Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2013/3: Recursive utility and the equity premium puzzle: A discrete-time approach

Knut K. Aase ()
Additional contact information
Knut K. Aase: Dept. of Business and Management Science, Norwegian School of Economics, Postal: NHH , Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: We study the recursive model of Epstein and Zin. We use directional derivatives to derive the model, and calibrate to the data of Mehra and Prescott (1985). By assuming that we can view income streams as dividends of some shadow asset, the model is valid if the market portfolio is expanded to include the new asset. Since the latter is not traded, the return to the wealth portfolio is not readily observable or estimable from available data. We demonstrate that we can get a good impression of how the model fares, by calibrating under various assumptions. As the return on the wealth portfolio decreases, the estimated impatience rate decreases to reasonable values, while the risk aversion and the EIS parameter estimates are both plausible. The results are promising for the recursive model.

Keywords: Recursive utility; the Epstein-Zin model; utility gradients; calibrations

JEL-codes: D51; D53; D90; E21; G10; G12

26 pages, First version: May 15, 2013. Revised: March 25, 2015.

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