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Risk-Sharing Externalities and Its Implications for Equity Premium in an Infinite-Horizon Economy

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Abstract

This paper examines asset prices when risk-sharing externalities are incorporated into an infinite-horizon model where consumers are exposed to the endogenous income risks. It is shown that there exist multiple types of equilibria depending on the degree of market participation. Under incomplete participation, income risks cannot be fully diversified as they induce higher precautionary savings, which are conducive in turn to higher asset prices. However, the exposure to additional dividend risks can lead at the same time to a lower demand for risky assets. The aggregate effect is an increase in the equity risk premium and a decrease in the risk-free rate. Thus, the evidence suggests that the equity premium and risk-free rate puzzles can be partly explained by infinite-horizon models with incomplete market participation.

Suggested Citation

  • Hiroaki Ohno, 2010. "Risk-Sharing Externalities and Its Implications for Equity Premium in an Infinite-Horizon Economy," Czech Economic Review, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, vol. 4(2), pages 168-188, June.
    • Handle: RePEc:fau:aucocz:au2010_168
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    1. S. Rao Aiyagari, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(3), pages 659-684.
    2. Annette Vissing-Jørgensen & Orazio P. Attanasio, 2003. "Stock-Market Participation, Intertemporal Substitution, and Risk-Aversion," American Economic Review, American Economic Association, vol. 93(2), pages 383-391, May.
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    Cited by:

    1. Hiroaki OHNO, 2011. "Limited Market Participation, Financial Intermediaries,And Endogenous Growth," Review of Economics & Finance, Better Advances Press, Canada, vol. 1, pages 53-62, August.

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    More about this item

    Keywords

    Risk-sharing externalities; endogenous income risks; incomplete market participation; asset prices;
    All these keywords.

    JEL classification:

    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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