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A number of existing studies have concluded that risk sharing allocations supported by competitive, incomplete markets equilibria are quantitatively close to first-best. Equilibrium asset prices in these models have been difficult to distinguish from those associated with a complete markets model, the counterfactual features of which have been widely documented. This paper asks if life cycle considerations, in conjunction with persistent idiosyncratic shocks which become more volatile during aggregate downturns, can reconcile the quantitative properties of the competitive asset pricing framework with those of observed asset returns. We begin by arguing that data from the Panel Study on Income Dynamics support the plausibility of such a shock process. Our estimates suggest a high degree of persistence as well as a substantial increase in idiosyncratic conditional volatility coincident with periods of low growth in U.S. GNP. When these factors are incorporated in a stationary overlapping generations framework, the implications for the returns on risky assets are substantial. Plausible parameterizations of our economy are able to generate Sharpe ratios which match those observed in U.S. data. Our economy cannot, however, account for the level of variability of stock returns, owing in large part to the specification of its production technology.
Excerpt from Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing Incomplete markets in the form of an inability to borrow against risky future income has been proposed as an explanation for the poor predictive power of the standard consumption-based asset pricing model.1 With complete markets, individuals fully insure against idiosyncratic income shocks, and individual consumption is proportional to aggregate consumption.2 With limited insurance markets, however, individual consumption variability may exceed that of the aggregate, and the implied asset prices may differ significantly from those predicted by a representative consumer model. In this paper we study an economy in which agents cannot write contracts contingent on future labor income realizations. They face aggregate uncertainty in the form of dividend and systematic labor income risk, and also idiosyncratic labor income risk. Idiosyncratic income shocks can be buffered by trading in financial securities, but the extent of trade is limited by borrowing constraints, short sales constraints and transactions costs. About the Publisher Forgotten Books publishes hundreds of thousands of rare and classic books. Find more at www.forgottenbooks.com This book is a reproduction of an important historical work. Forgotten Books uses state-of-the-art technology to digitally reconstruct the work, preserving the original format whilst repairing imperfections present in the aged copy. In rare cases, an imperfection in the original, such as a blemish or missing page, may be replicated in our edition. We do, however, repair the vast majority of imperfections successfully; any imperfections that remain are intentionally left to preserve the state of such historical works.
In this paper we reconsider the pricing of options in incomplete continuous time markets. We first discuss option pricing with idiosyncratic stochastic volatility. This leads, of course, to an averaged Black-Scholes price formula. Our proof of this result uses a new formalization of idiosyncrasy which encapsulates other definitions in the literature. Our method of proof is subsequently generalized to other forms of incompleteness and systematic (i.e. non-idiosyncratic) information. Generally this leads to an option pricing formula which can be expressed as the average of a complete markets formula.
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.
We examine an economy with aggregate and idiosyncratic income risk in which agents cannot contract on future labor income. Agents trade financial securities to buffer idiosyncratic shocks, but the extent of trade is limited by borrowing constraints and transactions costs. The effect of frictions on the equity premium is decomposed into two components: a direct effect due to the equation of net-of-costs margins and an indirect effect due to increased consumption volatility. Simulations suggest that the direct effect dominates and that the model predicts a sizable equity premium only if costs are large or the quantity of tradable assets is limited.
This paper studies the testable implications of consumption-based asset pricing models with incomplete markets when idiosyncratic income shocks are permanent and not lognormally distributed. It is shown that the theory places no testable restrictions (beyond absence of arbitrage) on either the macroeconomic data or the first N moments of the cross-sectional distribution of consumption (income) growth. More precisely, this paper shows that any quot;observedquot; joint process of aggregate consumption, arbitrage-free asset returns, and N moments of the cross-sectional distribution of consumption growth is an equilibrium outcome for some incomplete-markets economy (some pure discount factor and process of individual income). The proof is based on the construction of a personal-disaster process (process of extreme idiosyncratic events) which allows for arbitrary variations in idiosyncratic risk without affecting the first N moments of the cross-sectional distribution of consumption growth.