TY  - JOUR
AU  - Heaton,John
AU  - Lucas,Deborah
TI  - Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 4249
PY  - 1993
Y2  - January 1993
UR  - http://www.nber.org/papers/w4249
L1  - http://www.nber.org/papers/w4249.pdf
N1  - Author contact info:
John C. Heaton
Booth School of Business
University of Chicago
5807 South Woodlawn Avenue
Chicago, IL 60637
Tel: 773/702-7130
Fax: 773/702-0455
E-Mail: john.heaton@ChicagoBooth.edu

Deborah J. Lucas
MIT Sloan School of Management
100 Main Street, E62-640
Cambridge, MA 02142
Tel: 617/715-4816
E-Mail: dlucas@mit.edu
AB  - We examine asset prices and consumption patterns in a model in which agents face both aggregate and idiosyncratic income shocks, and insurance markets are incomplete. Agents reduce consumption variability by trading in a stock and bond market to offset idiosyncratic shocks, but transactions costs in both markets limit the extent of trade. To calibrate the model, we estimate an empirical model of labor and dividend income, using data from the PSID and the NIPA. Although the agents in the model are not very risk averse, the model predicts a sizable equity premium and a low riskfree rate. By simultaneously considering aggregate and idiosyncratic shocks, we decompose this effect of transactions costs on the equity premium into two components. The direct effect is due to the fact that individuals equate net-of-cost margins, so an asset with lower associated transactions costs will have a lower market rate of return. A second, indirect effect occurs because transactions costs result in individual consumption that more closely tracks individual income than aggregate consumption.
ER  -