When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (and When is it Not)?
50 Pages Posted: 1 Jan 2007 Last revised: 27 Aug 2012
Date Written: November 18, 2007
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 equilibrium, households only use the stock market to smooth consumption; the bond market is inoperative. Furthermore, the cross-sectional distributions of wealth and consumption are not affected by aggregate shocks. These results hold regardless of the persistence of idiosyncratic shocks, even when households face tight solvency constraints. A weaker irrelevance result survives when we allow for predictability in aggregate consumption growth.
Keywords: Market Incompleteness, Asset Pricing
JEL Classification: G12
Suggested Citation: Suggested Citation