TY - JOUR AU - Berk,Jonathan AU - Walden,Johan TI - Limited Capital Market Participation and Human Capital Risk JF - National Bureau of Economic Research Working Paper Series VL - No. 15709 PY - 2010 Y2 - January 2010 UR - http://www.nber.org/papers/w15709 L1 - http://www.nber.org/papers/w15709.pdf N1 - Author contact info: Jonathan B. Berk Graduate School of Business Stanford University 518 Memorial Way Stanford CA 94305-5015 Tel: 650/721-1280 Fax: 650/725-6152 E-Mail: jonathan.b.berk@gmail.com Johan Walden Haas School of Business University of California at Berkeley 545 Student services building, #1900 Berkeley, CA 94720 Tel: 510-643-0547 E-Mail: walden@haas.berkeley.edu. AB - The non-tradability of human capital is often cited for the failure of traditional asset pricing theory to explain agents' portfolio holdings. In this paper we argue that the opposite might be true --- traditional models might not be able to explain agent portfolio holdings because they do not explicitly account for the fact that human capital does trade (in the form of labor contracts). We derive wages endogenously as part of a dynamic equilibrium in a production economy. Risk is shared in labor markets because firms write bilateral labor contracts that insure workers, allowing agents to achieve a Pareto optimal allocation even when the span of asset markets is restricted to just stocks and bonds. Capital markets facilitate this risk sharing because it is there that firms offload the labor market risk they assumed from workers. In effect, by investing in capital markets investors provide insurance to wage earners who then optimally choose not to participate in capital markets. The model can produce some of the most important stylized facts in asset pricing: (1) limited asset market participation, (2) the seemingly high equity risk premium, (3) the very large disparity in the volatility of consumption and the volatility of asset prices, and (4) the time dependent correlation between consumption growth and asset returns. ER -