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

J. OF POLITICAL ECONOMY, Vol. 104 No. 3, June 1996

Posted: 11 Sep 1996  

John Heaton

University of Chicago - Finance

Deborah J. Lucas

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

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Abstract

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

Suggested Citation

Heaton, John and Lucas, Deborah J., Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing. J. OF POLITICAL ECONOMY, Vol. 104 No. 3, June 1996. Available at SSRN: https://ssrn.com/abstract=7722

John C Heaton (Contact Author)

University of Chicago - Finance ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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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