The Irrelevance of Market Incompleteness for the Price of Aggregate Risk
University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
Hanno N. Lustig
UCLA - Anderson School of Management; National Bureau of Economic Research (NBER)
CEPR Discussion Paper No. 5936
In models with a large number of agents who have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labour income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks. In spite of the missing markets, a representative agent who consumes aggregate income prices the excess returns on stocks correctly. This result holds regardless of the persistence of idiosyncratic shocks, as long as they are not permanent, even when households face binding, and potentially very tight borrowing constraints. Consequently, in this class of models there is no link between the extent of self-insurance against idiosyncratic income risk and aggregate risk premia.
Number of Pages in PDF File: 58
Keywords: Risk premium, idiosyncratic income risk, incomplete markets
JEL Classification: G12working papers series
Date posted: January 3, 2007
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