Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing / John Heaton, Deborah Lucas.

Format:

Book

Author/Creator:

Heaton, John.

Contributor:

National Bureau of Economic Research.

Lucas, Deborah.

Series:

Working Paper Series (National Bureau of Economic Research) no. w4249.

NBER working paper series no. w4249

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 1993.

Summary:

We examine asset prices and consumption patterns in a model in which agents face both aggregate and idiosyncratic income shocks, and insurance markets are incomplete. Agents reduce consumption variability by trading in a stock and bond market to offset idiosyncratic shocks, but transactions costs in both markets limit the extent of trade. To calibrate the model, we estimate an empirical model of labor and dividend income, using data from the PSID and the NIPA. Although the agents in the model are not very risk averse, the model predicts a sizable equity premium and a low riskfree rate. By simultaneously considering aggregate and idiosyncratic shocks, we decompose this effect of transactions costs on the equity premium into two components. The direct effect is due to the fact that individuals equate net-of-cost margins, so an asset with lower associated transactions costs will have a lower market rate of return. A second, indirect effect occurs because transactions costs result in individual consumption that more closely tracks individual income than aggregate consumption.

Notes:

Print version record

January 1993.