A Parsimonious Macroeconomic Model for Asset Pricing

Abstract

In this paper, I study asset prices in a two-agent macroeconomic model with two key features: limited participation in the stock market and heterogeneity in the elasticity of intertemporal substitution in consumption (EIS). The model is consistent with some prominent features of asset prices that have been documented in the literature, such as a high equity premium; relatively smooth interest rates; procyclical variation in stock prices; and countercyclical variation in the equity premium, in its volatility, and in the Sharpe ratio. While the model also reproduces the long-horizon predictability of the equity premium, the extent of predictability is smaller than in the data. In this model, the risk-free asset market plays a central role by allowing the non-stockholders (who have low EIS) to smooth the fluctuations in their labor income. This process concentrates nonstockholders' aggregate labor income risk among a small group of stockholders, who then demand a high premium for bearing the aggregate equity risk. Furthermore, this mechanism is consistent with the very small share of aggregate wealth held by non-stockholders in the US data, which has proved problematic for previous models with limited participation. I show that this large wealth inequality is also important for the model's ability to generate a countercyclical equity premium. Finally, when it comes to business cycle performance the model's progress has been more limited: consumption is still too volatile compared to the US data, whereas investment is still too smooth. These are important areas for potential improvement in this framework.

The Risk Premium and Long-Run Global Imbalances

“…By introduction of heterogeneity in trading technologies, our calibrated model forces a small fraction of Mertonian traders to absorb a large amount of aggregate risk. Therefore, our benchmark model generates a 6.35% equity premium and a 2.16% risk-free return, which are quite close to the estimates in Guvenen (2009).…”

“…Our model predicts the average trade deficit in the long-run equilibrium, while the recent surge of US trade deficit might still reflect the 2 In the asset pricing literature, the equity premium is generally considered at least higher than 6% and the risk-free rate is lower than 2%. For examples, Guvenen (2009) shows that US equity premium is 6.17% and the risk-free rate is 1.94%. Chien, Cole, and Lustig (2011) find that the equity premium is 7.53% and the risk-free rate is 1.05%.…”

Recursive Utility and the Equity Premium Puzzle: A Discrete-Time Approach

“…Several agents have been considered by e.g., Guvenen (2009) in a discrete time model, and by Aase (2014b) in the continuous-time model analogues to the one considered in the present paper.…”

Endogenous Risk in a DSGE Model with Capital-Constrained Financial Intermediaries

“…Typically, only …nancial intermediaries are assumed to invest directly in capital or in …rm assets and therefore, these institutions are key to risk pricing. Models with heterogenous agents and limited capital market participation have been able to generate substantial risk premiums as was shown in Danthine and Donaldson (2002), and Guvenen (2009) that is produced in our model mainly via the leverage constraint on …nancial intermediaries. This paper evaluates the risk channel originated by occasionally-binding capital constraints on …nancial intermediaries in a standard DSGE model.…”