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The Market Price of Aggregate Risk and the Wealth Distribution

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Author Info
Hanno Lustig (Dept. of Economics Stanford University)

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Abstract

Bankruptcy brings the asset pricing implications of Lucas's (1978) endowment economy in line with the data. I introduce bankruptcy into a complete markets model with a continuum of ex ante identical agents who have CRRA utility. Shares in a Lucas tree serve as collateral. The model yields a large equity premium, a low risk-free rate and a time-varying market price of risk for reasonable risk aversion gamma. Bankruptcy gives rise to a second risk factor in addition to aggregate consumption growth risk. This liquidity risk is created by binding solvency constraints. The risk is measured by the growth rate of a particular moment of the Pareto-Negishi weight distribution, which multiplies the standard Breeden-Lucas stochastic discount factor. The economy is said to experience a negative liquidity shock when this growth rate is high and a large fraction of agents faces severely binding solvency constraints. These shocks occur in recessions. The average investor wants a high excess return on stocks to compensate for the extra liquidity risk, because of low stock returns in recessions. In that sense stocks are ``bad collateral''. The adjustment to the Breeden-Lucas stochastic discount factor raises the unconditional risk premium and induces time variation in conditional risk premia. This explains why stock returns are highly predictable over longer holding periods.

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Paper provided by EconWPA in its series Finance with number 0111004.

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Length: 71 pages
Date of creation: 16 Nov 2001
Date of revision: 16 Nov 2001
Handle: RePEc:wpa:wuwpfi:0111004

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Related research
Keywords: Asset Pricing; Wealth Heterogeneity; Limited Commitment;

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Find related papers by JEL classification:
L11 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Production, Pricing, and Market Structure; Size Distribution of Firms
C81 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs - - - Microeconomic Data
F49 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Other
R38 - Urban, Rural, and Regional Economics - - Production Analysis and Firm Location - - - Government Policies; Regulatory Policies

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