Asset Pricing with Heterogeneous Agents, Incomplete Markets and Trading Constraints

No 2007-46, Working papers from University of Connecticut, Department of Economics

Abstract: The consumption capital asset pricing model is the standard economic model used to capture stock market behavior. However, empirical tests have pointed out to its inability to account quantitatively for the high average rate of return and volatility of stocks over time for plausible parameter values. Recent research has suggested that the consumption of stockholders is more strongly correlated with the performance of the stock market than the consumption of non-stockholders. We model two types of agents, non-stockholders with standard preferences and stock holders with preferences that incorporate elements of the prospect theory developed by Kahneman and Tversky (1979). In addition to consumption, stockholders consider fluctuations in their financial wealth explicitly when making decisions. Data from the Panel Study of Income Dynamics are used to calibrate the labor income processes of the two types of agents. Each agent faces idiosyncratic shocks to his labor income as well as aggregate shocks to the per-share dividend but markets are incomplete and agents cannot hedge consumption risks completely. In addition, consumers face both borrowing and short-sale constraints. Our results show that in equilibrium, agents hold different portfolios. Our model is able to generate a time-varying risk premium of about 5.5% while maintaining a low risk free rate, thus suggesting a plausible explanation for the equity premium puzzle reported by Mehra and Prescott (1985).

Keywords: asset pricing; equity premium puzzle; prospect theory; heterogeneous agents (search for similar items in EconPapers)
JEL-codes: G12 E44 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-mac and nep-upt
Date: Written 2007-11
Note: I am grateful for comments and encouragement to Christian Zimmermann. I also thank seminar participants at the University of British Columbia for helpful comments. Any conceptual or other errors are my fault.
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