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Equilibrium in securities markets with heterogeneous investors and unspanned income risk

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  • Christensen, Peter Ove
  • Larsen, Kasper
  • Munk, Claus

Abstract

In a finite time horizon, incomplete market, continuous-time setting with dividends and investor incomes governed by arithmetic Brownian motions, we derive closed-form solutions for the equilibrium risk-free rate and stock price for an economy with finitely many heterogeneous CARA investors and unspanned income risk. In equilibrium, the Sharpe ratio is the same as in an otherwise identical complete market economy, whereas the risk-free rate is lower and, consequently, the stock price is higher. The reduction in the risk-free rate is highest when the more risk-averse investors face the largest unspanned income risk.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 147 (2012)
Issue (Month): 3 ()
Pages: 1035-1063

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Handle: RePEc:eee:jetheo:v:147:y:2012:i:3:p:1035-1063

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Web page: http://www.elsevier.com/locate/inca/622869

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Keywords: Unspanned income; Heterogeneous preferences; Continuous-time equilibrium; Risk-free rate puzzle; Equity premium; Incomplete markets; Brownian motion;

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References

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Cited by:
  1. Jin Hyuk Choi & Kasper Larsen, 2013. "Taylor approximation of incomplete Radner equilibrium models," Papers 1310.2973, arXiv.org.

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