Does Market Incompleteness Matter for Asset Prices?

Abstract:     
In this paper we argue that market incompleteness resulting from limited stock market participation is important for understanding the behavior of asset prices. We build on Guvenen (2005) and study an otherwise standard real business cycle model incorporating limited participation and heterogeneity in the elasticity of intertemporal substitution, and examine some new implications for asset prices. Furthermore, existing asset pricing models with heterogeneity almost exclusively abstract away from labor-leisure choice which is a key element in macro models. We introduce this choice into our model and investigate its implications.

(This paper has been prepared for the Journal of the European Economic Association, Papers and Proceedings, 2006)

Number of Pages in PDF File: 13

Keywords: Limited stock market participation, the equity premium puzzle, elasticity of intertemporal substitution, heterogeneity, market incompleteness

JEL Classification: E32, E44, G12

Accepted Paper Series