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

Abstract: We consider agents in an exchange economy having preferences represented by scale invariant recursive utility, where the dynamics of both consumption and risky assets are given by jump-diffusions. In this setting we find state prices, where both diffusion and jump-size risk are priced. By including jumps, the theory has the potential to model insurance markets, as well as ordinary securities’ markets. In the latter case, we derive the equilibrium, real interest rate and risk premiums. In the former case we consider catastrophe futures related to negative shocks in consumption. We use the stochastic maximum principle to analyze the model. This method uses forward/backward stochastic differential equations, and seems indispensable in this theory.

Keywords: Recursive utility; jump dynamics; the stochastic maximum principle; jump size risk; catastrophe futures

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

Language: English

63 pages, February 24, 2025

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