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Market Incompleteness and the Equity Premium Puzzle: Evidence from State-Level Data

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  • Kris Jacobs

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  • Stephane Pallage
  • Michel A. Robe

Abstract

This paper investigates the importance of market incompleteness by comparing the rates of risk aversion estimated from complete and incomplete markets environments. For the incomplete-markets case, we use consumption data for 50 U.S. states. While the use of state-level data is conceptually inferior to the use of data on individual consumption, it may be preferable because state-level data are less susceptible to measurement errors. We find that the rate of risk aversion under the incomplete-markets setup is much lower. Furthermore, including the second and third moments of the cross-sectional distribution of consumption growth in the pricing kernel lowers the estimate of risk aversion. These findings suggest that market incompleteness ought to be seen as an important component of solutions to the equity premium puzzle. Ce papier étudie l'importance de la complétude du marché en comparant le taux d'aversion au risque estimé dans le cas de marchés complets et incomplets. Dans le cas de marchés incomplets, nous utilisons des données de consommation de 50 états américains. Bien que l'utilisation de données agrégées au niveau des états est conceptuellement moins justifiée que l'utilisation de données individuelles, ce choix est préférable du fait que les données agrégées sont moins sujettes aux erreurs de mesures. Nous trouvons que le taux d'aversion au risque sous l'hypothèse de marchés incomplets est plus petit. De plus, la prise en compte du deuxième et du troisième moment de la distribution transversale de la croissance de la consommation dans le pricing kernel réduit le taux d'aversion au risque estimé. Ces résultats suggèrent que l’incomplétude du marché devrait être regardé comme une composante importante de la solution du puzzle de la prime d’équité.

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Paper provided by CIRANO in its series CIRANO Working Papers with number 2004s-54.

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Date of creation: 01 Nov 2004
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Handle: RePEc:cir:cirwor:2004s-54

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Keywords: heterogeneity; idiosyncratic consumption risk; incomplete markets; consumption-based asset pricing model; risk aversion; equity premium puzzle; hétérogénéité; risque inhérent à la consommation; marchés incomplets; modèle d’évaluation d’actif basé sur la consommation; aversion au risque; puzzle de la prime d’équité;

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