Asset Pricing with Endogenously Uninsurable Tail Risks

This paper studies asset pricing implications of idiosyncratic risk in labor productivities in a model where markets are endogenously incomplete. Well-diversified owners of firms provide insurance to workers using long-term wage contracts but cannot commit to ventures that yield a net present value of dividends. We show that under the optimal contract subject to limited commitment, workers are uninsured against tail risks in idiosyncratic productivities. Risk compensations are higher when we calibrate the model to replicate the feature that tail risk in labor income is more pervasive in recessions relative to expansions. Besides salient features of equity and bond markets, the model is consistent with other empirical facts such as the cyclicality of factor shares and limited stock market participation.