The Irrelevance of Market Incompleteness for the Price of Aggregate Risk

58 Pages Posted: 3 Jan 2007

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)

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Date Written: November 2006

Abstract

In models with a large number of agents who have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labour income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks. In spite of the missing markets, a representative agent who consumes aggregate income prices the excess returns on stocks correctly. This result holds regardless of the persistence of idiosyncratic shocks, as long as they are not permanent, even when households face binding, and potentially very tight borrowing constraints. Consequently, in this class of models there is no link between the extent of self-insurance against idiosyncratic income risk and aggregate risk premia.

Keywords: Risk premium, idiosyncratic income risk, incomplete markets

JEL Classification: G12

Suggested Citation

Krueger, Dirk and Lustig, Hanno N., The Irrelevance of Market Incompleteness for the Price of Aggregate Risk (November 2006). CEPR Discussion Paper No. 5936, Available at SSRN: https://ssrn.com/abstract=954591

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Hanno N. Lustig

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