A Dynamic Agency Based Asset Pricing Model with Production

Abstract

We develop a general equilibrium model based on dynamic agency theory to study investment and asset prices. In our environment, neither firms nor workers can commit to compensation contracts that provide continuation values below their outside options. At the aggregate level, the presence of agency frictions amplifies the market price of risks and allows our model to generate a sizable equity premium with a low level of risk aversion. History dependent labor contracts generate a form of operating leverage and allow our model to match the key features of the aggregate and cross-section of investment and equity returns in the data. A variance decomposition of investment into discount rate news and cash flow news supports the mechanism of our model.

Keywords: Agency Frictions, Dynamic Optimal Contract, General Equilibrium, Heterogeneous Agents, Production-Based Asset Pricing, Value Premium, Investment, Incomplete Market

JEL Classification: E21, E23, E32, E44, G12