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Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing

John Heaton

University of Chicago - Finance

Deborah J. Lucas

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER)

January 1993

NBER Working Paper No. w4249

We examine asset prices and consumption patterns in a model in which agents face both aggregate and idiosyncratic income shocks, and insurance markets are incomplete. Agents reduce consumption variability by trading in a stock and bond market to offset idiosyncratic shocks, but transactions costs in both markets limit the extent of trade. To calibrate the model, we estimate an empirical model of labor and dividend income, using data from the PSID and the NIPA. Although the agents in the model are not very risk averse, the model predicts a sizable equity premium and a low riskfree rate. By simultaneously considering aggregate and idiosyncratic shocks, we decompose this effect of transactions costs on the equity premium into two components. The direct effect is due to the fact that individuals equate net-of-cost margins, so an asset with lower associated transactions costs will have a lower market rate of return. A second, indirect effect occurs because transactions costs result in individual consumption that more closely tracks individual income than aggregate consumption.

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Date posted: August 15, 2007  

Suggested Citation

Heaton, John and Lucas, Deborah J., Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing (January 1993). NBER Working Paper No. w4249. Available at SSRN: https://ssrn.com/abstract=478703

Contact Information

John C Heaton (Contact Author)
University of Chicago - Finance ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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Deborah J. Lucas
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Northwestern University - Kellogg School of Management ( email )
2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8333 (Phone)
847-491-5719 (Fax)
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