Wealth inequality and asset pricing

In an Arrow-Debreu exchange economy with identical agents except for their initial endowment, we examine how wealth inequality affects the equilibrium level of the equity premium and the risk-free rate. We first show that wea lth inequality raises the equity premium if and only if the inverse of abso lute risk aversion is concave in wealth. We than show that the equilibrium risk-free rate is reduced by wealth inequality if the inverse of the coeffi cient of absolute prudence is concave. We also prove that the combination o f a small uninsurable background risk with wealth inequality biases asset p ricing towards a larger equity premium and a smaller risk-free rate.