Asset Pricing with Limited Risk Sharing and Heterogeneous Agents

Abstract

We solve a model with incomplete markets and heterogeneous agents that generates a large equity premium, while simultaneously matching stock market participation and individual asset holdings. The high risk premium is driven by incomplete risk sharing among stockholders, which results from the combination of aggregate uncertainty, borrowing constraints and a (realistically) calibrated life-cycle earnings profile subject to idiosyncratic shocks. We show that it is challenging to simultaneously match asset pricing moments and individual portfolio decisions, while limited participation has a negligible impact on the risk premium, contrary to the results of models where it is imposed exogenously.

Keywords: Equity premium, incomplete risk sharing, life-cycle models, limited stock market participation, preference heterogeneity

JEL Classification: G11, G12