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Asset Pricing with Heterogeneous Agents, Incomplete Markets and Trading Constraints

  • Tsvetanka Karagyozova

    (University of British Columbia)

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).

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Paper provided by University of Connecticut, Department of Economics in its series Working papers with number 2007-46.

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Length: 62 pages
Date of creation: Nov 2007
Date of revision: 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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  1. Lee A. Lillard & Robert J. Willis, 1976. "Dynamic Aspects of Earnings Mobility," NBER Working Papers 0150, National Bureau of Economic Research, Inc.
  2. 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.
  3. Andrew B. Abel, 1990. "Asset Prices under Habit Formation and Catching up with the Joneses," NBER Working Papers 3279, National Bureau of Economic Research, Inc.
  4. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  5. N. Gregory Mankiw & Stephen P. Zeldes, 1990. "The Consumption of Stockholders and Non-Stockholders," NBER Working Papers 3402, National Bureau of Economic Research, Inc.
  6. Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
  7. Rajnish Mehra & Edward C. Prescott, 2003. "The Equity Premium in Retrospect," NBER Working Papers 9525, National Bureau of Economic Research, Inc.
  8. 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.
  9. Albert Marcet & Guido Lorenzoni, 1998. "Parameterized expectations approach; Some practical issues," Economics Working Papers 296, Department of Economics and Business, Universitat Pompeu Fabra.
  10. 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.
  11. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  12. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  13. 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.).
  14. Philippe Jorion & William N. Goetzmann, 1999. "Global Stock Markets in the Twentieth Century," Journal of Finance, American Finance Association, vol. 54(3), pages 953-980, 06.
  15. 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.
  16. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
  17. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
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