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

By:

Heaton, John

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w4249.Publication details: Cambridge, Mass. National Bureau of Economic Research 1993.Description: 1 online resource: illustrations (black and white)Subject(s):

E44 - Financial Markets and the Macroeconomy

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Abstract: 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.

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Previous	nber w4246 Exchange Rates as Nominal Anchors /	nber w4247 Corporate Control, Portfolio Choice, and the Decline of Banking /	nber w4248 Stoking the Fires? Co2 Emissions and Economic Growth /	nber w4249 Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing /	nber w4250 Real Effects of Monetary Shocks in an Economy with Sequential Purchases /	nber w4251 What Do We Know about Enterprise Zones? /	nber w4252 The Lifetime Incidence of State and Local Taxes: Measuring Changes During the 1980s /	Next

January 1993.

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.