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Pricing Risk in Economies with Heterogeneous Agents and Incomplete Markets

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  • Josep Pijoan-Mas

Abstract

Habit formation has been proposed as a possible solution to the equity premium puzzle. This paper extends the class of models that support the habits explanation in order to account for heterogeneity in earnings, wealth, habits, and consumption. I find that habit formation does indeed increase the equity premium. However, contrary to earlier results, the habit hypothesis does not imply a price for risk as large as the one measured in the data. There are three reasons for this. First, households in a habits economy modify their consumption/savings decision. Second, they modify their portfolio choice. These two changes in behavior diminish the consumption fluctuations faced by households. Third, the composition of the set of agents pricing risk in the economy changes so that relatively better self-insured households end up pricing risk. (JEL: D52, G12, E21, C68) (c) 2007 by the European Economic Association.

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Bibliographic Info

Article provided by MIT Press in its journal Journal of the European Economic Association.

Volume (Year): 5 (2007)
Issue (Month): 5 (09)
Pages: 987-1015

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Handle: RePEc:tpr:jeurec:v:5:y:2007:i:5:p:987-1015

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  1. Storesletten, Kjetil & Telmer, Chris & Yaron, Amir, 2001. "Asset Pricing with Idiosyncratic Risk and Overlapping Generations," CEPR Discussion Papers 3065, C.E.P.R. Discussion Papers.
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  10. Josep Pijoan-Mas 2 & Antonia Díaz & José-Víctor Ríos-Rull, 2001. "Habit Formation: Inplications For The Wealth Distribution," Economics Working Papers we015114, Universidad Carlos III, Departamento de Economía.
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Citations

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Cited by:
  1. Brekke, Kjell Arne & Johansson-Stenman, Olof, 2008. "The Behavioural Economics of Climate Change," Working Papers in Economics 305, University of Gothenburg, Department of Economics.
  2. Diaz, Antonia & Pijoan-Mas, Josep & Rios-Rull, Jose-Victor, 2003. "Precautionary savings and wealth distribution under habit formation preferences," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1257-1291, September.
  3. Johdo, Wataru, 2009. "Habit persistence and stagnation," Economic Modelling, Elsevier, vol. 26(5), pages 1110-1114, September.
  4. Pijoan-Mas, Josep, 2005. "Precautionary Savings or Working Longer Hours?," CEPR Discussion Papers 5322, C.E.P.R. Discussion Papers.
  5. Francisco Gomes & Alexander Michaelides, 2003. "Portfolio Choice With Internal Habit Formation: A Life-Cycle Model With Uninsurable Labor Income Risk," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 729-766, October.
  6. Yann Algan & Olivier Allais & Eva Carceles-Poveda, 2009. "Macroeconomic Effects of Financial Policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 678-696, October.
  7. Aleix Calveras & Juan José Ganuza & Gerard Llobet, 2005. "Regulation and opportunism: How much activism do we need?," Economics Working Papers 935, Department of Economics and Business, Universitat Pompeu Fabra.
  8. Santiago Budria & Antonia Diaz, 2006. "Term Premium And Equity Premium In Economies With Habit Formation," Economics Working Papers we065522, Universidad Carlos III, Departamento de Economía.
  9. Eva Carceles-Poveda, 2009. "Asset Prices and Business Cycles under Market Incompleteness," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(3), pages 405-422, July.
  10. Abel Elizalde & Rafael Repullo, 2004. "Economic And Regulatory Capital. What Is The Difference?," Working Papers wp2004_0422, CEMFI.
  11. Marco Cozzi, 2014. "The Krusell-Smith Algorithm: Are Self-fulfilling Equilibria Likely?," Working Papers 1323, Queen's University, Department of Economics.
  12. Santiago Budría & Antonia Díaz, 2006. "Term and Equity Premium in Economies with Habit Formation," Working Papers 2006-23, FEDEA.
  13. Eduard Dubin & Olesya V. Grishchenko & Vasily Kartashov, 2012. "Habit formation heterogeneity: Implications for aggregate asset pricing," Finance and Economics Discussion Series 2012-07, Board of Governors of the Federal Reserve System (U.S.).

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