Working Paper: NBER ID: w11132
Authors: Hanno Lustig; Yili Chien
Abstract: We introduce limited liability in a model with a continuum of ex ante identical agents who face aggregate and idiosyncratic income risk. These agents can trade a complete menu of contingent claims, but they cannot commit and shares in a Lucas tree serve as collateral to back up their state-contingent promises. The limited liability option gives rise to a second risk factor, in addition to aggregate consumption growth risk. This liquidity risk is created by binding solvency constraints, and it is measured by the growth rate of one moment of the wealth distribution. The economy is said to experience a negative liquidity shock when this growth rate is high and a large fraction of agents faces severely binding solvency constraints. The adjustment to the Breeden-Lucas stochastic discount factor induces substantial time variation in equity risk premia that is consistent with the data at business cycle frequencies.
Keywords: No keywords provided
JEL Codes: G0
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limited liability (K13) | liquidity risk (G33) |
| binding solvency constraints (G33) | liquidity risk (G33) |
| liquidity risk (G33) | stochastic discount factor (SDF) (D15) |
| liquidity risk (G33) | equity risk premia (G12) |
| binding solvency constraints (G33) | liquidity shocks (E44) |
| liquidity shocks (E44) | return shocks (E32) |
| liquidity shocks (E44) | future returns (G17) |
| liquidity conditions (E41) | asset pricing dynamics (G19) |