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RFS Advance Access published online on October 8, 2009
Review of Financial Studies, doi:10.1093/rfs/hhp079
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© The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

The Market Price of Aggregate Risk and the Wealth Distribution

YiLi Chien
Department of Economics, Purdue University

Hanno Lustig
Anderson School of Management, UCLA

Send correspondence to Hanno Lustig, 110 Westwood Plaza, Suite C4.21, Los Angeles, CA 90095-1481. E-mail: hlustig{at}anderson.ucla.edu.

JEL Classification: G12, E44


  Abstract

We introduce limited liability in a model with a continuum of ex ante identical agents who face aggregate and idiosyncratic income risk. These agents can trade a complete menu of contingent claims, but they cannot commit to honor their promises, and their shares in a Lucas tree serve as collateral to back up their state-contingent promises. The limited-liability option gives rise to a second risk factor, in addition to aggregate consumption growth risk. This liquidity risk is created by binding solvency constraints, and it is measured by the growth rate of one moment of the wealth distribution. The economy is said to experience a negative liquidity shock when this growth rate is high and a large fraction of agents faces severely binding solvency constraints. The adjustment to the Breeden-Lucas stochastic discount factor induces substantial time variation in equity risk-premims that is consistent with the data at business cycle frequencies.

We are grateful for suggestions and comments by Raman Uppal (the editor) and two anonymous referees. Lustig would like to thank his advisers, Robert Hall, Thomas Sargent, and Dirk Krueger, for their help and encouragement. Lars Hansen and Stijn Van Nieuwerburgh provided detailed comments.


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