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Pricing Risk in Economies with Heterogeneous Agents and Incomplete Markets

  • Josep Pijoan-Mas

Habit formation has been proposed as a possible solution to the equity premium puzzle. This paper extends the class of models that support the habits explanation in order to account for heterogeneity in earnings, wealth, habits, and consumption. I find that habit formation does indeed increase the equity premium. However, contrary to earlier results, the habit hypothesis does not imply a price for risk as large as the one measured in the data. There are three reasons for this. First, households in a habits economy modify their consumption/savings decision. Second, they modify their portfolio choice. These two changes in behavior diminish the consumption fluctuations faced by households. Third, the composition of the set of agents pricing risk in the economy changes so that relatively better self-insured households end up pricing risk. (JEL: D52, G12, E21, C68) (c) 2007 by the European Economic Association.

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Article provided by MIT Press in its journal Journal of the European Economic Association.

Volume (Year): 5 (2007)
Issue (Month): 5 (09)
Pages: 987-1015

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Handle: RePEc:tpr:jeurec:v:5:y:2007:i:5:p:987-1015
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