Asset Pricing with Limited Risk Sharing and Heterogeneous Agents

Francisco Gomes, Alexander Michaelides
2007 The Review of financial studies  
We solve a model with incomplete markets and heterogeneous agents that generates a large equity premium, while simultaneously matching stock market participation and individual asset holdings. The high risk premium is driven by incomplete risk sharing among stockholders, which results from the combination of borrowing constraints and (realistically) calibrated life-cycle earnings profiles, subject to both aggregate and idiosyncratic shocks. We show that it is challenging to simultaneously match
more » ... aggregate quantities (asset prices) and individual quantities (asset allocations). Furthermore, limited participation has a negligible impact on the risk premium, contrary to the results of models where it is imposed exogenously. JEL Classification: E21, G11. We present an asset pricing model that closely matches aggregate asset pricing moments (mean and standard deviation of stock returns and T-bill returns), while simultaneously matching individual allocations (stock market participation rate and asset holdings). The key ingredients of the model are household heterogeneity and market incompleteness. Households are heterogeneous along several different dimensions. First, they receive different uninsurable labor income shocks. Second we have a life-cycle model and therefore young agents, mid-life households and retirees all behave differently. Third, we introduce a fixed cost of stock market participation, and thus agents who have paid the cost have access to a larger investment opportunity set. Fourth, households have Epstein-Zin preferences (Epstein and Zin (1989) ) and we consider heterogeneity in both risk aversion and elasticity of intertemporal substitution. Market incompleteness results from both aggregate and (uninsurable) idiosyncratic shocks, combined with borrowing constraints. Aggregate uncertainty and the household preference parameters are calibrated to match the second moments of equity returns and (stockholders') consumption growth. The idiosyncratic uncertainty is driven by a (realistically) calibrated life-cycle stochastic earnings profile that agents cannot fully insure, and against which they cannot borrow. In this context, our baseline model yields a high risk premium (4.33%) and a low riskless rate (1.72%) with coefficients of relative risk aversion no larger than 5. The volatility of consumption growth, for both stockholders and non-stockholders, is also consistent with the data. Previous literature (e.g. Saito (1995), Basak and Cuoco (1998), or Guvenen (2003)) has argued that (exogenous) limited stock market participation can help to explain the equity risk premium puzzle. 1 In our model limited participation is derived endogenously and, consistent with the data, the non-participants are significantly less wealthy than households that own stocks. 2 Therefore, excluding those households from the equity market has a 1 The models in Heaton and Lucas (2000) and Polkovnichenko (2004) also have exogenous participation constraints, but obtain a smaller impact on the equity premium. 2 According to the latest numbers from the Survey of Consumer Finances, the participation rate is 88.84% among households with wealth above the median, and only 15.21% for those with wealth below the median.
doi:10.1093/rfs/hhm063 fatcat:c4bobugb35h5lmbbsc52crvmna