Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing
University of Chicago - Finance
Deborah J. Lucas
Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER)
J. OF POLITICAL ECONOMY, Vol. 104 No. 3, June 1996
We examine an economy with aggregate and idiosyncratic income risk in which agents cannot contract on future labor income. Agents trade financial securities to buffer idiosyncratic shocks, but the extent of trade is limited by borrowing constraints and transactions costs. The effect of frictions on the equity premium is decomposed into two components: a direct effect due to the equation of net-of-costs margins and an indirect effect due to increased consumption volatility. Simulations suggest that the direct effect dominates and that the model predicts a sizable equity premium only if costs are large or the quantity of tradable assets is limited.
JEL Classification: G12
Date posted: September 11, 1996