Incomplete Continuous-Time Securities Markets with Stochastic Income Volatility
40 Pages Posted: 18 Mar 2011 Last revised: 27 Apr 2013
Date Written: April 26, 2013
We derive closed-form solutions for the equilibrium interest rate and market price of risk processes in an incomplete continuous-time market with uncertainty generated by Brownian motions. The economy has a finite number of heterogeneous exponential utility investors, who receive partially unspanned income and can trade continuously. Countercyclical stochastic income volatility generates a countercyclical equilibrium market price of risk process and a procyclical equilibrium interest rate process, and we show that when the investors' unspanned income volatility is countercyclical, the resulting equilibrium displays both lower interest rates and higher risk premia compared to the equilibrium in an otherwise identical complete market.
Keywords: Incomplete markets, non-Pareto efficiency, stochastic volatility, stochastic interest rates, stochastic risk premia
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