Asset‐pricing Puzzles and Incomplete Markets

Abstract

ABSTRACT The representative agent theory of asset pricing is modified to incorporate heterogeneous agents and incomplete markets. The model features two types of agents who differ up to a nontradable, idiosyncratic component in their endowment processes. Numerical solutions indicate that individuals are able to diversify a substantial portion of their idiosyncratic income risk through riskless borrowing and lending alone. Restrictions on the variability of intertemporal marginal rates of substitution ( Hansen and Jagannathan (1991) ) are used to argue that incomplete markets, as modeled here, cannot account for the properties of asset returns that are anomalous from the perspective of representative agent theory.