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Asset Prices in a Huggett Economy

  • Toshihiko Mukoyama

    (University of Virginia)

  • Anthony A. Smith

    (Jr., Yale University)

  • Per Krusell

    (Princeton University)

This paper explores the asset-price implications in economies where there is no direct insurance against idiosyncratic risks but there are other assets---such as a riskfree bond or equity---that can be used for self-insurance, subject to exogenously imposed borrowing limits. We analyze an economy without production---an endowment economy---and we consider both the case with no aggregate risk and the case with aggregate risk. Thus, we analyze the economy originally studied, in the case without aggregate risk, in Huggett (1993). Our main innovation is that, by studying the case with ``maximally tight'' borrowing constraints, we can obtain full analytical tractability. Thus, like in Lucas's seminal asset-pricing paper, we obtain closed forms for all state-contingent claims, allowing us to study the price determination for all assets with payoffs contingent on aggregate events. In the Huggett economy, like in Lucas's, any asset pricing is obtained using a first-order condition, but in the Huggett economy only a subset of the consumers will typically have first-order constraints holding with equality---the others are borrowing-constrained. Thus, the analysis centers around who prices the assets, and around what the endowment risks of this agent are; in the Lucas economy, only the aggregate endowment risk matters. Moreover, identity/type of the consumer pricing an asset may change over time. We specifically illustrate by looking at riskless bonds, equity, and the term structure of interest rates.

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Paper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 181.

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Date of creation: 2008
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Handle: RePEc:red:sed008:181
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  1. 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.
  2. Sylvain Leduc, 1998. "Incomplete Markets, Borrowing Constraints, and the Foreign Exchange Risk Premium," Research in Economics 98-06-050e, Santa Fe Institute.
  3. 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.
  4. Fernando Alvarez & Urban J. Jermann, 2000. "Efficiency, Equilibrium, and Asset Pricing with Risk of Default," Econometrica, Econometric Society, vol. 68(4), pages 775-798, July.
  5. Albert Marcet & Kenneth J. Singleton, 1990. "Equilibrium asset prices and savings of heterogeneous agents in the presence of incomplete markets and portfolio constraints," Economics Working Papers 319, Department of Economics and Business, Universitat Pompeu Fabra, revised Jul 1998.
  6. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  7. 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.
  8. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
  9. 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.
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  11. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  12. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity in the Macroeconomy," GSIA Working Papers 1997-37, Carnegie Mellon University, Tepper School of Business.
  13. Ana Castaneda & Javier Diaz-Gimenez & Jose-Victor Rios-Rull, 2003. "Accounting for the U.S. Earnings and Wealth Inequality," Journal of Political Economy, University of Chicago Press, vol. 111(4), pages 818-857, August.
  14. 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.
  15. Fernando Alvarez & Urban J. Jermann, . "Quantitative Asset Pricing Implications of Endogenous Solvency Constraints," Rodney L. White Center for Financial Research Working Papers 10-99, Wharton School Rodney L. White Center for Financial Research.
  16. Flodén, Martin & Linde, Jesper, 1998. "Idiosyncratic Risk in the U.S. and Sweden: Is there a Role for Government Insurance?," Seminar Papers 654, Stockholm University, Institute for International Economic Studies.
  17. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  18. Boyan Jovanovic, 2004. "Asymmetric Cycles," NBER Working Papers 10573, National Bureau of Economic Research, Inc.
  19. Bewley, Truman, 1983. "A Difficulty with the Optimum Quantity of Money," Econometrica, Econometric Society, vol. 51(5), pages 1485-504, September.
  20. Lucas, Deborah J., 1994. "Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 325-341, December.
  21. Heaton, John & Lucas, Deborah, 1992. "The effects of incomplete insurance markets and trading costs in a consumption-based asset pricing model," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 601-620.
  22. Mas-Colell, Andreu & Whinston, Michael D. & Green, Jerry R., 1995. "Microeconomic Theory," OUP Catalogue, Oxford University Press, number 9780195102680, March.
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