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Equilibrium in securities markets with heterogeneous investors and unspanned income risk

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  • Christensen, Peter Ove
  • Larsen, Kasper
  • Munk, Claus

Abstract

In a finite time horizon, incomplete market, continuous-time setting with dividends and investor incomes governed by arithmetic Brownian motions, we derive closed-form solutions for the equilibrium risk-free rate and stock price for an economy with finitely many heterogeneous CARA investors and unspanned income risk. In equilibrium, the Sharpe ratio is the same as in an otherwise identical complete market economy, whereas the risk-free rate is lower and, consequently, the stock price is higher. The reduction in the risk-free rate is highest when the more risk-averse investors face the largest unspanned income risk.

Suggested Citation

  • Christensen, Peter Ove & Larsen, Kasper & Munk, Claus, 2012. "Equilibrium in securities markets with heterogeneous investors and unspanned income risk," Journal of Economic Theory, Elsevier, vol. 147(3), pages 1035-1063.
  • Handle: RePEc:eee:jetheo:v:147:y:2012:i:3:p:1035-1063
    DOI: 10.1016/j.jet.2012.01.007
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    Cited by:

    1. Jin Choi & Kasper Larsen, 2015. "Taylor approximation of incomplete Radner equilibrium models," Finance and Stochastics, Springer, vol. 19(3), pages 653-679, July.
    2. Kasper Larsen & Tanawit Sae Sue, 2015. "Radner equilibrium in incomplete Levy models," Papers 1507.02974, arXiv.org, revised Jul 2015.
    3. Tyler Abbot, 2017. "Heterogeneous Preferences, Constraints, and the Cyclicality of Leverage," Papers 1706.05877, arXiv.org, revised Nov 2017.
    4. Kim Weston, 2017. "Existence of a Radner equilibrium in a model with transaction costs," Papers 1702.01706, arXiv.org, revised Feb 2018.
    5. Jin Hyuk Choi & Kasper Larsen, 2013. "Taylor approximation of incomplete Radner equilibrium models," Papers 1310.2973, arXiv.org, revised Sep 2014.
    6. Björn Bick & Holger Kraft & Claus Munk, 2013. "Solving Constrained Consumption-Investment Problems by Simulation of Artificial Market Strategies," Management Science, INFORMS, vol. 59(2), pages 485-503, June.

    More about this item

    Keywords

    Unspanned income; Heterogeneous preferences; Continuous-time equilibrium; Risk-free rate puzzle; Equity premium; Incomplete markets; Brownian motion;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets

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