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Quantitative Asset Pricing Implications of Endogenous Solvency Constraints

  • Alvarez, Fernando
  • Jermann, Urban J

We study the asset pricing implications of an economy where solvency constraints are endogenously determined to deter agents from defaulting while allowing as much risk sharing as possible. We solve analytically for efficient allocations and for the corresponding asset prices, portfolio holdings, and solvency constraints for a simple example. Then we calibrate a more general model to U.S. aggregate as well as idiosyncratic income processes. We find equity premia, risk premia for long-term bonds, and Sharpe ratios of magnitudes similar to the U.S. data for low risk aversion and a low time-discount factor. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

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Article provided by Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 14 (2001)
Issue (Month): 4 ()
Pages: 1117-51

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Handle: RePEc:oup:rfinst:v:14:y:2001:i:4:p:1117-51
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  1. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
  2. Krusell, Per & Smith, Anthony A., 1997. "Income And Wealth Heterogeneity, Portfolio Choice, And Equilibrium Asset Returns," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 387-422, June.
  3. Fernando Alvarez & Urban J. Jermann, 1998. "Asset Pricing when Risk Sharing is Limited by Default," NBER Working Papers 6476, National Bureau of Economic Research, Inc.
  4. Ethan Ligon & Jonathan P. Thomas & Tim Worrall, 1997. "Informal Insurance Arrangements in Village Economies," Keele Department of Economics Discussion Papers (1995-2001) 97/08, Department of Economics, Keele University, revised Oct 2000.
  5. Kjetil Storesletten & Chris Telmer & Amir Yaron, . "Persistent Idiosyncratic Shocks and Incomplete Markets," GSIA Working Papers 24, Carnegie Mellon University, Tepper School of Business.
  6. John H. Cochrane & Lars Peter Hansen, 1992. "Asset Pricing Explorations for Macroeconomics," NBER Working Papers 4088, National Bureau of Economic Research, Inc.
  7. He, Hua & Modest, David M, 1995. "Market Frictions and Consumption-Based Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 94-117, February.
  8. Weil, P., 1991. "Equilibrium Asset Prices with Undiversifiable Labor Income Risk," Harvard Institute of Economic Research Working Papers 1564, Harvard - Institute of Economic Research.
  9. Backus, David K. & Gregory, Allan W. & Zin, Stanley E., 1989. "Risk premiums in the term structure : Evidence from artificial economies," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 371-399, November.
  10. Chris I. Telmer, 1991. "Asset Pricing Puzzles and Incomplete Markets," Working Papers 806, Queen's University, Department of Economics.
  11. Luttmer, Erzo G J, 1996. "Asset Pricing in Economies with Frictions," Econometrica, Econometric Society, vol. 64(6), pages 1439-67, November.
  12. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  13. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June.
  14. Narayana Kocherlakota, 2010. "Implications of Efficient Risk Sharing Without Commitment," Levine's Working Paper Archive 2053, David K. Levine.
  15. repec:cup:macdyn:v:1:y:1997:i:2:p:387-422 is not listed on IDEAS
  16. Mankiw, N. Gregory, 1986. "The equity premium and the concentration of aggregate shocks," Journal of Financial Economics, Elsevier, vol. 17(1), pages 211-219, September.
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