Market incompleteness and the equity premium puzzle: Evidence from state-level data

Kris Jacobs, Stéphane Pallage, Michel A. Robe

Research output: Contribution to journalArticle

Abstract

This paper investigates the importance of market incompleteness by comparing the rates of risk aversion estimated from complete and incomplete markets environments. For the incomplete-markets case, we use consumption data for the 50 US states. We find that the rate of risk aversion under the incomplete-markets setup is much lower. Furthermore, including the second and third moments of the cross-sectional distribution of consumption growth in the pricing kernel lowers the estimate of risk aversion. These findings suggest that market incompleteness ought to be seen as an important component of solutions to the equity premium puzzle.

Original languageEnglish (US)
Pages (from-to)378-388
Number of pages11
JournalJournal of Banking and Finance
Volume37
Issue number2
DOIs
StatePublished - Feb 2013
Externally publishedYes

Keywords

  • Consumption-based asset pricing model
  • Equity premium puzzle
  • Heterogeneity
  • Idiosyncratic consumption risk
  • Incomplete markets
  • Risk aversion

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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