Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing

Abstract

We examine an economy in which agents cannot write contracts contingent on future labor income. The agents face aggregate uncertainty in the form of dividend and systematic labor income risk, and also idiosyncratic labor income risk, which is calibrated using the PSID. The agents trade in financial securities to buffer their idiosyncratic income shocks, but the extent of trade is limited by borrowing constraints, short-sales constraints, and transactions costs. By simultaneously considering aggregate and idiosyncratic shocks, we decompose the effect of transactions costs on the equity premium into two components. The direct effect occurs because individuals equate the net-of-cost margins. A second, indirect effect occurs because transactions costs result in individual consumption that more closely tracks individual income. In the simulations we find that the direct effect dominates and that the model can produce a sizable equity premium only if transactions costs are large or the assumed quantity of tradable assets is limited.