DP6136 Asset Pricing with Limited Risk Sharing and Heterogeneous Agents

Author(s): Francisco J Gomes , Alexander Michaelides

Publication Date: February 2007

Keyword(s): equity premium , preference heterogeneity , incomplete risk sharing , life-cycle models , limited stock market participation

JEL(s): G11 , G12

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6136.asp.asp

We solve a model with incomplete markets and heterogeneous agents that generates a large equity premium, while simultaneously matching stock market participation and individual asset holdings. The high risk premium is driven by incomplete risk sharing among stockholders, which results from the combination of aggregate uncertainty, borrowing constraints and a (realistically) calibrated life-cycle earnings profile subject to idiosyncratic shocks. We show that it is challenging to simultaneously match asset pricing moments and individual portfolio decisions, while limited participation has a negligible impact on the risk premium, contrary to the results of models where it is imposed exogenously.