Asset Pricing with Heterogeneous Agents, Incomplete Markets and Trading Constraints
AbstractThe consumption capital asset pricing model is the standard economic model used to capture stock market behavior. However, empirical tests have pointed out its inability to account quantitatively for the high average rate of return and volatility of stocks over time for plausible parameter values. Recent research has suggested that the consumption of stockholders is more strongly correlated with the performance of the stock market than the consumption of non-stockholders. We model two types of agents, non-stockholders with standard preferences and stock holders with preferences that incorporate elements of the prospect theory developed by Kahneman and Tversky (1979). In addition to consumption, stockholders consider fluctuations in their financial wealth explicitly when making decisions. Each agent faces idiosyncratic shocks to his labor income as well as aggregate shocks to the per-share dividend but markets are incomplete and agents cannot hedge consumption risks completely. In addition, consumers face both borrowing and short-sale constraints. Data from the Panel Study of Income Dynamics are used to calibrate the labor income processes of the two types of agents. Our results show that in equilibrium, agents hold different portfolios. Our model is able to generate a time-varying risk premium of about 6% while maintaining a low risk free rate, thus suggesting a plausible explanation for the equity premium puzzle reported by Mehra and Prescott (1985).
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Bibliographic InfoPaper provided by University of Connecticut, Department of Economics in its series Working papers with number 2007-46.
Length: 62 pages
Date of creation: Nov 2007
Date of revision: Sep 2008
Note: I am grateful for comments and encouragement to Christian Zimmermann. I also thank Andra Ghent, seminar participants at the University of British Columbia and the University of Connecticut, and participants in the Canadian Economic Association 2008 Annual Meeting for helpful comments. Any conceptual or other errors are my fault.
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More information through EDIRC
asset pricing; equity premium puzzle; prospect theory; heterogeneous agents;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-12-15 (All new papers)
- NEP-DGE-2007-12-15 (Dynamic General Equilibrium)
- NEP-MAC-2007-12-15 (Macroeconomics)
- NEP-UPT-2007-12-15 (Utility Models & Prospect Theory)
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