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 and 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 premia that is consistent with the data at business cycle frequencies.
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This paper was revised on June 24, 2008
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