Two essays on equilibrium asset pricing and intertemporal recursive utility

Motivated in part by experimental evidence (e.g., Allais Paradox) contradicting expected utility theory, Epstein and Zin (1989) developed the more general class of intertemporal recursive utility functions. This class is attractive not only because it is consistent with the experimental evidence, but also because it permits a degree of separation between risk aversion and intertemporal substitution.;As a by-product, this paper provides a closed form solution for European Call Options as well as for other derivative securities. The derived formulac generalize those of Naik-Lee (1990), Cox-Ross (1976) and Merton (1976) in two respects: first, the magnitude of the jump may follow any distribution with finite moments; and second, the utility function is required to be recursive but is not necessarily an intertemporally additive von-Neumann Morgenstern utility. In addition, the formula derived here allows the following intuitive interpretation: the option price may be viewed as an expected value of the Black-Scholes Option Price, with respect to the number as well as the size of the jumps.;The second paper considers a heterogeneous agents Lucas style exchange economy in a discrete time framework. For a class of recursive utility functions containing the standard additive expected utility functions, I extend Duffie et.al. (1990) by demonstrating that there exist market equilibria characterized by stationary (ergodic) Markov processes for consumption, portfolio holdings, asset prices and the unobserved utilities. No assumptions about market completeness are made, and there are no restrictions on the underlying information filtration.;By-products of the second paper include: (i) an existence and uniqueness theorem for intertemporal recursive utility, (ii) dynamic programming theory--namely the Principle of Optimality as well as its corresponding Euler equation for an agent's consumption and portfolio choice problem under recursive utility, and (iii) a single-agent equilibrium asset pricing formula which generalizes that of Epstein and Zin (1989).;The purpose of the first paper is to cast light on the extent to which recursive utility is observationally distinguishable from the standard expected utility function. Kocherlakota (1990) provided an "observational equivalence" result based on the assumptions that consumption growth rates are i.i.d., and that the utility function is restricted to a subclass of recursive utility called Kreps-Porteus utility. Here, I demonstrate that Kocherlakota's observational equivalence result is not robust with respect to the utility specification by showing that even in an i.i.d. environment, given mixed Poisson-Brownian information structure and observations of the prices of the aggregate equity and the underlying European call option, recursive utilities in a large and well defined class are distinguishable from the standard expected utility functions.