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Asset Pricing with Heterogeneous Agents, Incomplete Markets and Trading Constraints

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  • Tsvetanka Karagyozova

    (University of British Columbia)

Abstract

The consumption capital asset pricing model is the standard economic model used to capture stock market behavior. However, empirical tests have pointed out its inability to account quantitatively for the high average rate of return and volatility of stocks over time for plausible parameter values. Recent research has suggested that the consumption of stockholders is more strongly correlated with the performance of the stock market than the consumption of non-stockholders. We model two types of agents, non-stockholders with standard preferences and stock holders with preferences that incorporate elements of the prospect theory developed by Kahneman and Tversky (1979). In addition to consumption, stockholders consider fluctuations in their financial wealth explicitly when making decisions. Each agent faces idiosyncratic shocks to his labor income as well as aggregate shocks to the per-share dividend but markets are incomplete and agents cannot hedge consumption risks completely. In addition, consumers face both borrowing and short-sale constraints. Data from the Panel Study of Income Dynamics are used to calibrate the labor income processes of the two types of agents. Our results show that in equilibrium, agents hold different portfolios. Our model is able to generate a time-varying risk premium of about 6% while maintaining a low risk free rate, thus suggesting a plausible explanation for the equity premium puzzle reported by Mehra and Prescott (1985).

Suggested Citation

  • Tsvetanka Karagyozova, 2007. "Asset Pricing with Heterogeneous Agents, Incomplete Markets and Trading Constraints," Working papers 2007-46, University of Connecticut, Department of Economics, revised Sep 2008.
  • Handle: RePEc:uct:uconnp:2007-46 Note: I am grateful for comments and encouragement to Christian Zimmermann. I also thank Andra Ghent, seminar participants at the University of British Columbia and the University of Connecticut, and participants in the Canadian Economic Association 2008 Annual Meeting for helpful comments. Any conceptual or other errors are my fault.
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Ellen R. McGrattan & Edward C. Prescott, 2003. "Average Debt and Equity Returns: Puzzling?," American Economic Review, American Economic Association, pages 392-397.
    3. Abel Andrew B. & Mailath George J., 1994. "Financing Losers in Competitive Markets," Journal of Financial Intermediation, Elsevier, pages 139-165.
    4. 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.
    5. Lillard, Lee A & Willis, Robert J, 1978. "Dynamic Aspects of Earning Mobility," Econometrica, Econometric Society, vol. 46(5), pages 985-1012, September.
    6. Mankiw, N. Gregory & Zeldes, Stephen P., 1991. "The consumption of stockholders and nonstockholders," Journal of Financial Economics, Elsevier, vol. 29(1), pages 97-112, March.
    7. Ferson, Wayne E. & Constantinides, George M., 1991. "Habit persistence and durability in aggregate consumption: Empirical tests," Journal of Financial Economics, Elsevier, vol. 29(2), pages 199-240, October.
    8. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
    9. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, pages 38-42.
    10. Marcet, Albert & Singleton, Kenneth J., 1999. "Equilibrium Asset Prices And Savings Of Heterogeneous Agents In The Presence Of Incomplete Markets And Portfolio Constraints," Macroeconomic Dynamics, Cambridge University Press, pages 243-277.
    11. Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
    12. Mehra, Rajnish & Prescott, Edward C., 2003. "The equity premium in retrospect," Handbook of the Economics of Finance,in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 14, pages 889-938 Elsevier.
    13. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-487, June.
    14. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
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    18. James M. Nason, 1988. "The equity premium and time-varying risk behavior," Finance and Economics Discussion Series 11, Board of Governors of the Federal Reserve System (U.S.).
    19. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
    20. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory and Asset Prices," The Quarterly Journal of Economics, Oxford University Press, vol. 116(1), pages 1-53.
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    Cited by:

    1. Azam Mohammadzadeh & Mohammad Nabi Shahiki Tash & Reza Roshan, 2016. "Investigating and Comparing Some Consumption-based Asset Pricing Models: The Case of Iran," International Journal of Economics and Financial Issues, Econjournals, vol. 6(4), pages 1884-1894.

    More about this item

    Keywords

    asset pricing; equity premium puzzle; prospect theory; heterogeneous agents;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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