Asset Pricing and Risk Sharing with Limited Enforcement and Heterogeneous Preferences

Abstract

We introduce heterogeneous preferences (heterogeneity in risk aversion and time discount factor) into a two-agent endowment economy with enforcement constraints, aggregate and idiosyncratic uncertainty (Alvarez and Jermann (2001)), and study the corresponding asset pricing and risk sharing implications. We show that the relative time discount factor and the interaction between heterogeneous risk aversion and aggregate uncertainty affect the evolution of the relative Pareto weight of agents over time. When both agents are not constrained, the relative Pareto weight of the more patient agent rises, and that of the less risk averse agent does so in booms and the reverse in recessions. We demonstrate that preference heterogeneity can generate a positive equity premium with only idiosyncratic uncertainty present since the conditional pricing kernel is time-varying depending on which agent is the marginal pricer. We use recursive Lagrangian method to solve a calibrated model and show that preference heterogeneity boosts the mean and volatility of equity premium quantitatively, when the more risk averse and/or the more patient agent cannot trade away most of his income risk with the other agent because of enforcement constraints.