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

See all articles by Dirk Krueger

Dirk Krueger

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

Hanno N. Lustig

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

Multiple version iconThere are 3 versions of this paper

Date Written: November 18, 2007

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 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

Krueger, Dirk and Lustig, Hanno N., When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (and When is it Not)? (November 18, 2007). Journal of Economic Theory, Vol. 145, No. 1, 2010, Available at SSRN: https://ssrn.com/abstract=954149 or http://dx.doi.org/10.2139/ssrn.954149

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Hanno N. Lustig

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