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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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  1. 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.
  2. S. Rao Aiyagari, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, Oxford University Press, vol. 109(3), pages 659-684.
  3. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers 01-90, Wharton School Rodney L. White Center for Financial Research.
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  5. Heaton, John, 1995. "An Empirical Investigation of Asset Pricing with Temporally Dependent Preference Specifications," Econometrica, Econometric Society, vol. 63(3), pages 681-717, May.
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  7. Lettau, Martin & Uhlig, Harald, 1997. "Preferences, Consumption Smoothing, and Risk Premia," CEPR Discussion Papers 1678, C.E.P.R. Discussion Papers.
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  9. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  10. 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.
  11. Boldrin, Michele & Christiano, Lawrence J. & Fisher, Jonas D.M., 1997. "Habit Persistence And Asset Returns In An Exchange Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 312-332, June.
  12. 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.
  13. 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.
  14. 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.
  15. 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.
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  18. N. Gregory Mankiw, 1986. "The Equity Premium and the Concentration of Aggregate Shocks," NBER Working Papers 1788, National Bureau of Economic Research, Inc.
  19. Díaz, Antonia & Ríos Rull, José Víctor & Pijoan Mas, Josep, 2001. "Habit formation: implications for the wealth distribution," UC3M Working papers. Economics we015114, Universidad Carlos III de Madrid. Departamento de Economía.
  20. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
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  24. 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.
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  28. Santiago Budria Rodriguez & Javier Diaz-Gimenez & Vincenzo Quadrini & Jose-Victor Rios-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.
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