Working Paper: NBER ID: w15709
Authors: Jonathan Berk; Johan Walden
Abstract: The non-tradability of human capital is often cited for the failure of traditional asset pricing theory to explain agents' portfolio holdings. In this paper we argue that the opposite might be true --- traditional models might not be able to explain agent portfolio holdings because they do not explicitly account for the fact that human capital does trade (in the form of labor contracts). We derive wages endogenously as part of a dynamic equilibrium in a production economy. Risk is shared in labor markets because firms write bilateral labor contracts that insure workers, allowing agents to achieve a Pareto optimal allocation even when the span of asset markets is restricted to just stocks and bonds. Capital markets facilitate this risk sharing because it is there that firms offload the labor market risk they assumed from workers. In effect, by investing in capital markets investors provide insurance to wage earners who then optimally choose not to participate in capital markets. The model can produce some of the most important stylized facts in asset pricing: (1) limited asset market participation, (2) the seemingly high equity risk premium, (3) the very large disparity in the volatility of consumption and the volatility of asset prices, and (4) the time dependent correlation between consumption growth and asset returns.
Keywords: Capital Markets; Human Capital; Risk Sharing; Asset Pricing
JEL Codes: G11; G12; J24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| labor contracts (J41) | capital market participation (G10) |
| capital market participation (G10) | Pareto optimal allocation (D61) |
| labor contracts (J41) | risk sharing (D16) |
| risk sharing (D16) | capital market participation (G10) |
| investors (G24) | insurance to wage earners (G52) |
| insurance to wage earners (G52) | opt out of capital markets (G19) |
| limited capital market participation (G19) | efficient equilibrium outcome (D61) |
| labor markets (J40) | risk sharing (D16) |
| labor contracts (J41) | equity risk premium (G12) |
| disconnect between consumption and asset price volatility (G19) | challenge for neoclassical models (E13) |