Asset Pricing in a Neoclassical Model with Limited Participation

Abstract

In this paper, I show that habit formation is perhaps not what it is commonly perceived to be: an extension of preference specification for the representative agent. Rather, it captures a dynamic interaction between aggregate financial income and aggregate labor income. I also show that existing specifications of consumption habit can be extended to incorporate a stochastic shock, which is interpreted as the labor income shock. As a result of these two innovations, I show that a habit formation model can explain the equity premium, equity volatility, and risk free rate puzzles simultaneously, and provide an equilibrium justification for the predictability of equity and bond returns by dividend/pride ration and term spreads - all in terms of observable sample moments of aggregate dividend income and labor income growth rates and reasonable values of risk aversion coefficient and the subjective discount rate.

To substantiate these claims, I present an extension of the Breeden-Lucas CCAPM by incorporating a particular form of heterogeneity assumption and a particular form of limited participation assumption. The resulting model features a richer technological specification (from the perspective of a production economy) or a richer standard assumptions of constant relative risk aversion, complete markets, and frictionless trading from the perspective of the marginal investor.