THE EFFECTS OF INCOMPLETE INSURANCE MARKETS AND TRADING COSTS IN A CONSUMPTION-BASED ASSET PRICING MODEL

Incomplete financial markets, coupled with undiversifiable idiosyncratic shocks, have the potential to explain a number of asset pricing puzzles. We study a model in which agents have access to a limited set of securities markets, while facing aggregate and individual uncertainty. Trade is limited by the presence of transactions costs, borrowing constraints, and short sales constraints. We find a systematic relation between the extent and type of market frictions, and their implications for asset prices and consumption policy. With trading costs or binding borrowing constraints, the risk-free rate falls and the risk premium rises relative to the complete markets case, and the term structure exhibits a positive forward premium. However, with costless access to either the stock or bond market, agents effectively smooth out transitory income shocks, and equilibrium asset prices resemble those in the complete markets case.