Solving Asset Pricing Models with Stochastic Dynamic Programming

The study of asset price characteristics of stochastic growth models such as the riskfree interest rate, equity premium and the Sharpe ratio has been limited by the lack of global and accurate methods to solve dynamic optimization models. In this paper a stochastic version of a dynamic programming method with adaptive grid scheme is applied to compute the above mentioned asset price characteristics of a stochastic growth model. The stochastic growth model is of the type as developed by Brock and Mirman (1972) and Brock (1979, 1982). In order to test our method it is applied to a basic stochastic growth model for which the optimal consumption and asset prices can analytical be computed. Since, as shown, our method produces only negligible errors as compared to the analytical solution it is recommended to be used for more elaborate stochastic growth models with different preferences and technology shocks, adjustment costs, and heterogenous agents. JEL Classification: C60, C61, C63, D90, G12