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Pricing Risk in Economies with Heterogenous Agents and Incomplete Markets

  • Josep Pijoan-Mas

    (CEMFI)

Habit formation has been proposed as a possible solution for explaining 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 increases the equity premium. However, contrary to the earlier results in the literature, the habit hypothesis does not imply a price for risk much higher than the one implied by models with intertemporally separable preferences. The main reasons for this are general equilibrium ones. First, with just two assets available, households can smooth out consumption fluctuations very well. Therefore, the higher utility losses of uncertainty imposed by habits will not command a high price of risk because households manage to avoid this risk. Second, the composition of the set of agents pricing the assets is sensitive to changes in the model. In an economy with habits, pricing agents turn out to be households facing very small consumption fluctuations. In addition I characterize three important properties of the model economy that relate to portfolio choice: willingness to hold risky assets (1) increases with wealth, (2) decreases with labor earnings and (3) decreases with habit stock.

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File URL: http://www.ssc.upenn.edu/~vr0j/caerp/WPapers/HabAssPr_CAERP.pdf
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Paper provided by Centro de Altisimos Estudios Rios Perez (CAERP) in its series Centro de Alti­simos Estudios Ri­os Pe©rez(CAERP) with number 3.

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Length: 38 pages
Date of creation: Dec 2002
Date of revision:
Handle: RePEc:cae:caerpp:3
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Web page: http://www.caerp.com/

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  1. Lettau, Martin & Uhlig, Harald, 1997. "Preferences, Consumption Smoothing, and Risk Premia," CEPR Discussion Papers 1678, C.E.P.R. Discussion Papers.
  2. Heaton, John, 1995. "An Empirical Investigation of Asset Pricing with Temporally Dependent Preference Specifications," Econometrica, Econometric Society, vol. 63(3), pages 681-717, May.
  3. Judd, Kenneth L., 1992. "Projection methods for solving aggregate growth models," Journal of Economic Theory, Elsevier, vol. 58(2), pages 410-452, December.
  4. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers 1-90, Wharton School Rodney L. White Center for Financial Research.
  5. Kjetil Storesletten & Chris Telmer & Amir Yaron, 1996. "Asset pricing with idiosyncratic risk and overlapping generations," Economics Working Papers 405, Department of Economics and Business, Universitat Pompeu Fabra, revised Jul 1999.
  6. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  7. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
  8. Ellen R. McGrattan & Edward C. Prescott, 2000. "Is the stock market overvalued?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 20-40.
  9. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  10. Castaneda, Ana & Diaz-Gimenez, Javier & Rios-Rull, Jose-Victor, 1998. "Exploring the income distribution business cycle dynamics," Journal of Monetary Economics, Elsevier, vol. 42(1), pages 93-130, June.
  11. Joao F. Cocco, 2005. "Consumption and Portfolio Choice over the Life Cycle," Review of Financial Studies, Society for Financial Studies, vol. 18(2), pages 491-533.
  12. Josep Pijoan-Mas 2 & Antonia Díaz & José-Víctor Ríos-Rull, 2001. "Habit Formation: Inplications For The Wealth Distribution," Economics Working Papers we015114, Universidad Carlos III, Departamento de Economía.
  13. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
  14. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of Security Market Data for Models of Dynamic Economies," NBER Technical Working Papers 0089, National Bureau of Economic Research, Inc.
  15. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  16. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1997. "Habit persistence and asset returns in an exchange economy," Working Paper Series, Macroeconomic Issues WP-97-04, Federal Reserve Bank of Chicago.
  17. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  18. Lettau, M. & Uhlig, H.F.H.V.S., 1997. "Preferences, Consumption Smoothing and Risk Premia," Discussion Paper 1997-60, Tilburg University, Center for Economic Research.
  19. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity, Portfolio Choice, and Equilibrium Asset Returns," GSIA Working Papers 1997-45, Carnegie Mellon University, Tepper School of Business.
  20. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
  21. repec:cup:macdyn:v:1:y:1997:i:2:p:387-422 is not listed on IDEAS
  22. Santiago Budria Rodriguez & Javier Diaz-Gimenez & Vincenzo Quadrini & Jose-Victor Rior-Rull, 2002. "Updated facts on the U.S. distributions of earnings, income, and wealth," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-35.
  23. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  24. João Cocco & Francisco Gomes & Pascal Maenhout, 1998. "Consumption and Portfolio Choice over the Life-Cycle," Center for Economic Studies - Discussion papers ces9805, Katholieke Universiteit Leuven, Centrum voor Economische Studiën.
  25. John Heaton & Deborah Lucas, 1993. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Papers 4249, National Bureau of Economic Research, Inc.
  26. 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.
  27. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  28. N. Gregory Mankiw, 1986. "The Equity Premium and the Concentration of Aggregate Shocks," NBER Working Papers 1788, National Bureau of Economic Research, Inc.
  29. repec:dgr:kubcen:199760 is not listed on IDEAS
  30. Imrohoruglu, Ayse, 1989. "Cost of Business Cycles with Indivisibilities and Liquidity Constraints," Journal of Political Economy, University of Chicago Press, vol. 97(6), pages 1364-83, December.
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