When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (and When is it Not)?

66 Pages Posted: 7 Dec 2006 Last revised: 11 Jul 2010

See all articles by Hanno N. Lustig

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Dirk Krueger

University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: October 2006

Abstract

In a standard incomplete markets model with a continuum of households that have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks and aggregate consumption growth is independent over time. In the equilibrium, which features trade and binding solvency constraints, as opposed to Constantinides and Duffie (1996), households only use the stock market to smooth consumption; the bond market is inoperative. Furthermore we show that the cross-sectional wealth and consumption distributions are not affected by aggregate shocks. These results hold regardless of the persistence of idiosyncratic shocks, and arise even when households face tight solvency constraints, but only a weaker irrelevance result survives when we allow for predictability in aggregate consumption growth.

Suggested Citation

Lustig, Hanno N. and Krueger, Dirk, When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (and When is it Not)? (October 2006). NBER Working Paper No. w12634, Available at SSRN: https://ssrn.com/abstract=938960

Hanno N. Lustig

Stanford Graduate School of Business ( email )

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Dirk Krueger (Contact Author)

University of Pennsylvania - Department of Economics ( email )

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