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Asset Pricing When Risk Sharing is Limited by Default

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  • Fernando Alvarez
  • Urban J Jermann

Abstract

We study the asset pricing implications of a multi-agent endowment economy where agents can default on contracts that would leave them otherwise worse off. We specialize and extend the environment studied by Kocherlakota (1995) and Kehoe and Levine (1993) to make it comparable to standard studies of asset pricing. We make contributions along two fronts. First, we extend the characterization of efficient allocations. Second, we present an equilibrium concept with complete markets and with endogenous solvency constraints. These solvency constraints are such as to prevent default at the cost of reduced risk sharing. We show a version of the classical welfare theorems for this equilibrium definition. We characterize the pricing kernel, and compare it to the one for economies without participation constraints: interest rates are lower and risk premia can be bigger depending on the covariance of the idiosyncratic and aggregate shocks. We show that those agents whose endowment is very similar to the aggregate endowment are irrelevant for asset pricing. In a quantitative example, for reasonable parameter values, the relevant marginal rates of substitution fall within the Hansen-Jagannathan bounds.

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Paper provided by David K. Levine in its series Levine's Working Paper Archive with number 1898.

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Date of creation: 08 Dec 2010
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Handle: RePEc:cla:levarc:1898

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  1. Narayana Kocherlakota, 2010. "Implications of Efficient Risk Sharing Without Commitment," Levine's Working Paper Archive 2053, David K. Levine.
  2. Hua He and David M. Modest., 1992. "Market Frictions and Consumption-Based Asset Pricing," Research Program in Finance Working Papers, University of California at Berkeley RPF-223, University of California at Berkeley.
  3. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  4. David K. Levine & William R. Zame, 1993. "Debt Constraints and Equilibrium in Infinite Horizon Economies with Incomplete Markets," UCLA Economics Working Papers 703, UCLA Department of Economics.
  5. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1987. "International real business cycles," Working Papers 426, Federal Reserve Bank of Minneapolis.
  6. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  7. Mankiw, N. Gregory, 1986. "The equity premium and the concentration of aggregate shocks," Journal of Financial Economics, Elsevier, vol. 17(1), pages 211-219, September.
  8. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  9. John H. Cochrane & Lars Peter Hansen, 1992. "Asset Pricing Explorations for Macroeconomics," NBER Working Papers 4088, National Bureau of Economic Research, Inc.
  10. Laitner, John, 1992. "Random earnings differences, lifetime liquidity constraints, and altruistic intergenerational transfers," Journal of Economic Theory, Elsevier, vol. 58(2), pages 135-170, December.
  11. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
  12. Manuel S. Santos & Michael Woodford, 1997. "Rational Asset Pricing Bubbles," Econometrica, Econometric Society, Econometric Society, vol. 65(1), pages 19-58, January.
  13. Patrick J. Kehoe & Fabrizio Perri, 2000. "International business cycles with endogenous incomplete markets," Staff Report, Federal Reserve Bank of Minneapolis 265, Federal Reserve Bank of Minneapolis.
  14. Alejandro Hernandez & Manuel Santos, 1994. "Competitive Equilibria for Infinite-Horizon Economies with Incomplete Markets," Working Papers 9407, Centro de Investigacion Economica, ITAM.
  15. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
  16. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(3), pages 443-87, June.
  17. Luttmer, Erzo G J, 1996. "Asset Pricing in Economies with Frictions," Econometrica, Econometric Society, Econometric Society, vol. 64(6), pages 1439-67, November.
  18. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  19. Kjetil Storesletten & Chris Telmer & Amir Yaron, . "Persistent Idiosyncratic Shocks and Incomplete Markets," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 24, Carnegie Mellon University, Tepper School of Business.
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