Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing (Classic Reprint) - Tapa dura

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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.

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