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The Market Price of Aggregate Risk and the Wealth Distribution

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  • Hanno Lustig

    (Dept. of Economics Stanford University)

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.

Suggested Citation

  • Hanno Lustig, 2001. "The Market Price of Aggregate Risk and the Wealth Distribution," Finance 0111004, University Library of Munich, Germany, revised 16 Nov 2001.
  • Handle: RePEc:wpa:wuwpfi:0111004
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    More about this item

    Keywords

    Asset Pricing; Wealth Heterogeneity; Limited Commitment;
    All these keywords.

    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 - - - Methodology for Collecting, Estimating, and Organizing Microeconomic Data; Data Access
    • F49 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Other
    • R38 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - Government Policy

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