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

  • John Heaton
  • Deborah Lucas

We examine asset prices and consumption patterns in a model in which agents face both aggregate and idiosyncratic income shocks, and insurance markets are incomplete. Agents reduce consumption variability by trading in a stock and bond market to offset idiosyncratic shocks, but transactions costs in both markets limit the extent of trade. To calibrate the model, we estimate an empirical model of labor and dividend income, using data from the PSID and the NIPA. Although the agents in the model are not very risk averse, the model predicts a sizable equity premium and a low riskfree rate. By simultaneously considering aggregate and idiosyncratic shocks, we decompose this effect of transactions costs on the equity premium into two components. The direct effect is due to the fact that individuals equate net-of-cost margins, so an asset with lower associated transactions costs will have a lower market rate of return. A second, indirect effect occurs because transactions costs result in individual consumption that more closely tracks individual income than aggregate consumption.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4249.

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Date of creation: Jan 1993
Publication status: published as Journal of Political Economy, Vol. 104, no. 3 (June 1996): 443-487.
Handle: RePEc:nbr:nberwo:4249
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