Asset Returns in an Endogenous Growth Model with Incomplete Markets

Abstract:     
This paper studies the testable implications of consumption-based asset pricing models with incomplete markets when idiosyncratic income shocks are permanent and not lognormally distributed. It is shown that the theory places no testable restrictions (beyond absence of arbitrage) on either the macroeconomic data or the first N moments of the cross-sectional distribution of consumption (income) growth. More precisely, this paper shows that any "observed" joint process of aggregate consumption, arbitrage-free asset returns, and N moments of the cross-sectional distribution of consumption growth is an equilibrium outcome for some incomplete-markets economy (some pure discount factor and process of individual income). The proof is based on the construction of a personal-disaster process (process of extreme idiosyncratic events) which allows for arbitrary variations in idiosyncratic risk without affecting the first N moments of the cross-sectional distribution of consumption growth.

Number of Pages in PDF File: 33

Keywords: Asset Pricing, Incomplete Markets, Personal Disasters, Testable Restrictions

JEL Classification: D52, G12

working papers series