Asset Pricing with Heterogeneous Agents, Incomplete Markets and Trading Constraints

Tsvetanka Karagyozova

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 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. 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. Data from the Panel Study of Income Dynamics are used to calibrate the labor income processes of the two types of agents. Our results show that in equilibrium, agents hold different portfolios. Our model is able to generate a time-varying risk premium of about 6% 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: E44 G12 (search for similar items in EconPapers)
Pages: 62 pages
Date: 2007-11, Revised 2008-09
New Economics Papers: this item is included in nep-dge, nep-mac and nep-upt
Note: I am grateful for comments and encouragement to Christian Zimmermann. I also thank Andra Ghent, seminar participants at the University of British Columbia and the University of Connecticut, and participants in the Canadian Economic Association 2008 Annual Meeting for helpful comments. Any conceptual or other errors are my fault.
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Citations: View citations in EconPapers (1)

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