A representative agent asset pricing model with heterogeneous beliefs and recursive utility

Abstract

In this paper, we consider a continuous-time pure exchange economy with multiple agents whose preferences are represented by a time-inseparable recursive utility. Agents are homogeneous in their preferences, but heterogeneous in their beliefs regarding the drift rate of the aggregate endowment process. Given a competitive equilibrium in this economy, we construct a tractable representative agent model that would approximate asset prices in the original multiple agents economy. We show that our model helps resolve many asset pricing puzzles, such as the equity premium puzzle, equity volatility puzzle, risk-free rate puzzle, and term premium puzzle.