Asset Pricing with Limited Risk Sharing and Heterogeneous Agents
London Business School
Imperial College Business School; Centre for Economic Policy Research (CEPR)
AFA 2006 Boston Meetings Paper
We solve a model with incomplete markets and heterogeneous agents that generates a large equity premium, while simultaneously matching individual allocations (stock market participation rate and asset holdings). Limited participation is derived endogenously and has a negligible impact on the risk premium, contrary to the results of models where it is imposed exogenously. We obtain a high risk premium with moderate risk aversion (5 or less). This is driven by incomplete risk sharing among stockholders, which results from the combination of borrowing constraints with a (realistically) calibrated life-cycle stochastic earnings profile subject to both aggregate and idiosyncratic shocks.
Number of Pages in PDF File: 47
Keywords: Equity Premium, Preference Heterogeneity, Incomplete Risk Sharing, Life-Cycle Models, Limited Stock Market Participation.
JEL Classification: E21, G11
Date posted: March 22, 2005