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When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (and when is it not)?

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  • Dirk Krueger
  • Hanno Lustig

Abstract

In a standard incomplete markets model with a continuum of households that have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks and aggregate consumption growth is independent over time. In the equilibrium, which features trade and binding solvency constraints, as opposed to Constantinides and Duffie (1996), households only use the stock market to smooth consumption; the bond market is inoperative. Furthermore we show that the cross-sectional wealth and consumption distributions are not affected by aggregate shocks. These results hold regardless of the persistence of idiosyncratic shocks, and arise even when households face tight solvency constraints, but only a weaker irrelevance result survives when we allow for predictability in aggregate consumption growth.

Suggested Citation

  • Dirk Krueger & Hanno Lustig, 2006. "When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (and when is it not)?," NBER Working Papers 12634, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:12634
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    Cited by:

    1. Ivan Werning, 2016. "Incomplete Markets and Aggregate Demand," 2016 Meeting Papers 932, Society for Economic Dynamics.
    2. Alisdair McKay & Tamas Papp, 2011. "Accounting for Idiosyncratic Wage Risk Over the Business Cycle," Boston University - Department of Economics - Working Papers Series WP2011-028, Boston University - Department of Economics.
    3. Challe, Edouard & Le Grand, François & Ragot, Xavier, 2013. "Incomplete markets, liquidation risk, and the term structure of interest rates," Journal of Economic Theory, Elsevier, vol. 148(6), pages 2483-2519.
    4. Dumas, Bernard J & Lyasoff, Andrew, 2009. "Incomplete-Market Equilibria Solved Recursively on an Event Tree," CEPR Discussion Papers 7138, C.E.P.R. Discussion Papers.
    5. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2009. "Quantitative Macroeconomics with Heterogeneous Households," Annual Review of Economics, Annual Reviews, vol. 1(1), pages 319-354, May.
    6. Favilukis, Jack, 2013. "Inequality, stock market participation, and the equity premium," Journal of Financial Economics, Elsevier, vol. 107(3), pages 740-759.
    7. Nicolae Garleanu & Leonid Kogan & Stavros Panageas, 2009. "The Demographics of Innovation and Asset Returns," Working Papers 2009-008, Becker Friedman Institute for Research In Economics.
    8. Allen, Franklin & Carletti, Elena & Gale, Douglas, 2014. "Money, financial stability and efficiency," Journal of Economic Theory, Elsevier, vol. 149(C), pages 100-127.
    9. Chien, YiLi & Naknoi, Kanda, 2015. "The risk premium and long-run global imbalances," Journal of Monetary Economics, Elsevier, vol. 76(C), pages 299-315.
    10. Florian Scheuer, 2013. "Optimal Asset Taxes in Financial Markets with Aggregate Uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 16(3), pages 405-420, July.
    11. François Grand & Xavier Ragot, 2016. "Incomplete markets and derivative assets," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 62(3), pages 517-545, August.
    12. Edmond, Chris & Weill, Pierre-Olivier, 2012. "Aggregate implications of micro asset market segmentation," Journal of Monetary Economics, Elsevier, vol. 59(4), pages 319-335.
    13. Christensen, Peter Ove & Larsen, Kasper & Munk, Claus, 2012. "Equilibrium in securities markets with heterogeneous investors and unspanned income risk," Journal of Economic Theory, Elsevier, vol. 147(3), pages 1035-1063.
    14. Yili Chien & Harold Cole & Hanno Lustig, 2011. "A Multiplier Approach to Understanding the Macro Implications of Household Finance," Review of Economic Studies, Oxford University Press, vol. 78(1), pages 199-234.
    15. Gârleanu, Nicolae & Kogan, Leonid & Panageas, Stavros, 2012. "Displacement risk and asset returns," Journal of Financial Economics, Elsevier, vol. 105(3), pages 491-510.
    16. Sydney Ludvigson & Stijn Van Nieuwerburgh & Jack Favilukis, 2012. "Foreign Ownership of U.S. Safe Assets: Good or Bad?," 2012 Meeting Papers 297, Society for Economic Dynamics.
    17. Bernard Dumas & Andrew Lyasoff, 2008. "Incomplete-Market Equilibria Solved Recursively on an Event Tree," NBER Working Papers 14629, National Bureau of Economic Research, Inc.
    18. Herskovic, Bernard & Kelly, Bryan & Lustig, Hanno & Van Nieuwerburgh, Stijn, 2016. "The common factor in idiosyncratic volatility: Quantitative asset pricing implications," Journal of Financial Economics, Elsevier, vol. 119(2), pages 249-283.
    19. Andrei Semenov, 2017. "Background risk in consumption and the equity risk premium," Review of Quantitative Finance and Accounting, Springer, vol. 48(2), pages 407-439, February.
    20. Dionne, Georges & Li, Jingyuan, 2014. "When can expected utility handle first-order risk aversion?," Journal of Economic Theory, Elsevier, vol. 154(C), pages 403-422.
    21. Li, Minqiang, 2010. "Asset Pricing - A Brief Review," MPRA Paper 22379, University Library of Munich, Germany.
    22. Esther Eiling, 2013. "Industry-Specific Human Capital, Idiosyncratic Risk, and the Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 68(1), pages 43-84, February.
    23. Johnson, Timothy C., 2012. "Inequality risk premia," Journal of Monetary Economics, Elsevier, vol. 59(6), pages 565-580.
    24. Espino Emilio, 2014. "Optimal portfolios with wealth-varying risk aversion in the neoclassical growth model," The B.E. Journal of Macroeconomics, De Gruyter, vol. 14(1), pages 1-26, January.

    More about this item

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G0 - Financial Economics - - General

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