An Analytic Approach for Stochastic Differential Utility for Endowment and Production Economies

In this paper, an analytic approach is applied to approximate stochastic differential utility for both endowment and production economies. This utility function satisfies a second order nonlinear differential equation and is analytic near the stationary mean of the state variable. The radius of convergence of its power series representation is at lease two standard deviations of the stationary distribution of the state variable around its mean. The main contribution of this paper is to use a higher order Taylor polynomial to accurately approximate the utility function, which confirms the empirical properties of the pricing kernel and equity premium on wealth. Copyright Springer Science+Business Media New York 2014