EVALUATING THE EFFECTS OF INCOMPLETE MARKETS ON RISK SHARING AND ASSET PRICING

We examine an economy in which agents cannot write contracts contingen t on future labor income. The agents face aggregate uncertainty in the form of dividend and systematic labor income risk, and also idiosyncr atic labor income risk, which is calibrated using the PSID. The agents trade in financial securities to buffer their idiosyncratic income sh ocks, but the extent of trade is limited by borrowing constraints, sho rt-sales constraints, and transactions costs. By simultaneously consid ering aggregate and idiosyncratic shocks, we decompose the effect of t ransactions costs on the equity premium into two components. The direc t effect occurs because individuals equate the net-of-cost margins. A second, indirect effect occurs because transactions costs result in in dividual consumption that more closely tracks individual income. In th e simulations we find that the direct effect dominates rand that the m odel can produce a sizable equity premium only if transactions costs a re large or the assumed quantity of tradable assets is limited.