Efficiency, Equilibrium, and Asset Pricing with Risk of Default

TLDR

The paper introduces a new equilibrium concept to analyze efficiency and asset pricing in the Kehoe–Levine and Kocherlakota frameworks. The equilibrium is defined by complete markets with endogenous solvency constraints that prevent default while reducing risk sharing. The study proves welfare theorems, identifies conditions for incomplete risk sharing, and shows that the pricing kernel yields lower interest rates and risk premia tied to shock covariance, with asset prices driven solely by highly idiosyncratic agents.

Abstract

We introduce a new equilibrium concept and study its efficiency and asset pricing implications for the environment analyzed by Kehoe and Levine (1993) and Kocherlakota (1996). Our equilibrium concept has complete markets and endogenous solvency constraints. These solvency constraints prevent default at the cost of reducing risk sharing. We show versions of the welfare theorems. We characterize the preferences and endowments that lead to equilibria with incomplete risk sharing. We compare the resulting pricing kernel with 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 the valuation of agents with substantial idiosyncratic risk.