Working Paper: CEPR ID: DP6136
Authors: Francisco J. Gomes; Alexander Michaelides
Abstract: 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.
Keywords: equity premium; incomplete risk sharing; lifecycle models; limited stock market participation; preference heterogeneity
JEL Codes: G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| borrowing constraints (F34) | high equity premium (G12) |
| aggregate uncertainty + borrowing constraints + lifecycle earnings profile (D15) | incomplete risk sharing (D52) |
| incomplete risk sharing (D52) | high equity premium (G12) |
| lifecycle earnings profile (J26) | asset allocation decisions (G11) |
| idiosyncratic shocks (D89) | wealth accumulation (E21) |
| borrowing constraints + idiosyncratic shocks (G59) | price of risk (G19) |
| limited stock market participation (G19) | risk premium (G19) |
| consumption volatility (E20) | stock return volatility (G17) |