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

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  • Kris Jacobs
  • 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

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 47.

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Date of creation: 11 Nov 2005
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Handle: RePEc:sce:scecf5:47

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Keywords: Heterogeneity; Idiosyncratic consumption risk; Incomplete markets; Consumption-based asset pricing model; Risk aversion; Equity premium puzzle;

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