Asset-pricing Puzzles and Incomplete Markets



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    • Graduate School of Industrial Administration, Carnegie Mellon University. This paper comprises a portion of my doctoral dissertation submitted to Queen's University at Kingston. Comments from an anonymous referee and the editor, René Stulz, have proven very beneficial. Thanks to Dan Bernhardt, George Constantinides, Mick Devereux, Al Douglas, Wayne Ferson, Allan Gregory, Peter Howitt, John Maxwell, Angelo Melino, Frank Milne, Ted Neave, Gregor Smith, Tony Smith, and especially David Backus for helpful suggestions. Financial support from the Social Sciences and Humanities Research Council of Canada is gratefully acknowledged.


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.