Asset Pricing when Risk Sharing is Limited by Default

Fernando Alvarez, Urban J. Jermann

NBER Working Paper No. 6476
Issued in March 1998
NBER Program(s):Asset Pricing

We study the asset pricing implications of a multi-agent endowment economy where agents can default on contracts that would leave them otherwise worse off. We specialize and extend the environment studied by Kocherlakota (1995) and Kehoe and Levine (1993) to make it comparable to standard studies of asset pricing. We make contributions along two fronts. First, we extend the characterization of efficient allocations. Second, we present an equilibrium concept with complete markets and with endogenous solvency constraints. These solvency constraints are such as to prevent default at the cost of reduced risk sharing. We show a version of the classical welfare theorems for this equilibrium definition. We characterize the pricing kernel, and compare it to the one for economies without participation constraints: interest rates are lower and risk premia can be bigger depending on the covariance of the idiosyncratic and aggregate shocks. We show that those agents whose endowment is very similar to the aggregate endowment are irrelevant for asset pricing. In a quantitative example, for reasonable parameter values, the relevant marginal rates of substitution fall within the Hansen-Jagannathan bounds.

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Document Object Identifier (DOI): 10.3386/w6476

Published: Alvarez, Fernando and Urban J. Jermann. "Efficiency, Equilibrium, And Asset Pricing With Risk Of Default," Econometrica, 2000, v68(4,Jul), 775-797.

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