Market Incompleteness and the Equity Premium Puzzle: Evidence from State-Level Data
23 Pages Posted: 5 Apr 2005
Date Written: March 2005
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: Suggested Citation