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RFS Advance Access published online on November 13, 2007
Review of Financial Studies, doi:10.1093/rfs/hhm063
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© The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

Asset Pricing with Limited Risk Sharing and Heterogeneous Agents

Francisco Gomes
London Business School and Centre for Economic Policy Research

Alexander Michaelides
Centre for Economic Policy Research and Financial Markets Group, Department of Economics, London School of Economics, UK

Address correspondence to F. Gomes, London Business School and Centre for Economic Policy Research, London Business School, Regent's Park, London NW1 4SA, UK; telephone: (44) 2072-62-5050; e-mail: fgomes{at}london.edu.

JEL Classification: G11, G12


  Abstract

We develop 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 aggregate uncertainty, borrowing constraints, and a (realistically) calibrated life-cycle earnings profile subject to idiosyncratic shocks. We show that it is challenging to simultaneously match asset pricing moments and individual portfolio decisions, while limited participation has a negligible impact on the risk-premium, contrary to the results of models where it is imposed exogenously.

We would like to thank Nicholas Barberis, Suleyman Basak, Joao Cocco, Joao Gomes, Dirk Krueger, Wouter den Haan, John Heaton, Tim Johnson, Nobuhiro Kiyotaki, Deborah Lucas, Tobias Moskowitz, Giovanna Nicodano, Anna Pavlova, Valery Polkovnichenko, Randi Rosenblatt, Bryan Routledge, Kjetil Storesletten, Raman Uppal, Annette Vissing-Jørgensen, Amir Yaron, Lu Zhang, two anonymous referees, and seminar participants at the AFA, CEPR ESSIM, NBER (AP and EFEL) Summer Meetings, the Utah Winter Finance Conference, the Society for Economic Dynamics Annual Meeting, WFA, University of Copenhagen, University of Gotemburg, University of Mannheim, University of Torino, London Business School, London School of Economics, Nuffield College (Oxford), University of North Carolina at Chapel Hill, Oslo University, and Said Business School for helpful comments and discussions. All remaining errors are our own.


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