Abstract
In an exchange economy with endowment inequality, we investigate how preferences with external habits affect the equity risk premium. We show that the dynamics of external additive habits with wealth inequality are complex when a background risk is present. It is ambiguous whether wealth inequality will increase or decrease the equity premium even when the income uncertainty is low. This result extends literature by suggesting that wealth inequality has a small role in explaining asset pricing puzzles.
Highlights
A consumer’s attitude towards risk has been a central topic in financial economics and asset pricing
The objective of this study is to examine the relationship between asset prices, wealth inequality, external habit formation and market incompleteness in the form of background risk
We inquire about whether taking into account the unequal distribution of wealth in an economy with background risk may contribute to the equity premium puzzle, when the preferences of the agents are habit forming
Summary
A consumer’s attitude towards risk has been a central topic in financial economics and asset pricing. We show that the dynamics of external additive habits with wealth inequality are complex when a background risk is present It is ambiguous whether wealth inequality will increase or decrease the equity premium even when the income uncertainty is low. This result extends literature by suggesting that wealth inequality has a small role in explaining asset pricing puzzles. A question that rises is whether the existence of this uninsurable risk can be a contributing factor for aggregate asset pricing anomalies, such as the equity premium and risk-free rate puzzles. Because the CRRA utility exhibits risk vulnerability, this suggests that the model with background risk has the potential to explain the observed equity premium with an economically realistic value of the agent’s original utility function curvature parameter. Risk vulnerability guarantees that any zero-mean background risk raises the aversion towards any other independent risk
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