogeneity we were interested in related to investors’ perceptions of the dynamics of fundamental sources of risk like expected consumption growth.

As an important first step, we still looked at the CRRA casewith two investors who differ in their beliefs but both being potentially wrong in their respective assessments. The interesting question is then which types of errors (e.g., with respect to the uncertainty around the expected growth rate or with respect to the speed with which the growth rate will revert back to its long-term mean) lead to more significant wealth losses over the long term.

In yet ongoing work we build on the insights from this analysis and examine a case where two investors equipped with recursive utility have different views on the likelihood of sudden drops in expected consumption (optimistic versus pessimistic). This model can also shed light on the question whether the presence of just a few optimists would already be enough to make the equity premium disappear as it is claimed in parts of the literature. Furthermore, we can explicitly investigate the relevance of market incompleteness.