Market Incompleteness and the Equity Premium Puzzle: Evidence from State-Level Data

23 Pages Posted: 5 Apr 2005

See all articles by Kris Jacobs

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Stephane Pallage

University of Quebec at Montreal - Department of Economics; Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE)

Michel A. Robe

University of Illinois at Urbana-Champaign

Multiple version iconThere are 2 versions of this paper

Date Written: March 2005

Abstract

This paper investigates the importance of market incompleteness by comparing the rate of risk aversion estimated from complete and incomplete markets environments. For the incomplete markets case, we use consumption data for 50 U.S. states. While the use of state level data is conceptually inferior to the use of data on individual consumption, it may be preferable because state-level data are less susceptible to measurement errors. We find that the rate of risk aversion under the incomplete markets setup is much lower. Furthermore, including the second and third moment of the cross-sectional distribution of consumption growth in the pricing kernel lowers the estimate of risk aversion. These findings suggest that market incompleteness ought to be seen as an important component of solutions to the equity premium puzzle.

Keywords: Heterogeneity, idiosyncratic consumption risk, incomplete markets, consumption-based model, risk aversion, equity premium puzzle

JEL Classification: G12

Suggested Citation

Jacobs, Kris and Pallage, Stephane and Robe, Michel A., Market Incompleteness and the Equity Premium Puzzle: Evidence from State-Level Data (March 2005). Available at SSRN: https://ssrn.com/abstract=695684 or http://dx.doi.org/10.2139/ssrn.695684

Kris Jacobs (Contact Author)

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Stephane Pallage

University of Quebec at Montreal - Department of Economics ( email )

P.O. Box 8888, Downtown Station
Montreal, Quebec H3C 3P8
Canada
514-987-3000 ext. 8730 (Phone)
514-987-8494 (Fax)

Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE)

Pavillon De Sève
Ste-Foy, Quebec G1K 7P4
Canada

Michel A. Robe

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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