When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (and when is it not)?

Dirk Krueger, Hanno Lustig

NBER Working Paper No. 12634
Issued in October 2006
NBER Program(s):   AP   EFG

In a standard incomplete markets model with a continuum of households that have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks and aggregate consumption growth is independent over time. In the equilibrium, which features trade and binding solvency constraints, as opposed to Constantinides and Duffie (1996), households only use the stock market to smooth consumption; the bond market is inoperative. Furthermore we show that the cross-sectional wealth and consumption distributions are not affected by aggregate shocks. These results hold regardless of the persistence of idiosyncratic shocks, and arise even when households face tight solvency constraints, but only a weaker irrelevance result survives when we allow for predictability in aggregate consumption growth.

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This paper was revised on July 20, 2009

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Document Object Identifier (DOI): 10.3386/w12634

Published: Krueger, Dirk & Lustig, Hanno, 2010. "When is market incompleteness irrelevant for the price of aggregate risk (and when is it not)?," Journal of Economic Theory, Elsevier, vol. 145(1), pages 1-41, January. citation courtesy of

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