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Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing

  • Heaton, John
  • Lucas, Deborah J

The authors examine an economy with aggregate and idiosyncratic income risk in which agents cannot contract on future labor income. Agents trade financial securities to buffer idiosyncratic shocks but the extent of trade is limited by borrowing constraints and transactions costs. The effect of frictions on the equity premium is decomposed into two components: a direct effect due to the equation of net-of-costs margins and an indirect effect due to increased consumption volatility. Simulations suggest that the direct effect dominates and that the model predicts a sizable equity premium only if costs are large or the quantity of tradable assets is limited. Copyright 1996 by University of Chicago Press.

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Article provided by University of Chicago Press in its journal Journal of Political Economy.

Volume (Year): 104 (1996)
Issue (Month): 3 (June)
Pages: 443-87

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Handle: RePEc:ucp:jpolec:v:104:y:1996:i:3:p:443-87
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  1. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April.
  2. Constantinides, George M, 1986. "Capital Market Equilibrium with Transaction Costs," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 842-62, August.
  3. John M. Abowd & David Card, 1986. "On the Covariance Structure of Earnings and Hours Changes," NBER Working Papers 1832, National Bureau of Economic Research, Inc.
  4. Lucas, Deborah J., 1994. "Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 325-341, December.
  5. Chris I. Telmer, 1991. "Asset Pricing Puzzles and Incomplete Markets," Working Papers 806, Queen's University, Department of Economics.
  6. Dumas, Bernard, 1989. "Two-Person Dynamic Equilibrium in the Capital Market," Review of Financial Studies, Society for Financial Studies, vol. 2(2), pages 157-88.
  7. Heaton, John & Lucas, Deborah, 1992. "The effects of incomplete insurance markets and trading costs in a consumption-based asset pricing model," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 601-620.
  8. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-62, April.
  9. S. Rao Aiyagari & Mark Gertler, 1990. "Asset Returns with Transactions Cost and Uninsured Risk: A Stage III Exercise," NBER Working Papers 3481, National Bureau of Economic Research, Inc.
  10. 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.
  11. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
  12. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
  13. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, vol. 59(2), pages 371-96, March.
  14. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  15. Albert Marcet & Kenneth J. Singleton, 1990. "Equilibrium asset prices and savings of heterogeneous agents in the presence of incomplete markets and portfolio constraints," Economics Working Papers 319, Department of Economics and Business, Universitat Pompeu Fabra, revised Jul 1998.
  16. S Rao Aiyagari & Mark Gertler, 1997. "Asset Returns with transaction costs and uninsured individual risk," Levine's Working Paper Archive 648, David K. Levine.
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