On the Range of the Risk-Free Interest Rate in Incomplete Markets

Abstract

In a model of a two-period exchange economy under uncertainty, we find both upper and lower bounds for the risk free interest rate when the agents' utility functions exhibit constant absolute risk aversion. These bounds are independent of the degree of market incompleteness, and so in particular these results show to what extent market incompleteness can explain the risk-free rate puzzle in this class of general equilibrium models with heterogeneous agents. A general method of finding these bounds without the assumption of constant absolute risk aversion is also presented.

Keywords: The risk-free rate puzzle, constant absolute risk aversion, incomplete markets, general equilibrium

JEL Classification: D52, D91, E21, E44, G12