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

- We propose an asset pricing model with heterogeneous beliefs and recursive utility.
- Recursive utility is required for the existence of non-degenerate equilibrium.
- Heterogeneous beliefs generate time-varying discount rate of a representative agent.
- Fluctuation in the discount rate explains the term-structure of bond yields.
- Our model can also replicate moments of equity returns and risk-free rates.

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.