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Asset Pricing Implications of Pareto Optimality with Private Information

  • Narayana R. Kocherlakota
  • Luigi Pistaferri

In this paper, we consider a dynamic economy in which the agents are privately informed about their skills, which evolve stochastically over time in an arbitrary fashion. We consider an asset pricing equilibrium in which equilibrium quantities are constrained Pareto optimal. Under the assumption that agents have constant relative risk aversion, we derive a novel asset pricing kernel for financial asset returns. The kernel equals the reciprocal of the gross growth of the x-th moment of the consumption distribution, where x is the coefficient of relative risk aversion. We use data from the Consumer Expenditure Survey (CEX) and show that the new stochastic discount factor performs better than existing stochastic discount factors at rationalizing the equity premium. However, its ability to simultaneously explain the equity premium and the expected return to the Treasury bill is about the same as existing discount factors.

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Paper provided by UCLA Department of Economics in its series Levine's Bibliography with number 321307000000000701.

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Date of creation: 12 Jan 2007
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Handle: RePEc:cla:levrem:321307000000000701
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