Efficiency, equilibrium, and asset pricing with risk of default

We introduce a new equilibrium concept and study its efficiency and asset p ricing implications for the environment analyzed by Kehoe and Levine (1993) and ICocherlakota (1996). Our equilibrium concept has complete markets and endogenous solvency constraints. These solvency constraints prevent defaul t at the cost of reducing risk sharing. We show versions of the welfare the orems. We characterize the preferences and endowments that lead to equilibr ia with incomplete risk sharing. We compare the resulting pricing kernel wi th the one for economies without participation constraints: interest rates are lower and risk premia depend on the covariance of the idiosyncratic and aggregate shocks. Additionally, we show that asset prices depend only on t he valuation of agents with substantial idiosyncratic risk.