DP5602 Pricing Risk in Economies with Heterogenous Agents and Incomplete Markets

Author(s): Josep Pijoan-Mas
Publication Date: March 2006
Keyword(s): equity premium, habit formation, incomplete markets
JEL(s): C68, D52, E21, G12
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5602

Habit formation has been proposed as a possible solution to the equity premium puzzle. This paper extends the class of models that support the habits explanation in order to account for heterogeneity in earnings, wealth, habits and consumption. I find that habit formation does indeed increase the equity premium. However, contrary to earlier results, the habit hypothesis does not imply a price for risk as big as the one measured in the data. There are three reasons for this. First, households in a habits economy modify their consumption/savings decision. Second, they modify their portfolio choice. These two changes in behavior diminish the consumption fluctuations faced by households. And third, the composition of the set of agents pricing risk in the economy changes so that relatively better self-insured households end up pricing risk.